In investing, betting on the success of a single industry is typically not a good idea, but a lot of investors make industry bets in their portfolios based on what they think is going to do well.

That is probably a mistake. I'm Ben Felix, Chief Investment Officer at PWL Capital, and I'm going to tell you why picking winning industries is a lot harder than you might think.

And yes, this might make you question that tech ETF that you're probably holding.

In 1900, most listed companies were rail companies, followed by banks. Today, technology stocks dominate, particularly in the US stock market.

The evolving composition of industries over time should be expected as the process of creative destruction moves the economy forward.

But what does it mean for investment returns? The counterintuitive reality is that winning industries don't always deliver winning stock returns.

As an investor, picking which industries will beat the market is really hard. It seems easy right now because technology has been winning for a while, but this won't necessarily be true forever.

And if history is any indication, it even seems unlikely. For example, I looked at the top performing industries by decade, starting in 1934 through to August 2024.

In the most recent decade, to no one's surprise, electronics equipment stocks returned more than 25% annualized.

That is a big number, but it's not the first industry to have such incredible returns. Office supply stocks dominated in the decade ending August 1944, aircraft stocks in 1954, computer hardware stocks in 1964, gold stocks in 1974, healthcare stocks in 1984, alcohol stocks in 1994, coal stocks in 2004, and shipbuilding and rail equipment stocks in 2014.

These Top performing industries had decade-long annualized returns of 25% on average, just like electronics equipment stocks in the most recent decade.

I can't predict the future, but one thing that all of these decade-long top performing industries have in common is that they were not the top performing industries in the following decade.

In fact, in all of my decade examples, except for alcohol and computer hardware, the prior decade's top performing industry trails the market in the subsequent decade.

Overall, they trail the market by on average 2.6% annualized over the next 10 years. The other challenge is that most industries underperform the market in the long run.

For the period July 1969 through August 2024, only 17 of 49 US industries in Ken French's database beat the market, while the remaining 32 industries trail the market by more than 2% annualized on average.

If it were only as easy as picking those winners ahead of time. For the most recent decade, it's been basically impossible to outperform technology stocks, which based on my anecdotal observations, has resulted in many people either overweighting or focusing solely on technology stocks in their portfolios.

The investor behavior of buying high and selling low is well documented, and it seems to be particularly strong when it comes to betting on industries and sectors.

Investor returns trail fund returns when investors get in and out of the fund in a way that causes them to miss out on the fund's performance, usually attributed to performance chasing behavior.

In Morningstar's 2024 Mind the Gap report, which analyzes investor return gaps for various types of funds, sector equity funds, which are a broader categorization than industries but conceptually similar, have by far the largest gap at negative -2.6% per year.

over 10 years. Similarly, a 2007 paper in the American Economic Review estimates investor return gaps for the NYSE and 19 major international stock markets at 1.3 to 1.5% per year, while the investor return gap for the NASDAQ, which tends to be more tech heavy, is estimated at a whopping 5.3%, suggesting that investors had poured in huge amounts of capital at exactly the worst possible time in NASDAQ's history.

There are two main problems with picking winning industries before the fact. One is asset pricing. If they are properly priced, stocks in a high growth industry will have high prices, making it harder for investors to earn high returns.

The other is industry specific risk, the uncompensated risk specific to an industry, which can show up if, for example, an industry is disrupted.

Taken together from the perspective of investment returns, it is not obvious which industries are going to win in the future.

Stocks are claims in the future earnings of a company. The price you pay for those future earnings is one of the most important determinant of your expected investment returns.

When expectations are high, realized earnings have to be even better than those high expectations for stock returns to be abnormally rewarded.

It's often obvious that an industry is becoming increasingly important economically, but due to asset pricing, the relationship between economic outcomes and stock returns is, in many cases, the opposite of what you might expect.

An important related concept is that stock returns are sensitive to per share earnings growth, not industry-wide earnings growth. An industry can grow, say, 10 times larger in terms of total industry-wide earnings, while per share earnings growth, which is what matters to investors, grows at a much slower pace.

