In one of my previous post, I argued for the need to distinguish between good sectors and bad sectors in portfolio investment. However, in the Indian capital market context, the availability and popularity of sector indices/ETF’s is still developing making it difficult to implement a sector based portfolio strategy. As an extension of that research, it may be worthwhile to see the link between sectors and companies. In simple terms, you may have a bad company in a good sector or a good company in a bad sector. How do you reconcile such conflicts?

Why Sectors matter?

Source: Reuters Eikon

BSE has 19 sector indices. If one tracks their annualized performance for the period January 2008 to September 2015, we can see that there is wide variation in their performance. While healthcare was the best performer (20.1% compounded return), Realty sector was the worst performer (-24.6% compounded return) with Sensex performing at 3.8% annualized. Out of the 19 sectors, 8 outperformed Sensex while others underperformed Sensex. Hence, sector performance matters.

Source: Reuters Eikon

While the annualized performance shows huge variation, even within a sector we see wide variation in performance as captured in the graph that depicts median performance. The best example is that of Healthcare, where the best performer clocked an annualized performance of 43.1% while the worst performer clocked an annualized performance of -29.1% with a median performance of 21.4%. Hence, it may not be enough to just bet on good sectors as even within good sectors we notice wide variation in performance.

The 4 Grid approach

Here is the dilemma while choosing companies. We may have good companies in bad sectors (like Castrol in Oil and Gas) or bad companies in good sectors (Financial Technologies). Hence, it may be worthwhile to regroup the index constituents across these four dimensions and assess their portfolio performance (based on market cap weights):

Good companies, good sectors (A)

Good companies, bad sectors (B)

Bad companies, good sectors (C)

Bad companies, bad sectors (D)

The definition of a good company/sector is that it outperforms the Sensex returns and conversely a bad company/sector is the one that underperforms the Sensex.

Here are the findings:

Grid A (Good companies, Good Sectors)

Grid A companies (67 of them) have outperformed both their sector and the wider Sensex with the highest performer clocking an annualized performance of 85% (Indiabulls Housing Finance) while the lowest performer clocking an annualized performance of 3.8% (Mphasis) still better than Sensex. All the more, when you group them as a portfolio (market cap weighted) the portfolio performance is an impressive 17.5% annualized compared to Sensex performance of 3.8%.

Grid A-Top10

Grid B (Good companies, Bad Sectors)

Grid B companies are drawn from sectors that has underperformed the Sensex but whose constituent companies have outperformed the wider Sensex and contains 24 companies with the highest performer clocking an annualized performance of 63% (Eicher Motors) while the lowest performer clocking an annualized performance of 4.4% (Siemens) still better than Sensex. All the more, when you group them as a portfolio (market cap weighted) the portfolio performance is 14.9% annualized compared to Sensex performance of 3.8%

Grid B –Top 10

Grid-C (Bad Companies, Good Sectors)

Grid C companies are drawn from sectors that has outperformed the Sensex but whose constituent companies have underperformed Sensex and contains 19 companies with the highest performer clocking an annualized performance of 1.2% (ICICI Bank) while the lowest performer clocking an annualized performance of -33.4% (Financial Technologies) far worse than Sensex. All the more, when you group them as a portfolio (market cap weighted) the portfolio performance is -5.0% annualized compared to Sensex performance of 3.8%

Grid C-top 10

Grid-D (Bad Companies, Bad Sectors)

Grid D companies are drawn from sectors that has underperformed the Sensex and whose constituent companies have also underperformed Sensex and contains 65 companies with the highest performer clocking an annualized performance of 3.6% (ACC) while the lowest performer clocking an annualized performance of -43.1% (Unitech) far worse than Sensex. All the more, when you group them as a portfolio (market cap weighted) the portfolio performance is -7.9% annualized compared to Sensex performance of 3.8%

Grid D-Top 10

Key Takeaways

A strong look at the sector to which a company belongs is key to identifying winners

There may be good companies in bad sectors and vice-versa. Hence, a sector bias should not cloud out opportunities.

In general, good companies come from good sectors. That is a killer combination to have in your portfolio (Remember Grid A)

In general, bad companies come from bad sectors. This should be avoided at all costs. (Remember Grid D)