 Hello and welcome to the session. This is Professor Farhad in which we would look at the industry analysis and how it applies to security analysis. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, please subscribe to my YouTube where I have close now to 2000 YouTube accounting, auditing, tax, finance as well as Excel tutorials. If you like my lectures, please like them and share them on my website, farhadlectures.com. You will find additional resources to complement this course as well as other courses. Please check out my website. So why do we have industry analysis? Why do we have to do industry analysis? Just like what we did with macroeconomics factor, we have to look at the industry factors as well. First, we look at the international environment at the macroeconomics, then we can look at the industry when we are doing security analysis. So it is difficult for an industry to perform well when the macroeconomy is failing. It's also unusual for a firm in a troubled industry to perform well. So after we look at the macroeconomy, not all industries perform the same way. Let's assume the macroeconomy is doing well, then we still have to look at a specific industry. Just as we looked at international economics where in different countries, the economy is performing differently, industries varies the same way. For example, here we have return on equity for certain industries and this is March 2007. If we notice iron and steel, the return on equity, it's the profit that the investors get based on net income, based on accounting figure, notice it's almost I would say 1% versus the aerospace, it's I would say 25% broadcasting, you know, around 24%, so on and so forth. So not all industries perform the same way. Same thing with the stock market return. Given the wide variation in profitability because they have different return, different net income, well guess what? Their stock will perform, also will have different performance across industries. For example, airline, this is again June 8, 2017, the industry grew at a little bit more than I would say 40%. That's the industry stock price performance, but this is not for a particular company. This is for the whole industry, but that's still pretty good. If we look on the other side, integrated oil and gas, they have a negative performance. So yes, indeed, studying the industry is important. So more likely if you invest in the airline, in an airline company, most likely you're going to perform well versus an integrated oil and gas, it's not performing as well. So the spread in performance across industries is remarkable, ranging from 40.9 to an 8.4 loss in the oil and gas industry, and we have in between. Again, this is from June 8, 2017. So the fact that in this year, 20 of the 22 industries, notice all of them has, all of them, the majority, which is 20 out of the 22 show positive return. This show the systematic or the market, the market factors. It means when one industry is, when the economy is doing well, usually all industries do well, but not at the same rate. Here's basically those are, I mean, relative, they're not as big as the other ones. So guess what? So what you can do is one can invest with an industry focused fund, like Fidelity. They offer more than 40 sector funds. So basically you'll buy the mutual fund and what you do is you select one industry and you don't have to worry about the performance of any particular company. Now, the return of the fund is based on the industry overall. Now, heaven said, so even within each industry, you're going to have different performance for companies. For example, here, we're looking at the application, software firms. This is the return on equity. Notice most of them are doing well, like Intuit, Oracle, Citrix, SAP, Microsoft, Adobe, except for example, cinematic negative 6.6. So overall, I would say if you invested in the software application industry, you should be fine. But if you selected that particular company, Semantic, Semantic to be more specific, then you're going to have a negative return on equity. And this is a return on equity. I don't know what their stocks is doing, but I can assure you if your return on equity is 61.64 Intuit, this stock should be doing fairly well. Now, how do we do this analysis? Because it can be difficult to determine in what industry a company falls. It's hard to draw the line between one industry and another. So a useful way to define industry group is given by the North American Industry Classification System. These codes are assigned to groups, to group firm for statistical analysis. So we do have a way, and this is how we computed those figures. We have specific industries. For example, the code for construction is 23. So code starting with 236, donate building construction. So 236, all of these are, notice, 236. 236 is building construction. 