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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
VU
Lesson # 15
SECTOR AND INDUSTRY ANALYSIS
The Importance of Industry/Sector Analysis:
Why Industry Analysis Is Important Over The Long Run:
Sector and industry analysis is important to investor success, because over the long run, very significant
differences occur in the-performance of industries and major economic sectors of the economy. To see
this, we will examine the performance of industry groups over long periods of time using price indexes
for industries.
Standard & Poor's calculates weekly and monthly stock price indexes for a variety of industries, with
data being available for approximately 60 years. Since the data are reported as index numbers, long-term
comparisons of price performance can be made for any industry covered. Note that the base number
for these S&P data is 1941-1943 =10; therefore, dividing the index number for any industry for a
particular year by 10 indicates the number of times the index has increased over that period.
What is an industry?
At first glance, the term industry may seem self-explanatory. After all, everyone is familiar with the
auto industry, the drug industry, and the electric utility industry. But arc these classifications as
clear-cut as they seem? Apparently not, because although we have had, industry classification
schemes for many years, the classification system for industries continues to evolve, as shown
below. Furthermore, different organizations use different classification systems.
Classifying Industries:
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Regardless of the problems, analyst's and. investors need methods with which to classify industries.
One well-known and widely used system is the Standard Industrial Classification (SIC) System
based on census data and developed to classify firms on the basis of what they produce. SIC codes
have 11 divisions, and within each of these divisions are several major industry groups
designated by a two-digit code. The major industry groups within-each division are further
subdivided into three-, four-, and five-digit SIC codes to provide more detailed classifications. The
larger the number of digits in the SIC system, the more specific the breakdown.
SIC codes have aided significantly in bringing order to the industry classification problem by
providing a consistent basis for describing industries and companies. Analysts using SIC codes can
focus on economic activity in as broad or as specific a manner as desired.
Other Industry Classifications:
The SIC system of industry classification is probably the most consistent system available.
However, in the Investments field, various well-known organizations have developed their
own industry groupings. For example, the Standard & Poor's (S&P) Corporation has provided
weekly stock indexes on 11 sectors and approximately 115 industry groups for a long time.
These weekly indexes have often been used to assess an industry's performance over time.
Other providers of information use different numbers of industries in presenting data. The
important point to remember is that multiple industry classification systems are used.
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Investment Analysis & Portfolio Management (FIN630)
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Analyzing Sectors / Industries:
Sectors and industries, as well as the market and companies, are analyzed through the study
of a wide range of data, including sales, earnings, dividends, capital structure, product lines,
regulations, innovations, and so on. Such analysis requires considerable expertise, and is
usually performed by industry analysts employed by brokerage firms and other: institutional
investors.
A useful first step is to analyze industries in terms of their stage in the life cycle. The idea is
to assess the general health and current position of the industry. A second step involves a
qualitative analysis of industry characteristics designed to assist investors in assessing the
future prospects for an industry. Each of these steps is examined in turn.
The Industry Life Cycle:
Many observers believe that industries evolve through at least four stages: the pioneering
stage, the expansion stage, the stabilization stage, and the deceleration in growth and/or
.decline stage. There is an obvious parallel in this idea to human development. The concept
of an industry life cycle could apply to industries or product lines within industries.
1. Pioneering Stage:
In the pioneering stage, rapid growth in demand occurs. Although a number of companies
within a growing industry will fail at this stage because they will not survive the
competitive pressures, most experience rapid growth in sales and earnings, possibly at an
increasing rate. The opportunities available may attract a number of companies, as well as
venture capital. Considerable jockeying for position occurs as the companies' battle each
other for survival, with the weaker-firms failing and dropping out.
Investor risk in an unproven company is high, but so are expected returns if the company
succeeds. Profit margins and profits are often small or negative. At the pioneering stage of
an industry, it can be difficult for security analysts to identify the likely survivors, just when
the ability to identify the future strong performers is most valuable: By the time it becomes
apparent who the real winners are, their prices may have been bid up considerably beyond
what they were in the earlier stages of development.
