Sector selection and Stock Selection for superior returns in Investing

Sector selection and Stock Selection for superior returns in Investing

Introduction 

Outcomes from the past if analysed thoroughly can help one arrive at various observations which can be used for better decision making in future. Sector selection is an important aspect in stock selection process for investing. Have you ever found any power company in the past that has provided extra-ordinary or superior returns to shareholder ? The answer from your end would be a NO in 99% cases for power companies. Similarly a lot of FMCG companies have provided multi-bagger returns in the past has been observed. So what is the fundamental difference ? Businesses which have natural demand, monopoly or some form of competitive advantage normally provide superior returns to shareholders in the longer run. Businesses like food products, alcohol, condoms, paint, pharma etc. fall in the above categories. Capital intensive businesses like energy, telecom, defense, steel, mining etc. generate relatively lower returns in their business and so shareholders value increases at a slower rate in such business. If one can understand these fundamental points than success rate in investing can be enhanced substantially.

"EFFICIENCY" is the driving Factor :

Stock selection process in investing is more or less revolving around Efficiency. Whether we are looking at returns or valuation or debt or any other factor. All we are looking for is to invest in an efficient business which can generate superior return with lesser capital and lesser risk.

Top-Down Approach : In this approach one identifies first the sector in which one wishes to invest and then looks for the best available companies in the sector.

Bottom-up Approach: In this approach one identifies first the stock in which one wishes to invest and then performs sector study to arrive at conclusion whether it is fit to invest.

Both the approaches are equally valid and effective. However, one point is to be kept in mind that investor must go across and understand primary information for all the sectors so that they can chose the best sectors and best stocks.

Sector Selection Important points : 

• Investing in sectors which have asset-light business model normally provides superior returns to Investor in the long-run. Eg. FMCG, service industry etc.

• Sectors which have natural demand for the products or services are attractive for investor. Eg. Pharma, consumer products etc.

• Sectors which are capital-intensive shall be avoided because larger capital is required for growth in such businesses and so the return on capital is lower for such stocks. Also as the technology keeps changing up gradations have to be made continuously on large scale basis so growth happens at a slower pace.

• Sectors which are highly regulated shall be analysed carefully before investing because change in government regulation can impact the returns in the stock. Eg. Insurance, real estate etc.

• Sectors which are unique or have some competitive advantage in the listed space can have potential for superior returns. Eg. Listed Art company or listed company manufacturing gas valves etc.

• Sectors which have a huge present and potential market size are good from investment perspective. Because as the market size is huge, the margins of such business is less likely to decline in future.