When Assessing Portfolio Risk, Look Beyond Sectors And Industries

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Includes: BA, BKNG, CECO, CMCSA, CXW, DG, HEI.A, HLT, HTZ, JPM, KO, LMT, PFE, UNH, UTX, XOM
by: Strubel Investment Management
Summary

Companies in different sectors and industries can be subject to similar risks.

We show two examples of "diversified" portfolios that all have the same risk.

Investors need to look outside the box as to what macroeconomic and geopolitical risks could affect their portfolio.

When assessing stock portfolios, people mainly focus on the various GICS sectors and industries and which are overweight or underweight. We like to focus on classifying companies by risks and macroeconomic drivers, not based on what sector of the market they are classified in.

Diversification isn't just about the number of stocks in your portfolio. You can have many stocks all subject to the same risk factor. For example, here's a list of six stocks which all superficially appear to be different and span three sectors (industrial, technology, and consumer discretionary). But they all have one common risk.

  • Boeing (BA)
  • United Technologies (UTX)
  • Booking Holding (BKNG)
  • HEICO Corp. (HEI.A)
  • Hertz Global (HTZ)
  • Hilton Worldwide (HLT)

You can probably guess what the common risk is - travel. You have a commercial jet manufacturer (Boeing), a jet engine and OEM aircraft component supplier (United Technologies), a replacement aircraft part supplier (HEICO), an online travel company (Booking Holding), a rental car company (Hertz), and a hotel company (Hilton). Despite this portfolio being "diversified" between six stocks and three sectors, it's actually all dependent on the same thing, growth in travel.

Now take the following list of 10 companies. It looks like a much better diversified portfolio, right?

  1. Career Education Corp. (CECO)
  2. CoreCivic (CXW)
  3. Pfizer (PFE)
  4. Dollar General (DG)
  5. Lockheed Martin (LMT)
  6. UnitedHealth Group (UNH)
  7. JPMorgan (JPM)
  8. Coca-Cola (KO)
  9. Exxon Mobil (XOM)
  10. Comcast (CMCSA)

We have a for-profit education company (Career Education), soft drink company (Coke), and a retailer (Dollar General) that all rely on consumer discretionary spending. Comcast is also a consumer discretionary company with theme parks and a movies division, but a good portion of its profit comes from high speed internet which should probably be considered a "staple" at this point. We have two healthcare companies - Pfizer and UnitedHealth - but they are different. One is a pharmaceutical manufacturer and the other is a health insurer. We have two companies that rely on government contracts in for-profit prison company CoreCivic and defense contractor Lockheed. However, each of those companies receives their revenue from a different part of the government budget, so there is some diversification there. Rounding things out are a large bank (JPMorgan) and a vertically integrated oil and gas company in Exxon.

However, there is one risk all of these have in common, at least in our opinion. They are all companies that could be at risk if Democrats sweep the 2020 elections, especially if a progressive candidate wins.

We already know that the Obama administration made some efforts to crack down on for-profit education companies and private prison companies. It's not a stretch to believe Democrats would attempt to enact similar policies again. So, CECO and CXW would be at risk again should Democrats regain the presidency.

Many Democratic candidates are campaigning on either expanded Medicare, Medicare for all, or adding some type of public option to Obamacare. All likely negatives for UNH. Indeed, healthcare costs have often polled as voters' number one concern. Even a reform as mild as letting Medicare negotiate drug prices could impact PFE to say nothing of wholesale healthcare reform.

Defense spending for a company like LMT could be at risk under a more progressive administration.

Raising the minimum wage could increase costs for companies like DG that depend on large numbers of low wage workers. Also, rising wages could mean consumers begin moving away from discount stores and back to buying brand name products at traditional low priced retailers.

Breaking up the big banks seems to be a perennial campaign slogan for many Democrats, and JPM could be at risk. What if a soda tax goes national? That could impact KO. The "Green New Deal" might mean lower demand for fossil fuels and lower profits for XOM.

Perhaps some of these risks may seem like a stretch, but the point is mainly just to illustrate how seemingly different companies in different sectors could all be impacted by the same event. Also, in an effort to be fair, we should point out that a lot of the negative risks we highlighted with Democrats winning in 2020 would come with corresponding positives for other companies in other sectors.

Summary

The takeaway is that investors need to think a bit outside the box when it comes to assessing risk. Just looking at the sectors and industries stocks are part of may not be enough to truly understand how events could affect your portfolio.

Disclosure: I am/we are long LMT, BA, BKNG. 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.