“Sector rotation as a strategy is core to us. I have been a big follower of sector rotation whether it is at IFL or Quest and I believe that this is something which has gone through the different cycles of the market whether it is 8 or 10 years and practically it has seen the various ups and downs”, says Aniruddha Sarkar, CIO and Portfolio Manager, Quest Investment Advisors

Sector rotation is a key strategy that is followed in stock selection. The main thing that drives the sector rotation is a business cycle. Business cycles are inevitable. The business cycle happens because of the forces of supply and demand, the movement of the GDP, capital availability, consumer confidence, and expectations about the future.

The business cycle comprises four phases

Trough: Consumer sentiments are low, less visibility of consumers’ income increasing or jobs being created, which leads to a weak demand which in turn leads to industrial production and output being at the bottom of the cycle. The central banks at this point come out with fiscal and monetary support, which acts as stimulus for the economy to recover or what we call the next stage of the business cycle – the expansion phase

Expansion: The whole economic cycle is in a stage of recovery. Consumer confidence picks up as there is now better visibility of consumer income picking up, jobs being created, demand for goods/services increases which leads to industrial activity picking up and central banks would have reduced the interest rates to support economic growth.

Peak: This phase is where the stock market is in a bullish phase. The growth of companies in the industries, which have been very strong in the expansionary phase, is peaking out. It is very risky to hold over leaded stocks at the peak of the cycle. However, interest rates increase due to inflationary pressure (because of the expansion phase).

Contraction: Consumer sentiments declining due to job losses, salary cuts leading to industrial activity also declining. This phase is the seed for the next phase which is ‘trough’.

Therefore, the business cycle plays a key role in sector rotation. So, why is the market so different from the economy? While markets are moving in a different direction but why is the economy on the ground show a different picture? According to Aniruddha Sarkar, “the stock market takes into account the future earnings of companies, which means the stock market looks ahead, at least 4-6 months before the economic picture starts improving. Or in other ways, the economy lags the equity market by almost 4-6 months if not more. Hence if you have to understand where the market stands as of today, it means understanding where the economic picture will be a few months from now”.

Hence, when the economy is to be in a full recession phase, the markets would have just started picking up. Typically, sectors that do well are the financial sector and the consumer discretionary sector. These sectors will outperform other sectors in the next one year and are considered good investments.

In the expansionary phase, you will find the IT, basic materials, and metal sectors doing well. At the peak phase sectors that do well are basic materials, energy, and staples. When the bear market sets in, but the economy is still doing well, you may have to be proactive and invest in sectors such as healthcare, FMCG, etc. They must be brought at the peak of the cycle since the market is at least 6 months before the economy starts unfolding

Hence, the idea is to invest in the right sector depending upon what macro factors are likely to impact sector earnings in the future.

“However, it is important to understand that no sector is likely to be in the bottom three or top three consistently for five years. This indicates that it is important to move in and move out of sectors while investing depending on where the earning cycle is”, says Aniruddha Sarkar.

All sectors go through earning cycle so do economies. Stock markets are a leading indicator of the business cycle in the economy. Valuation of the company indicates whether we are at the peak of the cycle or the bottom of the cycle for that particular sector.

Valuations of companies at bottom of the cycle are cheap and attractive, and as they go up in the cyclical upturn, valuations tend to become fair and expensive. The idea is to pick them up at the bottom of the cycle and move to another sector when the cycle is likely to peak out.

Looking at the pattern over the years, the cycle has changed, the duration of the cycle in fact has become shorter. “If you look at the pattern of the cycle, the duration of the cycle has changed because of excess liquidity in the global market, which means that something which is cheap and attractive gets over brought and expensive within a short span of time” states Aniruddha Sarkar.

That does not imply you keep moving in and out of the sector. The idea is to be in a particular sector for at least a couple of quarters and keep an eye on the valuation of those sectors and companies

Hence, investors must be aware as to when being in a particular sector and when to move out of the sector. This is how the sector rotation works.

Another factor that helps in identifying where the company’s value lies or if investors would want to be in that sector or not is to see that if the particular segment of the market is likely to see a multiple expansion as things are improving.

If we look at different sectors, we would see certain sectors that are early on their cyclical up moves because their earnings were not growing, their ROI and margins were low. Such company stocks are known as value stocks.

However, if you are following the whole sector pattern and sector rotation and if you are able to identify those sectors and companies in that sector, whose earnings and margins are likely to improve because demand is picking up, the company is launching a new product or expanding geographical boundaries, you will find that the whole P/E multiple expansion happens. This transition is where the value stocks migrate to growth stocks over a period of time.

One thing that investors must note is that while value stocks migrate and reach the growth stage, they should keep an eye on when the earnings start declining and there is a possibility of a P/E contraction. Hence, if investors do not come out of these sectors, they would be having a very expensive portfolio.

While we have understood sector rotation, next we need to understand company rotation. This means being in and out of a company.

So, the next question is how to identify which sector will do well and which will not do well in the next couple of quarters and which sectors will see earnings upcycle.

Aniruddha Sarkar believes that 4-5 sectors will be doing well, where very strong earnings upcycle can be seen. He is very bullish on these sectors for the last one year. These sectors, according to him, are somewhere slightly before the middle of the peak upcycle and are likely to see strong earnings and have scope for robust growth. He picks real estate, home improvements, IT & IT services, Auto and auto ancillaries, and Pharma and Chemicals sectors where peak earnings can be witnessed

The point is that all the companies’ stocks within a particular sector do not move in tandem in the same direction. For example, there may be some companies that are “hot favourites” on the market because of positive news from those companies. Because of such companies, the market tends to ignore some other companies within the same sector. Hence, we need to find those stocks where there is a huge mispriced opportunity and try to be out of companies that are “hot favourites”.

This is important because due to too much focus on these “hot favourites” there is so much noise, development in various sectors and companies go unnoticed. Hence we need to enter companies when valuations are comfortable and risk-reward is in favour and is not the most talked company.

One needs to exit when herd mentality kicks into any stock and it becomes over-owned by investors and the risk-reward is unfavourable. Hence, follow company rotation within selected themes depending on the risk-reward framework. Reduce or exit from companies when valuation reach the peak cycle multiples

Hence, keeping an eye on the valuation helps to do company and sector rotation and be active with our portfolio management. Policy changes and macro developments also throw new themes which benefit. Be active in managing cash levels in portfolio taking advantage of sharp swings in the market.

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