The Standard Industrial Classification (SIC) system was the basis for the collection and > analysis of [lie U.S. economy for more than 60 years. The SIC system, could be used to put i together a comprehensive Statistical analysis of an industry. Developed in the 1930s when manufacturing dominated the U.S. economy, ibis sysiem'was revised many times because of rapid changes in our economy, particularly the expansion of services. SIC codes aided significantly in bringing order [o the industry classification problem by providing a consistent basis for describing industries and companies. Analysis using 51C codes could focus on economic activity in as broad, or as specific, a manner ds desired. Nevertheless i the SIC system was criticized for not being able Co handle rapid changes tn the U.S. economy. This led to the development of the North American Industry Classi&-cation System (NAICS), which replaced the SIC codes in 1997. -
A NEW CLASSIFICATION SYSTEM—NAICS ".
The North American Industry Classification System (NAIC5) is a significant change for analyzing economic activities. It was developed using a production-oriented conceptual . framework; therefore, companies are classified into industries based on .the activity in which they are primarily engaged. Basically, companies that do similar things in similar ways are classified together. NAICS uses psuf-digit hierarchical coding system to classify ail economic activity into 20 industry sectors, which provides greater llexioihty relative to SK, coaes- rilteen 'ql these sectors are de vole d to services-producing sectors compared to five sectors thai' are mainly goods-producing sectdis...NAICS allows for the identification of 1,170 industries. Ninc.new service sectors and 250 new service industries are recognized. . , „'. Using NAIC5 codes, the Plasiics Product Manufacturing industry is coded 3261. Within [his code number aie several breakdowns, including among others, Plastic Pipe and Pipe Filling Manuiacturiri)i (326122), and Plastics Bottle Manufacturing (3261CO): . \ , ^
OTHER INDUSTRY CLASSIFICATIONS -
Thi: SIC system of indusiry cl.i.ssifi cation has pmbably been the most consistent system • availahk. As noted, NAICS L> a new classification sysiem providing more detail- However, in the Investments field several well-known invesimeni advisory companies have developed their own industry groupings. For example. Standard &r Poor's Corporation
provided weekly siock indexes on ll..'>ector5 and approximately 115-Indus try groups for a long lime. These weekly indexes have often been used to assess an industry's performance over time. As of March 2002. SfaP has been using a new system known as the Global Industry Class ilication Standard (G1CS) 10 provide "one complete, continuous set of global sector and industry dcfmiLions." This system divides everything into 10 "economic sectors": Consumer Discretionary, Consumer Staples, Energy. Financials, Healili Care, Industrials. Irifonnaiion Technology, Materials, Telecommunications Services, and Utiliiies, Within this framework there are 24 indu5try groupings, 64 industries, and 139 subindustries (as 01 April 2005), Tliis system is intunded to classify companies around the world and already includes 25,000-1- companies. Peer groups arc denned tightly. S&P's GICS system, developed Jointly with Morgan Stanley Capital International, provides considerably mote ('n ^il lii.i;! 'i&P's pfcvious classifii-.aiiun system. This ill tum will pcnnil users lo more icadily 1 customize porifolios and indexesriie Value Lilif: Invesimciit 5w-'c.y f.uws roughly 1,700 comp"nie^, divided imu approximately 96 inUu-'iirics, with a discussion of industry p»)'.,pccts prcccdine ill-'
1995. To see this. and March 2000 (when the stock market peaked after five consecutive years of strong-performance). long-term comparisons of price performance can be made tor any Industry covered. Other providers of information use different numbers of industries In presenting data. The important point 10 remember If that multiple industry classification systems are used. we Mil examine the performance of Industry groups over long periods of time using price indexes foe industries.Cire IIB S&P SOU Index W (Drugl) 1M1-43 =10 \m Broadcasc en Media Price of Indexel IMi-43 1941-19 1983 43 100 IBS W IS7 522 W w •' w I&S 1986 1309 for = 10 Selecte 3 10 d 1!M 134 393 W 1343 17W 2431 1037 2313 616 1789 «» Indunrit ' 200(1* 508 703 717 m 605 7071 1312 52*3 1W itts law.there--fore. Stock All with a Bur 19T1 AutamobJIei fl Aluminum 90 Btvefl(M 113 BwlrigM (Sofc '!•» (Alcoholic) EItLiriul 2BO Drink)) Enitrtilnm«nt M Equlpmini fOCKJl S9 Hultl. a continuously
Table 14. W7 30MI
. classifies lions can be quite useful to Investors because Value Line ranks their expected performance (relatively) for ihe year anead.
