Industry analysis is performed as part of an investor’s due diligence. We want to buy shares in companies that have the best chance of appreciation. Industry analysis can help us to determine whether an industry has good potential or not, and if it’s a good time to buy a particular stock based on where the industry is positioned in its cycle.
Why should an investor be concerned with industry analysis?
The overall profitability of an industry sector is important. Simply stated, some industry sectors provide much better returns than others.
There are also times in the economic cycle where certain types of companies perform better than others.
So, in assessing a stock we are also going to:
- consider the nature of the industry it resides in
- look at the factors affecting profitability that are relevant to the sector, and
- view the sector cycle in relation to other sectors and the market as a whole.
Industry analysis gives us the opportunity to not only look at general trends in the sector but also to compare our potential investment with others in the same sector.
Some pundits believe that the performance of industries are easier to predict than individual companies. There is a lot of merit in this idea.
The aim of the analysis is to determine if a stock is looking good from an industry perspective.
What are the attributes of companies in this sector?
The aim here is to gain an understanding of the industry and its dynamics.
What are the characteristics of the sector?
Keep these questions in mind as you look at companies in the sector:
- Do companies in this sector tend to be cyclical? In other words, is their profitability determined by definite economic cycles?
- Is this a capital intensive industry? Are high maintenance costs a part of doing business in this environment?
- How competitive is this sector? Are there lots of players or only a few key operators?
- Who are the industry leaders from a sales and a profitability perspective? Who has the highest margins (and hence lowest costs)?
- Which period in the economic cycle is most favorable for this type of industry?
- Do companies in this sector tend to be over reliant on debt as a means of funding the business?
What factors affect profitability in this sector?
Try to determine what drives profitability in the sector. Annual reports can provide a wealth of information about a company’s industry dynamics. If you flick through some annual reports for a few different companies in the sector you should be able to spot some common themes.
Learn as much as you can.
Where are we in cycle?
Why does this even matter? This is of great importance. Most stocks tend to move in synch with their industry sectors, so it makes sense to track the performance of industry sectors on an ongoing basis.
The best way to determine where an industry is in its cycle is to look at the long-term trend of the industry on a sector chart.
We’ll need to see 5 or 10 years of historical data so that we can determine the long-term trend.
If we place a 200-day (40-week) moving average on the chart it will help identify the trend.
The trend will either be up, down, or sideways.
If the trend is up, then the strongest stocks in that sector should be found and analyzed as they should make excellent investments.
If the trend is down or moving sideways, then stocks in that particular sector will be avoided.
For an uptrend, you want to see that the price is above a rising 40-week moving average. This generally indicates that the long-term trend is bullish and that stocks in this sector are worthy of your consideration.
For an investor, the ideal time to buy stocks is at the start of the sector’s long-term uptrend. That way, you can capture the majority of the upward move. Remember, most stocks move in the direction of their industry sector (my apologies for repeating this fact but I really want to drive it home).
Read the article on Market Trends for more information on stock market cycles.
S&P ASX 200 Information Technology sector (Australian IT sector)
The long-term trend in the chart above is clearly bullish, and at the time of writing, I have my eye on a number of stocks in this sector as potential investment candidates.
Where to find sector charts
US Sector Charts
Canadian Sector Charts
Click on the sector you’re interested in. Then select “Technical Analysis”. A chart will be displayed for the sector.
Set the Range to “max” and click on the 200 EMA link to place a 200-day moving average on the chart.
United Kingdom Sector Charts
Click on the sector you’re interested in (“Quotes” link). Then select “Technical Analysis”. A chart will be displayed for the sector.
Set the Range to “max” and click on the 200 EMA link to place a 200-day moving average on the chart.
Australian Sector Charts
Click on the sector you’re interested in. Then select “Technical Analysis”. A chart will be displayed for the sector.
Set the Range to “max” and click on the 200 EMA link to place a 200-day moving average on the chart.
Summary Points
- Industry analysis can provide some insight about the direction of a stock market sector
- Industry analysis provides a good opportunity to compare companies in the same industry
- By observing other companies in the same sector you’ll be able find useful clues that will help you make a more informed investment decision
- Continue on to Lesson 10: Company Valuation