2361, when you add the one to it, it's residential construction. And 236, 115, 6115, it's single family construction. So we have specific code for different industries. So the first five digits are common across all NAFTA countries, the U.S., Canada and America, U.S., Canada and U.S., Mexico and Canada. The sixth digit is country specific and allowed for a final partition of industry, of industry. So once you get to the sixth digit, this is based on the country. So firm with the same four digit codes are commonly taken to be in the same industry. So basically, if you're looking at, again, 236, 236 and another figure, it's basically the same industry, the same industry. So 2361 here, 2361, and this is 2362, which is non-residential, commercial non-residential building. So this is how they collect all this data. Now, the best way to illustrate this is to look at just another extreme example, but a good point to illustrate the point of why selecting an industry is important in your security analysis. Let's assume we're looking at a grocery store or grocery company or a jewelry company. So they're not all equally sensitive to the business cycles. Remember we talked about the business cycle in the prior session. So if we look at the jewelry and the grocery, and hopefully you would know right away that in good time when the company is expanding, the jewelry company, they will do very well. And in bad time, they don't do as well. But the grocery store, if you notice in blue, it kind of stays the same from 1993 to 2007. The average is almost the same versus the jewelry store that goes up and down. Clearly sales of jewelry, which is a luxury item, fluctuate more widely than those of the grocery. Notice it goes up and down, up and down, up and down. And what does it go with? It goes with the economy. Jewelry sales jumped in 1999 during the dot-com boom, but fell in 2001 when we had the recession. In contrast, sales growth in grocery industry is relatively stable. It does not matter whether we have a recession, and sometimes the recession do help more because people eat home, therefore they buy more grocery, or if we are experiencing an expansion. These patterns reflect the fact that jewelry is a discretionary good item, whereas most grocery products are staples for which demand will not fall significantly, even in hard times. Even in hard times, it might even be better. But to determine how sensitive an industry to the stock market or to the whole economy, we examine three factors that affect their earnings. One is their sensitivity to sales. Two is operating leverage, and three is the financial leverage. And we're going to look at each one of them separately, starting with sensitivity of sales. Well, if you're selling goods, goods that are considered necessities like food, medical equipment, show little sensitivity to business condition, it doesn't matter. You know, groups such as food, drugs, and medical services, they're not affected as much. I'm not saying they're not affected, they're not affected as much. For example, you may defer an elective surgery, but if you have to have a surgery, you're not going to wait. Okay? Other industries with low sensitivity are those for which income is not crucial determinant to demand, like what? Tobacco products are examples of this type of industry. Substitute. Another industry in this group is movies. For example, Netflix. Consumers tend to substitute movies for more expensive source of entertainment when income levels are low. For example, a lot of people, they cancel their cable because it's around $70 and they substituted with Netflix $14 a month. In contrast, firm in industries such as machine tools, steel, autos, and transportation are highly sensitive to the state of the economy. For example, you know, sales, auto sales was declining. The past now, in October, we're like six months into COVID, sales of auto slowed down. Slowed down. Why? Because we can defer, we can wait. It's a big ticket item. So these industries are sensitive more to sales versus Netflix subscribers went up operating leverage. What's operating leverage? It's the division between your fixed and variable income. So when you operate your business, do you have more of fixed income or more of variable or variable cost, fixed income, fixed cost and variable cost. Fixed costs are those that are incurred regardless of its production level. Fixed costs. Basically, you have this cost. You cannot get rid of it whether you have a million dollar of sales or no sales. Variable costs are costs that rise and fall as the firm produce more or less product. Variable costs. You only incur variable cost when you need to produce something. So if you don't produce it, you don't have that variable cost. So profit of firms with a greater variable cost as opposed to fixed costs will be less sensitive to business condition. Think of software company. If you have a software company and you have a slowdown in business, guess what? You simply lay off your employees and you no longer have expenses because your employees, your software engineers are your biggest cost. Therefore, you don't have any expenses. And let's assume you subscribe to a specific particular software. You just cancel your subscription. So it's very easy. Why? Because your cost is variable. Well, if you have two, three contracts, big contracts you rehire your employees, you're activate your subscription and you're back into business. So