Many investors are often drawn to popular sectors when seeking attractive stocks. They may, whether consciously or subconsciously, follow their peers towards industries that are performing well or that have impressive growth outlooks.
However, this could lead to them overpaying for stocks. The valuations of popular companies may have increased to levels that offer little or no margins of safety.
Therefore, in my view, searching for companies in sectors that are unpopular among investors could be a more logical approach. It may lead to the unearthing of relatively appealing risk/reward opportunities.
Unpopular sectors
Many of today's unpopular sectors may offer unfavorable growth opportunities in the short run. For example, changes to consumer behaviour could mean that brick-and-mortar retail stores have lower near-term earnings forecasts than their online-focused peers.
Similarly, the prospects for energy companies may currently seem far less enticing than businesses operating in cleaner energy industries. For instance, investors may be overlooking a potential rise in demand for oil and gas from developing economies because of a trend towards greener forms of energy in developed markets.
Meanwhile, banking stocks may currently be viewed less favorably by investors because of today's extremely low interest rates.
Investing opportunities
However, many companies operating in those industries and others have not suddenly become low-quality businesses within a matter of months. Clearly, their operating environments may be more challenging than they have been in recent years. However, they may be capable of adapting their strategies to capitalize on new growth opportunities.
Furthermore, in some cases, they could trade at prices that offer wide margins of safety. This may translate into higher returns for investors over the long run.
By contrast, popular industries such as the technology sector may have relatively high near-term growth prospects. However, their incumbents could be overvalued after recent gains. This may limit the return potential for investors, which could mean they represent an inefficient use of capital.
Application in today's stock market
Joel Greenblatt (Trades, Portfolio) has always sought to unearth undervalued shares in unpopular sectors. He delivered an annualized return of around 40% when running the Gotham Capital hedge fund between 1985 and 2006. As Greenblatt once said:
"If you spend your energies looking for and analysing situations not closely followed by other informed investors, your chance of finding bargains greatly increases."
In my view, Greenblatt's standpoint is of perennial relevance to value investors. Whatever the prevailing market conditions, some sectors are bound to be less popular than others. This could create buying opportunities for value investors who are prepared to go against the views of their peers.
Of course, it could take some time for today's under-followed and unloved companies to deliver on their potential. Investor views towards specific industries can be resistant to change. Likewise, companies with tough short-term outlooks may themselves take time to adapt to revised operating conditions in order to improve their financial performances.
However, investors who adopt a long-term view may have sufficient time to benefit from a favorable shift in market sentiment. Therefore, a patient approach that accepts a period of relative underperformance in the short run could pay off over the coming years.
Disclosure: The author does not own any stocks mentioned.
Read more here:
- Warren Buffett: Less Activity Can Produce Higher Returns
- Howard Marks: Contrarian Investing Produces the Best Results
- Li Lu: Honesty Is the Best Investing Policy
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