Industry Analysis Made Easy

By Nancy Zambell, Contributing Editor

In our first issue of Financially Fit, we discussed several ratios that are key to a thorough analysis of a company’s investment potential. We pointed out that finding companies with healthy cash flow, acceptable debt, growing sales and earnings, and a reasonable valuation level was a great starting point. We also noted that looking for stocks undiscovered by major institutions and hordes of Wall Street analysts often offer additional appreciation opportunities for investors. And lastly, we stressed the possible impact from large and/or consistent insider sells and buys.

All those ratios are essential to investors practicing fundamental analysis. This is the branch of security analysis that researches and evaluates the investment potential of equities based on the ‘fundamental’ strengths of their underlying businesses, in relation to their historical as well as their forecasted performance.

Yet, there is one more complementary sector of fundamental analysis that is also of extreme import: Analyzing the industry in which a company operates.

If you’ve been an investor for any length of time, you realize that major economic movements will affect pretty much any industry and any company within that industry.

Economic Influences

Most economy-watchers employ statistics like consumer spending, along with the Consumer price index (CPI), to gauge the pulse of the overall economy. Face it, if consumers (us) are not buying, companies will not make products to sell.

Likewise, the trends in manufacturing and the Producer Price Index (PPI) are closely followed to determine the current and future status of the health of industry, in general.

And while these indices have a macro affect across the nation, changes in other statistics and economic events will often impact different industries in very diverse ways.

For example, some investors like to play the movements of stocks in cyclical industries – those that are extremely sensitive to economic changes. These include steel, automotive, chemicals, raw materials, paper, travel and leisure, heavy equipment and construction. In general, when the economy slows, these industries suffer greatly, since the consumption of their products is often not essential to everyday living. But when the economy is booming, so are they, as more disposable income equates with the consumption of more ‘luxury’, or non-essential items.

On the other side of the equation, are defensive, or non-cyclical industries. No matter how rough the waters of the economy, we still need toothpaste, cleaning supplies, electricity and soap – necessities, or items we can’t live without. And while the companies in these types of industries tend to hold up pretty well in times of economic troubles, they may not exactly boom. But their steadiness can often mitigate the losses that more cyclical stocks may levy on your portfolio during those periods.

Those industries are pretty easy to figure out. Many investors have made fortunes by purchasing cyclicals when they thought the economy would strengthen and purchasing stocks in defensive industries when it looked like there would be a rough patch.

But what about those not-so-easy industries to figure out?

Savvy investors realize that the behavior of stocks as well as industries is not an exact science, and one can never accurately predict, with 100% certainty, the movement of investments. Yet each industry does come with its own peculiar set of reactions relative to economic, market and industry-specific events. Consequently, a study and awareness of them will do nothing but make you a better investor.

Let’s start with the economy. Following are some specific economic events and/or statistics and the industries that will be most severely affected by wholesale changes in them:

Interest rates are one of the most-talked about economic barometers, impacting almost every sector of the economy and markets. However, those industries most harshly affected by rate changes include housing, building products, utilities, REITs, banks, brokerage houses, mortgage companies, insurance companies, consumer finance, subprime lenders, fixed income, hotels, restaurants, and travel and leisure.

REITs, building products, banks, mortgage companies, insurance companies, and consumer finance companies will all feel an impact from rising or declining housing starts. Additionally, an accompanying statistic, vacancy rates, will also affect REITs, building products and commercial real estate businesses.

Changes in the price of oil permeate all sectors and all industries, but will most rapidly affect the automotive, airlines, air freight, trucking, railroad, retail, energy trusts, utilities, oil industry (refiners, transportation, equipment, and drillers), wholesalers and retailers, travel and leisure, hotels, restaurants, and energy companies.

Adjustments to and/or changes in regulations of currencies do not just affect foreign companies. The fortunes of banks, brokerage houses, mortgage companies, insurance companies, multinational corporations, and a slew of foreign investments (including many mutual funds and ETFs), may be impacted.