The Importance Analysfs_______
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. dividing the index number for any industry for a particular year by 10 indicates the number of limes ihe index has increased over lhai period. 1983.3CT CHAPTER 14
company analysis. Since the data are reponed as index numbers. Note that the base number for these'S&P data is 1941-1943 = lO. The top part of Table 14-1 shows the long-term price performance of randomly selected industries for the years 1973. level. Standard & Poor's has calculated weekly and monthly stock price indexes foe a variety of industries. These Industry. The S&rP 500 Composite Index In 1973 was almost 10 times (98/10) its 1941-1943. with data available fora 50-year-plus period.-1 Foor'i Weekly Using Data Standard & for Various Yeari.
lnriri».rKtallli^u^Rtp^ln^byp^m^ ll^o^ofSttnc^l^^tfc«lrt. i dtiwan ol lh« MeSriw-Hill Comflintn.PTll^'^5BlH[^faw"' KW.^»^taln]tolt*^^.tndofMirth S Solfla:Sl.
.Entcrtilnment Heilth Cara Money Center (Di-ugi) ftttall SinksSiorci SAP iOO Indax Campoilt*
307 1« 65 104 141
577 S« 66 IS9 241
IJ83 94?1 11 375 3S3
2431 7073 2223 SM 4t> 233 321 W 61« tW
almost tripled from 1995 to March 2000. Meanwhile. Tremepdous differences existed for industries in the 1980s and between periods in the 1960s and 2000. By March 2000. However. 1941-1943 through March 2000 shows that the entertainment industry increased more than 700'fold whili: the electrical equipment industry did almost as well at about 650 times the base. Therefore. and avoid the Money Center Banks and Retail Stores industries of the future. having declined from 1989 to 1995.4 limes the base. four (1982-1986). 1995. Notice the dramatic diHereuce in die Alcoholic Beverages industry and thf. rising to 28 times ihc base number. The lesson to be learned from Table 14-1 is simple. seven (1982-1989). 1986. An examination of the entire time period. Over the 30-year period 1943-1973. Table 14-1 provides both a 58-year-plus picture of industry performance (from 1941 to 1943). Notice how Money Center Banks did nothing between 1982 and 1986. such as three (1986-1989).
.l Stores. thirteen (19B2-1995). Broadcast Media performed in an incredibly strong manner over the enure period from 1982 to 1995.> about 150 times its base. ^Reta. this average growth rate For the index as a whole consisted cf widely varying perlonnance over the various industries covered by Standard & Poor's. / ^ Industry analysis pays because industries perform very differently over longer periods of time and investor performance will be significandy affected by the particular industries thai investors hold in their portfolios.Checking Your UnderlCiinduiJ 361 compounded average in excess of 8 percent annually over this 31-year period. the electrical equipment industry did well. 1989. the index wa. By 1983. while electrical equipment was 52 times higher. and almost redoubled again by March 2000. but the change troca 1995 to March 2000 is astounding. but then almost doubled and redoubled through 199S. and roughly eighteen (1982-2000) years. Investors are seeking to identify the Broadcast Media and Health Care (Drugs) industries of the future.' Soft Drink Beverages industry over the-period ending in both 1995 pnd March 2000. The lower half of Table 14-1 shows selected and matched Standard &i Four's Industry Stock Price indexes for ihe years 1982. while the eniertainment industry was only 3. the alcoholic beverages industry was only eight limes its original base. which approximates the maximum investing lifetime of many individuals. the auto industry was only about 50 times the base. and March 2000 Chased on 1941-1943 = 10). and a look at how much change can occur tn shorter periods of nmr.
-" -.' . there arc 10 broad sectors in this nuw clas. As noted previi.'
INDUSTRY PERFORMANCE OVER SHORTER PERIODS
What about shorter periods of time and recent data) Docs the same prind.S. What has been the major change in the U. and these are shown in Table 14-2 along with two indusiries in the IntonmiLiun Technology sci-tur. How important is industry analysis to investors? 2.'usly.p'ie hold true— that industries perform very differently? Let's consider S&iP's niiw GIC5 classification system and analyze-a five-year period cndinr in November 2.'iidcario" system. Industry class! fica Huns
.005. wS&cP. The ba^e tor ihcsc in.1. economy in the Ias[30 or tOyeau as far as industries are concerned? .
these sectors performed quite differently over this five-year period. the Health Care..77 Matcriili 9.36
Soi*cf: From Sl P Stctor Scortboird. Ptr(gr™rf.
is Decctnbcr 30. such as a year or a Eew years.64 Ttltconimufileacio" iAkci -~ 10.
