CLASSIFYING INDUSTRIESThe 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 - , ^^ -st

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 customize porifolios and indexes- 1

riie 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-'

SECTOR/INDUSTRYANALYSIS

company analysis. These Industry, classifies lions can be quite useful to Investors because Value Line ranks their expected performance (relatively) for ihe year anead,

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.

T h e I mpor t an ce of Sector / In du stry Analysfs_______

WHY INDUSTRY ANALYSIS IS IMPORTANT OVER THE LONG RUNSector 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. To see this, we Mil examine the performance of Industry groups over long periods of time using price indexes foe industries.

Standard & Poor's has calculated weekly and monthly stock price indexes foe a variety of industries, with data available fora 50-year-plus period. Since the data are reponed as index numbers, long-term comparisons of price performance can be made tor any Industry covered. Note that the base number for these'S&P data is 1941-1943 = lO.there--fore, 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.

The top part of Table 14-1 shows the long-term price performance of randomly selected industries for the years 1973. 1983,1995. and March 2000 (when the stock market peaked after five consecutive years of strong-performance). The S&rP 500 Composite Index In 1973 was almost 10 times (98/10) its 1941-1943. level, a continuously

Table 14.-1 Foor'i Weekly Price for IndunritUsing Data for Various Yeari. of 1941- = 10 '

IMi-43 3 1019T1 1983 1!M 200(1*

3CT CHAPTER 14

AutamobJIei fl 100 134 508Aluminum 90 IBS 393 703Btvefl(M 113 W W 717BwlrigM (Sofc '!•» IS7 1343 mEItLiriul 2BO 522 17W 605Enitrtilnm«nt M W 2431 7071fOCKJl S9 w 1037 1312Hultl- Cire IIB •' w 2313 52*3S&P SOU Index W I&S 616 1W1M1-43 =10

\m 1986 1789 itts law.Broadcasc en 1309 «» W7 30MIEntcrtilnment Heilth Cara (Di-

307 1« 577 S« IJ83 94?

2431 7073 2223 SMMoney Center 65 66 1 1 1 233 4t>

ftttall Siorci 104 IS9 375 321 WSAP iOO Indax 141 241 3S3 61« tW

•- tndofMirthSolfla:Sl.lnriri».PTll^'^5BlH[^faw"'SKW;^»^taln]tolt*^^,rKtallli^u^Rtp^ln^byp^m^ll^o^ofSttnc^l^^tfc«lrt. i dtiwan ol lh« MeSriw-Hill Comflintn.

Checking Your UnderlCiinduiJ 361

compounded average in excess of 8 percent annually over this 31-year period. By March 2000, the index wa;> about 150 times its base. However, this average growth rate For the index as a whole consisted cf widely varying perlonnance over the various industries covered by Standard & Poor's.

Over the 30-year period 1943-1973, the electrical equipment industry did well, rising to 28 times ihc base number, while the eniertainment industry was only 3.4 limes the base. By 1983, the alcoholic beverages industry was only eight limes its original base, while electrical equipment was 52 times higher.

An examination of the entire time period, 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. Meanwhile, the auto industry was only about 50 times the base. Notice the dramatic diHereuce in die Alcoholic Bev-erages industry and thf.' 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. 1986. 1989. 1995. and March 2000 Chased on 1941-1943 = 10). Therefore, Table 14-1 provides both a 58-year-plus picture of industry performance (from 1941 to 1943), which approximates the maximum investing lifetime of many individuals, and a look at how much change can occur tn shorter periods of nmr. such as three (1986-1989), four (1982-1986), seven (1982-1989). thirteen (19B2-1995). and roughly eighteen (1982-2000) years.

Tremepdous differences existed for industries in the 1980s and between periods in the 1960s and 2000. Notice how Money Center Banks did nothing between 1982 and 1986, but then almost doubled and redoubled through 199S, and almost redoubled again by March 2000. Broadcast Media performed in an incredibly strong manner over the enure period from 1982 to 1995, but the change troca 1995 to March 2000 is astounding. ^Reta.l Stores, having declined

from 1989 to 1995. almost tripled from 1995 to March 2000.

The lesson to be learned from Table 14-1 is simple. /

^ 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.

Investors are seeking to identify the Broadcast Media and Health Care (Drugs) industries of the future, and avoid the Money Center Banks and Retail Stores industries of the future.

