How Understanding Sectors Can Help to Minimize Risk - WSJ article by Chris Kenney

SHAREHOLDER SCOREBOARD
How to Weather Turbulence
What investors can glean from the Scoreboard; one key: understand relative risk among sectors.

By CHRIS KENNEYFebruary 25, 2008; Page R2
Investors are worried. The Dow Jones Industrial Average ended last year 6.4% below its October record close and has fallen further since then. The housing market is in turmoil, banks are posting big losses and economic growth may be about to grind to a halt.
What can the Shareholder Scoreboard offer investors as they weather market volatility and recession concerns and need to reassess their investment strategy?
The Shareholder Scoreboard was developed in 1996 to provide investors with a long-term perspective on the creation of value in the stock market. For various time periods, it reflects the trends, bubbles, corporate winners and laggards that have affected investor returns. But given the rising uncertainty in the economy today, it is likely that investors are much more concerned with the immediate future.
THE JOURNAL REPORT

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• See the complete Shareholder Scoreboard report.
FINDING THE COMPANIES THAT SHINE

PODCAST: Chris Kenney of L.E.K. talks with the Journal's Georgette Jasen about some of the main themes in this year's rankings, using the Scoreboard as a starting point for looking at companies and sectors, and other topics.

Although stock-market history clearly has limits in its ability to inform us about the future, there are several investment insights to be gleaned from this year's Scoreboard that may help investors calm their nerves and balance their portfolios as they look at 2008 and beyond.
The first thing is to put the stock-market volatility experienced in 2007 (and so far this year) in some perspective. Although investors with limited experience or short memories might have been struck by the market's turbulence, we have experienced far worse volatility in recent years. Second, for those who want to manage their portfolio risk more actively, it is important to understand relative risk across industry groups to avoid the next sector downdraft. Finally, individual-company risk can vary quite widely from one sector to another, so investors who like to pick individual stocks should examine the range of returns within a given industry.
A look at each of these issues can help investors manage market risk when it begins to feel most unmanageable.
Be Ready for Turbulence
Investors certainly had a bumpy ride last year. Average daily price swings for the companies in the Dow Jones U.S. Total Market Index were more than 50% greater in 2007 than in 2006. Turmoil within the housing sector bleeding into the financial sector led to both real and perceived volatility.
Because we are all most influenced by recent history, the roller coaster that investors rode in 2007 might lead some to believe that recent market volatility is at historically high levels. Investors might be inclined to keep their money on the sidelines and wait for calmer times.
But the truth is that relative to the past 10 years, 2007 market turbulence was well below average. Volatility is typically defined using a statistical measure called standard deviation, which looks at how much or how little data diverge from the average. As the first chart indicates, even though last year was turbulent, six of the past 10 years demonstrated even higher volatility.
What can investors do in turbulent times? Clearly, the tried-and-true strategy of diversifying across asset classes, geographic regions and sectors should be the first line of defense. For example, had you invested equally across all the Scoreboard industry sectors, the return would have been an average 13.8% annually over five years. Alternatively, the average annual return on just five sectors would range from 1.1% to 59.6%, depending on which sectors were chosen.
Broad diversification across stock sectors therefore is one of the most useful tools in managing risk. Ask yourself if there is any reason to have more than 10% of your stock portfolio in any one sector. Then be vigilant in rebalancing your portfolio as the value of your investments changes over time.
Watch Out for Maverick Sectors
Yet even reasonably diversified investors can be burned by industry sector risk. For example, just a 5% exposure to the home-building sector in 2007 would have reduced a portfolio's total value by 2.5%.
So it is also useful to understand the extent to which industry returns vary from the overall market. Investors who commit too much of their portfolio to "maverick" sectors -- those whose returns deviate enormously from the market average -- can inadvertently assume more risk than they intend.
To illustrate this, we have identified 10 industry sectors that, over the past five years, diverged the most from overall market returns on a month-by-month basis.
The measure used is called R-squared. Simply put, it shows the relationship of movements in each sector to movements in the overall market. If the movements are 100% correlated, this means that all the stock movements in a sector can be explained by movements in the market. Alternatively, if R-squared is 0%, then overall stock-market returns explain none of the returns in the sector and sector-specific factors are driving stocks. We consider sectors mavericks if less than a third of their returns are explained by returns on the overall market. Here are the top 10 maverick sectors for the past five years:
You can see that only about 5% of the returns in the home-construction sector were explained by overall stock-market movements. Similarly, the overall market explained less than 1% of the returns in travel and tourism.
There is a logical explanation for these sectors to be so detached from overall market returns. Pharmaceutical-company fortunes, for example, are not tied to the general economy nearly as much as to the prospects for specific drugs. Similarly, cyclical and capital-intensive sectors like autos, forestry and paper, and semiconductors can deviate substantially from overall market returns.
It is useful for investors to know what percentage of a portfolio is invested in maverick sectors. Though the past is not always prologue and industry dynamics can change, ask yourself how likely your target sectors are to move based on broad economic or sector-specific factors.
Another reason to identify maverick sectors is that, in moderation, they can be quite useful in diversifying portfolio risk. For the very reason that they tend not to move with the market as a whole, they can help offset movements in the market.
The implication is not to avoid these sectors but to keep your exposure manageable. Balance your stock investments with modest exposure to one or more maverick sectors, but don't let them grow to more than 10% of your total portfolio. And include a mix of more market-oriented sectors.
Among the sectors that most closely tracked market returns:
Some of these are sectors closely tied to industrial and commercial activity (industrial services, commercial vehicles and trucks). Sectors that are closely tied to movements in interest rates (utilities, life insurance) and relatively stable goods and services are also represented (medical supplies, waste and disposal services).
Stock Pickers Beware
Just as industry sectors can vary widely in their levels of volatility and risk, so too can companies within sectors. In some sectors, company stocks move quite closely with sector returns. In others, company returns can vary widely from sector returns. This is because company returns in these sectors are affected by unique factors rather than factors that affect all companies in this sector. In these cases, individual stocks carry greater risk.
Consider the semiconductor industry in 2007. Company returns deviated enormously from the average return of 28.6%. A top-performing company in this sector was MEMC Electronic Materials Inc., which generated a 126% return. The worst-performing company was Advanced Micro Devices Inc., whose return was minus 63%. Most investors diversify their investments to eliminate most of these company-specific effects. For those who may decide to own one or two stocks within a given sector, however, it is useful to know which sectors have companies whose returns deviate the most from the sector average.
Using standard deviation as a measure of how tightly data are clustered around the average (low standard deviation) or, conversely, how widely dispersed they are (high standard deviation), we can see that returns for companies in the following 10 sectors deviate the most from the sector average. Presumably that's where stock pickers are taking a proportionately greater risk when they invest.
Again, there is some logic behind "high deviation" sectors. Chemicals and semiconductors are capital-intensive and highly cyclical industries. The exposure of individual companies to these economic cycles can vary dramatically. Similarly, industries such as biotechnology, with companies that depend on the discovery and successful development of new products, should be expected to demonstrate a broad range of returns.
The sectors with the lowest standard deviation of company returns include:
These tend to be consumer-oriented products or slower-growth sectors where companies may have less opportunity to generate differentiated returns.
The key lesson from the Scoreboard data is that the market's volatility in 2007 wasn't extraordinary. If this volatility proves unbearable, you can always reduce your exposure to stocks. But there are two questions you might ask first:
• Am I too exposed to "maverick" sectors, those that don't track the overall market? • Am I too exposed to a small number of stocks in "high deviation" sectors, where returns on individual stocks deviate widely from the sector average?
Reflecting on the answers can help manage investment stress in turbulent times.