Industry Analysis. Fundamental Analysis Fundamental analysts look for companies whose financial...
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Transcript of Industry Analysis. Fundamental Analysis Fundamental analysts look for companies whose financial...
Fundamental Analysis
• 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…• Monetary and fiscal policies (taxes, money supply, inflation)
influence the aggregate economies of countries– Resulting economic conditions influence all industries and
companies• Alternative industries react to economic changes at different
points in business cycles– Demographic changes, foreign operations
• 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?
• 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
• The purpose of industry analysis is to identify which industries will be good for investors in the upcoming environment.
• 9 issues should be addressed:– 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:– 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:• 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:– 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
• The primary sources of industry-wide information are trade groups, for example:– 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.
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
Rotation Strategy
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
Economic Analysis
Industry Life CyclesStage Sales
Growth• Start-upRapid &
Increasing• ConsolidationStabl
e• MaturitySlowing• Relative
DeclineMinimal 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
Business cycle and industries
FinancialStocks
ConsumerDurables
CapitalGoods
ConsumerStaples
Basicindustries
Rotation Strategy
Rotation strategyTowards 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 offeringsOnce recovery begins• Consumer durables stocks are attractive• Cars, PCs, refrigerators, lawn tractors, and snow blowers• Reviving economy will increase consumer confidence and personal incomeTowards 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 serviceTowards 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 – 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 cross-industry effects
Rotation Strategy
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: GeneralMacroeconomic Conditions and Retail sales of Non-
durables Sample 1947-2003
-2%
-1%
0%
1%
2%
3%
4%
-3% -2% -1% 0% 1% 2% 3% 4% 5%
GDP growth
Non-D
ura
ble
Gro
wth
Correlation = 0.39
Industry Analysis
Retailing versus inflationSample: 1947-2006
-3%
-2%
-1%
0%
1%
2%
3%
4%
-1.0% -0.5% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5%
Inflation
Non
-Dura
ble
Gro
wth
Correlation = -0.27
Industry Analysis