Should you buy and hold cyclical, sensitive or defensive industries?

In my last post I looked at industry momentum portfolios and their composition. Even though many cyclical industries were frequently bought, the industry momentum portfolio outperformed the equal-weight benchmark of all industries.

Today I want to look at a subcategorization of industries into three groups:

• Cyclical

• Sensitive

• Defensive

To group the industries, I took a simple approach. I just sorted them by their average monthly return standard deviation and divided the list into three terciles. Only change I made was swapping the “beer” and the “chem” industries to be more consistent with what an average investor would think about these two industries. The industry defintions can be found here.

So how did you perform if you bought and held these groups of industries since 1927? Here are the results:

From the chart, we see that defensive industries indeed performed better than cyclical or sensitive industries over the last 96 years. However, if we have a closer look, this outperformance seems to be mainly a story of the 1990s and the 2010s. Considering today’s high valuation of largecap brand stocks like Coca Cola vs. big Cyclicals and Sensitives, this gap might start to close again in the coming decade. Or is the the Valuation spread just one big transitory late-cycle head fake? Who knows...

How big is the performance gap anyway? Let’s have a look:

By the nature of my portfolio construction, the volatility decreased notably in the order cyclical stocks > sensitive stocks > defensive stocks. Basically, we get some exposure to the Low-Volatility factor if we allocate to the defensive industry portfolio. However, the raw return was not substantially higher than that of cyclical stocks.

One might argue that you could lever the defensive portfolio to match the volatility of cyclicals. On a unlevered basis, however, a long-term investor would not fare much worse using the cyclical portfolio.

Let’s have a closer look on the period since 2000:

In this turbulent era, we can clearly see that defensive stocks experienced much lower drawdowns in major bear markets like 2002/03 and 2008/09. In 2011, 2016 and 2018-2020, they didn’t even really participate in downswings. It’s hard to know how sustainable this behavior is but I have to admit that this is remarkable if you look for a Buy and Hold Portfolio. Evidence suggests that if you want to hold single stocks or industries for the long run, most likely defensive industries give you the most return for your risk, even though cyclical stocks slightly outperformed on a raw return basis since 2000:

From the chart, we can also see that non-defensive industries trend up and down over multi-year periods. If we manage ride those trends, we should be able to use the volatility of these portfolios to our advantage. That is the whole premise of using momentum strategies.

(To be continued)