Stock Classifications (Part 2)

To continue with the different ways in which stocks are classified...

Sector/Industry

Different data sources segregate businesses into a variety of sectors. I’ll be using the sector classifications from Morningstar.com, which is a well-known source for data on mutual funds. Morningstar uses eleven broad sector classifications which it breaks into three "super sectors."

Cyclical Super Sector: Includes industries “…significantly impacted by economic shifts. When the economy is prosperous these industries tend to expand, and when the economy is in a downturn these industries tend to shrink.” [Source:  www.morningstar.com] There are four sectors included in the broad cyclical category.

1. Basic Materials: Companies that manufacture chemicals, building materials and paper products. This sector also includes companies engaged in commodities exploration and processing. 
2. Consumer Cyclical: Retail stores, auto and auto parts manufacturers, companies engaged in residential construction, lodging facilities, restaurants and entertainment companies. 
3. Financial Services: Companies that provide financial services which includes banks, savings and loans, asset management companies, credit services, investment brokerage firms, and insurance companies 
4. Real Estate: Mortgage companies, property management companies and Real Estate Investment Trusts. 

Sensitive Super Sector: “… includes industries that ebb and flow with the overall economy, but not severely so. Sensitive industries fall between the defensive and cyclical industries as they are not immune to a poor economy, but they also may not be as severely impacted by a poor economy as industries in the Cyclical Super Sector.” [Source:  www.morningstar.com] The four broad sensitive sectors are:

1. Communication Services: Companies that provide communication services using fixed-line networks or those that provide wireless access and services. This sector also includes companies that provide internet services such as access, navigation and internet related software and services. 
2. Energy: Companies that produce or refine oil and gas, oil field services and equipment companies, and pipeline operators. This sector also includes companies engaged in the mining of coal. 
3. Industrials: Companies that manufacture machinery, hand-held tools and industrial products. This sector also includes aerospace and defense firms as well as companies engaged in transportation and logistic services. 
4. Technology: Companies engaged in the design, development, and support of computer operating systems and applications. This sector also includes companies that provide computer technology consulting services. Also includes companies engaged in the manufacturing of computer equipment, data storage products, networking products, semiconductors, and components. 

Defensive Super Sector: “… includes industries that are relatively immune to economic cycles. These industries provide services that consumers require in both good and bad times, such as health care and utilities.” [Source:  www.morningstar.com] The three broad defensive sectors are:

1. Consumer Defensive: manufacturing of food, beverages, household and personal products, packaging, or tobacco. Also includes companies that provide services such as education & training services. 
2. Healthcare: biotechnology, pharmaceuticals, research services, home healthcare, hospitals, long-term care facilities, and medical equipment and supplies. 
3. Utilities: Electric, gas, and water utilities. 

Some people believe certain sectors might outperform other sectors at a specific point in time. Some mutual funds focus only on specific sectors. For instance, here are some different mutual funds that focus on the Technology sector:

• Fidelity Select IT Services Portfolio (FBSOX)
• USAA Science and Technology Fund (USSCX) 
• T. Rowe Price Global Technology Fund (PRGTX) 

It is possible to find mutual funds that focus on each of the eleven sectors. If you wanted, you could invest all your money in a sector that you believe will outperform the overall market; however, this is an extremely risky strategy.

A heatmap (finviz.com) of the S&P500 that is broken into sectors (and to some degree, industries within sectors) is shown below. This heatmap is for the past month. You can see that the UTILITIES sector has not performed well compared to the other sectors.

The overall stock market is not weighted equally in terms of sectors. For instance, the market cap of companies in the Technology sector is the highest, while the market cap of companies in the Utilities sector is the lowest. This changes over time, as the market cap of companies change. 

Developed vs Emerging Markets

A developed economy is one that has a high level of economic growth and security. Stock in companies that are based in a developed economy are said to trade in a developed market (DM). DMs have a high level of financial regulation, and investors have easy access to publicly-available information. Countries with DMs include the U.S., Canada, England, Japan and most of western Europe.

Emerging markets are markets in countries that do not have the same level of economic security and growth as developed markets. The political climate and exchange rate system may be highly unstable. The country may have only recently moved from a closed economy to an open-market economy. Civil wars may still erupt. The country may be receiving a large amount of donations from other countries. However, growth in these countries may also be high.  

Investing in stock in companies in emerging markets is riskier than investing in stock in developed countries. The following graph shows the returns for the MSCI Emerging Markets Index (an index of stocks in over 800 companies from 23 emerging market countries), the Russell 2000 Index (an index of the 2,000 smallest companies in the Russell 3000 Index—all of them based in developed countries) and the S&P500 (an index of 500 large U.S.-based companies). (Source: Callan Periodic Table of Investment Returns).

You can see that the returns of the emerging market index have higher peaks and lower valleys than either of the other two indices. The volatility of emerging market returns is greater than the others. From 1993 to 2013, the MSCI Emerging Markets index generated a higher average annual return (13.87%) than the other two indices, but the risk was much higher, as shown below.

You might think, “Wow, with average annual returns of 13.87%, I would be willing to accept nearly twice the risk of developed market returns.” The “average return” from the table above only takes each year’s return from the graph and calculates the arithmetic mean—by summing the annual returns and dividing by the number of years. It is NOT a cumulative measure. For a better understanding of what I mean, review the numbers in the table below. These values represent how much a $10,000 investment made in 1993 in each of the three indices would be worth at the end of 2014.

Even though the MSCI Emerging Markets Index had the highest average annual return, the ending value is the lowest of the three.  Thus, the average annual return (arithmetic mean) is not the best way to measure your return on an investment.  The best mean return measure to determine one’s annual change in wealth is the geometric mean. The geometric means for the three indices are:

Although the geometric mean for each index is below the index’s average return, it is the extreme volatility of the MSCI Emerging Markets index that causes its geometric mean to be so far below its average return—making its cumulative change in wealth lower than the other two indexes.

This doesn't mean you should exclude emerging markets from your investment portfolio.  Emerging markets have an interesting quality that I will discuss in a later post.

Next up:  I had originally intended to only include two posts on Stock Classifications; however this post is quite long already.  I'll finish the Stock Classifications post next week and the following week I will analyze several equity mutual funds in terms of all the different classifications.