Sunday, April 23, 2017

Sector Diversification

In my ebook The Bedokian Portfolio, I constantly harped on diversification of asset class and foreign financial markets, but I did not touch much on sector diversification. In this blog post, I would share a bit on the sector aspect.

What is a Sector

According to Investopedia, sector, or sometimes called the industry, is “… an area of the economy in which businesses share the same or a related product or service. It can also be thought of as an industry or market that shares common operating characteristics”1. In the degree of diversification for The Bedokian Portfolio, sector comes below region/country, since the same sector could perform well in one country but may not be in another.

There are a few ways to define sectors. One way is to classify them by primary, secondary and tertiary, which are companies related to raw materials, processing and manufacturing, and services, respectively, akin to a source-to-end-user process. Most investors would prefer to use the standard “10 sectors”2, namely financials, utilities, consumer discretionary, consumer staples, energy, health care, industrials, technology, telecommunications and materials. These 10 sectors, in turn, could be divided into sub-sectors. Our local stock exchange, SGX, also has its own sector classification3.

The sector is used and analysed in the second tier of fundamental analysis (FA) known as environmental factors. As I had mentioned in the ebook4, the sector represents the “playing field” of the companies involved. When conducting FA, besides analysing the company in question, you must consider the future heading of the sector in general as well.

Why is Sector Diversification Important

In my ebook, I had highlighted an example using the local telecommunications sector and buying up equities of the three companies does not equate to diversification, for any negative impact to the sector would result in losses5. In a somewhat true fashion, when news broke out on the authorities’ intention to grant a licence for a fourth company back in July 2015, all three existing companies’ share prices took a hit.

On a longer term, the drop in the price of oil for almost the past three years had brought the oil and its related industries to a low. Consumers of oil, however, are benefiting, such as transportation and manufacturing. It is precisely this scenario that, like asset classes, certain sectors will perform better than others in certain economic conditions.

Sector Diversification In The Bedokian Portfolio

It is advisable to have a myriad of sectors and industries for your Bedokian Portfolio, but do take note that a sector could be quite broad and sometimes the sub-sectors within it is not really correlated with one another (e.g. manufacturing of machinery and manufacturing of food). As a rule of thumb, the 12% limit rule (see here) should be used for individual companies and sector-based exchange traded funds, in the case for equities. To a certain extent, sector diversification should be practiced for bonds in terms of the corporate bond issuer’s industry.

REITs are a bit unique on the topic of sector diversification as they are a hybrid of equity and property, hence for simplistic sake it is better to have different types of REITs according to their nature, like retail, hospitality, industrial, etc.

1 – Investopedia. What is a ‘Sector’. (accessed 21 Apr 2017)

2 – Kuepper, Justin. The Ten Sectors of the Stock Market. 25 Dec 2015. (accessed 21 Apr 2017)

3 – Sectors are: Multi=Multi-Industry, MFG=Manufacturing, CONS=Construction, COM=Commerce, Hotels=Hotels&Restaurants, TSC=Transport, Storage&Comm., FIN=Finance, PROP=Properties, SERV=Services, AGR=Agriculture, MINQ=Mining/Quarrying, EGW=Electricity/Gas/Water 

4 – The Bedokian Portfolio, p88-89.

5 – The Bedokian Portfolio, p12.

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