The price of war has created fortunes for decades. During hostilities, defense, aerospace, hardware and software companies, find their services badly needed. And after the war, infrastructure and engineering firms are called upon for rebuilding.

Changes in Demographics influence many sectors, but primarily banks, auto, REITs, housing, insurance, health care and retail, especially apparel.

Industry Influences

Every industry is affected by competition. But some sectors, such as technology, biotech and pharmaceuticals, are more greatly impacted by new product introductions, existing product obsolescence, pricing and international competition and opportunities than others.

All companies in all industries are concerned with market share. Personally, I prefer to invest in companies that are hungry, the #2 or #3 leader in their industries, chasing after the King. And I like businesses that operate in expanding markets.

But many influential factors are industry-specific. In addition to the major economic markers I mentioned above, these industries will also be heavily impacted by their own internal issues:

It’s not just interest rates and the price of oil that affect the Automobile industry. Costly incentives and rebates can drastically reduce the bottom line, but increase sales. R&D costs and opportunities as a result of investments in alternative energy vehicles can hurt or help a company. An eye for future trends or a reliance on the old stand-by models can make or break a manufacturer. And don’t forget the related aftermarket and auto parts industries, which are generally, inversely-related to the new auto manufacturing sector.

Retail is sensitive to distribution changes and opportunities, technology improvements (like RFID), pricing wars and fashion trends.

If you invest in Biotech and Pharmaceuticals, you should look at their alliances with other companies, get to know the FDA processes and approvals, and how government regulation may affect them.

Banking is extremely sensitive to all the major economic changes we discussed, but also will be heavily impacted by mergers and acquisitions and what is occurring in the bank’s specific regional economies.

Changes in technology, pricing and international competition are probably the three most influential factors in the Communications industry. New products are introduced at a breathtaking speed, creating very expensive obsolescence that can severely change the market leadership.

Many Utilities are still heavily regulated, which will impact bottom lines. Additionally, purchased/sold power, alternative energy, distribution, the age of infrastructure and regional economies will affect their fortunes. And in the case of the natural gas and oil sectors, reserves, storage, R& D, transportation and new discoveries will be important.

Food, food processing, and beverages are all affected by commodity pricing, economies of scale, transportation, distribution and new product introductions.

Hardware and Software businesses are very sensitive to changes in the stock markets as well as the general economy. Additionally, they live and die by book to bill ratios, outsourcing trends, pricing wars, foreign competition, R&D, new product introductions and obsolescence.

Government reimbursement programs like Medicare and Medicaid, as well as private insurance payments, continue to drive the ‘health’ of the Health Care industry. But it is also influenced by changes in technology and demographics.

Insurance is widely sensitive to changes in government reimbursements, regional and national disasters, demographics and regulatory requirements.

In addition to broad economic changes, international and regional trade agreements, tariffs, and outsourcing will all impact the Manufacturing sector.

This list – by no means – is intended to cover every industry, but it does give you an idea of supplementary factors – besides the company itself – that are worth researching.

Fortunately, you can get a bird’s-eye-view of the current and historical states of the industries in which you are interested by looking at scores of industry indices. Dow Jones, the company that brings us the Dow Jones Industrial Index, has an index for almost every industry, including toys, apparel retailers, restaurants and bars, travel and tourism, gold mining, trucking, drug retailers, oil equipment and services, chemicals, paper, construction and materials, aerospace and defense, railroads, , food producers, tobacco, medical equipment, airlines, gambling, mobile telecommunications, electricity, full-line insurance, real estate holding and development, mortgage finance and semiconductors – just to name a few!

I think you get the picture! Additionally, the major exchanges and many brokerage firms offer their own indexes. Just go to your Internet search engine and type in the industry in which you are interested and ‘index’ and you will be surprised at the number of indices available. Use them as an indicator of historical and current performance and then compare your company’s performance to them, and it will give you a good idea of how your company’s fortunes change in relation to its competition.

Lastly, I’ll leave you with this thought: Remember, that just because an industry is booming, it doesn’t necessarily follow that every company within it will also soar. Ultimately, from a fundamental perspective, it’s the company that counts!

Until next week…

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


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