Financial Policy

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Financial Policy

• Industry Analysis

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Learning Objectives

• To understand return differences between
  industries during different time periods.
• To understand whether there is consistency in the
  returns for industries over time.
• To evaluate whether the performance of firms
  within an industry are consistent.
• To evaluate whether there is a difference in risk
  between different industries.
• To understand how the risk for a given industry
  changes over time.

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Learning Objectives

• To understand the difference between cyclical and
  structural changes for an industry.
• To learn how an industrys life cycle can affect
  a given industry.
• To understand the nature of the five basic
  competitive forces that determine the intensity
  of competition in an industry.

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Why Do Industry Analysis?

• To determine whether the performance of firms
  within an industry are consistent over time.
• To determine whether there are differences
  between the returns for alternative industries
  during different time periods.
• To determine whether an industry that performs
  well in one period will continue to perform well
  in the future. That is, can we use past
  relationships between the market and an industry
  to predict future trends for the industry?
• To determine whether the risk between industries
  and within industries is consistent.

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Cross-Sectional Industry Performance
Studies of annual industry performance have found
that different industries have consistently shown
wide dispersion in their rates of return.
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Cross-Sectional Industry Performance
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Cross-Sectional Industry Performance
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Cross-Sectional Industry Performance
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Cross-Sectional Industry Performance
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Cross-Sectional Industry Performance
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Cross-Sectional Industry Performance
These results imply that industry analysis is
important and necessary to uncover performance
differences that will help identify both
profitable and unprofitable opportunities.
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Industry Performance Over Time
In another group of investigations, researchers
tried to determine whether industries that
perform well in one time period would continue to
perform well in subsequent time periods.
In this case, investigators found almost no
association in industry performance year to year
or over sequential rising or falling markets.
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Industry Performance Over Time
These studies imply that past performance alone
does not help to project future industry
performance.
The results do not, however, negate the
usefulness of industry analysis. They simply
confirm that investors must project future
industry performance on the basis of future
estimates of the relevant variables.
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Performance of Companies Within an Industry
If all firms within an industry perform
consistently during a specified time period,
investors would not need company analysis.
Industry analysis alone would be enough.
However, most research typically shows wide
dispersion among companies within an industry.
This raises an obvious question. Is industry
analysis useless because all firms in an industry
do not move together over time?
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Performance of Companies Within an Industry
The answer is NO. Industry analysis is still
valuable because it is much easier to evaluate a
company once relevant industry factors are
evaluated and the effects of these factors on a
company are understood.
By fully appreciating industry characteristics
and trends, you reduce the risk that your
analysis of a particular company will be in error.
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Differences in Industry Risk
One study that investigated industry risk
examined two questions 1. Did risk differ among
industries during a given time period? 2. Were
industry risk measures stable over time?
The study found a wide range of risk among
different industries, and the difference in risk
levels typically widened during rising and
falling markets.
On a positive note, however, the analysis
indicated that industry risk was reasonably
stable over time.
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Differences in Industry Risk
In general, these results can be interpreted as
follows.
Although risk measures for different industries
showed substantial cross-sectional dispersion,
the risk measures for individual industries are
stable over time.
This means that the analysis of industry risk is
necessary, but that historical analysis can aid
attempts to estimate the future risk for an
industry.
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Summary of Research on Industry Analysis
1. During any time period, industry returns vary
within a wide range, which means that industry
analysis can be useful in evaluating companies
within a particular industry. 2. The rates of
return for individual industries vary over time,
so we cannot simply extrapolate past industry
performance into the future. 3. The rates of
return of firms within industries also vary, so
company analysis is a necessary follow-up to
industry analysis.
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Summary of Research on Industry Analysis
4. During any time period, different industries
risk levels vary within wide ranges, so we must
examine and estimate the risk factors for
alternative industries, as well as returns. 5.
Risk measures for individual industries remain
fairly constant over time, so historical risk
analysis can be very useful when estimating
future risk for an individual industry.
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