.t3 Comnninlcailoni Equlprnint -12J8 InlernetSoftwar* and Sarvkt* .77 percent.6 percent annual rate of change.Sf .17 HMh. Htprlntid by pcnwiiion of KcGraw-KU. ZOOS.ins Equipment had a positive annual rate of ctiange. Djta end November 1005_______ ___________________________Annual Rate ofChanga Consumr Dlicitttonvy 161 S Contumer Scipl*l 0.ThtOii<)iKik. Table 14-2 shows annual rates of change over this five-year period.382 CHAPTER14 SECTOR/1NDUSTRYANALYSIS Table l'5-l PerformaneeofSectoriintilndusiriesUsingS& P's GSIC CliSiificationSy stem. / As we can see. 2. Now consider the two industries shown within Information Technology. Information Technology. Meanwhile. ^ Over shorwr periods of time.97 tnv.hCire -3. Imjiiiu').79 Induscrlali Q.8 percent annual rate of change.51 Informiciori Tedinatog)' —8. p. Internet Software and Services was growing at almost a +21 percent annual rate. 11. M. sectors and industries within sectors exhibit widely varying performance. Conimunicati. Telecommunications Services and Utilities sectors had negative annual rates of pn-e change.1994 = 100. While Co niiounica lions Equipment experienced a —22. t-or the year 2004.43 Utilities -4. and noticr how differently they performed over this five-year period. Diumbw 7. 10-1S Riwidlll 3. frith the Energy sector performing approximately 20 dmes belter than the Industrial secior in terms of annual raic of change. but Internet Soffn'are and Services experienced an incredible 66.
An index of the lelecommunicaitons sector would show a dramatic rise in the latt 1990s. WorldCuro. and Qwest. Many of the companies in this industry were market favorites. The tele conirnunica lions sector was one of the great growth stories of the late 1990s. it was easy [or the industry to raise large amounts of capital by borrowing. When stock prices were rising so rapidly in the late 1990s with the lech stock boom. Telecom was deregulated in 1996. Predictions of how quickly Internet traffic would grow proliferated. OneWthe major contributing factors to what happened to the iclecom industry is the huge amount of money thai pouted into the industry abcr it look off. such as Global Crossing.
.HOW ONE INDUSTRY CAN HAVE A MA)OR IMPACT ON INVESTORS—THE TELECOM INDUSTRY
Let's consider an example of a sector moving into and out of favor with investors in a very dramatic manner. investors realized chat the need for communications and bandwidth services could noi grow at ilic rates that had been predicted. Amazingly. after only a couple of years of recognizing the iclecotn industry as a superstar industry.
CROSS-SECTIONAL VOLATILITY HAS INCREASED
Finally. capital Structure. regulations. earnings. and there were plenty of bankruptcies and accounting scandals by that lime. innovations. dividends. The idea is to assess the general henlth and current position of the industry. Telecom collapsed and in all likelihood represented the greatest bursting of a bubble in one sector in history in terms of total dollars lost. A useful first step is 10 analyze industries in terms of iheir stage in the life cycle.the mid-1990s. as was [he economic recession that Started in 2001. Each of these sicps is examined in turn. The Russell study found that cross-seciional volatility began to rise In .
See^B's/EJia^ogsftfdes I-Sectors and industries. including sales. A new study by the Frank Russell Company measures cross-sectional volatility. Obviously.One estimate is thai investors In the telecommunica lions industry had lost S2 trillion by mid-2002. as well as the market and companies.Ankl)iz[ngSecCori/lnduitriei 383
Meanwhile. and financial companies. retail companies. the crushing debt loads these companies had assumed were catching up with •thetn. and so on.
