Industry Analysis
Fundamental Analysis
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Fundamental analysts look for companies whose financial health is good
and getting better, and which are undervalued by the market
They scour financial reports, calculate ratios, compare to other similar
companies, etc
Fundamental analysts believe that “earnings drive stock prices” at least in the
long run
Fundamentalists tend to be buy and hold investors, as opposed to
technicians who tend to be shorter-term traders
Approach to Fundamental Analysis: Domestic and global economic analysis,
Industry analysis, Company analysis
3-step process…
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Monetary and fiscal policies (taxes, money supply, inflation) influence the
aggregate economies of countries
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Resulting economic conditions influence all industries and companies
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Demographic changes, foreign operations
Alternative industries react to economic changes at different points in
business cycles
Identify best companies in promising industries
Why industry analysis?
• For industries that have a strong, consistent industry
influence, such as oil, gold, steel, autos, and railroads,
one can reduce the extent of company analysis after
industry analysis
• Even for such industries that do not have a strong
influence, industry analysis is valuable because it is
easier to select a superior company from a good
industry than to find a good company in an unhealthy
industry
Industry Analysis
• Once we have done a thorough economic analysis, we
ask the question “which industries will benefit most
from the upcoming economic environment?”
• This will lead to several industries, and our analysis
will lead us to choose the one that we find to be best
positioned.
What is an Industry?
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An industry is a group of companies which produce similar
goods and/or services.
Until recently (and often still), industries were classified by
Standardized Industrial Classification (SIC) codes, but this was
replaced by the North American Industry Classification System
(NAICS, http://www.census.gov/epcd/www/naics.html) which
is much more detailed than SIC.
SIC codes were 4-digit, while the NAICS uses 6 digits for a
much finer, and more useful, breakdown of industries.
NAICS will also facilitate comparisons of companies in the US,
Canada, and Mexico (it was developed by all three countries for
this purpose).
Components of Industry Analysis
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The purpose of industry analysis is to identify which industries will be
good for investors in the upcoming environment.
9 issues should be addressed:
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Competitive Structure
Permanence
Phase of Life Cycle
Vulnerability to External Shocks
Regulatory and Tax Conditions
Labor Conditions
Historical Financial Performance
Financial and Financing Issues
Industry Stock Price Valuation
Competitive Structure
• Some of the questions to be answered are:
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What companies are in the industry?
What are their market shares?
Which are publicly traded?
Has the number of competitors been rising, fallen, or
remained stable?
Permanence
• Some of the questions to be answered are:
– Is the industry likely to survive in the long-run?
– Are there any major technological threats (such as laser
printer was to the dot matrix printer)?
– Are there regulatory threats?
Phase of Life Cycle
• Some of the questions to be answered are:
– Where is the industry in its life cycle? The best returns
and most risk tend to occur early in the cycle.
– The possible phases are:
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Birth Phase
Growth Phase
Mature Growth Phase
Stabilization or Decline Phase
Vulnerability to External Shocks
• Some of the questions to be answered are:
– Could major portions of the industry be nationalized by
foreign governments?
– Are they dependent on supplies of key commodities (such
as oil)?
– Are they subject to external political whims? (South
Africa’s gold industry suffered when Apartheid became an
international issue.)
– Are they subject to fashion trends that may soon change?
Regulatory and Tax Conditions
• Some of the questions to be answered are:
– What are the current regulations that the industry faces?
– Are there likely to be new regulations?
– Are the industry’s products subject to special taxes (such
as “sin taxes” on alcohol and tobacco products or the
“windfall profits” tax on oil companies in the 1970’s)?
– Are there special tax breaks offered to the industry?
Labor Conditions
• Some of the questions to be answered are:
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What percentage of the industry’s workers are unionized?
Are the unions generally hostile or complacent?
Is unionization increasing or decreasing?
Are qualified workers easily obtainable, or are they
difficult to find? This has been a particular problem for
the high-tech industries.
Historical Financial Performance
• Some of the questions to be answered are:
– What is the historical record of industry revenue, earnings
and dividends?
– Are these financial variables cyclical, counter-cyclical?
– Have they been growing slowly, rapidly, or about average?
– What is the average cost structure in the industry? Heavy
on fixed costs? Or, are variable costs the lion’s share?
Financial and Financing Issues
• Some of the questions to be answered are:
– How much debt does the average firm have?
– What is the mix between fixed assets and current assets?
Is it labor intensive or capital intensive?
– What is the average age of the fixed assets? Will they have
to be replaced soon?
Industry Stock Price Valuation
• Some of the questions to be answered are:
– What is the historical average P/E for the industry?
– How high has it been? What were the economic
conditions when the highs were hit?
– How low has it been? What were the economic conditions
when the lows were hit?
– Where is it now? Where should it be, based on historical
economic comparisons?
– What kinds of capital gains and dividend yields have
historically been generated?
