Sunglasses, Vets, and the Sectoral Allocation Myth

Clients often ask why our funds have a high exposure to the healthcare sector and whether this poses risks.

This is actually a valid question. It is widely believed that a diversified portfolio balanced across sectors will reduce the impact on a fund’s performance of a downturn or shock in a given sector.

This is the view of “top-down” allocators, who argue that managing sector exposures provides sufficient diversification to reduce the risk they associate with volatility.

Diversification is not that simple. What matters when constructing portfolios is our belief that earnings drive stock prices, and that belief is why we instead take a “bottom-up” approach to allocation to make sure that earnings come from as diverse a set of sources as possible.

For example, we examine the extent to which a portfolio will be exposed to Chinese luxury consumers or to value-based healthcare reform in the US.

Intuitively, this sounds like the logic of the top-down sector approach favored by many managers. However, this similarity is only true if the categories used to assess diversification appropriately group companies with similar earnings drivers and therefore similar sources of risk. In our opinion this is not the case.

Categorization: Complex problem

The Global Industry Classification Standard (“GICS”) is the most widely used industry framework for sector portfolio management. The framework groups companies into a tiered classification system according to their main business activities, with revenue being the key determinant.

The disadvantage is that many companies do not fit neatly into one industry or sector. By focusing on the ‘core business’, the overall exposure of the company, the nuances of its business model and the long-term secular growth drivers that may be spread across industries and sectors are lost.

This means that categories alone may say little about what a company does or how it makes money, and thorough research is still non-negotiable.

For large, diversified conglomerates with revenues spread across multiple industries and markets, the challenge of categorizing by core business activity is obvious. But more importantly, even the narrowest subcategories often fail to distinguish between very specialized, very different businesses.

Sunglasses, pets and subsectors

To illustrate these points, let’s look at the healthcare sector as defined by the GICS system. As mentioned, this is the largest sector allocation in our funds. But while these companies may be classified as “Healthcare,” they all have different growth and risk factors, which means the earnings of these companies are much more diverse than the blunt labeling suggests.

According to the GICS model, the healthcare sector can be divided into two industry groups, which include six industries, as shown in the chart below.

Source: Seilern Investment Management

However, even within one of these six industries, companies may have significantly different growth drivers and business models. To illustrate this, let’s consider two companies in our investing universe: IDEXX Laboratories and EssilorLuxottica.

Both are classified in the healthcare sector, in the same industry group “Healthcare Equipment & Services” and in the same industry “Healthcare Equipment & Supplies”.

IDEXX is a global leader in testing and diagnostic services for companion animals and provides the veterinary industry with tools to help effectively treat animals, diagnose disease and improve the standard of care.

Factors influencing the company’s long-term growth are related to the increasing number of pet owners and their “humanization”, as a result of which “pet parents” increasingly treat their pets like children and therefore devote a greater share of their disposable income to their health.

EssilorLuxottica is a world leader in the eyewear industry. It designs, manufactures, distributes and retails prescription lenses, spectacle frames and sunglasses.

One of the main long-term drivers of growth is the increasing prevalence of myopia caused by prolonged use of screens such as phones and tablets, as well as rising affluence and the large number of people with untreated vision problems, which also affect economic growth.

Same sector, different fundamentals

A purely top-down, sector interpretation would suggest that holding both of these stocks in a portfolio would provide no diversification benefits and, in theory, they should perform similarly.

However, if we compare the share price performance, it turns out that their five-year correlation coefficients are only 63%, which indicates their very different growth factors. This is a seemingly low result for two companies that, even at one of the most granular levels of GICS categorization, purport to be in the same industry.

This illustrates the limitations of using a top-down approach to risk management. The different growth factors mean that the risks for these companies are also very different. For IDEXX, the risk to its profits would be a weakening demand for animal health care, while for EssilorLuxottica, the risk to its profits would be a decline in myopia rates.

So if one share were to be affected and the share price suffered, it is very unlikely that the other company would also see its share price affected.

Bottom-up approach

Given this, a top-down sector allocation framework is not a true reflection of the concentration of risk in a portfolio. Instead, investors should look at “aggregate risk,” or how closely correlated companies’ earnings are. This approach can only be implemented by examining each business model in detail from a bottom-up perspective of the key drivers of earnings, rather than from a top-down perspective of the industries and sectors in which a company nominally operates.

Akash Bhanot, research analyst at Seilern Investment Management. The views expressed above should not be considered investment advice.