.iiilny has increased significantly. or the variation in returns across various sectors of the market. An increase in cross-sectional volatility enhances chc importance of industry/sector analysis. By examining thr variations in irlurns . some judgment about cross-sec tional volatility can be made. consider another iidicaiion thai paying attention to the relative pcrforroance of industries and sectors is important. are analyzed through the Study of a wide range of data. product lines. Any ability to distinguish between the lop andbonom performers should pay off. Suah analysis requires considerable expertise and is usually performed by industry analysts employed by brokerage firms and other institutional investors. cross-sec lional vnl. Sectors here refer to such groups of companies as utilities. But the study Found lhat even ignoring [he tech sector. A second step involves a qualitative analysis of indusiry characierisiics designed to assist investors in assessing the future prospects [or an industry. what happened in ilu technology sector contributed to tins vol-iulUy. and even after some deciinc in 2000 and 2001 it was twice what it was in 1395.imoug the ditferi:m sectors on a month by month basis.
rapid growth in demand occurs.THE INDUSTRY LIFE CYCLE
Many observers believe that industries evolve through at least four stages' pioneering. and each stage is discussed in the CYoluilon (rom following section. Although a number of companies within a growing industry dtdmt will fail at this stage because they will not survive the competitive pressures. and deceleration in growth anil/or decline. Profit margins and profits arc often small or negative. Investor risk in an unproven company is high but so arc expected returns if the company succeeds. stabilization. There is an obvious parallel in this idea to bulumy Lite human development. 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. At the pioneering
. with the weaker firms failing and dropping out. The concept of an industry life cycle could apply Cycle The soya to industries or product lines within industries. possibly at an increasing rate. expansion. most experience rapid growth In sales and earnings. The industry life-cycle of*n indusuy's concept Is depicted in Figure 14-1. pioneering 10 (Ufailuulon and Pioneer! 118 Stage In the pioneering stage.
a dearly unsustainable number over the longer run.. the survivors from the pioneering stage are idcaufiable.i^ stage. it can be difficult for security analysis to identify the likely survivors.Investors arc more willing to invest'.. . their prices may have h-rn bid up considerably beyond what they were in the earlier stages ol devLLipincT. In the early 1980Si the microcomputer business—'' . They continue to g-ow and to prosper.-•.384 CHAPTER 14
Figure 11. Stabilization Stage Industries eventually evolve into the stabjUzation stage (sometimes referred to as the maturiiysiagc). Expansion Stage In the second stage of an industry's life cycle. industries are improving their produce sod perhaps lowering their prices.•he^e mdus-tries now thai their potential has been demonstrated and ihe risk of failure '. Profit margins are very high.^ pior' . They are more stable and solid. Given . the.
Pioneeri Expansi Slablizalio on lima n ng stage of an industry. there were an csrimatcd 150 mdnufacturers of h«me computers. hardware and software— offered a good example of companies in "J. By 19o3. The i:e. the expansion stage. but the rate of growth is more moderate than before. just when the ability to identify the future strong performers is most -alii. Management's ability to control costs and produce operating efficiencies becomes very important in terms of affecting individual company profit
.. di—reased. and at this stage i'.he explosion in expected demand for these products.. At the expansion stage of the cycle. . Products become more standardized and less innovative.1
The industry Ufa cycle. Tnis is probably the longest part of the industry life cycle. iiims entered/che business hoping to capture some share of the total market."'y often aiLraci considerable invcsunenL funds. at whicli point the growth begins to moderate. Dividends often become payable. Financial policies become firmly established at this stage. many n^. .i. and costs are stable rather than decieasing through efficiency moves.iLIc^ By the time It becomes apparent who the real winners are.. further enhancing the attractiveness of these companies to a number of investors. for example. marketplace is full of competitors.a"L uase is widened and strengthened.
but typically the industry growth rate matches the growth rate for the economy as a whoie. Assessing the Industry Life Cycle The industry life-cycle classification of industry evolvenient helps Investors to assess the growth potential of different companies in an
. Rates of return on invested capital will' tend to be low. Declining Stage An industry's sales growth can decline as new products are developed and shifts in demand occur. Industries at this stage continue to move along.Think of the industry for home radios and black-and-while televisions.margins. Some nrm5 in an industry experiencing decline face significantly lower profits or even losses.
and the risk. an appealing characteristic lo investors. even the general framework may not apply to some industries that are not categorized by many small companies struggling for survival. Based on the stage of the industry. and investors must be careful not to attempt to categorize every industry. companies in the fourth stage of the industrial life cycle.