Cyclical Changes in the economy arise from the
ups and downs of the business cycle.
Wall Street folklore suggests that industry
performance is related to the stage of the
business cycle. However, what makes industry
analysis challenging is that although the
folklore may be true ON AVERAGE, every business
cycle is different and those who look only at
history are in danger of missing the current and
evolving trends that will determine future market
performance.
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
By looking ahead to the next stage of the
business cycle, investors can try to purchase
industry groups stocks at current prices in
order to take advantage of future sales and
earnings growth. The following graphic is
designed to demonstrate which kinds of companies
and stocks typically excel at different points in
the business cycle.
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
When Do Industry Groups Excel?
Where are we now?
Basic Industries Excel
PEAK
PEAK
Consumer Durables Excel
The Business Cycle
Financial Stocks Excel
Capital Goods Excel
Consumer Staples Excel
TROUGH
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
How Inflation affects Industries
Higher inflation is generally perceived to be
negative for most industries because (a) It
causes higher market interest rates, (b) it
increases uncertainty about future prices and
costs (leading to higher risk perceptions), and
(c) it harms firms that are unable to pass
through all their cost increases to customers.
While these adverse effects are true for most
industries, some industry groups actually benefit
from inflation.
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
How Inflation affects Industries
Higher inflation is generally perceived to be
negative for most industries because (a) It
causes higher market interest rates, (b) it
increases uncertainty about future prices and
costs (leading to higher risk perceptions), and
(c) it harms firms that are unable to pass
through all their cost increases to customers.
For example, firms in natural resource industries
benefit if their production costs do not rise
with inflation since their oil, mineral or metal
output will likely sell at higher prices.
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
How Inflation affects Industries
Higher inflation is generally perceived to be
negative for most industries because (a) It
causes higher market interest rates, (b) it
increases uncertainty about future prices and
costs (leading to higher risk perceptions), and
(c) it harms firms that are unable to pass
through all their cost increases to customers.
In addition, industries that have high operating
and financial leverage may benefit because many
of their costs are fixed in nominal terms while
revenues increase with inflation.
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
How Interest Rates Affect Industries
Banks generally benefit from volatile interest
rates while stable interest rates lead to heavy
competitive pressures that squeeze their interest
margins.
Also, higher interest rates harm capital goods
industries and housing and automotive sectors but
help do-it-you-self type industries like auto
repair and companies like Home Depot.
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
How International Events Affect Industries
A myriad of international events can effect the
domestic economy and markets.
For example, during the fall of 1997, an Asian
monetary and capital market crisis was thought to
be a major reason for the over 500 point decline
in the Dow in October.
Also, the invasion of Kuwait by Iraq in 1990
caused oil prices to skyrocket and set into
motion the first U.S. recession since 1982.
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
How International Events Affect Industries
More predictably, a weaker U.S. dollar helps U.S.
exporters because U.S. goods become comparatively
cheaper in overseas markets while the goods of
foreign competitors become comparatively more
expensive in the United States.
In addition, economic growth in world regions or
specific countries will benefit industries that
have a large presence in those areas.
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
How Consumer Sentiment Affects Industries
Because it comprises about two-thirds of GDP,
consumption spending has a large impact on the
economy.
Optimistic consumers will be more willing to
spend and borrow money for expensive goods, such
as houses, cars, new clothes, and furniture.
The performance of consumer cyclical industries
such as these will be affected by changes in
consumer confidence and consumers willingness to
borrow and spend money.
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Links Between the Economy Industry Sectors
CYCLICAL EFFECTS
How the Availability of Production Inputs Affect
Industries
Manufacturers using minerals, oil, or other raw
materials as inputs in the production process
will perform better when theses inputs are
relatively abundant.
Changing demographics may expose some industries
to a shortage of entry-level workers or highly
trained personnel.
Companies in industries able to work around such
shortages will have a competitive advantage over
their rivals who cannot.
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Links Between the Economy Industry Sectors
STRUCTURAL EFFECTS
Structural Changes occur when the economy is
undergoing a major change in organization or in
how it functions. As a result, excess labor or
capital may exist in some sectors and shortages
may exist in others.
Structural changes need to be examined by
industry analysts for the implications they hold
for the industry under review.
Structural effects include social influences,
technology, politics, and regulation.
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Links Between the Economy Industry Sectors
STRUCTURAL EFFECTS
Social Influences Demographics
Because of the WWII baby boom, the fastest
growing age groups in the 2000s will be those in
their 40s, 50s, teens, and over 70. Declining in
population will be those between 18 and 24 years
of age.
The changing age-profile of Americans has
wide-ranging implications. It may result in a
shortage of entry-level workers or to find
qualified workers to replace aging baby-boomers.
