What Is a Pure Play? How They Work, Advantages, and Risks

Summary

We know that we shouldn’t keep all eggs in one basket but we all like to bet on the winning horse or the underdog for that matter. When it comes to financial markets, we call it pure play. A pure play is an investment that exposes an investor to a single industry or market segment. In contrast to diversification via investment in firms with a diverse viewpoint, pure play companies specialize in a particular area. While pure-play stocks and funds may help investors diversify and extend their portfolios, it is important to remember that their risks and considerations vary from those of a typical stock.

Let's look at what pure plays are, how they operate, their primary advantages and downsides, and how to use them as part of a balanced investing strategy:

What Is a Pure Play Company?

Pure play companies make most of their money from one industry or area. Upstox is a pure tech and finance bet. Oil drilling and exploration enterprises are energy pure plays.

Conglomerates, such as Reliance and Adani Group, have subsidiaries in technology, financial services, consumer products, and manufacturing. Conglomerates specialize, while pure plays diversify.

Some of the most common pure play sectors include:

• Technology - Companies like Infosys, HCL, and Freshworks focus solely on technology and software.
• Biotech and pharmaceuticals - Ranbaxy, Bharat Biotech, and Sun Pharma work exclusively in healthcare.
• Retail - Companies like Avenue Supermarkets, and Shoppers Stop work only in consumer sales.

Benefits of Pure Play Investing

Investing in pure play stocks or funds can offer investors several advantages:

1. Diversification: Pure plays diversify a portfolio into niche areas that may react differently from the market. Biotech stocks provide healthcare exposure apart from other sectors.
2. Focused exposure: Pure plays allow investors to wager heavily on their favorite sectors. This boosts involvement in high-growth regions.
3. Specialization: The emphasis of pure play firms helps them to better serve their specialty than less concentrated rivals. Pure plays specialize in their specialty.
4. Transparency: Pure plays allow investors to identify their sector and industry. In contrast, conglomerates may have unclear performance drivers across business lines.
5. Potential for massive growth: Pure play stocks may outgrow diversified corporations exponentially in high-growth areas. Investors in pure play chipmakers like Nvidia and AMD gained greatly from the semiconductor boom.
6. Possible takeover: Pure plays are often acquired. Competitors may buy pure plays to swiftly capture crucial sector market share. Takeover premiums benefit investors.

Risks of Pure Play Investing

While they offer advantages, pure play stocks and funds also pose risks that investors must consider:

1. Insufficient diversification: Pure stocks represent one industry. This contrasts with broad index funds that diversify. Pure plays carry greater non-diversifiable risk.
2. Industry downturn vulnerability: Pure plays' fortunes depend on one industry. Their sales and share price might plummet if their industry declines. Mortgage lenders during the 2008 financial crisis posed this risk.
3. High volatility: Pure play businesses have more volatile shares than diversified organizations. Their stock values grow in bull markets and decrease in sector falls.
4. Acquisition risk: A pure play bought out by a rival may not provide investors the greatest price and lose a specialty investment.
5. Small size: Many pure plays are small or mid-cap companies with little history. These have less liquidity, increasing volatility.
6. High valuations: Pure plays in hot areas are expensive. Investors may overpay for hyped rallies. When pure play multiples surpass industry standards, be cautious.

Building a Pure Play Portfolio

For investors interested in utilizing pure plays, here are some approaches to consider:

• #1 Allocate a portion of your portfolio: Instead of overdoing pure bets, devote 10–20% of a portfolio. This maintains diversity and allows sector bets.
• #2 Invest across different pure play industries: Think beyond one pure play area. Look for pure bets in IT, energy, healthcare, finance, and other attractive sectors.
• #3 Utilize pure play ETFs: ETFs following biotech, semiconductors, and cybersecurity indices may replace choosing equities. This diversifies.
• #4 Rebalance periodically: Rebalance by cutting allocation to pure bets in rising sectors, recording gains. Switch to pure plays in calmer areas.
• #5 Hedge with options: Protective puts can prevent pure play declines. This hedges downside without stock liquidation.
• #6 Buy on dips: Do not chase pure plays after massive runs. Buy on big price decreases to capitalize on mean reversion.
• #7 Utilize stops: Protect pure play stocks from unforeseen collapses using stop loss orders. Setting stops enforces risk management discipline.

Pros and Cons of Pure Play ETFs

Here are the benefits and drawbacks to be considered when seeking pure play exposure:

Pros

1. Provides diversification across a specialized sector
2. Managed by professionals with expertise in niche areas
3. Low expense ratios compared to actively managed mutual funds
4. Trades throughout the day like stocks
5. Often tax efficient with low portfolio turnover

Cons

1. Still carries higher risk than broad-based index ETFs
2. Thematic ETFs may have high turnover and trading costs
3. Niche focus raises volatility compared to total market funds
4. Can have higher expense ratios than ETFs tracking major indexes
5. May need rebalancing if sector exposure gets oversized

Just as with individual stocks, moderation is key when investing in pure play ETFs. They can be used strategically as satellite holdings around a core portfolio.

Summing Up

Strategic pure play investing may boost returns during bull markets when sectors rise. Having said that, pure bets should not be the cornerstone of a portfolio due to their volatility and must be positioned smartly with broad market index funds.