CheeSsjgag Y®asH' g-Js^ a a-stalling
3. The industry life cycle tends to focus onsales and share of the market and investmeni in the industry. of companies. but it also poses the greatest risk.It is the second stage. or all companies within a par. What does an increase in the cross-sectional volatility of various sectors mean to Investors in general? . First. what are the implications for investors? The pioneering stage may oiler the highest potential returns. Second. Finally. This type of analysis lias its limitations. Although all of these [actors arc important to investors. they are not the final items of interest. Investors Interested primarily in capital gains should avoid the maturity stage. Such risk may be appropriate for some investors. This helps in estimating the return potential. These companies often offer con tinu ing-stability in earnings and dividend growthClearly. Industries thai have survived the pioneering stage otien offer good opportunities. Given these qualifications to industry life-cycle analysis. are usually to be avoided. it is only a generalization. into neat categories that may noi apply.Checking Your Under itand ing 385 industry. Growth is rapid but orderly.« licular industry. but many will wish to avoid the risk inhereal In this stage. Investors should seek to spot industries in this stage and avoid them. ^. Several companies in a particular industry will fail or do poorly. ° QUALITATIVE ASPECTS OF INDUSTRY ANALYSIS
The analyst or investor should consider several important qualitative
. the bottom line in security analysis is stock prices. decline. Companies at this stage may have relatively high-dividend payouts because they have fewer growth prospects. they can better assess the potential of different companies within an industry. expansion. a function of the expected stream of benefits and the nsk involved. that is probably of most interest to investors.
It continued to do badly in 1973 and aflctward. The Historical Performance As we have learned. Although the prist cannot simply be extrapolated into ihe future. In Table 14-1 we saw that the lead and zinc industry performed poorly in both 1950 and 1960 (in relation to the base of 1941-1943).factors that can characterize an industry. The broadcast media industry on the other hand showed Strength at each of the 1950 and 1960 checkpoints since 1982Investors should consider the historical record of sales and earnings growth and price performance. Although performance is not always consistent and predictable on the basis of the past. Knowing about these Eaciors will help investors to analyze a particular Industry and will aid in assessing its future prospects.
. an industry's track record should not be ignored. ii does provide sonic useful mfomution. some industries perform well and others poorly over long periods of lime.
Rivalry between existing competitors 4.The strength of each of these factors is a function of industry structure.386 CHAPTER H SECTOR/ INDUSTRTANALTSIS
Competition The nature of the competitive conditions existing In an Industry can provide useful information in assessing ifs future. prohibitive cost of building plants. Bargaining power of buyers 3. This intensity is not a matter of luck but a reflection of underlying factors dial determine the strength of five basic competitive factors: 1. Is the industry protected from the entrance of new competitors as a result of control of raw materials. Bargaining power of suppliers These five competitive forces arc shown as a diagram in Figure 14-2. The important point of the Poncr analysis is that industry profitability is a function of industry structure.
.these influence the components of return on investment. Threat of new entrants 2. which involves the search for a competitive position in an industry.l profitability The five competitive forces determine industry profitability because .1 The intensity of competition in an industry determines that industry's ability to sustain above-average returns. and so forth? Michael Porter has written extensively on the Issue of competitive strategy. Ac level of production needed to operate profitably. which in turn determine industry profitability. Threat of substitute products or services 5. industries vary from the standpoint of inheren. Because the strength of these five factors varies across industries (and can change over time). Investors must analyze industry structure 10 assess the strength of the five competitive forces.
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Tht five competitive force* that determine industry pMifitability. Itiduiuy Sinictun and Compttiuw Sttitegy: Ktyi to PraCfbiliiir' Financial Aaalyus Joanvil (July-Augusl 1980).d. IW).
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be well aware that they exist and may continue.New Industries with tremendous potential are. and will be. 1984. appropriate portfolio changes can be made. Therefore. The intio-duction of micro compuiers by IBM in 1982. such as the brokerage industry (which can now also offer similar services in many respects).Government Effects Government regulations and actions can have significtol effects on industries. at the very least. Consider the breakup of AT&T as of January 1. Such an action has to affect the relative performance ot these two industries as well as some of their other competitors. may never recover to their former positions. Other hardware manufacturers sought to be compatible with IBM's personal computer. forever changed that industry. The investor must attempt to assess the results of these effects or. printers. major industries will be affected. Asl second example. emerging. however. dynamic industry with numerous competitors.@eoe--/S^^ys^ry Analysis as an Imrestoe*
Numerous investors use sector analysis in their investing strategy. whereas some traditional industries. for example. such as Steel. This one action has changed the telecommunications industry permanently and perhaps others as well. The strategy at the beginning of these events is to invest to the
. in the early 1980s the microcomputer industry was a young. the deregulating of the financial services industries resulted in banks and savings and loans competing more directly wilh-each other. if an investor can spot important changes in the sector or industry quickly enough. and suppliers rushed to supply items such as software. some nf whom enjoyed phenomenal success in/a short time. offering consumers many of the some services. Structural shifts can occur even within relatively new industries. Institutional investors such as mutual funds analyze industry groupings carefully in order to determine which are losing momentum and which are gaining. The premise here ts simple—companies within the same industry group are generally affecied by the same market and economic conditions.
