I recently read something interesting in William O’Neil’s book titled “How to Make Money in Stocks”. Based on his research he concluded that three out of every four stocks follow the trend prevailing in the sector to which they belong. Put in context this would mean that if the automobile sector as a whole is not performing well, i.e. the ‘stock price performance’ of Tata Motors, M&M and Maruti Suzuki has been below par, then it is unlikely that Ashok Leyland will do well no matter how good the business prospects and fundamentals of Ashok Leyland.
While explaining the concept of Economic Cycle, Investopedia states, “During times of expansion, investors seek to purchase companies in technology, capital goods and basic energy. During times of contraction, investors will look to purchase companies such as utilities, financials and healthcare”. I may safely add FMCG companies to that list for an emerging economy like India, with rising disposable incomes and with the average age of its population being 27.
ECONOMIC CYCLES – DIFFERENT INDUSTRIES REACT DIFFERENTLY TO THEM
Some industries are very vulnerable to economic cycles while others are somewhat unaffected by them. For example, FMCG and pharmaceutical stocks are considered defensive bets in times of economic slowdowns as it is believed that demand for these products does not substantially reduce in times of economic slowdowns. Industries which experience only modest gains during expansionary periods may also suffer only mildly during contractions (example – agro-products) and those that recover fastest from recessions may also feel the impact of a downturn earlier and more strongly than other industries (example – Banking).
Stock Investing and Sector Rotation
So should you be constantly looking at investing in stocks which belong to “Flavor of the month” industry sectors? Sure, why not, but 2 problems. First, how do you know the current economic cycle? Ask yourself – are we in a recession or are we recovering? Or, are we yet to fall into a recession? No one believes that we are in an upswing of any sorts (in June 2013). Second, while it is true that different sectors of the economy outperform (and/or underperform) the broader markets as the economy itself moves from one cycle to the other, the performance of sectors is not uniform in every economic cycle. So the sectors which outperformed in the last upswing may not necessarily outperform this time around.
Nevertheless, the methodology and steps listed below will help you uncover with great certainty, both, sectors which are likely to outperform and those which will underperform (which to my mind are a lot more important to identify), the broader markets in a given economic cycle.
Note: The chart at the end expresses only a personal opinion on companies and sectors listed therein. It is meant for the limited purpose of explanation of the contents of this article. Nothing should be considered as a representation that investment in any given sector or company is suitable or appropriate at any given time or to your individual circumstances, or otherwise constitutes a personal recommendation to you.
Steps in industry analysis:
1. Read the available industry reports and statistics available on web.
2. It is important to look at the different market segments in a particular industry. For example, if you look at chemical industry, you need to understand the sub-industries like fertilizers, paints etc.
3. Look at the demand-supply scenario for a particular product/ industry by studying the past trends and forecasting future outlook.
4. Study the competitive scenario: There is a framework of industry analysis, called “Porter’s five forces” model. In this model, five parameters are analyzed to see the competitive landscape. They are:
♦ Barriers to entry
♦ Bargaining power of supplier
♦ Threat of substitutes
♦ Bargaining power of buyer
♦ Degree of rivalry among the existing competitors
5. Find and study the recent developments, innovation in the industry.
6. Look at the industry valuations (P/E)
7. In Industry analysis, it is important to focus and understand the industry life cycle.
Industry Life Cycle is an important parameter in determining the profitability of companies in a given industry. In other words, no matter how good one is at finding great businesses with improving fundamentals, if its industry group is out of favor, the stock will most likely to go down anyway.
The different stages of the industry life cycle:
Introduction stage: In this stage, the industry is in its infancy. This phase include the development of a new product, from the time it is initially conceptualized to the point it is introduced in the market. The firm having an innovative idea will have a period of monopoly, until competitors start to copy and / or improve on the product. For investors, during the introduction stage there is significant risk as the companies will require huge amount of cash to promote their products. The other risks at this stage are: technical problems in manufacture, packaging, storage, etc., insufficient production capacity, obstacles in distribution, customer reluctance to new products.
Growth stage: If the new product becomes successful, sales will start to grow and the product may begin to be exported to other markets and substantial efforts will be made to improve its distribution. During this phase new competitors will enter the market, slowly eroding the market share of the innovating firm. Competition will mainly be on the basis of product innovations and price. In the growth stage, companies require a significant cash outlay towards more focused marketing efforts and expansion. It is during this phase that companies may start to benefit from economies of scale in production. This stage of industry growth, while still presenting risk to investors, demonstrates the capability of the industry.
Maturity Stage: At this stage, the product become standardized and widely available in the market and distribution is also well established. Competition increasingly takes place over cost and production increases in low cost locations. This is the stage where the industry will start to see slowed growth in the sales. Late entrants come in this stage seeking to capture market share through lower-cost offerings, thus requiring the existing companies to continue their marketing efforts. For investors, maturity of an industry can mean relatively stable stock investments with the possibility of income through dividends.
Decline stage: As the product begins to become obsolete, production and distribution of the product also decline. Eventually, the product will be outdated, an event that marks the end of its life cycle. A decline is inevitable in any industry as technological innovations and changing consumer tastes adversely affect sales. At this stage, some companies may exit the industry or merge and consolidate. An investor should approach stocks in declining industries with caution.