1. How important is industry analysis to investors?2. What has been the major change in the U.S. economy in the

Ias[30 or tOyeau as far as industries are concerned? - ,' .-" - - '

INDUSTRY PERFORMANCE OVER SHORTER PERIODS

What about shorter periods of time and recent data) Docs the same prind,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 2.005. As noted previi.'usly, there arc 10 broad sectors in this nuw clas.'iidcario" system, and these are shown in Table 14-2 along with two indusiries in the IntonmiLiun Technology sci-tur. The ba^e tor ihcsc in; wS&cP. Industry class! fica Huns

382 CHAPTER14 SECTOR/1NDUSTRYANALYSIS

Table l'5-l PerformaneeofSectoriintilndusiriesUsingS&P's GSIC CliSiificationSy stem. Djta end November 100 5 _______

___________________________Annual Rate ofChangaConsumr Dlicitttonvy

161 S Contumer Scipl*l 0.97tnv.Sf . 10-

1S Riwidlll 3.17 HMh.hCire -3.79 Induscrlali

Q.51 Informiciori Tedinatog)' —8.t3 Comnninlcailoni Equlprnint

-12J8 InlernetSoftwar* and Sarvkt* . M.77 Matcriili

9.64 Ttltconimufileacio" iAkci -~ 10.43 Utilities

-4.36

Soi*cf: From Sl P Stctor Scortboird. Imjiiiu'). Ptr(gr™rf.ThtOii<)iKik, Diumbw 7, ZOOS, p. 11. Htprlntid by pcnwiiion of KcGraw-KU.

is Decctnbcr 30,1994 = 100. Table 14-2 shows annual rates of change over this five-year period. /

As we can see, these sectors performed quite differently over this five-year period, frith the Energy sector performing approximately 20 dmes belter than the Industrial secior in terms of annual raic of change. Meanwhile, the Health Care, Information Technology, Telecommunications Services and Utilities sectors had negative annual rates of pn-e change,

Now consider the two industries shown within Information Technology, and noticr how differently they performed over this five-year period. While Co niiounica lions Equipment experienced a —22.6 percent annual rate of change, Internet Software and Services was growing at almost a +21 percent annual rate. t-or the year 2004, Conimunicati..ins Equipment had a positive annual rate of ctiange, 2,77 percent, but Internet Soffn'are and Services experienced an incredible 66.8 percent annual rate of change.

^ Over shorwr periods of time, such as a year or a Eew years, sectors and industries within sectors exhibit widely varying performance.

HOW ONE INDUSTRY CAN HAVE A MA)OR IMPACT ON INVESTORS—THE TELECOM INDUSTRYLet's consider an example of a sector moving into and out of favor with investors in a very dramatic manner. The tele conirnunica lions sector was one of the great growth stories of the late 1990s. 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. When stock prices were rising so rapidly in the late 1990s with the lech stock boom, it was easy [or the industry to raise large amounts of capital by borrowing.

An index of the lelecommunicaitons sector would show a dramatic rise in the latt 1990s. Many of the companies in this industry were market favorites, such as Global Crossing, WorldCuro, and Qwest. Amazingly, after only a couple of years of recognizing the iclecotn industry as a superstar industry, investors realized chat the need for communications and bandwidth services could noi grow at ilic rates that had been predicted.

Ankl)iz[ngSecCori/lnduitriei 383

Meanwhile, the crushing debt loads these companies had assumed were catching up with •thetn, as was [he economic recession that Started in 2001, Telecom collapsed and in all likelihood represented the greatest bursting of a bubble in one sector in history in terms of total dollars lost- One estimate is thai investors In the telecommunica lions industry had lost S2 trillion by mid-2002, and there were plenty of bankruptcies and accounting scandals by that lime.

CROSS-SECTIONAL VOLATILITY HAS INCREASEDFinally, consider another iidicaiion thai paying attention to the relative pcrforroance of industries and sectors is important. A new study by the Frank Russell Company measures cross-sectional volatility, or the variation in returns across various sectors of the market. Sectors here refer to such groups of companies as utilities, retail companies, and financial companies. By examining thr variations in irlurns .imoug the ditferi:m sectors on a month by month basis, some judgment about cross-sec tional volatility can be made.

The Russell study found that cross-seciional volatility began to rise In .the mid-1990s, and even after some deciinc in 2000 and 2001 it was twice what it was in 1395. Obviously, what happened in ilu technology sector contributed to tins vol-iulUy. But the study Found lhat even ignoring [he tech sector, cross-sec lional vnl.iiilny has increased significantly.

