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What ratios are relevant in the selection of equity sectors?

What ratios are relevant in the selection of equity sectors?
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Shares (equities) are classified, among other criteria, according to sectors, e.g. healthcare, consumer goods, energy etc. Shareholders pursue different approaches when it comes to the classification process. In this report we follow the methodology of MSCI, a US financial service provider that offers international equity indices and risk analyses.

Healthcare shares with gains, energy shares with losses

The individual sectors have gone through a rather diverse set of developments in the recent past, as the table underneath illustrates. Whereas the listed healthcare sector has recorded an increase of 21.1% p.a. in the past five years, the holders of energy shares have had to absorb a loss of 3.2% p.a. In both cases, dividend payouts have been accounted for in the performance. That being said, in the past twelve months the healthcare sector has ended up among the losers, whereas utilities and telecoms companies have come out on top.

Performance of global sector indices (annualised; including dividends)

5 years (p.a.)
in %		 1 year
in %
Healthcare 21,1 -4,1
Non-cyclical consumer goods 14,9 7,3
IT 13,4 -1,1
Consumer cyclicals 13,2 -0,9
Industrials 8,8 -1,1
Telecoms 7,5 5,7
Financials 5,1 -8,3
Utilities 4,8 5,9
Base materials -1,7 -7,8
Energy -3,2 -7,8
Sources: MSCI sector indices in local currency; Bloomberg (as of 3 May 2016)

Note: The performance does not account for fees. Past performance is not indicative of future development.

Relevant ratios in sector selection

What are the criteria that one should adhere to when choosing sectors? In stock selection, some commonly used terms are those of “value” and “growth” as well as “large caps” and “small caps”. Does this approach work for sectors as well, or are there other ratios with a higher success rate? In order to answer this question we analysed various ratios for the following sectors (MSCI classification):

Sectors (according to MSCI)

  • Consumer cyclicals
  • Non-cyclical consumer goods
  • Energy
  • Base materials
  • Financials
  • Utilities
  • IT
  • Telecoms
  • Industrials
  • Healthcare

We examined the following key ratios over a period of 20 years:

Ratio (acronym) Ratio Strategy
P/BV Price/ book value Purchase of the five most attractive (“cheapest”) sectors
PE Price/earnings ratio Purchase of the five most attractive sectors
DY Dividend yield Purchase of the five sectors with the highest dividend yield
ROE Return on equity Purchase of the five sectors with the highest profitability
EPS trend Deviation of most recent earnings from long-term trend Purchase of the five sectors with the most significant negative deviation from the long-term trend
EPS slope Regression of the earnings of the past ten years Purchase of the five sectors with the highest slope
MOM 6M 6M performance Purchase of the five sectors with the best performance over the past six months (momentum strategy)
ROE trend dev Trend profitability of equity over the past ten years Purchase of the five sectors with the biggest positive deviation
EPS growth 5Y earnings growth Purchase of the five sectors with the highest earnings growth

This is how we proceeded in order to derive the success of a particular investment strategy: for example, in case of P/BV, we examined how the five most attractive (“cheapest”) sectors have performed in comparison with all ten, also equally weighted MSCI sectors.

Performance of different strategies in comparison

Index = equity index with equal sector weightings
ROE = Return on equity (purchase of the five most profitable sectors)
DY = Dividend yield (purchase of the five sectors with the highest dividend yield)
MOM 6M = Momentum strategy (purchase of the five sectors with the best performance in the past six months)
Sources: Datastream; own calculations
Note: The performance does not account for fees. Past performance is not indicative of future development.

High profitability, momentum, and an above-average dividend yield ensure higher rate of return

Our analysis reveals that two specific ratios would generate an ongoing surplus return vis-à-vis the overall market: investors should focus on those sectors that are highly profitable and those that come with high momentum. A portfolio consisting of the five sectors with the highest dividend yield also outperformed an equity index with equal sector weightings. Please refer to the chart.

Attractive valuation does not guarantee success

Selecting sectors with low price/book value or price/earnings ratios is not overly promising; neither is the earnings growth rate of the past five years.

We are currently developing a strategy on the basis of our findings that we will introduce in our next blog entry.

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