Industry Analysis

Submitted By Aaron NematNejad

In a previous article we described how to pick stocks based on a relative value approach within an industry. In this article we describe methods to screen for industries as opposed to the stocks within them. Many market practitioners stress the importance of industry analysis and maintain that however good the quality of a stock is, it is highly unlikely to outperform if the industry is performing poorly. Many of the ideas in this section have been taken from TV presenter and market practitioner, Jim Cramer.

What is Industry Stock Analysis?

Industry analysis is the analysis made in a specific sector or industry. This compares to stock analysis which is the research provided on a particular company and stock, or macroeconomic analysis which analyzes the fundamentals of a specific country. Industry analysis investigates the general fundamentals of the equities within the industry but more importantly investigates the state of external factors and how they should affect the particular industry or sub sector. Different macroeconomic data and other statistics have a particular bearing on certain industries and analysts gauge to see how these data will affect them. Furthermore industry analysts also investigate the level of demand such as consumer tastes and supply such as competition within the industry and how stock prices should get affected by them.

Why the need for Industry Analysis?

Many analysts suggest that resisting the business cycle is futile. For the simple reason that most prices are governed by large financial institutions that buy and sell the majority of the volume of stocks and these institutions generally give a very heavy weighting to the performance or the expected performance of a specific industry. After market risk, this is the most influential factor in the performance of a stock.

To summarize there are two reasons why industry analysis is important. 1. Generally the performance of a company is a function of the performance of the industry. For example if raw material in a particular industry has gone up then all the companies in the industry will get affected. 2. Psychological reasons. If an industry suddenly gets in vogue or if a sudden change in the news is perceived to be good or bad for an industry the price of the stock will be affected mainly from what the average investor believes and most investors will follow industry trends.

How are Industries Broken Down?

Industries are broken down by groups and subgroups. Different benchmark indices which track stocks within a country have different levels of narrowness to define the different sectors or industries. For example the S&P 500 has 147 different industries which means that on average each industry has just over 3 stocks in it. The Russell 1000 index has only 12 industries which means that each industry has on average over 83 stocks included in it, and Japan’s Topix Index has 33 industries.

Narrowing down industries has its advantages and disadvantages. The advantages are that it will be a lot easier to pick a stock from a specific industry, especially if one were to develop a long/short position with the purpose of removing industry and market risk. The disadvantage is that if one is limited by the amount of capital one has to invest it will be very difficult to create a diversified portfolio because there are too many industries to learn.

Industry Cycle Vs Economic Cycle

A specific industry cycle is not necessarily the same as the business cycle. Very often a specific industry will outperform or even drive in the opposite direction to the general economic cycle. For example pharmaceutical stocks are generally resistant to the business cycle. Most individuals buy drugs for the sole purpose of curing illness, for this reason we cannot assume that there will be much correlation between demand for medicine and the economy (one could make the case that as a recession occurs more people get ill as a result of the stress and therefore by more drugs, however there isn’t any serious research to make the case). For this reason as a recession approaches, pharmaceutical supermarket and housing stocks are the generally recommended industries. These industries are termed as “countercyclical”.

Examples of Factors Affecting Different Industries

This is the most difficult part of the article to write because the opinions presented are dynamic and can change with times. For this reason this section is written with a lot of generalizations so that they are treated as rules of thumb and not always hard facts.

Commodity Driven Industries

There are many sectors that are dependent on raw costs. Any business that uses plastic in its manufacturing process should be sold if resin costs (cost of plastics) rise. Chemical companies use a lot of natural gas in their production process and should be sold if the price of natural gas rises above a certain expected level. Similarly with metals, companies that rely on cheap iron or copper prices should be sold if these commodities become more expensive.

Fiscal Dependant Industries

There are many industries that rely on government spending and different political parties winning seats will have a major affect on stock prices. For example if the democrats are in power it is wise to buy healthcare companies or anything that makes money from Medicaid or Medicare because the democrats are likely to spend more money there than the Republicans would. Other sectors that rely on government spending include construction and machinery where the revenues are very much dependent on how much Congress decides to give to federal highway bills. Defense contractors very much depend on which political party is in power. Democrats generally will spend less on defense than Republicans would. The Pentagon is the specific organization that makes a lot of the decisions on defense spending, so it’s always best to analyze what the Pentagon is deciding.

Transportation companies should be looked at with care. What kind of goods and services do these transportation companies deliver? If the demand for the goods are subject to the economic cycle then the transportation company will also be affected by it because it is a derived demand. More importantly however is to gauge as to the perception that the market has on what type of company it is. For example CSX Corporation is an international freight transportation company. Even though CSX doesn’t usually transport cyclical goods, the market didn’t really take this into account and still went short during the middle of 2006.

Industries Dependent on the Fed

Managed healthcare companies which are generally growth companies, drive in the same direction as the Fed. If the economy is slowing and the Fed raises rates managed health care companies will rise in price.

Banks should generally be sold when the Fed raises rates. Many of the banks make money by issuing loans such as mortgages. If interest rates rise demand for mortgages goes down. Banks make money from the spread in interest rates they make by lending money to long term borrower and receiving money from current account holders. There is no reason to believe that spreads will narrow or widen if interest rates rise or fall. For this reason banks generally depend on the quantity of loans made which is a function of interest rates.

If the economy is slowing, the government is less willing to spend on the construction of roads and government buildings. Generally when the Fed raises rates banks go down first followed by industrial and machinery companies.

Industries that are Dependent on BRIC Countries

BRIC stands for Brazil, China, Russia and India. Many market practitioners believe that many of the companies that do business in BRIC countries are set to make a lot of money because these are high growth countries which are especially good for cyclical and industrial stocks. Off course one has to be cautious because even these countries can go through economic downturns but it is important to note that many of the companies on the S&P 500 are tied to the performance of these countries. It is not so simple to tell which companies are exposed to which countries. The best method is to check a company’s annual report. There will be a breakdown in sales by region if the company does a lot of business abroad. There you can see if a good chunk of money is coming from the BRIC countries.

The Financial Cycle Illustrated

The below diagram displays a chart with a guide to what the major institutions buy and sell at different points in the economic cycle. The numbers on the chart refer to the numbers below as a guide to the best way to invest at specific points in the economic cycle.

industry cycle