Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) vice chairman Charlie Munger (Trades, Portfolio)’s views on sector rotation could be extremely insightful for investors.
Rotating between different sectors is a popular strategy that essentially aims to sell holdings in industries with relatively unattractive prospects, and buy stocks in sectors with more upbeat outlooks. For example, many investors sold out of large-cap technology companies earlier this year and bought stocks in industries that could stand to benefit the most from a post-pandemic reopening of the economy.
However, gauging which sectors will perform well in the future is a very difficult task. There are a wide range of risks and potential catalysts that can affect their return prospects. This can mean that, ultimately, investors who seek to rotate between different sectors eventually choose the wrong industry at the wrong time. This can lead to an inefficient allocation of capital in the long run.
Munger's strategy
Munger has previously discussed his views on the sector rotation strategy. As he once said:
“A standard technique that appeals to a lot of people is called ‘sector rotation.’ You simply figure out when oils are going to outperform retailers, etc. You just kind of flit around being in the hot sector of the market making better choices than other people. And presumably, over a long period of time, you get ahead. However, I know of no really rich sector rotator. Maybe some people can do it. I'm not saying they can't. All I know is that all the people I know who got rich—and I know a lot of them—did not do it that way.”
In my view, Munger’s statement that he knows of no one who made large sums of capital from using a sector rotation strategy is telling. It may sound like a very logical and appealing strategy in theory. However, putting it into practice on a consistent basis over the long run could produce the same challenges as economic forecasting and estimating company earnings. There are simply too many known unknowns to make accurate judgments about an entire industry’s future.
Moreover, focusing on the appeal of a specific sector may cause an investor to miss out on buying opportunities elsewhere. For example, they may only be willing to invest in certain industries that they feel optimistic about. This may cause them to ignore or avoid high-quality companies that trade at low prices, and which offer superior risk/return opportunities, in other industries. Likewise, they may end up overpaying for a stock, or purchasing low-quality companies, based on their positive views for a specific sector.
Focusing on companies
In my opinion, it is more logical for investors to follow Munger's lead and focus on building their knowledge of a limited number of industries, rather than trying to assess all of the stock market’s sectors. This may make it easier to identify the best value investing opportunities in a variety of stock market conditions.
Of course, there will be periods of time when those sectors deliver disappointing returns. For example, they may be unpopular among investors, or they could be experiencing challenging trading conditions. However, pre-empting such periods, and successfully avoiding them via sector rotation, could prove to be an impossible task for even the most experienced investors.
Therefore, a simpler strategy that relies on detailed industry knowledge and company fundamentals, rather than trying to predict the future, may lead to a more efficient allocation of capital.
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