So far, we have seen the importance of general macroeconomic health for overall market performance. Now, we will take it a step further, we will dig a little deeper and discover why sector and industry performance is critical for security performance.
First of all, we will describe the concepts of sector and industry to set a foundation for further analysis (introduced in our Equity Funds section):
A county’s economy is made up of all the businesses in it, which are divided into different general segments (sectors) depending on the underlying business activity that they perform.
Normally, an economy can be divided into 11 sectors that comprise nearly all business activity within it:
- Technology Sector
- Financial Sector
- Utility Sector
- Healthcare Sector
- Real Estate Sector
- Consumer Discretionary Sector
- Consumer Staples Sector
- Industrials Sector
- Materials Sector
- Energy Sector
- Communications Sector
E.g. a vaccine manufacturing company such as Pfizer Inc. is logically part of the Healthcare Sector because its principal business activity is related to health.
An industry is a more specific group of companies that operate in a similar business field within a sector, they are in the same line of work offering similar products or services. Basically, a sector is a general group of companies and an industry is a subgroup within a sector. The 11 sectors we listed above are broken down into different industries, which vary in number depending on the sector.
E.g. Pfizer Inc., which is part of the Healthcare Sector, is in the Drug Manufacturers industry.
In reality, it is difficult to define where the line is between one industry and the other. Therefore, the North America Industry Classification System (NAICS) codes were created. These are codes assigned to group companies for statistical analysis where the first two digits of the code indicate very broad industry classifications and the following digits define industry grouping more narrowly. For example, companies in the construction industry are assigned codes starting with 23. Then adding a digit, making it 236 would narrow it down to building construction companies. Adding another digit: 2361, would go even further to residential building companies, etc.
It gets even more complicated than that, but for the purpose of investing and getting the right exposure, it is not necessary to go so deep; as long as you understand that there are different sectors that are broken down further into industries, you are good to go.
Industry & Sector Analysis
Industry and sector analysis is important for the same reason that macroeconomic analysis is: just as it is difficult for an asset class or and industry or sector to perform well when macroeconomic conditions are bad, it is unusual for a specific company in a troubled industry or sector to perform well. Similarly, just as we have seen the economic performance can vary widely across countries, performance can also vary tremendously across industries and sectors.
Industry & Sector Performance
Below, you can see the dispersion of sector performance. It shows the 1-year return for the 11 main sectors in the US as of 9/30/2020. The performance ranges from a 43% return for the Technology Sector to a negative 51% return for the Energy Sector.
The fact that there is such a wide variation in performance, with some sectors significantly under pressure (such as the energy sector) and some sectors skyrocketing, is proof that sector and industry-specific analysis is required in order to minimize negative volatility in your portfolio.
There are many ways for any investor to gain exposure to specific sectors or industries through investment funds like ETFs (which we will dig into in future segments).
Sensitivity to the Business Cycle
Once we have understood where the economy is and we have a sense of where it is headed, it is necessary to determine the implications of that forecast for specific sectors and industries. Not all are equally sensitive to the business cycle.
Let’s take a look at the following example that compares the annual change in sales in jewelry and grocery stores.
We can clearly see how jewelry sales, which is a luxury good, fluctuate more widely than those of grocery stores. Jewelry sales are extremely volatile and seem very positively correlated to the business cycle, as sales declined dramatically in times of turbulence (such as in 2008). In contrast, sales growth in the grocery industry is relatively low but much more stable as there were no years with negative growth (crossing below 0%).
These patterns are clear indications that discretionary goods (such as jewelry) are way more influenced by macroeconomic activity than staples (such as grocery products).
Factors of Sensitivity to the Business Cycle
There are three main factors to analyze to determine the sensitivity of a company’s earnings to the business cycle:
Sensitivity of Sales
As we saw in the above example, necessities (or staples) like food or toilet paper will show little sensitivity to business conditions. Industries where customer’s income is not a crucial determinant of demand (such as tobacco or movies) also have low sensitivity to business cycles. Conversely, industries like autos or steel are highly sensitive to the health of the economy.
Operating leverage refers to the relationship between the variable and fixed costs for a company.
- Fixed costs are those that a company will have to pay regardless of how much it produces or sells, like rent, salaries, etc.
- Variable costs are those that change as production levels change, like raw materials, etc.
If you think about it, companies with a lot more variable costs than fixed costs are likely to suffer less in economic downturns because they may be able to reduce their costs as production whines down due to reduced sales. This helps maintain a healthy level of profitability even in rough times. Conversely, profits will swing much more for companies with high fixed costs because they won’t be able to adjust their costs to reduced sales.
The following example compares a company with higher levels of variable costs to another company with higher fixed costs. We will see three graphs: to the left, we can see the sales and costs figures of the company with variable costs; to the right, we find the sales and costs for the company with fixed costs; and the bottom graph represents the profit (sales – costs) for each company across the same time period.
We can easily see how the company with variable costs can adapt to lower sales by reducing its costs, hence maintaining a fairly stable profit in downturns. Conversely, the one with more fixed costs has better profits in booming periods but it suffers much more when sales are under pressure.
This financial leverage factor refers to the use of borrowing (debt) by a company. Since interest payments on debt must be paid regardless of sales, they are important fixed costs that will increase the level of sensitivity to business cycles.
We will examine how to measure these factors in future sections, for now, it is important to know what they are and that we must take them into account to determine risks under certain economic conditions.
It is also important to understand that it may not always be right to choose companies that are less sensitive to business cycles even though they are normally safer and more consistent. This is because, while being riskier and underperforming in downturns, cyclical companies (companies that are more affected by business cycles) normally offer higher returns in economic upturns.
As we have seen in past sections and will revisit in future ones, it is crucial to understand whether the higher returns are worth the increased risks.
In the next section, we will discover an investment strategy that can be used to benefit from business cycle fluctuations and the different effects it has on each sector.