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Links Between the Economy Industry Sectors
STRUCTURAL EFFECTS
Social Influences Demographics
Because of the WWII baby boom, the fastest
growing age groups in the 2000s will be those in
their 40s, 50s, teens, and over 70. Declining in
population will be those between 18 and 24 years
of age.
While the graying of the population may
positively impact the financial services
industry, it may have a negative impact on
industries such as retailing..
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Links Between the Economy Industry Sectors
STRUCTURAL EFFECTS
Social Influences Life-Styles
Life-styles deal with how people work, live, form
households, consume, enjoy leisure, and educate
themselves. Consumer behavior is affected by
trends and fads.
The rise and fall of designer jeans,
bellbottoms, divorce rates, suburbanization,
dual-career families, and computer-based
education have impacted industries such as
catalog and TV shopping, fast food, tobacco, and
home entertainment.
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Links Between the Economy Industry Sectors
STRUCTURAL EFFECTS
Social Influences Social Values
Returns to nature, environmental consciousness,
civil rights, the changing role of women, and
concern over the use of tobacco and alcohol all
reflect the changing social values in the United
States.
Changes in societys values and outlook on issues
can lead to changes in labor force participation,
education, and consumption patterns. All of
these factors may have positive or negative
influences on various industries.
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Links Between the Economy Industry Sectors
STRUCTURAL EFFECTS
Technology
Trends in technology can affect both the industry
product and the manufacturing and delivery
process.
For example, there is less need for carburetors
on cars because of electronic fuel-injection
technology. The engineering process has changed
because of the advent of computer-aided design.
The perpetual improvement of designs in the
semiconductor industry has made that industry one
that is difficult to evaluate. The information
superhighway has become a reality and may lead to
further linkages between telecommunications and
cable TV.
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Links Between the Economy Industry Sectors
COMPETITIVE STRUCTURE OF AN INDUSTRY
In addition to cyclical and structural
influences, microeconomic factors affect
industries. For example, monopolistic industries
tend to be regulated oligopolistic industries
may be characterized by either tough competitive
actions or a live and let live managerial
philosophy competitive industries are dynamic
and are the toughest to evaluate.
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Links Between the Economy Industry Sectors
COMPETITIVE STRUCTURE OF AN INDUSTRY
The competitive environment of an industry
determines the ability of firms to sustain
above-average rates of return on invested
capital. This may be described graphically below
Potential Entrants
Threat of new entrants
Bargaining power of suppliers
Bargaining power of buyers
Industry Competitors
Suppliers
Buyers
Threat of substitutes
Rivalry among existing Competitors
Substitutes
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Links Between the Economy Industry Sectors
COMPETITIVE STRUCTURE OF AN INDUSTRY
The relative effect of each of these five factors
can vary dramatically among industries.
Rivalry Among Existing Competitors For each
industry, you must judge if the rivalry among
firms is currently intense and growing, or polite
and stable by examining the level of price and
non-price competition over time. Rivalry
increases when many firms of relatively equal
size compete in an industry. When estimating the
number and size of firms, be sure to include
foreign competitors Furthermore, slow growth
causes competitors to fight for market share and
increase competition.
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Links Between the Economy Industry Sectors
COMPETITIVE STRUCTURE OF AN INDUSTRY
The relative effect of each of these five factors
can vary dramatically among industries.
Threat of New Entrants Although an industry may
have few competitors, you must determine the
likelihood of firms entering the industry. High
barriers to entry such as low current prices
relative to costs, keep the threat of entrants
low. Other barriers to entry include large up
from financial investments, large economies of
scale, extensive and hard-to-reach distribution
channels, and government licensing or patents.
Without one or more of these barriers, it would
be easy for competitors to enter the industry,
thus driving down prices, profits, and stock
prices and returns.
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Links Between the Economy Industry Sectors
COMPETITIVE STRUCTURE OF AN INDUSTRY
The relative effect of each of these five factors
can vary dramatically among industries.
Threat of Substitute Products Substitute products
limit the profit potential of an industry because
they can bid down prices that firms can charge.
Although almost everything has a substitute, you
must determine how close the substitute is in
price and function to an industrys product.
As an example, the threat of substitute glass
containers hurt the metal container industry. In
the food industry, consumers constantly
substitute between beef, pork, chicken, and fish.
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Links Between the Economy Industry Sectors
COMPETITIVE STRUCTURE OF AN INDUSTRY
The relative effect of each of these five factors
can vary dramatically among industries.
Bargaining Power of Buyers Buyers can influence
the profitability of an industry because they can
bid down prices or demand higher quality or more
services by bargaining among competitors. The
most vulnerable firm is a one customer firm that
supplies a single large manufacturer such as for
auto parts manufacturers. Buyers will be more
cost conscious if the cost of an item represents
a large percentage of the firms total costs.
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Links Between the Economy Industry Sectors
COMPETITIVE STRUCTURE OF AN INDUSTRY
The relative effect of each of these five factors
can vary dramatically among industries.
