Ruth Saldanha: Many investors focus on diversifying their holdings by style, such as value or growth, or by market capitalization, including both large cap stocks and smaller cap stocks. But investors should also keep in mind the importance of economic sectors as they are building their portfolios. Dan Lefkovitz is a Strategist with Morningstar Indexes, and he is here today to share some insights on sector considerations.
Dan, thank you so much for being here today.
Dan Lefkovitz: Great to be with you, Ruth.
Saldanha: So, your research has found that globally, sector allocations have had a significant return on portfolios. Can you tell us a little bit more about what you found from a global perspective?
Lefkovitz: Yeah, economic sector can really be a massive driver of portfolio returns. We often see huge disparities in the performance of different sectors of the equity market, 2023 being really a case in point. So, if we look at our 11 global equity sector indexes, the best performer in 2023 by far was technology. It was up 53%. The worst performer was utilities, which gained just 1%. So, if you had too little technology exposure in your portfolio, you underperformed. If you were heavy on utilities, you likely underperformed as well.
Saldanha: So, let's talk a little bit more about technology. In 2023, tech was one of the best-performing sectors and actually not just in 2023, but almost for a decade before that as well. Tell us a little bit more about technology and where it's placed today.
Lefkovitz: Yeah, you're absolutely right. Technology has been by far the dominant economic sector of the global equity market for years now, going back 10, even 15 years. And if you think about some of the dominant trends, not just in investing, but just in society and in business, things like e-commerce and mobile computing, the cloud, now we have artificial intelligence, cybersecurity is another one, these have really been the dominant themes and investment markets. And some of the big beneficiaries of these themes are some of the largest companies now in the world. So, in the U.S., of course, we have Microsoft (MSFT) and Apple (AAPL) and NVIDIA (NVDA) that are now worth over a trillion dollars in market value. Taiwan Semiconductor (TSM) has become the largest public company outside of the U.S. In Europe, we have ASML (ASML), which is also involved in semiconductor manufacturing, one of the largest public companies in Canada. You have Shopify (SHOP). So, all of these companies have benefited from tech trends.
In terms of implications, if you've been underexposed to technologies I've mentioned, that's been a big disadvantage to your portfolio. Canadian investors, the Canadian equity market being light on technology – our Morningstar Canada Index has only 9% in technology stocks. So, if you are a Canadian investor with significant home country bias, if you're heavy to Canadian equities, you've likely missed out on some of the phenomenal gains from the global technology sector. Now our Morningstar Canada Index has 18% in energy stocks. So, double the level of technology. Energy was one of the worst performers in 2023. It had a good 2022 after the Russia invasion of Ukraine sent oil prices through the roof. But looking back over the past 10, 15 years, energy has been an underperformer in the global equity market. And I think that these sort of sector dynamics help explain why the Canadian equity market has underperformed the U.S. market and global equities over the past 10, 15 years.
Saldanha: Let's talk about the U.S. market a little bit more. Your research has found that the U.S. market has sector risk. Can you tell us a little bit more about that?
Lefkovitz: Yeah. Well, as an American looking at the Canadian equity market, I've always sort of thought it was a fairly lopsided market with a lot of exposure to a few economic sectors. Energy, as I mentioned, 18%. We have financial services, the big banks, 33%. Basic materials, another big weight. But now when I look at the U.S. equity market, I also think it has significant exposure to just a few sectors, technology foremost among them. So, if you look at our Morningstar U.S. Market Index, which is a broad gauge of the U.S. equity market, it's about 30% technology stocks now, which is really incredible. It surpassed the level it hit in 2021, which is a big year for technology. It's now the highest it's been since 2000, before the bursting of the dotcom bubble.
And it's important to remember that when we talk about the technology sector, that's not even including some companies like Meta Platforms, former Facebook; Alphabet, the parent company to Google, those are actually classified in the communication services sector now that you've got Amazon.com and Tesla, which are in the consumer cyclicals sector. So, there is a lot of exposure in the U.S. market to technology stocks and then sort of techie, kind of tech adjacent stocks. Yeah, I think sector is a big risk factor that investors should be paying attention to. If you're heavy on U.S. equities, you've got a lot of exposure to technology. If you have a growth bias to your portfolio, you've probably got even more exposure to technology, less so if you're heavy on dividend paying stocks or small caps or equities outside of the U.S.
Saldanha: That makes sense. If an investor wants to play a different sector story or if they want to get out of technology or into something else, what are some of the options in order to play various sectors right now?
Lefkovitz: Yeah, there are different ways that investors allocate between sectors. There's something called the sector rotation strategy. It's been around for a long time. The idea is to align your sector allocation with the business cycle. So, when the economy is doing very well, you want to be in sectors with a lot of economic sensitivity, maybe financial services or consumer discretionary companies. If the economy is in a trough, in a downturn, you'd want to be in defensive areas like maybe healthcare, utilities, consumer staples. I think it's hard to get that sort of thing right. We saw in 2023 a lot of economists were predicting hard landing or soft landing for the U.S. economy. It didn't land at all. So, it's a little hard to know where the business cycle is.
Valuation is another way to allocate across sectors. It's a longer-term oriented strategy. It doesn't always pay off immediately. But at Morningstar, we have our equity research team that are assigning fair value estimates to 1,500 companies across the world, across economic sector. So, you can take those fair value estimates, compare them to share prices, and aggregate them to the sector level to get a view of where valuations are on a sector basis, so which sectors of the equity market are overvalued or undervalued.
Saldanha: So finally, as we stand today, from your perspective, what are some of the biggest risks and the biggest opportunities for investors from a sector perspective?
Lefkovitz: Yeah. Well, I'm going to rely on the valuation estimates of Morningstar's equity research team. And you won't be surprised to hear me say that technology is a sector that we think looks a little bit rich, looks a little bit overvalued. Not that there aren't still, at the company level, certain stocks that are attractively valued, but in the aggregate, we think the technology sector now is looking rich, looking overvalued after its huge run up in 2023 and of course, the outperformance that we saw for over a decade prior. Other sectors of the market are looking a lot more attractive. Healthcare is one – and I'm talking globally here – healthcare is a sector that is not very heavily represented in the Canadian equity market. So Canadian investors might want to have global healthcare exposure here to take advantage of attractive valuations and a lot of great companies. A better story for Canadian equity investors is that the energy sector is looking attractively valued to us. Now, again, that's not necessarily a view for 2024, but over the long term, we think that there are a number of sectors that look attractively valued that have upside potential.
Saldanha: Thank you so much for joining us today, Dan.
Lefkovitz: Thanks for having me, Ruth.
Saldanha: For Morningstar, I'm Ruth Saldanha.
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