Its the company, not the sector, that matters

published 31 October 2005

Picking stocks is a mugs game, says Nick Louth in the FT. For proof, look no further than the "mediocre performance" of professional fund managers. Then remember that even Peter Lynch, "the legendary investor" whose stockpicking skills helped Fidelity's US-based Magellan Fund soar 2,700% over 13 years, did not find it easy. "Of the stocks I buy, three months later I'm happy with less than a quarter of them," he once said. So why bother with it? The fact is that much of the performance of a share is down to the industry or sector it is in, rather than being particular to the share. "Oil price rises affect all oil-company shares, higher interest rates tend to hit all housebuilders and Intel's forecast for microchip demand affects all companies in the sector." So if you pick the right sectors, "it may not matter too much" how well you research the shares inside them. As a strategy, this only works if it is easier to predict the movement of sectors than it is individual stocks. The good news is that it is.

There is a "seasonal movement" known as "sector rotation" in which certain sectors find favour with investors at particular points in the economic cycle. The pattern recurs over and over again. Small, so-called cyclical firms and technology tend to be "the snowdrops of the upturn" in that they rise before we have seen any real economic improvements. Mature cyclicals (chemicals and paper, for example) are the crocuses, and general industry and banks are the daffodils (they flower only once there is clear evidence of an upturn). Next come the "late summer flowers" of the pharmaceuticals and finally the "roses that last right up to Christmas", the tobacco utilities and food producers, which rise even as the economy cools. The latter are considered defensive stocks, says Jeremy Lacey in Shares: they tend to produce the things that are in demand in good times and bad, and hence can offer earnings that grow independent of the general business cycle. When the market is falling, they should not fall as much as the cyclicals. Most of this is common sense, says Louth. In a downturn, you don't want to own cyclicals whose earnings are heavily geared to small changes in orders or sales. Back in 2002, for example, it was crazy to hold IT hardware firms; the collapse in corporate spending had been well flagged and the sector fell an average of 82%. Whether you were holding the best or the worst firm, "you were going to lose money". Yet last year, "it was a different story". As signs of improved business confidence appeared, "the walking wounded of the technology revolution" soared: IT hardware was the best-performing sector.

The strategy may seem to make sense, says Richard Miles in The Times, but it isn't that simple. A study by Credit Suisse First Boston has "come to the defence of the stockpicker". It shows that those who pick the right companies "can reap far higher profits than those who simply jump from one sector to another". Sector choice was important in 1999 when a single decision (buy technology or not?) determined who did well and who did not, but even then there was "a vast gulf" between the best and worst firms. Consider the returns in the pharmaceutical sector over the last 12 months. As a whole, it has gained less than 15%. Inside that, heavyweight GlaxoSmithKline has risen a mere 4.3%, but Galen Holdings has returned 118%.

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It is a similar story in life assurance: Britannic Assurance has more than doubled; Old Mutual has risen only 15%. Then go back to IT hardware in 1999. Conventional wisdom might have it that you couldn't have gone wrong, but according to CSFB, you most certainly could have: the top quartile in the sector returned 281%, the bottom quartile lost 11%. "Choose any year or any sector and, if the CSFB data is correct, the conclusion is usually the same." There is no doubt about it - picking sectors is all very well, but picking the right stock inside those sectors is of much, much greater importance.

A simple, but effective way to invest

More than a decade ago, Michael O'Higgins, a US fund manager, outlined in his book, Beating the Dow, a simple approach to investing, says Peter Temple in the FT. Over the periods 1961 to 1995, stocks selected using his method produced an annual performance 5% better than the Dow.It doesn't work in "rampant bull markets" such as those of 1999-2000, but most of the rest of the time the system "delivers the goods". Better still, it works not just for the Dow, but for other indices, such as the UK's FT 30. The idea is simple. You get a list of the 30 stocks in the index. Then take the ten highest yielding and invest equal amounts in the five with the lowest prices. After a year, reinvest the proceeds (plus dividends) in five new shares selected in precisely the same way. At the end of year two, do the same again. "And so on." A similar performance has been achieved by investing only in the one with the second-lowest price.

Last year, Temple selected five stocks using this method and over the year they returned an average of 117%. The single stock selection (Royal & Sun Alliance) was up 81%. A "satisfactory outcome" given there is also income to add, says Temple (the FTSE 100 rose by just 24% over the same period).

So "what is the message for the year ahead"? For the FT 30, the five stocks selected would be P&O, BAE Systems, Royal & Sun Alliance, Invensys and GKN (see page 11). The average yield is 4.8%. Three of the five were on the list last year, "but that is probably as it should be" and, once again, if you were picking just one stock, it would be Royal & Sun Alliance. For the Dow, the five stocks would be General Electric, JP Morgan Chase, SBC Communications, AT&T and Exxon Mobil, with the single stock (O'Higgins called this the PPP, or "penultimate profit prospect") being SBC.

This may all seem simple and mechanical, but the performance it produces is hard to argue with. It is "cheap, easy to operate and transparent", but, best of all, "your broker will not get rich on the commission it generates".