Sector Investing: Can 1 + 1 = 3?

| About: SPDR S&P (SPY)

Summary

Within the taxonomies that define them, traditional sector investing is not all that exciting.

However, overlay an undefined sector onto a traditional one and you may have something.

This article explores six such overlays being pursued by dominant transnational companies.

It's hard not to open a good investment website without seeing a sector article up front and a pull-down tab taking you to a sectors database with a slice-and-dice tool. Apparently, the experts are convinced that traditional sector analysis is worthwhile. Yes, sectors have their place with respect to portfolio diversification and cyclical investing. But I wonder if sectors, over time, deliver much more than beta-level results.

Passé for Two Reasons

For two important reasons, sector analysis falls short. First, foundational taxonomies and definitions are grounded in the past, i.e. what is known about products or services as they are viewed in history. Take Standard & Poor's "Global Industry Classification Standards/GICS," for example. This construct contains 11 sectors, 24 industry groups, 68 industries and 157 subindustries that categorize "all major public companies" … "for use by the global financial community." Among just the mining sub-sectors - gold, precious metals, steel and so forth - there is no mention of lithium critical to battery technology, and copper was only added to GICS a month or so ago. I could go on.

Or switch gears to FTSE's "Industry Classification Benchmark System/ICB". This taxonomy consists of 10 industries, 19 "supersectors", 41 sectors, and 114 subsectors. Fully seven of the latter are devoted to REITs but only two to "pharmaceuticals and biotechnology," those being "biotechnology" and "pharmaceuticals" - apparently, there wasn't room for companies focused on cancer or infectious diseases. And, neither in biotech nor food does a pigeonhole exist for firms involved with genetics. Herein lies the second reason that sector analysis is largely passé - leading companies work to separate themselves from the herd by redefining themselves and, in the process perhaps, redefining their industry. Sector models can never keep up.

Breaking New Ground

But what if investors overlay companies that are dominant in their historically-defined sector with those that are leading major change in a yet undefined or emerging sector? Take ABB Ltd. (NYSE:ABB) and Siemens (OTCPK:SIEGY) (OTCPK:SMAWF) (OTC:SMQFY), for example. ABB, a diversified industrial, is undergoing a metamorphosis focusing on its power/grid management and automation/robotic offerings, neither of which merits a sub-sector in the taxonomies I've seen. In the case of Siemens, we see a conglomerate that may be partially reinventing itself to be a climate change company as evidenced by its work around tropical disease testing and wind energy. If mining and real estate can rank classification status, why doesn't addressing the causes and consequences of global warming?

The same holds true of General Dynamics (NYSE:GD) and Lockheed Martin (NYSE:LMT), the first of which is producing LNG-powered container ships with Lockheed moving into the waste energy business. Or, what about Total (NYSE:TOT) (OTCPK:TTFNF), the major integrated oil company that may be establishing a beachhead in solar power, an area calling for consolidation? Or Monsanto (NYSE:MON) that just last week licensed CRISPR-Cas9 gene-editing technology from MIT's Broad Institute and Harvard.

Let's take a very preliminary look at some numbers with generous allowances for sample bias, time frame, externalities and other factors. In the table below, we see that had one taken an equal position in all the companies above (as I have), year to date, you would have seen appreciation in those assets of 13.25% or more than double the S&P 500 on top of dividends averaging 3.26% a full percent above of the average of the same index.

Year-to-Date

Appreciation

Difference vs.

S&P 500

Dividend

Yield

Difference vs.

S&P 500

S&P 500 5.00% n/a 2.20% n/a
ABB Ltd. 26.90% +21.90% 3.34% +1.14%
Siemens 21.33% +16.33% 3.27% +1.07%
Gen'l Dynamics 12.02% +7.02% 1.98% -0.22%
Lockheed 13.07% +8.07% 2.97% +0.77%
Total 2.56% -2.44% 5.93% +3.73%
Monsanto 3.66% -1.34% 2.11% -0.09%
Click to enlarge

Going About It

If this hypothesis holds true - that overlaying an undefined/emerging sector onto a traditionally-defined one and looking for dominant/transnational companies serving both - then how would one begin to identify what's new? Well, certainly not by looking within GICS or ICB. No, I advocate keeping your pointer away from that sector pull-down tab and studying the world from far-flung non-financial sources. As but only two of hundreds of resources, a start would include DARPA that is also very active with industry, and Health and Human Services/BARDA as a key R&D funder in that space.

Having identified potentially promising new sectors, there is still no need to return to old sector taxonomies. Why? Because straight-forward web searches will lead you to transnational companies that are working in these areas and, from their names alone, you should know what sector they already dominate. I'm partial to companies that have commanding market share because it indicates that customers, suppliers, investors, regulators and other stakeholders trust them. Therefore, when combining the emerging with the traditional, it makes sense to me to focus on firms that have a lot of market share. Global top-10 lists are to be found everywhere.

Take Another Picture

Thomas Kuhn in his timeless classic The Structure of Scientific Revolutions introduced the concept of paradigm shifts - breakthrough moments where, "one conceptual worldview is replaced with another." Kuhn and others challenge us to be prepared to put aside our traditional frames of reference in favor of new ones. The layering of an emerging sector onto one that is traditionally-defined represents a lesser paradigm shift but one, nevertheless, that may hold alpha-level potential.

Disclosure: I am/we are long ABB, SIEGY, GD, LMT, TOT, MON.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Always do your own due diligence in counsel with a competent investment advisor who puts your interests ahead of their own.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.