Investors often describe their portfolios by the investments they own.

Banks. Property. Healthcare. ETFs.

But portfolios are not driven by those labels. Beneath every investment sits a set of return drivers that impact its success or failure.

In my previous article, I proposed that identifying return drivers was key in unlocking portfolio diversification in a highly correlated market. Understanding the returns drivers can help investors make better decisions about portfolio construction.

The question remains, how do investors spot return drivers in their own portfolio?

To illustrate this, let’s dissect the distinct return drivers in common holdings in Aussie portfolios.

Different sectors, different drivers

Take Commonwealth Bank (ASX.CBA), Goodman Group (ASX.GMG) and CSL (ASX.CSL).

One is a bank, one develops industrial property and data centres and one is a global healthcare company.

The important distinction is that they are driven by different underlying mechanisms.

Commonwealth Bank’s earnings are largely influenced by Australian mortgage growth, lending margins and the financial health of borrowers.

Goodman Group is increasingly leveraged to demand for logistics infrastructure and data centres. The company has positioned itself to benefit from long term trends in e-commerce, cloud computing and AI-related investment.

CSL’s earnings are tied to healthcare demand, plasma collection economics and the success of its research and development pipeline. CSL Behring is the plasma business, which is driven by plasma collections primarily in the US.

The primary drivers for each ASX heavyweight are distinctly different. While all companies are influenced by broader economic and market conditions to some degree, the factors that ultimately drive earnings for each business are unique.

A slowdown in Australian housing credit growth will impact Commonwealth Bank more than it will CSL. Likewise, changes in plasma supply in the US is likely to have little impact on Goodman.

Same sector, different drivers

Sectors are not always good indicators for return drivers. For example, lets examine Commonwealth Bank and Macquarie Group (ASX.MQG).

Both are classified as financials on the ASX, yet their earnings are driven by very different factors.

As we mentioned, CBA’s returns are closely linked to Australian borrowers.

Macquarie’s earnings are spread across four key segments: asset management, banking, Macquarie capital and commodities & global markets. The commodities & global markets segment benefits in times of market volatility.

Higher volatility in commodities drives more client trading, hedging and market making in this segment.

While both operate within the financial sector, the risks and opportunities that drive their earnings are not the same.

Looking only at sector classifications may lead investors to assume the two companies provide similar exposures when the underlying return drivers tell a different story.

Similar commodities, overlapping drivers

Return driver analysis can also reveal situations where diversification is weaker than it first appears.

Consider BHP (ASX.BHP) and Rio Tinto (ASX.RIO).

While both companies produce a range of commodities, a significant portion of earnings remain linked to iron ore and copper demand. In turn, demand for both commodities has been heavily influenced by Chinese economic growth over the past two decades.

Prior to China joining the World Trade Organisation in 2001, global demand for most commodities was largely stable for decades. However, China’s economic reforms saw rapid demand growth for commodities such as iron ore and copper.

I previously wrote that we expect China to transition to a more consumption focused, less commodity driven economy. The key question for investors is how dependent commodity prices, and its beneficiaries (Rio Tinto & BHP) remain on Chinese demand for iron ore and copper.

China Dominates Demand for Iron Ore and Copper

This does not mean BHP & Rio Tinto are inherently the same investments. However, it illustrates how investors can unknowingly concentrate risk even when owning multiple companies with the same underlying drivers.

Comparatively, a company such as Woodside (ASX.WDS) provides an interesting contrast.

Woodside’s earnings are influenced far more by geopolitical events outside of China, that directly impact the oil and LNG markets. In fact, we have seen this play out during the US-Iran conflict.

Woodside shares less of the same drivers of returns to BHP and Rio. As a result, BHP and Woodside may offer more diversification than a portfolio concentrated in BHP and Rio Tinto.

A framework to identify return drivers

Every company trading on the ASX is exposed to different levels of macro and company-specific risk.

Sometimes you’ll discover that seemingly unrelated companies are exposed to similar risks. In other cases, businesses operating in the same sector may be driven by very different factors.

Analysing the return drivers of every holding in your portfolio may sound daunting. The reality is, it is more a thought exercise than a complex analysis.

A simple three-step framework can help you begin to understand the true drivers of your portfolio.

1. What needs to happen for this company to succeed?

Start with the business itself.

What is going to drive earnings and cash flow over time?

For different companies, it may come from acquiring businesses, launching new products or expanding into new markets.

As we’ve seen in the examples above, identifying the key drivers at the company level is the first step. It forces investors to understand exactly what needs to go right for an investment to succeed.

It also helps uncover the assumptions embedded in a portfolio.

2. What factors influence those drivers?

Next, ask what sits beneath those primary drivers.

Is the company reliant on housing activity, commodity demand, technological investment, healthcare spending or something else entirely? Think about the customers for the products and services sold by a company. What impacts their demand?

The objective is to identify the factors that have the greatest influence on future earnings.

This is often where common exposures begin to emerge and where investors can start to distinguish between genuine diversification and hidden concentration.

3. Where does overlap occur?

Once you’ve identified those drivers, compare them across your portfolio.

Some holdings will be exposed to very different forces. Others may rely on many of the same conditions to succeed.

The more overlap that exists, the more concentrated your portfolio may be than it first appears.

Looking through these three lenses can help investors move beyond sectors and investment labels to better understand what is driving portfolio returns.

Wrap up

Investors don’t build diversified portfolios by collecting different labels.

They build them by understanding the factors driving each investment and how those factors interact across the portfolio.

Sometimes the overlap will be greater than expected. Sometimes it will be smaller. Either way, understanding the drivers behind your holdings provides a clearer picture of the risks you’re taking.

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