In the early 1980s, the microcomputer business--both hardware and software-- offered a
good example of companies in the pioneering stage. Given the explosion in expected
demand for these products, many new firms entered the business hoping to 'capture some
share of the total market. By 1983, there were estimated 1JC manufacturers, of home
computers, a clearly unsustainable number over the longer run.
2. Expansion Stage:
In the second stage of an industry's life cycle, the expansion stage, the survivors from the
pioneering stage are identifiable. They continue to grow and to prosper, but the rate of
growth is more moderate than before.
At the expansion stage of the cycle, industries are improving their products and perhaps
lowering their prices, they are more stable and solid, and at this stage they often attract
considerable investment funds Investors are more willing to invest in these industries now
that their potential has been demonstrated and the risk of failure has decreased.
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Investment Analysis & Portfolio Management (FIN630)
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Financial policies become firmly established at this stage. The capital base is widened and
strengthened. Profit margins are very high. Dividends often become payable, further
enhancing the attractiveness of these companies to a number of investors.
3. Stabilization Stage:
Industries eventually evolve into the stabilization stage (sometimes referred to as the
maturity stage), at which point the growth begins to moderate. This is probably the longest
part of the industry life cycle. Products become more, standardized and less innovative, the
marketplace is full of competitors, and costs are stable rather than decreasing through
efficiency moves, for example. Management's ability to control costs and produce operating
efficiencies becomes very important in terms of affecting individual company profit
margins.
Industries at this stage continue to move along, but typically the industry growth rate
matches the growth rate for the economy as a whole.
4. Declining Stage:
An industry's sales growth can decline as new products are developed and shifts in demand
occur. Think of the industry for home radios and black-and-white televisions. Some firms in
an industry experiencing decline face significantly lower profits or even losses. Rates of
return on invested capital will tend to be low.
Q u a l i t a t i v e Aspects of Industry Analysis:
The analyst or investor should consider several important qualitative factors that can
characterize an industry. Knowing about these factors will help investors to analyze a par-
ticular industry and will aid in assessing its future prospects.
The Historical Performance:
As we have learned, some industries perform well and others poorly over long periods of
time. Although performance is not always consistent and predictable on the basis of the
past, an industry's track record should not be ignored.
Investors should consider the historical record .of sales and earnings growth and price
performance. Although the past cannot simply be extrapolated into the future, it does
provide some useful information.
Competition:
The nature of the competitive conditions existing in an industry can provide useful
information in assessing its future. Is the industry protected from the entrance of new
competitors as a result of control of raw materials, prohibitive cost of building plants, the
level of production needed to operate profitably, and so forth?
Michael Porter has written extensively on the issue of competitive strategy, which involves
the search for a competitive position in an industry. The intensity of competition in, an
industry determines that industry's ability to sustain above-average returns. This intensity is
not a matter of luck, but a reflection of underlying factors that determine the strength of five
basic competitive factors:
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1. Threat of new entrants
2. Bargaining power of buyers
3. Rivalry between existing competitors
4. Threat of substitute-products or services
5. Bargaining power of suppliers
The five competitive forces determine industry profitability because these influence the
components of return on investment. The strength of each of these factors is a function of
industry structure.
The important point of the Porter analysis is that industry profitability is a function of
industry structure. Investors must analyze industry structure to assess the strength of the five
competitive forces, which in turn determine industry profitability.
Government Effects:
Government regulations and actions can have significant effects on industries. The investor
must attempt to assess the results of these effects or, at the very least, be well aware that
they exist and may continue.
Consider the breakup of AT&T as of January 1*1984.' This one action has changed the
telecommunications industry permanently and perhaps others as well. As a second example,
the deregulating of the financial services industries resulted .in banks and savings and loans
competing more directly with" each other, offering consumers many of the same services.
