Changing cycles

First, though, let's address the underlying logic and the method. It's axiomatic that good sector selection is a major factor behind good portfolio performance. Get exposure to the right sectors at the right time and the performance of an equity portfolio pretty well takes care of itself, regardless of the companies chosen.

Bearbull tackles this challenge by drawing a chart in which sectors are distinguished by the cyclicality of their profits along one axis and by the characteristics of their revenues along the other. By 'characteristics', chiefly I mean whether the companies of a sector sell goods or services that their customers would think of as 'big-ticket' or 'small-ticket'. So, at one extreme tobacco companies and drinks makers sell small-ticket items. The price of a packet of cigarettes or a bottle of scotch has risen much faster than inflation these past few years, but such items still represent small-ticket 'consumables' for those who buy them. At the other extreme, housebuilders sell the ultimate big-ticket, or 'capital', items to consumers, just as many engineering companies sell big-ticket pieces of capital equipment to business customers.

Simultaneously, many small-ticket sales can be cyclical or non-cyclical. Cigarette sales - thanks to nicotine's addictive quality - are marvellously non-cyclical. Yet demand for booze - addictive, but less so - is much more cyclical. As a result, tobacco companies go at one end of the chart axis that denotes degrees of cyclicality (alongside, for example, pharmaceuticals companies and food producers). Meanwhile, beverages companies go towards the other end, close to general retailers and holiday operators.

The end result is a chart divided into four segments: cyclical/small-ticket; non-cyclical/small-ticket; cyclical/big-ticket; non-cyclical/big-ticket. Effectively, we can forget that fourth segment - no big-ticket sales are non-cyclical.

Granted, much about this categorisation is open to debate - just how do we separate sectors driven by small-ticket, consumable sales from those driven by big-ticket, capital ones? It's not clear cut when, within the same sector, some companies specialise in consumables while others focus on capital items. For instance, in the aerospace & defence sector, Chemring sells consumables while BAE Systems majors on capital goods. Yet the lines get further blurred. BAE makes many of the components for, and then does the final assembly of, the Typhoon jet fighter - at around £125m a plane, a big-ticket item if ever there was. Yet BAE also generates small-ticket revenues (relative to the cost of a Typhoon) maintaining and upgrading the aircraft in service with the UK's armed forces.

Similarly, cyclicality is endlessly debatable since everything, but everything, moves to a certain cycle. That said, there are degrees of cyclicality. No one would argue that drinks group SABMiller is more cyclical than pharmaceuticals giant GlaxoSmithKline. But is logistics group Wincanton more cyclical than bus and train operator Stagecoach?

All this is grist to the mill, since the chief purpose of the exercise is to get the thought processes going, but it helps answer the questions: where am I now and where should I be headed? The table shows that the Bearbull Income Portfolio's holdings are concentrated on non-cyclical, small-ticket sectors. That has been okay this past year. But at some stage it will be right to head towards those sectors that are labelled 'cyclical/big-ticket' in the table 'From small ticket to big'.

These are clustered towards the bottom of the table because of their poor performance this past year. As much as anything that has been caused by investors' frustration over the inability of the world's developed economies to break free of the debts that bind them. While debt depresses all, sectors that are driven by decisions to do big-ticket capital spending will be hardest hit.

There will come a time when this will change, though it's important to grasp that it will not be triggered by yet another round of quantitative easing (QE), or something very similar. The purpose of QE is, metaphorically, to deliver a shot of adrenaline into a fading economy. It aims to boost the level of prices thus reducing the chances of deflation and depression fostering each other in a descending spiral. As such, it provides a temporary fix, which might explain why cyclical small-ticket sectors such as Travel & Leisure and General Retailers have performed decently over the past year.

However, QE does not address underlying causes; or, at least, it does so only tangentially and in a limited way since raising the price level helps erode the real burden of debt. Arguably it is only when the bigger factors - the supply-side restrictions in developed economies - have been tackled that the capital-spending cycle will get going in a way big enough to boost the profits of many companies that lie in the cyclical/big-ticket segment of the chart. That may not happen any time soon. At worst, if, say, western Europe's economies reproduce something like the Japanese experience, it may not happen at all.

But we need not get into that debate here. Partly for the purposes of better diversification in the Bearbull Income Portfolio, I am assuming that fairly soon it would be sensible to get more exposure to the sectors marked in italics in the table - oil equipment & services; real estate; engineering; construction & materials; and mining. At the very least the correlation in share price movements of, say, Carr's Milling (already in the income fund) and BAE Systems or BHP Billiton should be pretty weak. So the table, 'Cyclical possibilities' does what its title suggests - it shows the obvious high-yield candidates among big companies in the appropriate sectors.

Miserably, the engineering sector does not provide any candidates; or, at least, not unless I dip down into the smallish-cap stocks. Hill & Smith - market capitalisation £249m - is a possibility, for example. In mining, the yields on offer are also less than the income fund's threshold (1.2 times the yield on the All-Share index). Yet I might argue that Eurasian Natural Resources has the funds - and the history of doing so - to pay one-off dividends that effectively make the yield satisfactory.

But at least the table provides food for thought and a starting point. The aim is to swap the income fund's capital in electricity generator Drax (see Bearbull, 3 Aug 2012) for something at the cyclical/big-ticket end of the economy. I'll report back.