QUALIPORT
Sectors To Avoid

By Maynard Paton (TMFMayn)
February 13, 2003

"Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected": You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital." -- Warren Buffett, Berkshire Hathaway (NYSE: BRK.A) 1996 annual report.

So: focus on certain areas, gain specialised knowledge and watch your investment returns improve.

Over time, the Qualiport's watch list has taken the 'circle of competence' mantra to heart. At the moment, the portfolio concentrates on eight general areas: banks, tobacco, ports, media, engineers, home furnishing retailers, stock exchanges and tabletop battle games.

Granted, some of those sectors have a wider scope than others. Media for instance covers newspapers, television and radio. However, stock exchanges and tabletop battle games involve just the London Stock Exchange (LSE: LSE) and Games Workshop (LSE: GAW) respectively, since these companies pretty much are their sectors.

All in all, if there are any more company/sector additions to the watch list, there's a risk the circle will become too wide and the knowledge base will become too thin.

To avoid the information overload, investors must blockade unfavourable industries from their thoughts. In terms of the Qualiport, the following sectors won't see the light of day on these pages any time soon:

Aerospace & Defence: Even with the war drums beating, picking a long-term defence winner remains as difficult as ever. Lumpy contracts, covert products and a limited customer base make the industry a no-go zone.

Automobiles & Parts: Consists mainly of car dealers or parts suppliers to the manufacturers. The dealers operate on wafer thin margins and have virtually no competitive advantage. The suppliers must deal with a few, powerful customers, most of whom are themselves perennial strugglers because of the motor industry's inherently poor economics.

Chemicals: Too obscure. Chemicals, gases, precious metals, paint; it's not obvious how Joe Punter can find out the strengths and weaknesses of such products and their manufacturers, especially as a lot of competition comes from overseas. Sector bellwether ICI (LSE: ICI) currently hitting a multi-decade share price low doesn't inspire either.

Electricity: A political football, it being a regulated industry and at risk from government interference. Price caps can't do much for profit growth. Following recent acquisitions (and rumours), Buffett is quite a fan of the sector. Best leave the price control issues to him.

Info Tech Hardware: Far too dynamic. Investors face a huge risk of product redundancy as IT technology advances ad infinitum. Rather disturbingly, sector pin-up ARM Holdings (LSE: ARM) was only founded 13 years ago. Remember: change is bad. Long-term investors should seek products that will remain the same forever.

Insurance: Too many black holes. Profits are inherently based on assumptions concerning possible liabilities, the eventual accuracy of which often leaves a lot to be desired. Cutthroat competition with domestic policies has never done investors many favours either. But again, it's another industry liked by Buffett, although he appoints his own underwriters.

Oil & Gas: Too difficult. Who really understands the accounts of BP (LSE: BP.)(NYSE: BP) and Shell (LSE: SHEL)(NYSE: SC)? Oil majors are good for a diversified buy and forget portfolio, but those who run a focused portfolio ought to understand the nuances of 'replacement cost profits' and so on. Either that, or punt on risky, out-of-the-way prospectors.

Steel & Other Metals: Basically Corus (LSE: CS.). Too much cheap foreign competition, too much capital expenditure, too much debt. What more reasons do you need to stay away?

Utilities, Other: Another political football, but this time with water inside. Again, price caps and politics traditionally do nothing for loyal shareholders.

Summary

Plenty of generalities and personal prejudices there, which perhaps could mean the odd wondershare gets overlooked. No matter.

Investors should seek an easy life. To be successful long-term, a focus on the simple and the obvious is key. Go with what you know. Block out those areas where tricky accounts, rapid industry development, political issues, dominating customers and impenetrable products are prevalent and can make the investment journey one full of unpleasant surprises.

As Buffett says: "Investors should remember that their scorecard is not computed using Olympic-diving methods:  Degree-of-difficulty doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analysed an investment alternative characterized by many constantly shifting and complex variables."

The author owns shares in Games Workshop and the London Stock Exchange