Such an action has to affect the relative performance of these two industries as well as some
of their other competitors, such as the brokerage-industry (which can now also offer similar
services in many respects).
Structural Changes:
A fourth factor to consider is the structural Changes that occur in the economy, As_ the
United States continues to move from an industrial society to an information-
communications society, major industries will be affected. New industries with tremendous
potential are, arid will be, emerging, whereas some traditional industries, such as steel, may
never recover to their former positions.
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Evaluating Future Industry Prospects:
Ultimately, investors are interested in expected performance in the future. They realize that
such estimates are difficult and are likely to be somewhat in error, but they know that equity
prices are a function of expected parameters, riot past, known values. How then is an
investor to proceed?
Assessing Longer-Term Prospects:
To forecast industry performance over the longer run, investors should ask the following
questions:
1) Which industries are obvious candidates for growth and prosperity over, say, the
next decade?
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Investment Analysis & Portfolio Management (FIN630)
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2) Which industries appear to be likely to have difficulties as the United States changes
from an industrial to an information-collecting and information- processing
economy?
Picking Industries for Next Year:
On a shorter-run basis, investors would like to be able to estimate the expected earnings for
an industry and the expected multiplier and combine them to produce an estimate of value.
However, this is not easy to do? It requires an understanding of several relationships and
estimates of several variables. Fortunately, considerable information is readily available to
help investors in their analysis of industries. Investors should beware of the primary sources
of information about industries.
Te determines industry performance for shorter periods of time (e.g., one year), investors
should ask themselves the following question: Given the current and prospective economic
situation, which industries are likely to-show improving earnings? In many respects, this is
the key question for industry security analysis. Investors can turn to IBES, .which complies
institutional brokerage earnings estimates, for analysts' estimates of earning'; for various
industries, which are revised during the year.
Business Cycle Analysis:
A useful procedure for investors to assess industry prospects is to analyze industries by their
operating ability in relation to the economy as a whole. That is, some industries perform
poorly during a recession, whereas others are able to weather it reasonably well. Some
industries move closely with-the business cycle, outperforming the average industry in good
times and underperforming it in bad times. Investors should be aware of these relationships
when analyzing industries.
Growth Industries:
Most investors have heard of, and are usually seeking; growth companies. In growth
industries, earnings are expected to be significantly above the average of all industries, and
such growth may occur regardless of setbacks in the economy. Growth industries in the
1980s included genetic engineering,-microcomputers, and new medical devices! Current
and future growth industries include robotics and cellular telephones. Clearly, one of the
primary goals of fundamental security analysis is to-identify the growth industries, of the
near and far future.
Defensive Industries:
At the opposite end of the scale are the defensive industries, which are least affected by
recessions and economic adversity. Food has long been considered such an industry. People
must eat, and they continue to drink beer, eat frozen yogurt, and so on, regardless of the
economy. Public utilities might also be considered a defensive industry.
Cyclical Industries:
Cyclical industries are most volatile--they do unusually well when the economy prospers
and are likely to be hurt more when the economy fakers. Durable goods are a good example
of the products involved in cyclical industries. Autos, refrigerators, and stereos, for
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Investment Analysis & Portfolio Management (FIN630)
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example, may be avidly sought when times are good, but such purchases may be postponed
during a recession, because consumers can often make do with the old units.
Cyclical are said to be "bought to be sold." When should investors pursue cyclical
industries? When the prices of companies in the industry are low, relative to the historical
record and P/Es are high. This seems counterintuitive to many investors, but the rationale is
that earnings are severely depressed in a recession and therefore the P/E is high, and this
may occur shortly before earnings turn around.
These three classifications of industries according to economic conditions do not constitute
an exhaustive set. Additional classifications are possible and logical. For example, interest-
sensitive industries are particularly sensitive to expectations-about changes in interest
rates; the financial services, banking, and real estate industries are obvious examples of
interest-sensitive industries. Another is the building industry.
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