Economic trends can and do affect industry performance. By identifying and monitoring key assumptions and variables, we can monitor the economy and gauge the implications of new Industry
Analysis Process Summary of Research on Industry Analysis
information on our economic outlook and industry analysis. Recall that in order to “beat the mar- ket” on a risk-adjusted basis, we must have forecasts that differ from the market consensus and we must be correct more often than not.
Economic trends can take two basic forms: cyclical changes that arise from the ups and downs of the business cycle, and structural changesthat occur when the economy is undergo- ing a major change in how it functions. For example, excess labor or capital may exist in some sectors whereas shortages of labor and capital exist elsewhere. The “downsizing” of corporate America during the 1990s, transitions from socialist to market economies in Eastern Europe, and the transition in the United States from a manufacturing to a service economy are all examples of structural change.2Industry analysts must examine structural economic changes for the impli- cations they hold for the industry under review.
Most observers believe that industry performance is related to the stage of the business cycle.
What makes industry analysis challenging is that every business cycle is different and those who look only at history miss the evolving trends that will determine future market performance.
Switching from one industry group to another over the course of a business cycle is known as a rotation strategy. When trying to determine which industry groups will benefit from the next stage of the business cycle, investors need to identify and monitor key variables related to eco- nomic trends and industry characteristics.
Exhibit 14.2 presents a stylized graphic of which industry groups typically perform well in the different stages of the business cycle. Toward the end of a recession, financial stocks rise in value because investors anticipate that banks’ earnings will rise as both the economy and loan demand recover. Brokerage houses become attractive investments because their sales and earnings are expected to rise as investors trade securities, businesses sell debt and equity, and there is an increase in mergers during the economic recovery. These industry selections assume that when the reces- sion ends there will be an increase in loan demand, housing construction, and security offerings.
Once the economy begins its recovery, consumer durable firms that produce expensive con- sumer items, such as cars, personal computers, refrigerators, lawn tractors, and snow blowers,
2An excellent discussion of structural changes in the U.S. economy and the implications of these changes for the busi- ness cycle, the stock market, and some specific industries is contained in William C. Dudley and Edward F. McKelvey,
“The Brave New Business Cycle: No Recession in Sight” (New York: Goldman, Sachs & Co., January 1997).
ECONOMIC C YCLE
T r o ugh
Peak
Financial Stocks Excel
Capital Goods Excel
Basic Industries
Excel
Consumer Staples Excel Consumer
Durables Excel
EXHIBIT 14.2 THE STOCK MARKET AND THE BUSINESS CYCLE
Source: Adapted from Susan E. Kuhn, “Stocks Are Still Your Best Buy,” Fortune, 21 March 1994, 140. © 1994 Time Inc. All Rights Reserved. Source of data: Merrill Lynch.
become attractive investments because a reviving economy will increase consumer confidence and personal income. Once businesses recognize the economy is recovering, they begin to think about modernizing, renovating, or purchasing new equipment to satisfy rising demand and reduce costs. Thus, capital goods industries such as heavy equipment manufacturers, machine tool makers, and airplane manufacturers become attractive.
Cyclical industries whose sales rise and fall along with general economic activity are attractive investments during the early stages of an economic recovery because of their high degree of oper- ating leverage, which means that they benefit greatly from the sales increases during an economic expansion.3Industries with high financial leverage likewise benefit from rising sales volume.4
Traditionally, toward the business cycle peak, the rate of inflation increases as demand starts to outstrip supply. Basic materials industries such as oil, metals, and timber, which transform raw materials into finished products, become investor favorites. Because inflation has little influence on the cost of extracting these products and they can increase prices, these industries experience higher profit margins.
During a recession, some industries do better than others. Consumer staples, such as phar- maceuticals, food, and beverages, outperform other sectors during a recession because, although overall spending may decline, people still spend money on necessities so these “defensive”
industries generally maintain their values. Similarly, if a weak domestic economy causes a weak currency, industries with large export components to growing economies may benefit because their goods become more cost competitive in overseas markets.
We have identified certain industries that typically make attractive investments over the course of the business cycle. Generally, investors should not invest based upon the current eco- nomic environment because the efficient market has already incorporated current economic news into security prices. Rather, it is necessary to forecast important economic variables at least three to six months in the future and invest accordingly. The following subsections consider how changes in several important economic variables may affect different industries.
As noted in chapter 12, higher inflation is generally negative for the stock market, because it causes higher market interest rates, it increases uncertainty about future prices and costs, and it harms firms that cannot pass their cost increases on to consumers. Although these adverse effects are true for most industries, some industries benefit from inflation. Natural resource industries benefit if their production costs do not rise with inflation, because their output will likely sell at higher prices. Industries that have high operating leverage may benefit because many of their costs are fixed in nominal (current dollar) terms whereas revenues increase with inflation. Indus- tries with high financial leverage may also gain because their debts are repaid in cheaper dollars.
Banks generally benefit from volatile interest rates, because stable interest rates lead to heavy competitive pressures that squeeze their interest margins. High interest rates clearly harm the housing and the construction industry, but they might benefit industries that supply the do-it-yourselfer. High interest rates also benefit retirees whose income is dependent on interest income.
Interest Rates Inflation
492 CHAPTER 14 INDUSTRYANALYSIS
3As discussed in Chapter 1, operating leverage arises from the existence of fixed costs in a firm’s operating structure.
Industries with large fixed expenses will have high degrees of operating leverage. This means a small percentage change in sales can result in a large percentage change in operating income.
4As noted in Chapter 10, financial leverage arises from fixed financial costs (that is, interest expense) in a firm’s capital structure. Industries that have extensive debt financing (such as banks or utilities) will have net income that is sensitive to small changes in operating income.
Both domestic and overseas events may cause the value of the U.S. dollar to fluctuate. A weaker U.S. dollar helps U.S. industries because their exports become comparatively cheaper in over- seas markets while the goods of foreign competitors become more expensive in the United States. A stronger dollar has an opposite effect. Economic growth in world regions or specific countries benefits industries that have a large presence in those areas. The creation of free trade zones, such as the European Community and the North American Free Trade Zone, assist indus- tries that produce goods and services that previously faced quotas or tariffs in partner countries.
Because it comprises about two-thirds of GDP, consumption spending has a large impact on the economy. Optimistic consumers are more willing to spend and borrow money for expensive goods, such as houses, cars, new clothes, and furniture. Therefore, the performance of consumer cyclical industries will be affected by changes in consumer sentiment and by consumers’ will- ingness and ability to borrow and spend money.