Sector Study Session

Let’s explore some potential investing strategies in 4 different stock sectors: technology, healthcare, energy, and real estate. We’ll start with tech, which had a huge drop today worth serious examination.

Technology

The big five names in technology are Facebook (FB), Amazon (AMZN), Apple (AAPL), Microsoft (MSFT), and Google (Alphabet, Inc.) (GOOG/GOOGL), which have come to be known as F.A.A.M.G. It’s not a great acronym, as I’m still not quite sure how to say it: “Faaaaahmuguh?”

I have been hesitant to invest directly in any of these 5 for several reasons:

• They tend to be overvalued–although Apple was a recent exception that Warren Buffet jump on. Amazon is currently trading at 183x earnings. I typically avoid stocks priced above 20x earnings.
• Their high market caps mean that if you already possess index funds like those typically offered in 401(k) and 403(b) retirement plans, you probably already have plenty of exposure to them. For example, the Vanguard Total Stock Market Index Fund (VTSMX) is 9.92% FAAMG, so my Vanguard Target 2050 Fund (VFIFX), which holds the VTSMX, is 5.34% FAAMG.
• I question how much more room the biggest companies in the world have to grow.
• I am concerned that the huge institutional ownership of these stocks has decreased demand for them and therefore inflated their prices.
• I am concerned that the huge institutional ownership of these stocks makes them vulnerable to changes in the investment management industry.

Goldman Sachs released a research report today that demonstrates the vulnerability of these stocks, which are widely owned by passive investors seeking low volatility.

The fear is that if fundamental events cause volatility to rise, these same passive vehicles will sell and exacerbate downside volatility. Low realized volatility can potentially lead people to underestimate the risks inherent in these businesses including cyclical exposure, potential regulations regarding online activity or antitrust concerns or disruption risk as they encroach into each others businesses.

This vulnerability was shown today, when the NASDAQ 100 (QQQ) had a 1-day drop of 2.5%, not coincidentally on the same day that the CBOE Volatility Index (VIX) hit a 23-year low of 9.37. As you can see from the chart below, the NASDAQ started dropping shortly after the VIX hit its low.

Healthcare

Let’s switch gears from big tech to small bio-tech.

Biotechnology start-ups provide interesting profit-making opportunities, but they are purely speculative, require a lot of knowledge and research, and can be incredibly risky. The other issue is that there seems to be a common problem of manipulation of stock prices by larger stakeholders and institutions. Luckily, Strong Bio Stock Club, led by F. Thomas Crump, provides a strategy outline that minimizes many risks and gives individual investors a chance to get into this market.

One key element of biotech and pharmaceutical investing is understanding the phases of studies on drugs and therapies and how these affect risk. Strong Bio emphasizes that individual investors stay on the sidelines until phase 2 or 3.

Simply put, it’s too long of a process to get a drug or treatment approved to invest in any phase 1 or phase 2 money-hungry company. It should be patiently watched with no position as it develops. Occasionally a phase 2 result can generate a buyout, so one shouldn’t completely eliminate phase 2 companies from investment, but it’s so rare that it’s probably safer not to invest or to invest only a little at these stages. Investments can be reinforced on dips deep into pivotal phase 3 data, preferably after one or two dilutive events, and coupled with negative press in spite of positive interim data and results.

…

Save the biggest positions for deep into phase 3 with good data in hand and seemingly strange manipulation of lower and lower prices per share coupled with dilutive events, sometimes unnecessary, and negative press that doesn’t have much merit, especially if pumped out from sources that commonly bash on many stocks over and over.

Stocks with promise can and will trade with a market cap below their cash value in spite of a mature pipeline candidates that seems to be meeting FDA approval criteria. Don’t let this frustrate investment, rather, borrow from these forces to maximize handsome profits. Currently, being late to the party is favorably “down with that”.

It is important to note that purchasing these stocks below cash value reduces risk, but does not eliminate it. I have personal experience holding a stock for an extended period of time with it never returning to book value. The board eventually decided on a merger instead of a liquidation, making shareholders wait even longer for a return to book value that may eventually never happen.

Energy

Investors looking for energy exposure have a lot to consider. Oil and gas commodity prices can be volatile. New drilling methods have had them lower in recent years, putting a lot of stress on the oil and gas industries. I love renewable energy, but in its youth it is mostly a speculative venture. The coal industry has been in decline for a century. Oil will be the next fossil fuel to die.

These conclusions have led me to take a good look at natural gas and ultimately decide on Golar LNG Partners LP (GMLP), a liquified natural gas (LNG) carrier and master limited partnership (MLP), for my dividend fund.

Tyler Crowe wrote a great piece on LNG transport for The Motley Fool today, which explains why it is such an interesting investment prospect:

Investing in LNG is an intriguing idea. Growth rates for the LNG trade are well above any others in the fossil fuel industry, and the lower carbon emissions of natural gas suggests it will have a much longer window of use than other fossil fuels.

…

What makes Golar LNG in particular even more intriguing is its investment in floating LNG liquefaction and regasification facilities. Its joint venture with oil services giant Schlumberger aims to offer producers and resource-rich countries a way to monetize their “stranded” natural gas reservoirs — offshore gas deposits that aren’t large enough to justify building stationary LNG terminals. More than 40% of the world’s natural gas deposits are classified as stranded, so this is an immense market opportunity just waiting for Golar and Schlumberger to capture it.

Crowe’s piece focuses on GasLong (GLOG) and GasLog Partners (GLOP) and Golar LNG (GLNG) and Golar LNG Partners (GMLP). He emphasizes some of the risks involved in investing in MLPs like GLOP and GMLP.

Real Estate

Real estate investment trusts (REITs) are one of the easiest securities to add to a portfolio to improve its diversification. As Richard A. Ferri explains in his book, All About Asset Allocation,

Real estate is one of the few asset classes that has exhibited low correlation with stocks and bonds over extended periods of time. A well-diversified portfolio that holds real estate investments alongside stock and bonds has provided superior portfolio returns over one that does not include real estate. This was true even during the poor real estate market that occurred in the mid-2000s.

The 2008 financial crisis revealed the vulnerabilities of the real estate sector, particularly on the mortgage side, but that doesn’t change the fact that real estate is an essential part of a dynamic, diversified investment portfolio.