Chief Investment Strategist
Sectors like themes are a good way to filter the equity market and why ways to diversify a portfolio or get exposure to the right long-term trends. MSCI, the world’s leading index provider, has defined 11 sectors (see table below) that all captures different part of the economy and equity market. Four of them (energy, consumer staples, health care, and utilities) are defined as defensive, meaning that they are less sensitive to changes in the economic cycles (changes in economic growth). So which sectors offer the most attractive long-term returns with the data we have today?
As our table below shows, the four most attractive sectors are health care, IT, financials, and energy. Health care is by far the most attractive driven by the highest expected real earnings growth which is even eclipsing the IT sector. The latest growth momentum in obesity drugs by Eli Lilly and Novo Nordisk is definitely helping explaining the power in the health care sector.
It is also worth noting that utilities and real estate are the two worst sectors offering unattractive long-term returns. Their dividend yield might be close to 4% but these two sectors are also the only ones that are issuing capital (negative buyback yield) to shore up their balance sheets. This is not surprising given both sectors heavily use debt to fund their operations and with higher bond yields financial pressure is on the rise.
A final observation is that only five sectors have positive real earnings growth estimates highlighting the “grand rotation” in the economy from the old and capital intensive sectors to those driven by intangibles.
EPS (g) is the long-term expected real earnings growth, LT e(r) is the the long-term expected return, MOM is the 12-month price momentum in the sector, and P/E is the 12-month forward price-to-earnings ratio.
As our table with long-term returns shows, the energy sector’s high capital return yield is dragged down by low expected real growth rates for earnings. To see why take a look at the chart below. It measures revenue per share in USD over the past 10 years. Not exactly a growth venture. In fact, the annualised nominal growth has been -0.2%, but with inflation running at 2.7% annualised over the same period, the real revenue growth has been -2.9% annualised. This reflects a combination of stronger USD, weaker energy prices, and weak volume growth.
Long-term investors should understand that while the energy sector is attractive seen from a high dividend yield and lots of buyback of own shares, the expected real growth rate is expected to be negative. Electrification in the decades to come will likely not make things better. Quite the contrary. So why have energy in the portfolio at all? Because it is a defensive sector, and the sector that provides the most protection should inflation come back to bite.
Many retail investors are brought up to think that P/E ratios are the answer to everything. Whether something is expensive or not. It is not that simple. The way you build up your long-term expectations are by starting with the dividend yield. Next you add the buyback yield (which is the amount of shares the company buys back over the past year). Buybacks are another way (often tax efficient) to return capital to shareholders. The sum of the two is called the capital return yield. This is the long-term expected real return to shareholders under the assumption that a company or sector can grow earnings with inflation (so zero percent real growth). If a company or sector can grow faster than inflation the expected real earnings growth rate is added and you then have the long-term estimated return. We use historical real revenue growth as the future indicator for real earnings growth as this is more stable, but the underlying assumption is that the profit margin will not change much in the future.
The sum of these three factors (dividend yield, buyback yield, and real long-term earnings growth adds up the expected long-term return. As can be seen by the first table, health care has a better expected return compared to financials despite being valued at a significant P/E premium showing exactly the point that P/E ratio is not a good indicator for long-term returns.
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