When we look at the past in investing, all of us have a tendency to want to find the simplest explanations for the things that occurred. But beneath the surface, there is often much more going on than meets the eye.
I recently wrote an article where I looked at the top five most read interviews we did in the past year for our Five Questions series and the major lessons from each of them. There were some excellent lessons in all of those interviews and I learned a lot from every one of them. But the most important lesson I took away from our first year of Five Questions came from a different interview I did. This lesson was a reminder to me that I always need to look below the surface to see what is going on, because the easiest explanation often doesn’t tell the full story. I learned it from Lawrence Hamtil of Fortune Financial Advisors, who I interviewed back in July.
The lesson is that for anything that happens in investing, it is essential to understand the sector story behind it.
It is easy to underestimate how much of what happens in investing is driven by sectors. When a strategy performs well, it is often because it was overweight the best performing sectors. And when one performs poorly, the opposite is often true.
Let’s look at some examples of how looking at the sector story can lead to a different conclusion than the obvious one.
The Underperformance of Value
Value stocks have struggled in the past decade. There have been many explanations offered for that. One that is often missed, though, is the simplest one: value strategies tend to underweight technology stocks, and technology has been the best performing sector by a wide margin. Value strategies have also tended to be overweight financials, energy, and retail for most of the decade, which have been among the worst performers.
The chart below looks at the performance of the SPDR Sector ETFs for these sectors for the most recent decade. As you can see from the chart, technology stocks more than doubled the performance of financials and retail stocks, and their return beat energy by over 300%. Any strategy that was underweight technology and overweight the other three would have had a terrible decade, and that is exactly what happened with value.
Source: Yahoo Finance
The Downfall of the Price/Book
If you dig into the individual value metrics, you can see an even bigger sector impact. The Price/Book has been the most used value metric in academic research. It also has the worst long-term record of the major value metrics. But its long-term performance relative to the other value metrics, though not stellar, was much better before the financial crisis. Its performance since then has been nothing short of terrible. Again, if you dig beneath the surface, there is a major sector-based explanation for this.
This chart goes back to the beginning of 2008 and looks at the performance of financials (dark blue), technology (light blue) and the S&P 500 (purple).
Source: Yahoo Finance
Of the strategies we follow, those that use Price/Book as their primary metric have had the least exposure to technology and the greatest exposure for financials since the financial crisis. When you consider the fact that technology is up 300%+ over that period and financials are up 30%, that has been a massive headwind that would have been impossible to overcome. In contrast, if you look at strategies based on EV/EBITDA, they typically have no exposure to financials because it can’t properly evaluate them. On a relative basis, this has explained a lot of the underperformance of the Price/Book in the period.
If things were to change and financials were the best performing sector over the next decade, Price/Book would probably be one of the best performing value metrics. This wouldn’t mean that its long-term problems were solved. Issues like its inability to deal with intangibles and negative equity would still be there. They would just be masked by the sector story behind the scenes. Someone who didn’t look at the sector story could mistakenly conclude that the issues with Price/Book were behind it, when in reality this sector shift would tell us little about its long-term viability.
Are Emerging Market Stocks Cheap?
Another place looking at the sector story can give you a much clearer picture of what is going on is in analyzing the performance and valuations of emerging market stocks. Emerging market stocks have struggled for a long time now relative to their US counterparts. They also appear on the surface to be very cheap. But again, looking at the sector story paints a different picture.
Here is the sector breakdown of the Vanguard FTSE Emerging Markets ETF.
Source: Morningstar
And here is the sector breakdown of S&P 500
Source: Morningstar
What you see in these two charts are the same types of differences I mentioned earlier with value stocks. Emerging markets have significantly less technology exposure, and significantly larger weightings to sectors like financials and materials. So you would expect that they would underperform in a period dominated by technology. And that is exactly what has happened.
If you want to make the argument that emerging markets are cheap, as places like GMO have, you can certainly do that, but you also need to understand that they are cheap in large part because they have larger weightings to sectors that are cheap. If you build a US portfolio with the same sector allocations as the emerging market ETF above, you will find that emerging markets are not as cheap on a relative basis as you might think.
The Importance of Looking Beneath the Surface
In no way am I trying to suggest that sectors explain everything. All of the things I have discussed in this article have other valid explanations outside of sectors. What I am suggesting, though, is that sectors play a much larger role in what occurs in investing than many people realize. If you are going to analyze anything in investing, it is important to always pay attention to the sector story behind it. That was one of my biggest lessons of 2019.
Photo: Copyright: 123rf.com / jiss