The fastest-growing industries attract more competition, and the existing companies in that industry may be more aggressive in raising new capital to finance their growth.

The result is that the growing industry-wide earnings do not show up one for one in growth and earnings per share. They are diluted.

This may lead to earnings per share growth that trails the market's high expectations. The way this tends to play out is simple: the highest growth industries typically don't have the highest stock return.

Take the industry returns of the 49 US industries in Ken French's database for the period July 1969 through August 2024.

The best performers were not the rapidly growing industries like software, computers, and electronics; they were tobacco, entertainment, and defense, like missiles and tanks.

Alcohol was close behind. Another interesting illustration of this phenomenon is the original S&P 500 stocks.

The S&P 500 is designed to represent leading companies in leading industries of the US economy. To maintain its representativeness, the index is reconstituted annually, meaning some companies are removed, while others, often in new and exciting industries, are added to the index.

A 2006 paper in the Financial Analyst Journal compares the returns of the original stocks in the S&P 500 to the actual performance of the index for the period March 1957 through December 2003.

The portfolio of original stocks and its descendants outperforms the index. The authors offer the explanation that companies tend to become candidates for the S&P 500 Index when investor demand for stocks in that particular industry is high.

They also show that the relationship between sector growth, measured by its aggregate market value, has a weak relationship with investment returns in their sample.

Some sectors that outperform the S&P 500 like energy shrunk dramatically in terms of aggregate market value, while sectors that expanded greatly, like financials and technology, produce mediocre or below average returns.

An interesting recent example of index inclusion at a high price, followed by poor performance, is Tesla's addition to the S&P 500.

It was added in December 2020 after a run of incredible performance and a rapidly rising relative valuation. Since its addition to the index, it has underperformed the index itself by 5.8% annualized.

This represents a consistent trend, as examined in a 2023 paper in the Financial Analyst Journal.

Stocks added to the S&P 500 Index tend to have high valuations, while those removed tend to have low valuations. The result overall, additions tend to underperform deletions in the 12 months following the transactions.

This again goes to show that in general, stocks in less exciting industries tend to perform well because they trade at lower relative valuations, while stocks in newer and more exciting industries tend to have high relative prices and low expected returns.

If you're looking for boring industries to invest in after hearing that, I wouldn't. Concentrating a portfolio in industries with low relative valuations is still unwise due to industry-specific risk.

Rather than picking cheap industries in an effort to increase expected returns, it likely makes more sense to tilt toward cheaper stocks within industries while maintaining diversification across industries.

This is supported by a 2023 study which finds that taking positions in industries and countries based on their aggregate characteristics, rather than tilting toward higher expected return stocks within industries in countries, leads to portfolio concentration that is unjustified by an increase in expected returns.

Picking winning industries as an investor is beyond difficult, expected economic growth is already reflected in stock prices.

High expected growth industries often have disappointing returns, and industry-specific risk can derail even the best investment thesis. The best performing industries of the past do not typically go on to be the best performing industries in the future.

They tend to underperform the market. Finally, investors seem to have behavioral challenges in capturing the returns of stocks in narrow categories like sectors and industries, likely because the industries get their attention after recently positive returns when valuations are high and expected returns are low.

For investors who want higher expected returns than simply owning a market index, systematically tilting toward higher expected return stocks within industries while maintaining broad industry diversification likely makes more sense than making uncompensated industry bets.

Thanks for watching. I'm Ben Felix, Chief Investment Officer at PWL Capital. If you want to learn more about how PWL helps Canadians avoid the temptation of chasing past industry returns, you can book a meeting with us below.

Why Betting On “Winning” Industries Almost Never Works

I post videos on investing, financial decision-making, and living a good life.

My name is Ben Felix. I am a Portfolio Manager and the Head of Research at PWL Capital. I am a CFA charterholder and CFP professional. I am securities licensed in Canada by CIRO.

All channel content is produced and owned by PWL Capital Inc.


Why Betting On “Winning” Industries Almost Never Works

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