Backtesting Identifies Strongest Sectors

GuruFocus feature highlight and deep analysis

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Dec 23, 2016
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As the U.S. stock market remains significantly overvalued, investors should stay defensive for early 2017.

Three market sectors –Â consumer cyclical, consumer defensive and health care – outperformed the exchange-traded funds for both the Standard & Poor’s 500 index and the Dow Jones industrial average during the backtesting period for 2006-2016. This suggests that these three sectors have the highest defensive potential.

Brief description of the All-in-One Guru Screener and the Backtesting feature

With our All-in-One Guru Screener, you can screen for company stocks that fit your investing style. The screener contains over 150 predefined filters conveniently located under several tabs, as illustrated in Figure 1.

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Figure 1

Note the red 3 next to the Fundamental tab. These red numbers indicate the number of active filters under each of the tabs, which are briefly discussed below.

  • Fundamental: This tab contains five columns of filters, ranging from revenue and market cap to the date of initial public offering and number of warning signs. The most common financial metrics can be found underneath this tab.
  • Valuation Ratio: This tab lists filters about company valuation including key valuation metrics like the price-earnings (P/E) ratio and other advanced valuation metrics like the price to earnings power value.
  • Profitability: This tab lists filters about profit margins, including operating margin and gross margin.
  • Growth: This tab lists the compound annual growth rate (CAGR) of revenue, earnings, book value, debt to revenue and asset value for one year, five years and 10 years.
  • Valuation Rank: This tab lists filters for (P/E, P/S or P/B) (greater or less than) Nth percentile of industry, i.e., these filters list the companies that have high or low valuation ratios relative to competitors.
  • Price: This tab lists filters about the company’s stock price, number of shares and the relative prices historically.
  • Gurus: This tab allows you to choose which gurus made trades in the company stocks.
  • Insiders: This tab allows you to screen for insider cluster buys, CEO buys and chief financial officer buys.
  • Customized! This tab allows you to create your own filter based on a formula. When you click on the blue “create new filter” button, you will see a popup window similar to the one shown in Figure 2. Enter the desired formula in the box given, then click on “save” to save the filter.

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Figure 2

As you activate filters, the screener lists all of the company stocks that meet your selected criteria underneath the gray “filter box.” The default tab, “Active Filters,” lists the results in columns. Click the gray up/down arrows to sort the screener results based on a select filter.

After you finish generating a screener, you can backtest a “test portfolio” with the selected filters with Backtesting. This tab is conveniently located next to the “Active Filters” tab among the tabs in the results section. For more information about the Backtesting feature, please refer to our new feature announcement on Backtesting.

The best sectors to invest in based on backtesting results

To determine which sectors offer the best defensive-investing potential, we can backtest a portfolio of the top 20 companies within a sector based on market cap and compare the portfolio returns to the S&P 500 and DJIA ETFs. Figure 3 compares the overall return of each of five sectors to the overall return of the two ETFs during the backtesting period from January 2006 to January 2016.

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Figure 3

Based on Figure 3, we can observe that the consumer cyclical, consumer defensive and health care sectors outperformed the benchmarks during the 10-year period while energy/industrials and technology significantly underperform the benchmarks. This suggests that the former three sectors have higher defensive-investing potential than do energy and technology companies.

Consumer cyclical/consumer discretionary

Despite the cyclical nature of the consumer discretionary sector, the sector still outperformed the market benchmark during 2006-2010. As illustrated in Figure 4, the consumer discretionary sector significantly outperformed the benchmarks in 2009, 2010, 2012 and 2013 when the economy was booming. Even though the sector underperformed the benchmark during recessions, the loss was not substantially worse than the loss for the market. Additionally, the consumer cyclical sector outperformed the benchmark during the oil recession of 2015.

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Figure 4

Companies like Toyota Motor Corp. (TM, Financial)(TSE:7203, Financial), Nike Inc. (NKE, Financial), The Home Depot Inc. (HD, Financial) and Walt-Disney Co. (DIS, Financial) generally had strong financial strength and business predictability before the 2008 financial crisis. As of December, Nike has the strongest defensive potential with a predictability rank of 4 stars.

Consumer defensive/consumer staples

Unlike consumer discretionary companies, which offer nonessential but luxury goods, consumer staples companies offer goods and services essential for daily life including packaged foods and beverages. This sector features companies like The Walmart Stores Inc. (WMT, Financial), Proctor & Gamble Co. (PG, Financial) and The Coca-Cola Co. (KO, Financial).

As discussed in a previous article, the consumer defensive sector offers good defensive potential as companies that have poor financial strength still outperform the market benchmark. The backtesting results based on all companies further show the high defensive potential in consumer staples companies. As illustrated in Figure 5, a portfolio of the largest 20 consumer staples companies based on market cap only realized an annualized loss of 18.23%, outperforming the Dow market return by about 15% and the S&P 500 return by about 20%. The sector had a 7.13% annualized gain during 2015, the other year when both market returns were in the red during the 10-year period.

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Figure 5

Health Care

Like the consumer defensive sector, the health care sector is also among sectors in the “Defensive” super sector. This suggests that health care companies have good defensive potential as discussed in a previous article. The health care sector features companies like Johnson & Johnson (JNJ, Financial) and Pfizer Inc. (PFE), the former having a 3.5-star predictability rank as of December.

Health care companies slightly underperformed consumer defensive companies likely due to an annualized loss of 7.19% for 2016. The backtesting results for the top 20 health care companies by market cap are summarized in Figure 6.

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Figure 6

See also

Among the three sectors discussed, the consumer staples sector has the lowest Shiller P/E ratio among the market sectors. Only the energy and industrials sectors have lower Shiller P/Es. This suggests that these sectors are undervalued relative to the market, and offer the highest value potential to investors.

The Buffett-Munger model portfolio generally outperformed the S&P 500 during the past seven years. This suggests that the co-managers of Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial), Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio), developed a robust four-criterion investing approach. As a premium member, you can access all value screeners, including the Buffett-Munger Screener that lists the best companies for defensive investing. You also have access to over 150 gurus’ portfolios, including the aggregated portfolio of gurus.

Premium Plus members get further access, including up to 10 years of backtesting and the Manual of Stocks for all companies. (Premium members are limited to just three years of backtesting and the Manual of Stocks for S&P 500 companies only.) If you are not a member, we invite you start to a free seven-day trial.

Disclosure: The author has no position in the stocks mentioned in this article.

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