Brief Summary
This video discusses the challenges of picking winning industries for investment returns. While it might seem tempting to bet on industries that are currently performing well, historical data shows that past winners often underperform in the future. This is due to factors like asset pricing, industry-specific risk, and investor behavior. The video suggests that instead of focusing on specific industries, investors should focus on diversifying their portfolios across industries and tilting towards higher expected return stocks within those industries.
- Picking winning industries is difficult because high growth industries often have high valuations, leading to lower returns.
- Industry-specific risk can negatively impact even the best investment thesis.
- Investors tend to chase past performance, leading to poor returns.
Why Picking Winning Industries Is So Hard
Ben Felix, Chief Investment Officer at PWL Capital, explains why picking winning industries for investment returns is a lot harder than it seems. He argues that while technology stocks have been performing well recently, this trend is unlikely to continue forever. He provides historical data showing that top-performing industries in one decade often underperform in the following decade. For example, electronics equipment stocks were the top performers in the most recent decade, but they were not the top performers in the previous decade.
The Challenges of Picking Winning Industries
The video highlights two main challenges with picking winning industries: asset pricing and industry-specific risk. Asset pricing refers to the fact that stocks in high-growth industries often have high prices, making it harder for investors to earn high returns. Industry-specific risk refers to the uncompensated risk specific to an industry, which can arise from factors like disruption or technological change.
Earnings Dilution and Industry Growth
The video explains the concept of earnings dilution, which occurs when the fastest-growing industries attract more competition, leading to slower per-share earnings growth. This is because existing companies in the industry may raise new capital to finance their growth, diluting the earnings per share. As a result, the highest growth industries often don't have the highest stock returns.
The S&P 500 and Index Inclusion
The video uses the S&P 500 as an example to illustrate the relationship between index inclusion and stock performance. It highlights that companies tend to be added to the S&P 500 when investor demand for stocks in that industry is high, often at high valuations. This can lead to underperformance after inclusion, as seen with Tesla's addition to the index in 2020.
The Importance of Diversification and Value Tilting
The video concludes by emphasizing the importance of diversification and value tilting. Instead of concentrating a portfolio in industries with low relative valuations, it suggests tilting towards cheaper stocks within industries while maintaining diversification across industries. This approach helps to mitigate industry-specific risk and potentially improve returns.
Investor Behavior and Industry Chasing
The video discusses the behavioral challenges investors face when trying to capture returns from narrow categories like sectors and industries. Investors often chase past performance, leading them to invest in industries with high valuations and low expected returns. This behavior can result in poor investment outcomes.
Conclusion: Focus on Value Tilting and Diversification
The video concludes by recommending that investors who want higher expected returns than simply owning a market index should focus on systematically tilting towards higher expected return stocks within industries while maintaining broad industry diversification. This approach is likely to be more successful than making uncompensated industry bets.
