Avoiding Doomed Sectors, Redux

by: David Merkel, CFA

Those that have followed me for a while know that I rotate industries.  The idea is to buy:

  • Strongly capitalized companies that are at their cyclical trough, or
  • Moderate-to-strongly capitalized companies where pricing trends are under-discounted.  Often these companies have positive price momentum.

Also, the idea is to avoid:

  • Sectors where valuation metrics are cheap, but the industries are in terminal decline.
  • Weakly capitalized companies and industries where product pricing is weak.

The sectors to avoid are what I term “doomed sectors” though it applies better to the first example of the two.  My favorite example of a doomed sector is newspapers.  I don’t care how cheap they get, I am not buying.  They are obsolete.  As for the second example, think about depositary financial companies, or companies that take a lot of credit risk.  Eventually they will bounce back, but it will take a while.

Here’s my current industry ranks:

IndustryRanks-9-12-08Click to enlarge


So, why don’t I dig through Hotels/Gaming, Air Transport, and Homebuilding?  Hotels are overbuilt.  Air Transport is a losers’ game; there are always romantic male entrepreneurs willing to invest at subpar prospective returns, because they like to see the planes fly.  Homebuilding?  There is a glut of homes.

If you can avoid bad sectors, your performance will be pretty good.  That has helped me over the past eight years.

I like investing in the green zone, in industries that I think have a future.  Good picks there can last for years.  There is another way to play my industry model, though.  Put money in the top ten industries, and keep it there as the best industries change.  The trouble is, it is a high turnover strategy, though it beats the index by about 6%/year.  I’m not sure what trading friction would do to the return advantage.

That’s my view on industry rotation.  I prefer playing for longer periods and slower trading, but the system can be used in a momentum mode.