^sai^a 5-p. As the United Stales continues to move from an industrial society to an information-communications sociery. When a sector trend is spotted. Structural Changes A fourth factor to consider is the structural changes thai occur in the economy. these investors rotate into the favorable sector and out of a sector losing favor with investors. IBM's decision to enter this markel significanLly altccicd virtually every part o( the industry. and additional memory boards.
then. secondary companies are identified and invested in. Ultimately. But they kno^ that equity prices arc a function of expected parameters. When these companies rise in price and appear to be fully valued. How. known values.
EVALUATING FUTURE INDUSTRY PROSPECTS
Ultimately. and money rotates out of [his sector and into a new one. or economic conditions for the sector become less favorable. investors are interested in expected performance in the future.likely best performing companies in the sector. is an investor [o proceed?
. They reaaze thai such estimates are difficult and are likely to be somewhat in eiroc. not past. which points out why company analysis (Chapter 15) is imporiani. the entire sector becomes fairly valued or overvalued.
such industries as microcomputers. in ihe laic 1990s. growth stocks (pined 2. outperforming the average industry in good times and undcrpcrfonuing it in bad limp. In growth industries. Which industries are obvious candidates for growth and prosperity over. some industries perform poorly during a recession. lost about 20 percent
. investors should ask the following questions.) 2. growth companies. and new medical devices. rniciocompuicrs. say. technology finns could have been identified. Which industries appear likely to have difficulties as the United Stales changes from an industrial to an in forma [ion-cot lee ting and -processing economy?
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. Iw example. should be aware of these relationships. 1. lliandu llic cyclical stocks explained below.suchas 1990. the software Industry. whereas others are able to weather it reasonably well. in analyzing industries. That Is. and such growth may occur regardless of setbacks in tlii. Most investors have heard of. one oi the primary goals of fundamental security analysis is to identify the growth industries of the near and far future. Some industries msvc closely with the business cycle. carnings-are expected to be significantly above the average of all industries. Current and future growth industries include robotics and cellular telephones. Ctearly. Growth stocks suffer much less during a [ccessicn. and cellular telephones could have been identified.Assessing Longer-Term Prospects To forecast industry performance over the longer run. economy. the next decade? (In the early 1980s.. InvesLors.5 percent in 1990 while cyclical. Growth industries in the 1980s included genetic engineering. and are usually seeking. telecommunications.
cyclical stocks declined 20 percent. cyclical industries are likely to be affected more than other industries.At the opposite end of die scale are the defensive Industries. and this may occur shortly before earnings turn around-Countercyclical industries also exist. declined 40 percent. Additional classifications are possible and logical. and they continue to drink beer. cyclicals do very well. investors should carefully analyze the stage of the business cycle and the likely movements in Interest rates. This seems counterintuitive to many Investors. Cycllcals are said 10 be 'bought lo be sold. In the 1990 recession." When should investors pursue cyclical industries? When the prices of companies in the industry are low. a prime example of a cyclical company.Another is the building industry. because consumers can often make do with the old units. refrigerators. These three' classifications of industries according to economic conditions do not constitute an exhaustive set. and P/Es are high. and heavy equipment. Public utilities might also be considered a defensive industry. Interest-sensitive industries are particularly sensitive to expectations about changes in interest rates. and real estate industries are obvious examples of interest-sensitive industries. whereas defensive industries are the least likely to be affected. and so on. People must eat.alysis. For example. three limes as much as the S&tP 500. but the rationale is that earnings are severely depressed m a recession and therefore. when the economy recovers. The gold mining industry is thought 10 follow this paiiem. Cyclical industries arc most volatile—they do unusually well when the economy prospers and are likely to be hurt more when the economy falters. whereas an expected drop in interest raies will have the opposite cffcctThese statements reinforce the importance of market a-. Durable goods are a good example of the products involved in cyclical industries. On the other hand. Auios. Whai are the implications of these classifications for investors? To predict the performance of an industry over shorter periods of time. may be avidly sought when limes are good. tor example. En 1994. eat frozen yogurt.the F/E is high. 1C the economy is heading into a recession.0 the hi-storicat record. General Motors. reladve 1.Not
. Food has long been considered such an industry. banking. which are least affecied by recessions and economic adversity. regardless of [he economy. an expected rise in interest rates will have negative implications tor the savings and loan industry and the home building Industry. actually moving opposite to the prevailing economic trend. but such purchases may be postponed during a recession. The financial services. Similarly. Withsuch guidelines investors may make better buy-or-sell decisions.