An increase in cross-sectional volatility enhances chc importance of industry/sector analysis. Any ability to distinguish between the lop andbonom performers should pay off.

See^B's/EJia^ogsftfdes I--Sectors and industries, as well as the market and companies, are analyzed through the Study of a wide range of data, including sales, earnings, dividends, capital Structure, product lines, regulations, innovations, and so on. Suah analysis requires considerable expertise and is usually performed by industry analysts employed by brokerage firms and other institutional investors.

A useful first step is 10 analyze industries in terms of iheir stage in the life cycle. The idea is to assess the general henlth and current position of the industry, A second step involves a qualitative analysis of indusiry characierisiics designed to assist investors in assessing the future prospects [or an industry. Each of these sicps is examined in turn.

bulumy Lite Cycle The soya of*n indusuy's CYoluilon (ro

THE INDUSTRY LIFE CYCLEMany observers believe that industries evolve through at least four stages' pioneering, expansion, stabilization, and deceleration in growth anil/or decline. There is an obvious parallel in this idea to human development. The concept of an industry life cycle could apply to industries or product lines within industries. The industry life-cycle concept Is depicted in Figure 14-1, and each stage is discussed in the following section.

Pioneer! 118 Stage In the pioneering stage, rapid growth in demand occurs. Although a number of companies within a growing industry will fail at this stage because they will not survive the competitive pressures, most experience rapid growth In sales and earnings. possibly at an increasing rate. 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, with the weaker firms failing and dropping out.Investor risk in an unproven company is high but so arc expected returns if the com-pany succeeds. Profit margins and profits arc often small or negative. At the pioneering

384 CHAPTER 14 SECTQR/INDUSTHVANALTSIS

stage of an industry, it can be difficult for security analysis to identify the likely survivors, just when the ability to identify the future strong performers is most -alii.iLIc^ By the time It becomes apparent who the real winners are. 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—'' . hardware and software— offered a good example of companies in "J.^ pior' . ..i^ stage. Given ;he explosion in expected demand for these products, many n^.. iiims entered/che business hoping to capture some share of the total market. By 19o3. there were an csrimatcd 150 mdnufacturers of h«me computers, a dearly unsustainable number over the longer run.

Expansion Stage In the second stage of an industry's life cycle, the expansion stage, the survivors from the pioneering stage are idcaufiable. They continue to g-ow and to prosper, but the rate of growth is more moderate than before.

At the expansion stage of the cycle, industries are improving their produce sod perhaps lowering their prices. They are more stable and solid, and at this stage i'."'y often aiLraci considerable invcsunenL funds- Investors arc more willing to invest'- •he^e mdus-tries now thai their potential has been demonstrated and ihe risk of failure '; ,-•; di—reased. . Financial policies become firmly established at this stage. The i:e.i..;a"L uase is widened and strengthened. Profit margins are very high. Dividends often become payable, further enhancing the attractiveness of these companies to a

Figure 11.1

The industry Ufa cycle.

Pioneering

Expansion lima

Slablizalion

number of investors.

Stabilization Stage Industries eventually evolve into the stabjUzation stage (sometimes referred to as the maturiiysiagc), at whicli point the growth begins to moderate. Tnis is probably the longest part of the industry life cycle. Products become more standardized and less innovative, the. marketplace is full of competitors, and costs are stable rather than decieasing through efficiency moves, for example. Management's ability to control costs and produce operating efficiencies becomes very important in terms of affecting individual company profit margins.Industries at this stage continue to move along, but typically the industry growth rate matches the growth rate for the economy as a whoie.

Declining Stage An industry's sales growth can decline as new products are developed and shifts in demand occur- Think of the industry for home radios and black-and-while televisions. Some nrm5 in an industry experiencing decline face significantly lower profits or even losses. Rates of return on invested capital will' tend to be low.

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

Checking Your Under itand ing 385

industry. Based on the stage of the industry, they can better assess the potential of different companies within an industry. This helps in estimating the return potential, and the risk, of companies.

This type of analysis lias its limitations. First, it is only a generalization, and investors must be careful not to attempt to categorize every industry, or all companies within a par- « licular industry, into neat categories that may noi apply. Second, even the general framework may not apply to some industries that are not categorized by many small companies struggling for survival. Finally, the bottom line in security analysis is stock prices, a function of the expected stream of benefits and the nsk involved.

