NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra

Module-8
Session-15
Industry Analysis I
Outline

Brief Content
Why industry analysis?
Financial/ Market performance of different industries
Industry analysis process
Business cycle and industrial sectors
Industry life cycle
Analysis of industry competition (Porters Five Forces Model)

Why Industry Analysis?

In previous module, we discussed about economic analysis the first stage of E-I-C analysis. Although
overall economy has got its own cycle of ups and downs, all industries in the economy need not
necessarily move in tandem with the economy. Some industries lag the economy, some might lead. At the
same time, the performance of different industries varies. Hence it is important to analyse the industry
the second stage of E-I-C analysis.
Different industries have got different risk-return characteristics during a particular time period. The
stages of the industries can also be different. Some might be mature while some industries might be at a
nascent stage of development. In a particular industry also, different companies vary in their performance
and stage of development. Hence for the analyst it might be opportune to make buy or sell
recommendation based on industry.
Figure 15.1 shows the sales growth of two different industries over a 10 year period of time. One can see
that the two industries have shown considerable difference in sales growth. Similarly Figure 15.2 shows
the average return on net worth (RoNW in %) of companies in of different industries vis--vis S&P CNX
Nifty and BSE Sensex for 2008-09. While the RoNW is around 15 to 16% for the two indices, the same
varies from -6.6% for textile industry to 22% for IT industry. Figure 15.3 provides the annual index return
of S&P CNX Nifty, BSE Sensex and different sector indices. One can observe a wide variation in the
return shown by different sector specific indices. These provides ample justification for analyzing the
industry performance while doing security analysis. While industry analysis is essential, it is not enough
only to do so. Firms in a particular industry perform differently from each other. Hence analysis of firm/
company is also essential. This is discussed in sessions 17 and 18.
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Figure 15.1: Sales Growth in Sample Industries

Source: Prepared with data from CMIE-Prowess

Figure 15.2: Return on Net Worth (RoNW in %), 2008-09 of different industries and indices

Source: Prepared with data from CMIE-Prowess

Figure 15.3: Annual Index Return, 2009-10

Source: Prepared with data from CMIE-Prowess. Calculated by comparing 30-day average index value on 31
March 2010 over 31 March 2009. All indices except S&P CNX NIFTY and BSE SENSEX are defined by CMIE, India.

Industry Analysis Process

The first thing one has to find out is the industry classification. Because of continuous development in
product and process technologies, innovation and technological changes, the structure of different
industries change from time to time. Hence it is difficult to categorize the economy into different
industries for all the time at once. This keeps changing, if not frequently. There are different ways in
which industry classification is done. One such way is two digit/ three digit standard industry codes
(SIC). The examples of such codes are as below:
Table 15.1: Sample two digit and three digit SIC Codes in India
SIC
Code
01
011
013
016
017
018
019

Name of the industry

AGRICULTURAL PRODUCTION-CROPS
Cash Grains
Field Crops, Except Cash Grains
Vegetables and Melons
Fruits and Tree Nuts
Horticultural Specialties
General Farms, Primarily Crop

SIC
Code
29
291
295
299
49
491
492
493

Name of the industry

PETROLEUM AND COAL PRODUCTS
Petroleum Refining
Asphalt Paving and Roofing Materials
Misc. Petroleum and Coal Products
ELECTRIC, GAS, AND SANITARY SERVICES
Electric Services
Gas Production And Distribution
Combination Electric And Gas, And Other Utility

Source: http://exim.indiamart.com/sic-codes/

Another alternate industry classification which is accepted worldwide is the industry group given by
North American Industry Classification System (NAICS Codes). NAICS assigns two digit 11 for major
industry: Agriculture, Forestry, Fishing and Hunting. Further in this category sub industries are identified
with six digit codes. For example, 111110 is assigned to Soybean Farming, 111422 is assigned to
Floriculture Production 1. Different stock exchanges and other agencies also classify industries and
develop sector specific indices to track the market performance of different industry sectors. The industry
classification by different agencies might not be the perfect one, but it serves the purpose to a
considerable extent for security analysis.
Industry analysis process comprises of different elements viz. business cycle vs. industry sectors,
structural economic changes vs. alternate industries, industry life cycle and industry competition analysis.
The business cycle and industrial sectors: Business cycle denotes the ups and downs in the economy.
Industry performance is related to these movements in the economy. However all the industries do not
move in tandem with the economy where lies the challenge for the analyst to choose an industry for
investment. The investors should be prudent to switch from one industry to another at opportune time.
This is known as industry or sector rotation. Investors should be able to identify the industry that is likely
to do better than others in a particular stage of the business cycle. This can be done by monitoring
relevant economic trends and industry characteristics.
Figure 15.1: Business Cycle

Figure 15.2: Rotation Strategy

Source: Sam Stoval, BusinessWeek Online, A Cyclical Take on

Performance, July 8, 2004, as reproduced in Bodie, Kane, Marcus
and Mohanty, Investments, 8e, Tata McGraw Hill, 2009.