. and in 1996 prices dropped more than 60 percent. particular Industries. or avoiding. but such knowledge is also valuable in selecting. As shortages occurred in the early 1990s and prices rose. consider the memory-chip industry. A glut. Furthermore. suppliers rushed to build ntw plants in order to cash in on the demand for chips. The stock prices of chip makers suffered sharp drops in mid-1996 as the results of this activity became apparent. but sales were slipping. emerged.only do investors need 10 know the state of the economy and market before deciding to invest. investors need to consider the possibility of overcapacity as well as global competitionA5 an example of applying business cycle considerations to industry analysis. By the end of 19S5. memory-chip production was growing in excess of 20 percent.
To determine iilclustry performance for shurter periods or time (e. Fortunately. which are revised during the year. Investors can turn to the Institutional Brokers' Estimate System (1BES).500 largest companies on the Coni|)ustat database measured by market capitalization) produced an average annual return of 18 percent compared to 12. which industries are likely 10 show improving earnings? In many respects. considerable information is readily available to help investors in their analysis of industries.3 Other questions 10 Lonsider arc the likely d.PICKING INDUSTRIES FOR NEXT YEAR
Ona shorter-run basis. Dreman also found that buying the lowest F/E stocks across industries produced smaller losses when the market is down relative 10 the market as a whole and tu the highest F/E group. Which Industries arc likely to show improving P/E ratios? Dreman has also' reported on the issue of whether.'' Of course. The average forecast error grouped by industries was 50 percent (median error of 43 percent). Given the importance of earnings and the availability. Standard &r Poor's was estimating that the banking industry's profits would increase 15 percent for the year. Dreman reported on a study of 61 industries for a 17-year period. one year). investors pay loo much for favored companies in an industry.g. for example.. and 15 percent showed errors of 80 percent or more. investors must also consider the likely P/E ratios for industries.4 percent for the liighcst 20 percent F/E group. like companies. However.They would like 10 be able to estimate [lie expected earnings for an industry and the expected multiplier and combine them to produce an estimate of value. investors should ask themselves [he following question: Given the current and prospective economic situation. s big difference. are investors able to make relatively easy investment choices? The answer is no. while IBES estimated 29 percent—obviously. Threes-fourths of all estimates within industries missed reported earnings by 30 percent or more. In one recent year. this is not easy to do. li requires an understanding of several relationships and estimates of several variables. investors would like la value industries along the lines discussed in Chapter 13 for the market. Iluying the lowest 20 percent of P/Es in cadi of 44 industry groups over 25 years (based on the 1. for analysts' estimates of earnings for various industries. of earnings estimates for industries and companies. this is the key question for industry security analysis. which compiles institutional brokerage earnings estimates. Investors should be aware ot the primary sources of information about industries and the nature of the information available. Only 16 of the 61 industries over the 17 years showed forecast errors of 29 percent or less. because earnings estimates are notoriously inaccurate.i LClion of interest rates and which industries would be most affected by a significant
il. an increase in defense spending. leads lo . renewed inflation. other things being equ. it stands to reason. A change in interest rates. if you can reasonably forecast a deciiniii^ number of COITIF/liiors in an industry. and so on? As with all security analysis.change in interest raics. Much ol this process is comn. we can use several procedures in analysing industries. such as a new administration. new technology.1 change in the discount rate (and a change in the multiplier).on sense. the remaining ["inns will be more profitable. other things being equal. For example.
. Which industries arc likely 10 be most affected by possible future political events. that.