Why sector diversification offers extra comfort in uncertain times

Making forecasts about the future direction of shares and markets is hard. Faced with a global pandemic of uncertain proportions, it’s next to impossible.

Volatility is sweeping the stock market on a daily basis and it’s anyone’s guess just how far the economic impact of coronavirus will spread.

Some sectors have been sucker-punched by the crisis, such as airlines, leisure and travel. In a few cases, companies are facing a battle for survival. Early evidence suggests that many others are reinforcing their finances wherever they can. Credit lines are being drawn down, dividends and buybacks are being shelved and in some cases staff are being furloughed.

For investors, it’s an incredibly unsettling time.

There’s an old saying (originally by John F. Kennedy, I think) that the time to repair the roof is when the sun is shining. During the decade-long equity bull run that came after the financial crisis in 2009 it was easy to forget the wisdom of being prepared for the worst.

When it comes to managing a portfolio of shares, taking defensive measures in the good times can easily feel like the wrong choice. But here we are in a situation hardly anyone predicted that’s unfolded at devastating speed.

Few will have the stomach to start fixing their portfolios while the storm rages. But in the weeks and months ahead it might be worth thinking about how to be better prepared for any weather in the future. One way of doing that is to consider how diversification can help to avoid the risk of too much sector specific exposure...

Diversification - the only free lunch in finance

The cyclical nature of business and economies means that different stocks behave differently depending on the conditions. It’s worth taking account of this when it comes to building an all-weather portfolio.

If your positions all tend to do well when the economy is booming, then things could get sticky if a recession, economic shock or unexpected global pandemic should suddenly emerge. But equally, if your stocks are all safe havens in times of economic strife, it’s unlikely you’ll get the big upside when the economy takes off.

To understand this better, you can map the stock market based on three main super-sectors: Cyclicals, Defensives and Sensitives. Between them, they account for the 10 main business sectors:

• Cyclicals: Basic Materials, Consumer Cyclicals, Financials
• Defensives: Healthcare, Consumer Defensives, Utilities
• Sensitives: Industrials, Energy, Telecoms, Technology

Cyclical sectors are generally the most sensitive to macro trends and the health of the economy. Among them are high street retailers and housebuilders. These industries have done well in the years after the financial crisis but they face pressure when consumer confidence starts to waver. Many are now likely to suffer as the economy is thrown into turmoil.

Defensives, on the other hand, tend to be less reliant on the domestic economy because they sell goods that are in constant demand. They include pharma companies and utility groups, which are heavily regulated and have much more predictable outlooks. Supermarkets are included too - and their share prices have wobbled but remained relatively stable in recent weeks.

Screening for defensive options

To give you an idea about how some defensive shares have fared over the past few months, here's a screen that focuses on mid- and large-cap shares in Utilities, Consumer Defensives and Healthcare. The names are sorted by relative price strength over the past three months.

These shares haven’t been immune to volatility, but they have all held up much better than the market average. They range from healthcare stocks like Silence Therapeutics, Hikma, Vectura and Astra Zeneca to supermarket groups like J Sainsbury and Wm Morrison.

With turmoil likely to continue in share prices for the foreseeable future, buying opportunities need to be considered carefully. But looking further ahead, the advantages of diversifying across sectors has once again been brought into focus by the variable performances across the market in recent weeks. Sector diversification won’t protect you completely, but it might offer some comfort from whatever conditions arise in the future.