Irrespective of market conditions, some sectors always outperform the broader indices
The downside of sector funds is easy to understand. There are company-specific risks and industry-specific risks. For example, management quality is company-specific, while raw material pricing is industry-specific. A sector fund is highly exposed to industry-specific risk and unable to cherry-pick the best companies. Hence, sector funds tend to be more volatile than the overall market.
The sound advice is to generally avoid sector funds, except when broadly diversifying a portfolio. But in some phases of the business cycle, industry-specific factors favour every company in a given sector. Then, even the worst-run company will give decent returns. In such situations, there is no point trying to choose between the market leaders and the also-rans. Buy the entire sector! For example, in 1999-2000, an investor, who created an ICE-focussed portfolio, would have outperformed diversified equity.
Not every sector has devoted funds. But investors can emulate sector-fund strategy by buying many companies in the same sector. Such a strategy is especially rewarding if you pick the right sector in a bear-market. Even in the worst bear markets, some sector usually deliver positive returns.
Agro-commodities for example, can be disconnected from the overall economy. Their prices depend on specific supply-demand equations. Sugar was a performer through 2008 and 2009, a period that included one of the worst-ever Indian bear markets.
A broadly diversified portfolio lost over 60 per cent between January 2008-March 2009. Portfolios overweight in "hot" sectors like real estate lost 90 per cent or more. Sugar stocks on the other hand, held value and continued to outperform through the bull market that started in March 2009.
In the past nine months, the broad market has delivered great returns. The Nifty has more or less doubled from its March 2009 lows of 2500-2600. But most sectors are still below the record peaks of January 2008.
Apart from sugar, the IT sector has been the outstanding performer of 2009. It's actually the only major industry showing capital gains over January 2008. In 2009, the CNXIT index rose over 140 per cent (Jan 2009-Dec 2009) and it's about 15 per cent higher than its January 2008 levels. Contrast with the Nifty, which is up about 70 percent over January 2009 and down about 20 per cent in terms of January 2008.
At first glance, the CNXIT's stockmarket performance seems out of synch with fundamentals. IT sector advisories and projections have been muted and quarterly results have been average. The US is still the key market and the US economy remains weak. The rupee, which was at 49 versus USD in January 2009, has strengthened to below Rs 47, deflating IT earnings. Plus, there was Satyam and its (continuing) fallout.
The answers to the conundrum are centred on valuations. Although IT reacted sharply to the bear market, it also started to attract value-buying. EPS growth projections were conservative and unexciting. But by January 2009, the industry PE ratios were single-digit. Investors figured IT was offering PE-EPS Growth (PEG) ratios that looked a lot better than the cut-off fair value of 1.
That outperformance doesn't necessarily IT remains a buy in 2010. Earnings will pick up but the CNXIT's December 2009 ratios of 24 PE (last 4 Quarters) are a stretch. Few IT companies will log over 25 per cent EPS growth, which means much of the sector is over-valued.
Among other major sectors, banking is under the gun. Commercial credit is growing but inflation is also rising. The fundamentals don't look great since interest rates will climb but the BankNifty valuation is 13-14. The PEG ratio looks positive for banking. But there are clear differences between private sector banks PEs and PSU bank PEs and banking EPS can be very misleading.
Realty and Infrastructure (which covers the gamut of construction, power, telecom, etc.) are other industries that have taken beatings in 2008 and 2009. The PEG equations don't yet add up for realty stocks, which are still stabilising after a phase of massive over-valuation.
In infrastructure, construction is down, telecom is stuck in the imponderables of 3G auctions and spectrum allocation, oil and gas could offer specific plays depending on policy direction, transportation (shipping and aviation) hasn't picked up yet. The power sector is attracting hype that could make a temporary mockery of valuations. But investments there would be based on the hopes of making a quick buck rather than buy-and-hold.