Sources of Industry Information
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The primary sources of industry-wide information are trade groups, for
example:
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Semiconductor Industry Association (http://www.semichips.org/)
Wards (automobiles, http://www.wardsauto.com/)
Electronics Industry Association (http://www.eia.org/)
Software Publishers Association (http://www.spa.org/)
There are also many trade magazines that may, or may not, be published
by the trade associations.
Additionally, Value Line Investment Survey
(http://www.valueline.com/) publishes an analysis of each of the
industries that they cover.
Finally, research analysts at brokerage firms often provide reports on
the industries that they cover.
Rotation Strategy
Business cycles and industries
• Cyclical industries
– High sensitivity to economy (High betas)
– Outperform others at the start of recovery from recession
– E.g. producers of durable / capital goods
• Defensive industries
– Little sensitivity to business cycle (Low betas)
– Outperform others at the beginning of recession
– E.g. food producers, utilities
Economic Analysis
GDP and business cycle
• Business cycle
– Recurring patterns of
recessions and recovery
– Peak is transition from the
end of an expansion to the
start of a contraction
– Trough is bottom of
recession as the economy
enters recovery phase
Industry Life Cycles
Stage  Sales Growth
• Start-upRapid &
Increasing
• ConsolidationStable
• MaturitySlowing
• Relative DeclineMinimal
or Negative growth
Sector Rotation
• Portfolio is adjusted by selecting companies that
should perform well for the stage of the business
cycle
– Peaks – natural resource extraction firms
– Contraction – defensive industries such as pharmaceuticals
and food
– Trough – capital goods industries
– Expansion – cyclical industries such as consumer durables
Rotation Strategy
Business cycle and industries
Basic
industries
Consumer
Durables
Consumer
Staples
Financial
Stocks
Capital
Goods
Rotation strategy
Towards the end of a recession
• Financial stocks begin to rise
• Anticipate that banks’ earnings will rise as both the economy and loan demand recover
• Brokerage houses may also be attractive as investors trade securities and companies sell debt and
equity
• Assumes that recession will end soon followed by increase in loan demand, housing construction,
and security offerings
Once recovery begins
• Consumer durables stocks are attractive
• Cars, PCs, refrigerators, lawn tractors, and snow blowers
• Reviving economy will increase consumer confidence and personal income
Towards an increase
• Capital goods are attractive
• Equipment manufacturers, machine and tool die makers, and airplane manufacturers
• Businesses think about modernizing, renovating, purchasing new equipment, providing better
service
Towards business cycle peak
• Basic materials industries, which transform raw materials into finished products are good
• Oil, gold, aluminum, and timber products
• Inflation typically rises leading to higher prices for these industries. Costs are typically less
sensitive to inflation.
During a recession
• Consumer staples outperform
• Pharmaceuticals, food, beverages
• People still need to spend money on necessities
Rotation strategy example
Source: Global Research Highlights – Merrill Lynch (1/14/2004)
Rotation Strategy
Rotation strategy – Empirical evidence
• Industry Momentum – Grinblatt and Moskowitz (JF, 1999)
– Categorize stocks into 20 industries based on SIC
– Buy stocks in the six industries that performed the best in the past six
months (winners)
– Sell stocks in the six industries that performed the worst in the past
six months (losers)
– Winners outperform losers by about 1% the following month
– Winners outperform losers by about 5% the following year
• Implications: Rotate into winners and out of losers. Market is
slow to react to industry prospects
Rotation Strategy
Rotation strategy – Empirical evidence
• Industries as leading Indicators: Hong, Torous, and Valkanov
(2003)
– Some industries predict overall market – Retail, services, metals and
petroleum
– Predict returns up to two months in advance
– Two standard deviation increase in returns of these industries predict
.9% increase in market returns
– Ability to predict depends on how well the industry returns predict
changes in industrial production
– True across major world markets
– Gradual information diffusion – Investors seem to focus attention
on particular industries without fully taking into account crossindustry effects
Industry Analysis
Industry analysis example
• Macroeconomic Variables and Industry growth
• Qualitative Analysis:
– Industry trends and competitive positioning
• Operating Efficiency
– Financial Statement Analysis
• Valuation Ratios
– Industry Benchmarks
Industry Analysis
Retailing: General
Macroeconomic Conditions and Retail sales of Non-durables
Non-Durable Growth
4%
Sample 1947-2003
3%
Correlation = 0.39
2%
1%
0%
-3%
-2%
-1%
0%
-1%
-2%
1%
2%
3%
4%
GDP growth
5%
Industry Analysis
Retailing versus inflation
Non-Durable Growth
4%
Sample: 1947-2006
3%
2%
Correlation = -0.27
1%
0%
-1.0%
-0.5%
0.0%
-1%
-2%
-3%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
Inflation
3.5%
Industry Analysis
Industry Analysis
Industry Financials - Benchmarks
Industry Analysis
Industry Analysis
Industry Analysis
Next step
• Industry analysis should lead into company analysis
• How to analyze a retail company?
– Sales per square foot, Inventory turnover, Real estate,
Credit cards
• What are the key value drivers?
– Same-store sales