What not to buy – Part 2: sectors

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Last month I wrote about narrowing your investment focus down to the top 100 stocks. Today I’ll cut that down further – to only 68 stocks – by looking at what stock market sectors to avoid. Then in my next column, I’ll show you how to reduce the set even further to about 40.

My aim is to get down to a group of about 20-25 stocks to choose from, and then invest in 15-20 of them while keeping my eye on the remainders. Lack of jealousy in stock picking is my motto. I don’t care if I don’t have the top 20 best performers – I just want my portfolio to grow and grow, and preferably above the rate of the benchmark index. So far so good.

So let’s take a look at the stock market sectors.

Each of the 200 stocks in the benchmark ASX index are best thought of as belonging to one of the 11 major sectors of the Global Industry Classification System (GICS). You can see these sectors listed in Table 1.

Many fund managers will try to keep the sectoral allocation of their stocks in rough proportion to that of the index so that their fund’s performance is less likely to deviate by too much from the benchmark.

To give some insight into these sectors, I have listed the biggest 20 companies by sector in Table 1. Eight of the top 20 stocks are in Financials and three sectors have no top 20 companies. The biggest in these three sectors are Newscorp (Discretionary), Computershare (IT) and AGL (Utilities).

I also show the proportions by value for these sectors at the end of the latest financial year and for the first year for which data is available (200/01) in Table 1. If an investor had $100,000 and wanted to try and mimic the index, he or she might invest about $7,400 (7.4%) in Energy and $27,600 (27.6%) in Materials, etc. I’ll deal with the stock selection issue in my next column.

Top 20 companiesTwo things jump out at me from Table 1.

First, the sectors are far from equal in size. Second, the sector weights have changed dramatically over the last decade or so. As the resources boom took hold, Energy and Materials have grown at the expense of Financials and a few others.

The $100,000 index weighted portfolio would only require an allocation of about $600 in IT. At that level, the sector is hardly worth the effort, especially when brokerage and paperwork are taken into account. And IT in this country is nothing like in the US – there’s no Apple, IBM, Microsoft, Google or Intel here.

Computershare may be a great company, but I’d have to be so ‘overweight’ in IT for it to make any difference to my overall portfolio, so I just ignore that sector.

I show the average total returns (including reinvested dividends) in Table 2. Although some people focus on dividends, to me the whole package is important. Of course, franking credits play an important part in a DIY fund. But looking at Telcos (dominated by Telstra), I can see that dividends have been paid largely at the expense of capital gains. Financials (especially the big four banks) look like a much better dividend play to me.

Then there’s property. It suffered disproportionately in the global financial crisis. Given the problems with valuing property at the best of times – and the potential problems with retail going forward – I choose to avoid Property and Telcos completely.

My philosophy is this: I know I don’t need to invest in every good company – just a reasonable number of good companies, and no bad companies certainly helps!

Staples, Health and Utilities are so-called defensive sectors. That is, they don’t experience the same degree of volatility as the likes of Discretionary and Materials. My problem with Staples is that its growth is to some extent limited by the size of the Australian market.

Meanwhile, many of the Health companies have big export programmes. The dollar isn’t helping exports at the moment, but I still favour Health over Staples. Utilities seem to me to have energy-related growth opportunities. So for me, Utilities and Health are in, and Staples is out.

Finally, I got completely out of Discretionary stocks in mid-May. I don’t think anyone has a good handle on where the consumer is going at the moment. If things change I’ll reconsider. But for now, that leaves me with only six of the 11 sectors to focus on. Much easier!

Woodhall Investment Research Pty Ltd

ABN 17 141 486 160

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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