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I have come across many articles which talk about diversification and have yet to come across one which I feel is truly comprehensive and can cover most aspects of differentiating stocks by certain categories. Many academic articles talk about diversification requiring investing into stocks which are negatively correlated to achieve better risk reward ratios, but how does one actually do it?
In this multi-part article, I will attempt to address the different categories and how it affects diversification of risks. Each stock can be categorized into the following manner.
1. Cyclicality of Industry
2. Size
3. Growth Potential / Maturity Level
4. Business Fundamentals
5. Dividend Levels
6. Economic Moats
7. Location of Markets
Cyclicality of Industry - Defensive, Cyclical or Counter Cyclical
Cyclicality of industry can be classified into mainly defensive, cyclical or counter cyclical. While many people talk about sector rotation as a strategy, that is a minor theme. The major theme is still how the stock price and earnings correlate to the market as a whole. We generally use market indexes i.e. STI, S&P, DJIA, Hang Seng to gauge market temperature, so how correlated the stock is to a market index is one of the main ways to determine cyclicality. The correlation to index is known as beta, with 1 being a perfect correlation and -1 being perfectly negatively correlated.
Defensive stocks are generally low beta stocks close to 0, which means low correlation to market index. They consist of industries such as healthcare, consumer goods, telcos which have resilient earnings no matter what state the economy is in.
Cyclical stocks are generally higher beta stocks larger than 1 or more, which can swing quite wildly. Cyclical stocks consist of industries such as oil & gas, banking, construction etc. The stock price and earnings normally fluctuate according to the economic cycle.
Counter cyclical stocks are negative beta stocks which mean that when the economy is doing well, the stock doesn’t do well but the stock outperforms when the economy is in recession. While such stocks are considered very rare, there are certain industries related to cost cutting such as human resource and information technology. Another type of stocks which are largely counter cyclical are mortgage REITs and gold related stocks. Generally speaking, it usually makes sense to have a portfolio diversified according to beta levels. A good mix of low beta, high beta and even negative beta stocks help to increase the risk reward ratios. You can also actively invest according to the market cycle to take advantage of market timing, i.e. sell defensives, buy cyclicals when the market is at the bottom and sell cyclical, buy defensives when the market is peaking.
I didn’t expect this post on cyclicality of industries alone to be so long! I will leave the rest for next posts, stay tuned!
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