If you've ever sat through a finance course, you would have learned about correlation.
The theory is that similar companies are exposed to the same variables, causing their stock prices to move in the same direction.
This creates the need for a diversified portfolio, which is why many experts suggest investors hold 15-30 uncorrelated stocks.
Companies in the same sector are often viewed as highly correlated.
For example, the big four banks operate in the banking sector. Australian banks collectively benefit when the RBA raises the cash rate because they can then raise mortgage rates and make more money. They are also disadvantaged when unemployment spikes, as this increases the likelihood of mortgage defaults.
A similar logic can be applied to the consumer discretionary sector. The sector is considered relatively cyclical, tied to the state of the economy.
In theory, when the economy is booming, consumer discretionary companies should benefit as people have more money to spend at their stores. This should translate into higher share prices for consumer discretionary stocks. On the flip side, when unemployment and inflation are up, consumers may be less inclined to spend on discretionary purchases.
However, that logic went out the window last week when ASX furniture retailers Nick Scali Ltd (ASX: NCK) and Temple & Webster Group Ltd (ASX: TPW) provided trading updates.
Nick Scali's shares fell more than 15% in a day, while Temple & Webster's update sent its shares soaring more than 30%.
What happened?
Nick Scali craters on earnings downgrade
Last week, Nick Scali released a trading update which sent its share price down sharply.
In that update, the furniture retailer advised that Q1 FY27 sales had struggled, with sales orders down 15% from the same period last year and store traffic down 10%.
The company projected that profit for the first half of FY27 would be between $28 million and $32 million. This is down from $41 million in the same period a year ago.
Management attributed the decline to challenging market conditions, specifically blaming the housing downturn for hampering demand for its furniture.
Nick Scali also experienced a costly cybersecurity incident in August that left its enterprise resource planning systems unavailable for several weeks.
Temple & Webster takes off
Given Nick Scali's disappointing update, investors may have expected fellow furniture retailer Temple & Webster's share price to suffer the same fate when providing a trading update at their Annual General Meeting.
Both are furniture retailers, so they are in the same sector.
However, this was not the case.
Instead, Temple & Webster rallied more than 30%.
During its AGM, management said revenue from 1 July to 19 October has declined 8% from the same period last year. However, a bright spot was the contribution margin dollars, which increased 16%. CEO Susie Sugden also advised that the company is aiming to return to double-digit growth by FY28, which investors may have viewed positively.
Why the extreme difference in share price reactions?
On the surface, both results may have looked similar. Both companies experienced a slow start to FY27, with revenue declining.
However, notably, Temple & Webster's revenue decline was almost half as severe as Nick Scali's.
Their target markets could explain why.
As a more upmarket furniture retailer, Nick Scali customers may be less inclined to buy expensive furniture in this high-inflation environment. This can cause customers to delay their purchases or even 'trade down' by shopping at more budget-friendly furniture stores.
The other major consideration is valuation.
Heading into the week, Nick Scali shares were down roughly 40%, while Temple & Webster shares had fallen a staggering 70%.
So, the market had already priced in a lot of bad news into the Temple & Webster share price. When a company's share price is so battered down, any piece of good news can send it soaring.
This very scenario played out for CSL Ltd (ASX: CSL) shares in August. After trading above $300 in 2021, the CSL share price fell to a 10-year low of around $90 after several earnings downgrades.
In its August results, management projected the company would deliver steady revenue in FY27 and return to NPAT growth of 5%.
Heading into the result, the shares had become so cheap. Any piece of good news was enough to lure investors back in, delivering the company its best trading day in 20 years with its share price ending 18% higher.
Foolish takeaway
Portfolio diversification by buying around 15-30 uncorrelated stocks has long been an effective risk-mitigation strategy.
It remains wise for investors to buy several shares that are exposed to different risk factors and benefit from different macroeconomic conditions.
However, shares in the same sector do not always move in the same direction.
Investors must also consider business specifics to gain a deeper understanding of risk factors. For discretionary retail shares such as Nick Scali and Temple & Webster, this includes their target markets.
An understanding of valuation is also crucial. Shares with higher valuations are far more likely to severely decline on an underwhelming result than those with lower valuations.
This dynamic underpinned Warren Buffett's 'margin of safety' principle – that is, buying stocks that are trading well below what they're worth to soften the impact of any bad news.
The post Temple & Webster +30%, Nick Scali -15%: Why did sector correlation go out the window last week? appeared first on The Motley Fool Australia.
Motley Fool contributor Laura Stewart has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended CSL and Temple & Webster Group. The Motley Fool Australia has recommended CSL, Nick Scali, and Temple & Webster Group. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.
The Motley Fool's purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. 2026