The industry life cycle tends to focus onsales and share of the market and investmeni in the industry. Although all of these [actors arc important to investors, they are not the final items of interest. Given these qualifications to industry life-cycle analysis, what are the implications for investors?

The pioneering stage may oiler the highest potential returns, but it also poses the greatest risk. Several companies in a particular industry will fail or do poorly. Such risk may be appropriate for some investors, but many will wish to avoid the risk inhereal In this stage.

Investors Interested primarily in capital gains should avoid the maturity stage. Companies at this stage may have relatively high-dividend payouts because they have fewer growth prospects. These companies often offer con tinu ing-stability in earnings and dividend growth-

Clearly, companies in the fourth stage of the industrial life cycle, decline, are usually to be avoided. Investors should seek to spot industries in this stage and avoid them.

^- It is the second stage, expansion, that is probably of most interest to investors. Industries thai have survived the pioneering stage otien offer good opportunities. Growth is rapid but orderly, an appealing characteristic lo investors.

CheeSsjgag Y®asH' g-Js^ a a- sta ll in g 3. What does an increase in the cross-sectional volatility of various sectors mean to Investors in general? . °

QUALITATIVE ASPECTS OF INDUSTRY ANALYSIS

^

The analyst or investor should consider several important qualitative factors that can characterize an industry. Knowing about these Eaciors will help investors to analyze a par-ticular Industry and will aid in assessing its future prospects.

The Historical Performance As we have learned, some industries perform welland others poorly over long periods of lime. Although performance is not always consistent and predictable on the basis of the past. an industry's track record should not be ignored. 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). It continued to do badly in 1973 and aflctward. The broadcast media industry on the other hand showed Strength at each of the 1950 and 1960 checkpoints since 1982-

Investors should consider the historical record of sales and earnings growth and price performance. Although the prist cannot simply be extrapolated into ihe future, ii does provide sonic useful mfomution.

386 CHAPTER H SECTOR/ INDUSTRTANALTSIS

Competition The nature of the competitive conditions existing In an Industry can provide useful information in assessing ifs future. Is the industry protected from the entrance of new competitors as a result of control of raw materials, prohibitive cost of building plants, Ac level of production needed to operate profitably, and so forth?

Michael Porter has written extensively on the Issue of competitive strategy, which involves the search for a competitive position in an industry.1 The intensity of competition in an industry determines that industry's ability to sustain above-average returns. This intensity is not a matter of luck but a reflection of underlying factors dial determine the strength of five basic competitive factors:

1. Threat of new entrants2. Bargaining power of buyers3. Rivalry between existing competitors4. Threat of substitute products or services5. Bargaining power of suppliers

These five competitive forces arc shown as a diagram in Figure 14-2. Because the strength of these five factors varies across industries (and can change over time), industries vary from the standpoint of inheren,l profitability -

The five competitive forces determine industry profitability because .these influence the components of return on investment- The strength of each of these factors is a function of industry structure.

The important point of the Poncr analysis is that industry profitability is a function of industry structure. Investors must analyze industry structure 10 assess the strength of the five competitive forces, which in turn determine industry profitability.

Finn 14-1Tht five

competitive force* that determine industry pMifitability. '

SouiCf: AJprbmd wkh tb* pTTnJalo'lOfLht Feu Prtu, idl>l»ano<SlrnuJ Scluur, AdukhiMlNnc Group, from.

conwrmviAowN-

TAGE:Cn«k) Ml Grown

Iu(oMr« SiifMrtor Nrkr-mmbrKdi—ILto-ur. CoorthtO Has tff HdMl iXw.AlrWHiwn.d.

'See MicIiKl E. Forw, Itiduiuy Sinictun and Compttiuw Sttitegy: Ktyi to PraCfbiliiir' Financial Aaalyus Joanvil (July-Augusl 1980). 30--11. Stt ttio Miduet PIHIH. ComptlUfvt Aaronlay: Croiling ana 5ui(alBlji( SufOW Pt'foniww (Nor YBI|L Fiec Pit**, IW).

Government Effects Government regulations and actions can have significtol effects on industries. The investor must attempt to assess the results of these effects or. at the very least, be well aware that they exist and may continue,

Consider the breakup of AT&T as of January 1, 1984. This one action has changed the telecommunications industry permanently and perhaps others as well. Asl second example, the deregulating of the financial services industries resulted in banks and savings and loans competing more directly wilh-each other, offering consumers many of the some services. Such an action has to affect the relative performance ot these two industries as well as some of their other competitors, such as the brokerage industry (which can now also offer similar services in many respects).

