Why Betting On “Winning” Industries Almost Never Works

in investing betting on the success of a single industry is typically not a good idea but a lot of investors make industry bets in their portfolios based on what they think is going to do well that is probably a mistake I'm Ben Felix Chief investment officer at pwl Capital and I'm going to tell you why picking winning Industries is a lot harder than you might think and yes this might make you question that Tech ETF that you're probably holding in 1900 most listed companies were rail companies followed by Banks today technology stocks dominate particularly in the US Stock Market the evolving composition of Industries over time should be expected as the process of creative destruction moves the economy forward but what does it mean for investment Returns the counterintuitive reality is that winning Industries don't always deliver winning stock returns as an investor picking which Industries will beat the market is really hard it seems easy right now because technology has been winning for a while but this won't necessarily be true forever and if history is any indication it even seems unlikely for example I looked at the top performing industries by decad starting in 1934 through to August 2024 in the most recent decade to no one's surprise Electronics equipment stocks returned more than 25% annualized that is a big number but it's not the first industry to have such incredible returns office supply stocks dominated in the decade ending August 1944 aircraft stocks in 1954 computer hardware stocks in 1964 gold stocks in 19 1974 healthc care stocks in 1984 alcohol stocks in 1994 coal stocks in 2004 and ship building and rail equipment stocks in 2014 these top performing Industries had decade long annualized returns of 25% on average just like Electronics equipment stocks in the most recent decade I can't predict the future but one thing that all of these decade long top performing Industries have in common is that they were not the top performing Industries in the following decade in fact in all of my decade examples except for alcohol and computer hardware the prior decades top performing industry Trails the market in the subsequent decade overall they Trail the market by on average 2. 6% annualized over the next 10 years the other challenge is that most Industries underperform the market in the long run for the period July 1969 through August 2024 only 17 of 49 us Industries in Ken French's database beat the market while the remaining 32 Industries Trail the market by more than 2% and IED on average if it were only as easy as picking those winners ahead of time for the most recent decade it's been basically impossible to outperform technology stocks which based on my anecdotal observations has resulted in many people either over waiting or focusing solely on technology stocks in their portfolios the investor behavior of buying high and selling low is well documented and it seems to be particularly strong when it comes to betting on Industries and sectors investor returns Trail fund returns when investors get in and out of the fund in a way that causes them to miss out on the fund's performance usually attributed to Performance chasing behavior in morning Stars 2024 mind the gap report which analyzes investor return gaps for various types of funds sector Equity Funds which are a broader categorization than Industries but conceptually similar have by far the largest gap at negative - 2. 6% per year over 10 years similarly a 2007 paper in the American Economic Review estimates investor return gaps for the nysse and 19 major International stock markets at 1.

3 to 1. 5% per year while the investor return gap for the NASDAQ which tends to be more Tech heavy is estimated at a whopping 5. 3% suggesting that investors had poured in huge amounts of capital at exactly the worst possible time in nasdaq's history there are two main problems with picking winning Industries before the fact one is asset pricing if they are properly priced stocks in a high growth industry will have high prices making it harder for investors to earn high Returns the other is industry specific risk the uncompensated risk specific to an industry which can show up if for example an industry is disrupted taken together from the perspective of investment returns it is not obvious which Industries are going to win in the future stocks are claims in the future earnings of a company the price you pay for those future earnings is one of the most important determinant of your expected investment returns when expectations are high realized earnings have to be even better than those high expectations for stock returns to be abnormally rewarded it's often obvious that an industry is becoming increasingly important economically but due to asset pricing the relationship between economic outcomes and stock returns is in many cases the opposite of what you might expect an important related concept is that stock returns are sensitive to per share earnings growth not industrywide earnings growth an industry can grow say 10 times larger in terms of total industrywide earnings well per share earnings growth which is what matters to investors grows at a much slower Pace the reason is earnings dilution the fastest growing Industries attract more competition and the existing companies in that industry may be more aggressive in raising New Capital to finance their growth the result is that the growing industrywide earnings do not show up one for one in growth and earnings per share they are diluted this may lead to earnings per share growth that Trails the Market's high expectations the way this tends to play out is simple the highest growth industries typically don't have the highest stock return take the industry returns of the 49 us Industries in Ken French's database for the period July 1969 through August 2024 the best performers were not the rapidly growing Industries like software computers and electronics they were tobacco entertainment and defense like missiles and tanks alcohol was close behind another interesting illustration of this phenomenon is the original S&P 500 stocks the S&P 500 is designed to represent leading companies in leading industries of the US economy to maintain its representativeness the index is reconstituted annually meaning some companies are removed While others often in new and exciting Industries are added to the index a 2006 paper in the financial analyst Journal compares the returns of the original stocks in the S&P 500 to the actual performance of the index for the period March 1957 through December 2003 the portfolio of original stocks and its Descendants outperforms the index the authors offer the explanation that companies tend to become candidates for the S&P 500 Index when investor demand for stocks in that particular industry is high they also show that the relationship between sector growth measured by its aggregate market value has a weak relationship with investment returns in their sample some sectors that outperform the S&P 500 like energy shrunk dramatically in terms of aggregate market value while sectors that expanded greatly like financials and Technology produce mediocre or below average returns an interesting recent example of index inclusion at a high price followed by poor performance is Tesla's addition to the S&P 500 it was added in December 2020 after a run of incredible performance and a rapidly Rising relative valuation since its addition to the index it has underperformed the index Itself by 5.