Figure 15.1 shows a typical business cycle and figure 15.2 suggests which industry is likely to do better at
a particular stage of business cycle, so that one can rotate the investment from one industry to another.
When the business cycle is at its peak, the basic materials industries like oil, metals etc. [source of raw
materials] should become investor favorites. Inflation, which is high at the time of peak have little effect
on these industries and these industries can increase prices thus showing higher profit margins. During
recession, some industries perform better than others. Although the aggregate spending of people decline
during recession, the spending on necessities remain almost intact. Hence consumer staples like
pharmaceuticals, food and beverages outperform other sectors during a recession. Cyclical industries like
consumer durables, luxury items benefit the most at the time of expansion. The firms with high financial
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The full list of industry classification by NAICS can be found at: http://www.naics.com/

or operating leverage show higher growth in profit in relation to growth in sales. Banking industry also
performs better during expansion. Since cyclical industries behave the way the business cycle behaves,
the investor should switch from this sector when contraction sets in. Investors need to forecast important
economic variables and switch to industries accordingly just before the opportune time.
Structural Economic Changes vs. Alternate Industries: besides cyclical changes, the structural changes
like those in demographics, technology, lifestyles and regulatory environment also affect different
industries differently. Demographics includes growth in population, age distribution, geographic
distribution of people, income distribution and changes in all such attributes over time. Looking at India,
the population in the young group is quite high. Hence industries like retail, lifestyle products, fashion
etc. are likely to do better. The industries like information technology (IT) and IT enabled services also do
better because of availability brainpower. Lifestyles the set of living standard, consumption pattern,
education level etc. keep changing from time to time. At present, in India, one can see a lot of consumer
interest in entertainment like multiplexes, restaurants, travel and leisure, automobiles. People also would
like to spend in high-end consumer products, gadgets etc. Technology affects how products are produced
and delivered. This makes some industries redundant and new industries come into vogue. Developments
in information technology added with that in mobiles, have changed the banking service delivery. People
need not visit banks for a host of banking services. Cloud computing is likely to make the local serves and
computer data storage redundant. Ready-mix concrete does away with the retailing of building materials
and reduces time to construct for buildings. With technology like bar coding, radio-frequency
identification (RFID) the tracking of inventory is on real time basis for retailers and suppliers also come
to know the stock level on real time basis so that the replenishment can take place before stock-out
occurs. Regulatory and political changes also affect the industries in a great way. With proper regulatory
mechanism, one can see investor interest in telecom, insurance, pension fund etc. in India. Retail sector is
expected to see foreign players since foreign direct investment is recently [November December, 2012]
allowed in multi brand retail.
Besides the above, the life cycle of industry and level of competition in a particular industry also affect
the industry performance. These are discussed in the subsequent session.

References:
Bodie et al (2009), Investments, 8e, Tata McGraw Hill, New Delhi
Mayo, Herbert B. (2009), An Introduction to Investments, 1/e, Cengage Learing
Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson (Cengage)
Learning, New Delhi
Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, Tata McGraw Hill, New
Delhi
Source of Data: Prowess Database, Center for Monitoring Indian Economy

Questions and Answers

Q.1: Why is industry analysis important as part of security analysis?
Ans.: Among other things, the following issues are addressed by industry analysis, thus making it one of
the essential tools of security analysis.

Difference in returns for alternative industries during a specific period of time

Relationship between the market and an individual industry
Difference in risks for alternative industries
How consistent are industry returns over time?
How sensitive a particular industry is to changes in business cycle?

Q.2: What is meant by sector rotation?

Ans.: As a part of sector rotation, portfolio is adjusted by selecting companies that should perform well
for the stage of the business cycle. For example, during peaks it will be better to invest in natural
resource extraction firms and move to defensive industries such as pharmaceuticals and food in the period
of contraction. Similarly it may be appropriate to invest in capital goods industries during trough and
cyclical industries such as consumer durables during expansion phase.