Structural Changes A fourth factor to consider is the structural changes thai occur in the economy. As the United Stales continues to move from an industrial society to an information-communications sociery. major industries will be affected- New Industries with tremendous potential are, and will be, emerging, whereas some traditional industries, such as Steel, may never recover to their former positions.

Structural shifts can occur even within relatively new industries, for example, in the early 1980s the microcomputer industry was a young, dynamic industry with numerous competitors, some nf whom enjoyed phenomenal success in/a short time. The intio-duction of micro compuiers by IBM in 1982, however, forever changed that industry. Other hardware manufacturers sought to be compatible with IBM's personal computer. and suppliers rushed to supply items such as software, printers, and additional memory boards. IBM's decision to enter this markel

significanLly altccicd virtually every part o( the industry.

^sai^a 5-p.@eoe--/S^^ys^ry Analysis as an Imrestoe*SECTOR ROTATIONNumerous investors use sector analysis in their investing strategy. The premise here ts simple—companies within the same industry group are generally affecied by the same market and economic conditions. Therefore, if an investor can spot important changes in the sector or industry quickly enough, appropriate portfolio changes can be made.

Institutional investors such as mutual funds analyze industry groupings carefully in order to determine which are losing momentum and which are gaining. When a sector trend is spotted, these investors rotate into the favorable sector and out of a sector losing favor with investors. The strategy at the beginning of these events is to invest to the likely best performing companies in the sector, which points out why company analysis (Chapter 15) is imporiani. When these companies rise in price and appear to be fully valued, secondary companies are identified and invested in. Ultimately, the entire sector becomes fairly valued or overvalued, or economic conditions for the sector become less favorable, and money rotates out of [his sector and into a new one.

EVALUATING FUTURE INDUSTRY PROSPECTSUltimately, investors are interested in expected performance in the future. They reaaze thai such estimates are difficult and are likely to be somewhat in eiroc, But they kno^ that equity prices arc a function of expected parameters, not past, known values. How, then, is an investor [o proceed?

Assessing Longer-Term Prospects To forecast industry performance over the longer run, investors should ask the following questions;

1. Which industries are obvious candidates for growth and prosperity over, say, the next decade? (In the early 1980s, such industries as microcomputers, the software Industry. telecommunications, and cellular telephones could have been identified; in ihe laic 1990s, technology finns could have been identified.)

2. 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 ANALYSISA useful procedure for investors to assess industry prospects is to analyze industries by their operating ability in relation to the economy as a whole. That Is, some industries perform poorly during a recession, whereas others are able to weather it reasonably well. Some industries msvc closely with the business cycle, outperforming the average industry in good times and undcrpcrfonuing it in bad limp; InvesLors, in analyzing industries, should be aware of these relationships.

Most investors have heard of, and are usually seeking, growth companies. In growth industries, carnings-are expected to be significantly above the average of all industries, and such growth may occur regardless of setbacks in tlii; economy. Growth industries in the 1980s included genetic engineering, rniciocompuicrs, and new medical devices. Current and future growth industries include robotics and cellular telephones. Ctearly, one oi the primary goals of fundamental security analysis is to identify the growth industries of the near and far future.

Growth stocks suffer much less during a [ccessicn.suchas 1990. lliandu llic cyclical stocks explained below. Iw example, growth stocks (pined 2.5 percent in 1990 while cyclical., lost about 20 percent

At the opposite end of die scale are the defensive Industries, which are least affecied by recessions and economic adversity. Food has long been considered such an industry. People must eat, and they continue to drink beer, eat frozen yogurt, and so on, regardless of [he economy. Public utilities might also be considered a defensive industry.

Cyclical industries arc most volatile—they do unusually well when the economy prospers and are likely to be hurt more when the economy falters. Durable goods are a good example of the products involved in cyclical industries. Auios, refrigerators, and heavy equipment, tor example, may be avidly sought when limes are good, but such purchases may be postponed during a recession, because consumers can often make do with the old units.

In the 1990 recession, cyclical stocks declined 20 percent, three limes as much as the S&tP 500. En 1994, General Motors, a prime example of a cyclical company, declined 40 percent. On the other hand, when the economy recovers, cyclicals do very well.

