How sector rotation works

Commodity stocks like cement, steel, fertilisers and sugar are especially open to sector-wide moves

Traders rotate through sectors during the results season. This is how it works: A market leader in a given sector declares results. There is, naturally, some focus on that stock and the price swings, depending on the consensus opinion of whether the results meet or beat expectations. That focus further translates into a focus on other players in the sector. 

Any business carries three elements of ‘risk’, for want of a better term. Every business must deal with variables that affect all businesses operating in the given region such as tax rates, infrastructure, per capita, etc. The goods and services tax (GST) for example, is a national ‘risk’ for all businesses. The second ‘risk’ involves variables specific to that sector. For example, every steel company must source iron ore and every cement business needs limestone, and changes in those raw material supplies are critical as is demand for the product. The third element is company-specific and depends on management decisions, ranging from hires and fires, to the modes by which finances are managed, distribution chains set up, etc.

All three elements are important. The first factor (country-wide risk) is automatically discounted. Changes here can lead to industry-wide upgrades or downgrades. For example, GST has led to an upgrade of most automobile companies because the indirect tax regime allows for offsets that are beneficial to all automobile makers. The third factor leads to comparisons between peer businesses —this is why investors decide that company A is a better bet than company B. 

The second factor is as important as the third. Warren Buffett once pointed out that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it’s the reputation of the business that remains intact! The opposite is also true — an average manager can generate high profits working in a business with a “reputation for good economics”. Some businesses will offer low returns by their nature; others are massively cyclical; there is little that even the most brilliant manager can do to change these situations.

Commodity stocks like cement, steel, paints, the petroleum sector, fertilisers and sugar are especially open to sector-wide moves. So are highly cyclical sectors such as information technology (IT), construction, real estate and automobiles. Even the so-called perennials like pharmaceuticals and fast-moving consumer goods (FMCG) are vulnerable to government action and regulation (the first, country-wide or global risk). Pharma, for example, has taken a hammering for the past 18 months due to the US government action. IT stocks are affected by America’s visa policies. FMCG was hurt by demonetisation; it may be rescued by the GST, perhaps. 

So, sectors tend to see coordinated movements. There will be market leaders that outperform and laggards that underperform due to the third factor of management, competence. But, the trends will tend to be in the same direction for all stocks. 

Current trends over the past month or so suggest there’s renewed optimism about the metals and energy stocks. The metals and energy trends are driven by global movements. Metals have seen a revival as global growth has picked up. This has made a major difference to Indian metals majors. 

Crude oil and gas prices remain low, which has helped Indian refiners record higher gross refining margins (GRMs). Reliance has done very well in the April-June quarter in terms of maintaining high GRM. It’s anticipated that Bharat Petroleum Corporation (BPCL) and Hindustan Petroleum Corporation (HPCL) will do well. Also, merger rumours have had a positive effect on HPCL. 

At the same time, the FMCG index is underperforming. But, this is mainly due to the hammering heavyweight ITC has suffered. Tata Global, Jubilant, Dabur and Hindustan Unilever have all beaten the Nifty. Going by ITC’s history, the stock price will recover soon.