Bargaining Power of Suppliers Suppliers can alter
future industry returns if they increase prices
or reduce the quality or services they provide.
Suppliers are more powerful if there are few of
them and if they are more concentrated than the
industry to which they sell, and if they supply a
critical input to several industries for which
few substitutes exist.
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Links Between the Economy Industry Sectors
INDUSTRY LIFE CYCLE
Another tool to help predict industry sales is to
view the industry over time and divide its
development into stages. A five-stage model
would include the following 1. Pioneering
Development 2. Rapidly Accelerating Industry
Growth 3. Mature Industry Growth 4. Stabilization
and Market Maturity 5. Deceleration of Growth and
Decline
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Links Between the Economy Industry Sectors
INDUSTRY LIFE CYCLE
Net Sales ()
Mature Growth
Pioneering Development
Rapid Accelerating Growth
Deceleration of Growth and Decline
Stabilization Market Maturity
Time
Stage 1
Stage 5
Stage 4
Stage 3
Stage 2
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Links Between the Economy Industry Sectors
INDUSTRY LIFE CYCLE
Pioneering Development
During this stage, the industry experiences
modest sales growth and very small or negative
profit margins and profits. The market for the
industrys product or service is small, and firms
incur significant development costs. Cash flow
is usually negative and financing sources are
usually tapped out.
Because of an uncertain industry future and the
competition to come, it is difficult to identify
winners at this time. One current example of
an industry in this stage is interactive cable.
Currently, only a small percentage of homes are
properly wired for interactive cable, and company
alliances are forming to try to exploit this
technology in the marketplace.
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Links Between the Economy Industry Sectors
INDUSTRY LIFE CYCLE
Rapid Accelerating Growth
During this stage, a market develops for a
product or service and the demand becomes
substantial. The limited number of firms in the
industry face little competition and individual
firms can experience substantial backlogs.
Profit margins are very high, and these profits
attract new competitors.
During this phase, profits can grow at over 100
per year. Usually, a few firms will emerge as
industry leaders, both in terms of product
offering and market share. These firms may be
attractive for investment purposes -- but only if
their shares are not already overpriced.
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Links Between the Economy Industry Sectors
INDUSTRY LIFE CYCLE
Mature Growth
The rapid growth during Stage 2 satisfied most of
the demand for industry goods or services. This
large sales base may still keep sales growth
above normal, but it no longer accelerates. For
example, if overall economic growth is 5, sales
for this industry may continue to grow at 10 to
15.
Also, the rapid growth in sales and profit
margins will continue to attract competitors to
the industry. As this happens, profit margins
will begin to decline toward more normal levels.
Dividends rise from the low levels during Stage
2. Examples of industries in this stage would
include personal computers, and specialized
retail segments such as Office Depot or Home
Depot.
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Links Between the Economy Industry Sectors
INDUSTRY LIFE CYCLE
Stabilization and Market Maturity
During this Stage, which is usually the longest,
the industry growth rate matches the growth rate
for the overall economy. Although sales growth
is in line with the economy, profit growth varies
by industry and by individual firms within the
industry because managements ability to control
costs differs among companies..
Competition produces tight profit margins, and
rates of return on assets and capital eventually
decline. More generous dividends are paid as
firms in the industry may have difficulty finding
attractive reinvestment opportunities. Examples
include the supermarket industry and the cola
segment of the soft drink industry in the U.S.
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Links Between the Economy Industry Sectors
INDUSTRY LIFE CYCLE
Deceleration of Growth and Decline
During this final Stage, the industrys sales
growth declines because of shifts in demand or
growth of substitutes. Profit margins continue
to decline and some firms experience low profits
or even losses. Firms that remain profitable may
show very low rates of return on capital and
investors begin thinking about alternative uses
for the capital tied up in this industry. An
example of an industry in this stage of
development would be mainframe computers.
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Links Between the Economy Industry Sectors
INDUSTRY LIFE CYCLE
Implications for Investors
Although these stages may be viewed as
generalizations, they should help analysts and
investors estimate potential industry growth.
This, in turn, should assist you in analyzing the
prospects for a company within a given industry.
It is important to note, however, that even an
industry in Stage 5 can be converted to a Stage 2
industry by product innovations that attract new
consumers to use the product. For example,
roller skating was reinvigorated by the
development of in-line skates, and skiing was
reinvigorated by the development of snowboards.
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Estimating Industry Growth
Growth retention rate (RR) x return on equity
(ROE)
RR 1 dividend payout rate
ROE NPM x TAT x Equity Multiplier
Net Profit Net Income x Sales
x Total Assets Equity Sales
Total Assets Equity
Note This information can be obtained from the
Financial Analysts Handbook. It may also be
available from Research Insights.
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Links Between the Economy Industry Sectors
Sources of Industry Information
Standard Poors Industry Survey Standard and
Poors Analysts Handbook Value Line Investment
Survey Trade Magazines Trade Associations
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Finding Industry Information Online
Industry Research Desk