Cycllcals are said 10 be 'bought lo be sold." When should investors pursue cyclical industries? When the prices of companies in the industry are low, reladve 1.0 the hi-storicat record, and P/Es are high. This seems counterintuitive to many Investors, but the rationale is that earnings are severely depressed m a recession and therefore- the F/E is high, and this may occur shortly before earnings turn around-Countercyclical industries also exist, actually moving opposite to the prevailing economic trend. The gold mining industry is thought 10 follow this paiiem.

These three' classifications of industries according to economic conditions do not constitute an exhaustive set. Additional classifications are possible and logical. For example, Interest-sensitive industries are particularly sensitive to expectations about changes in interest rates. The financial services, banking, and real estate industries are obvious examples of interest-sensitive industries- Another is the building industry.

Whai are the implications of these classifications for investors? To predict the performance of an industry over shorter periods of time, investors should carefully analyze the stage of the business cycle and the likely movements in Interest rates. 1C the economy is heading into a recession, cyclical industries are likely to be affected more than other industries, whereas defensive industries are the least likely to be affected. Withsuch guidelines investors may make better buy-or-sell decisions. Similarly, an expected rise in interest rates will have negative implications tor the savings and loan industry and the home building Industry, whereas an expected drop in interest raies will have the opposite cffcct-

These statements reinforce the importance of market

a-.alysis.Not only do investors need 10 know the state of the economy and market before deciding to invest, but such knowledge is also valuable in selecting, or avoiding, particular Industries. Furthermore. investors need to consider the possibility of overcapacity as well as global competition-

A5 an example of applying business cycle considerations to industry analysis, consider the memory-chip industry. As shortages occurred in the early 1990s and prices rose, suppliers rushed to build ntw plants in order to cash in on the demand for chips. By the end of 19S5, memory-chip production was growing in excess of 20 percent, but sales were slipping. A glut, emerged, and in 1996 prices dropped more than 60 percent. The stock prices of chip makers suffered sharp drops in mid-1996 as the results of this activity became apparent.

PICKING INDUSTRIES FOR NEXT YEAROna shorter-run basis, investors would like la value industries along the lines discussed in Chapter 13 for the market- 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. However, this is not easy to do. li requires an understanding of several relationships and estimates of several variables. Fortunately, considerable information is readily available to help investors in their analysis of industries. Investors should be aware ot the primary sources of information about industries and the nature of the information available.

To determine iilclustry performance for shurter periods or time (e.g.. one year), investors should ask themselves [he following question: Given the current and prospective economic situation, which industries are likely 10 show improving earnings? In many respects, this is the key question for industry security analysis. Investors can turn to the Institutional Brokers' Estimate System (1BES), which compiles institutional brokerage earnings estimates, for analysts' estimates of earnings for various industries, which are revised during the year.

Given the importance of earnings and the availability, of earnings estimates for industries and companies, are investors able to make relatively easy investment choices? The answer is no. because earnings estimates are notoriously inaccurate. In one recent year, for example, Standard &r Poor's was estimating that the banking industry's profits would increase 15 percent for the year, while IBES estimated 29 percent—obviously, s big difference.

Dreman reported on a study of 61 industries for a 17-year period. Threes-fourths of all estimates within industries missed reported earnings by 30 percent or more, and 15 percent showed errors of 80 percent or more. The average forecast error grouped by industries was 50 percent (median error of 43 percent). Only 16 of the 61 industries over the 17 years showed forecast errors of 29 percent or less,''

Of course, investors must also consider the likely P/E ratios for industries. Which Industries arc likely to show improving P/E ratios? Dreman has also' reported on the issue of whether, like companies, investors pay loo much for favored companies in an industry. Iluying the lowest 20 percent of P/Es in cadi of 44 industry groups over 25 years (based on the 1,500 largest companies on the Coni|)ustat database measured by market capitalization) produced an average annual return of 18 percent compared to 12.4 percent for the liighcst 20 percent F/E group. 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.3

Other questions 10 Lonsider arc the likely d;i LClion of interest

rates and which industries would be most affected by a significant change in interest raics. A change in interest rates, other things being equ;il. leads lo .1 change in the discount rate (and a change in the multiplier). Which industries arc likely 10 be most affected by possible future political events, such as a new administration, renewed inflation, new technology, an increase in defense spending, and so on?

As with all security analysis, we can use several procedures in analysing industries. Much ol this process is comn.on sense. For example, if you can reasonably forecast a deciiniii^ number of COITIF/- liiors in an industry, it stands to reason, that, other things being equal, the remaining ["inns will be more profitable.