We have already learned that sectors rotate from time to time. But for investment purposes, it is essential to identify the right sector at the right time. So, let us learn how.
How to select the best stocks where the most profit can be generated while being in the right sector?
There are essentially two steps for successfully screening stocks:
1)Buy the Gloom, Sell the Optimism- Consider this is the holy grail for employing the sector rotation strategy. Investors must be courageous enough to slowly accumulate these stocks at times when the earnings are at their worst and the outlook is dim. Similarly, you should systematically exit your position at the peak of the cycle when long calls on the sector become a crowded trade and analyst upgrades continue to pour in every other day.
2)Ride the trend- Once you have identified a sector that is due for re-rating, you must hold onto the stock for a longer time period instead of selling it for a quick 10-15% gain. Once a sector breaks out of slumber, the potential for outsized gains is quite high. Let us understand this better with the help of an example:
The above graph shows the stock of Balrampur Chini Mills breaking out after a 16-year consolidation. We are considering an individual stock since there is no index to track the performance of sugar stocks in India.
Getting back to the topic, Investors will notice that once the stock broke out from its narrow consolidation range, it gave tremendous returns. As of 6th July 2021, the stock is at ₹345 which approximately implies a 70% return from the trendline level.
Booking profits is extremely critical and must be done in a systematic manner instead of squaring the position at the first signs of a bounce. For instance, you can square off a certain proportion of your position at fixed intervals (Reducing your position by say 15% after every 10% gain) Alternatively, you can make use of trailing stops.
And these phenomenal returns aren’t just limited to one stock, the entire sugar sector has been in a strong bull grip off late.
Track the Exchange Sectoral Indices - Sectoral indices give a snapshot and benchmarking data of certain sectors or industries. It allows investors to track how various sectors of the market are performing.
Overall, there is a general market consensus that the NSE indices are better constructed than those of the BSE, still investors can use their own discretion.
Examples of sector indices include energy, services, healthcare, consumer products, industrial, materials, utilities, technology & communications and financials. The price performance of a particular stock must be compared with the index to check whether the stock has outperformed/underperformed its peers. Similarly, a sectoral index can be compared with the headline indices (Nifty, Sensex)
The above image shows the performance of different sectors over a one-month period as on 29th April, 2021.
When we’re trading, our goal is to generate short-term profits and the in-depth understanding of any sector or company for that matter is not needed. On the contrary, if we are a long-term investor, we need to know the dynamics of the sector in and out. Additionally, we need some basic understanding of technicals to determine entry & exit points.
Below are the steps to trade in a sector:
A.The first step to trade using sector rotation is by finding a sector which is currently about to enter into/ is already in an uptrend.
B.After finding such a sector, we must stick to market leaders that have the potential to be the stars of the bull-run. The market leaders are not necessarily the ones with the highest market capitalization, but the ones who are best placed to reap gains in a sectoral upcycle.
Events and themes: There are a host of themes which can be capitalized in the stock markets each having its own specialized area to deal with. Each area in itself is a major threshold of an economic upturn for the economy as a whole. Themes pertaining to financial schemes lauded by the government or socio-economic policies which can not only shape the entire economy but can also change the way the society looks today, the COVID pandemic theme or the crude oil price rise – All these themes and events have specific impacts on sectors and stocks which can be easily identified.
Say for example: The Government of India’s Production Linked Incentive (PLI) Scheme gave a huge boost to the manufacturing sector. The stock of Dixon Technologies has been on a tear ever since then:
Similarly, the Covid Pandemic had a positive impact on the entire Healthcare sector and related stocks.
Management Guidelines: The Management and con-call analysis also helps an investor to identify the sector play. The strong and good companies release their con-call analysis and investor presentations every quarter. Going through them also gives a decent understanding about the sector in play.
Let us understand this with a particular example: We take the FMCG sector under which we will be studying about Dabur Ltd. Management & Discussion Analysis of Dabur Limited Annual Report 2020 states the following with respect to FMCG Sector Analysis
“The Fast-moving Consumer Goods (FMCG) sector is the 4th largest sector of the Indian economy. During FY 2019-20, the sector witnessed growth of 7.2% as per AC Nielsen, which is almost half of the 14% growth reported in FY 2018-19. “The sector saw a sharp slowdown during the year on account of moderation in economic activity, low farm incomes and weak rural wage growth, liquidity crunch in the system, high unemployment levels and down trading across categories. By March 2020, the sectoral growth dropped to 3.3% in value terms and 0.5% in volume terms. The Coronavirus pandemic has further impacted the sector since March 2020 due to restrictions on the movement of goods, supply side bottlenecks and impact on consumption. Consumers have been stocking up essential products such as packaged foods, staples, tea, coffee, milk, detergents and other products of daily usage. During this phase, demand has also surged for health and hygiene products as these aspects came into sharp focus. There was a surge in demand for hygiene products like sanitizers and disinfectants in addition to immunity building OTC (Over- The- Counter) and healthcare products. However, discretionary and nonessential items have seen weak demand as the focus during the lockdown has been on food and hygiene.”
The above extract clearly shows how the management report can give an idea about the entire sector slowing down. And the best part is how stock prices reflect the same. As a matter of fact, NIFTY FMCG Index has been the worst performer in the market bull-run after the COVID Pandemic struck.