SIMON BROWN: Don’t buy second place

I wrote last week about the difference between top-down and bottom-up strategies to select sectors or stocks that offer great potential. I also suggested that I like a combination of both: using top-down to find sectors and then bottom-up to identify the best in that sector.

I also mentioned that I will often just use an exchange traded fund (ETF) for a sector.

For example, the local real estate investment trust (Reit) sector was too expensive and peaked in late 2017 — and then the pandemic took it out at the knees. But by 2022 things were looking better. Debt had been reduced and they traded at a discount to NAV, an important valuation metric in Reits.

Office properties remained a significant challenge, and to a fair degree remain so and probably will for many years. But overall it was a sector I really liked. I started looking at the different stocks and it quickly became apparent that many offered a good investment opportunity. So in the end I simply bought an ETF on the local Reit sector.

Now make sure you really understand the ETF. Buying the Satrix Resi ETF, because you are bullish on gold and gold miners, won’t work. That’s because even though the ETF has gold exposure, it also has a lot of platinum group metals, coal and iron ore, all diluting the gold exposure. So when I was bullish on gold I bought individual gold miners and the gold ETF.

This brings us to a real risk. When investing, we often want to buy the dogs in the hope that they may one day become the sector winners, but they seldom manage that.

Winning stocks tend to keep on winning. They have the systems and processes in place that have got them to the top. They know how to do it and all they need to do is keep on doing what they do.

A great example is the Pick n Pay vs Shoprite* debate. Shoprite has been the clear winner for close on two decades. Superior margins, better growth and a number of internal strategies got it to be in front and kept it there.

The temptation is to buy the stock that is lagging, in this case Pick n Pay, in the belief (hope?) that one day it will catch up and offer more upside. The second-place player becoming No 1 would be a great investment. But you need to see real evidence of it catching up and showing potential to become the best, otherwise you’ve just found yourself invested into the No 2 in a sector. It may make money but will probably underperform the winner.

Finally, often the winner in a sector is expensive because everybody else also sees what you see. I still don’t buy second place, I simply wait. One of the beauties of a market is that all stocks go on sale at some point.

* The writer holds shares in Shoprite