your cost is variable. You can easily reduce it. In economic downturn, these firms can reduce cost as output fall in response to falling sales. Very easy. Same thing with the law firm. Why? You just lay off your employees and you're good to go. Profit for firms with high fixed costs, think of the auto industry or the airline company will swing more widely with sales because costs do not offset revenue variability. Think of airline companies. Let's assume the company, they have two trips every day from New York to California and from California to New York, one in the AM and one in the PM. Regardless of whether the economy is doing well or not, whether the demand is up or high, their cost is practically most of their cost is fixed. What's the good thing about fixed cost? The good thing about fixed cost is once you reach, let's assume your fixed cost is for every trip, your fixed cost is $10,000 for the sake of illustration. So what happened is, and this is zero. So what happened is if you have to cover, let's assume an airline company, the trip has a fixed cost of $10,000. Once they cross this fixed cost, once they cover the fixed cost, everything else above the fixed cost is profit, 100% profit. But the key is to jump over this hurdle. The difference with the variable cost. So variable cost, if you want to make a dollar of profit, you have to incur maybe 60 cent of cost. If you want to make another dollar, you have to incur 60 cent per cost. So the cost will stay with you. As you make profit, you have more cost. But at the same time, if you have no sales, you don't have to incur the cost. For industries with high fixed cost, they have the cost upfront. There is nothing they can do about it. In good times, guess what? In good times, they may make $300,000 profit in one trip. Why? Because once they cover the fixed cost, every additional customer is pure profit. That's the pro and the con of fixed costs. I want to talk about this in a moment on the next slide when we talk about financial leverage. These firms are said to have high operating leverage as small swings in business condition can have a large impact after profitability. So simply put, unless you reach the $10,000, you are at a loss. Once you go above that $10,000, everything else is practically 100 percent gain, unquote 100 percent. Financial leverage is something very similar to the operating leverage. They know this, they go, they both word to use leverage. And what is leverage? Basically, when we say operating or financial, what is leverage? Leverage, it's using something else. You're leveraging something else. Here you're leveraging your debt. You're using other people's money. You're using other people's money to lever, to help you, to propel you, to lever you. So interest payment on debt must be paid regardless of sales. So basically, this is what we're talking about fixed cost. So interest cost is a fixed cost. But interest cost, we deal with it separately because it's very important to pay your bank. Otherwise, you will go out of business. It's as simple as that. So these are fixed costs that also increase in the sensitivity of profit to business condition. Same thing. If you have a loan, the first thing you have to do is you have to cover your cost of that loan before you make any profit. Therefore, if you have a high leverage, well, you're going to have to have, and the economy goes down south, you're going to be in trouble. So investors should not always prefer industries with lower sensitivity to the business cycle. Why? What all depends on your risk, but why not? Firms and sensitive industries will have high beta stocks and are obviously riskier. That's good. But while they swing lower in downturn, they also swing higher in upturn. So it's all about the key is how much risk you are expecting to hold for compensating. What's your risk tolerance? This is basically what it goes down to. The key is whether the expected return on the investment is fair compensation for the risk rotation. What is sector rotation? Is the shift of portfolio more heavily into the industry or sector groups that are expected to outperform based on one assessment of the state of the business cycle. So not all industries perform the same in any business cycle. Notice we go up, we reach a peak, we contract, we go down, we reach a trough, then we expand again, we reach a peak up and down. Now not all companies perform the same in those changes. So what's going to happen is this, if you know, if you know you are at a peak and you're going to go through a contraction, so let's start from there, you want to switch back to defensive companies like healthcare. So once you're at the, once you know we reach the peak, now we're going to go down, you want to buy consumer stable, utilities, financial, and at the end of the contraction, at the end of the contraction, once you know, once you know we reach the trough, you want to start to buy financials and technology. Then you will go into consumer discretionary like jewelry, materials, you know, up to industries, industrial energy, then we reach the peak again. Once we reach the peak again, then the process, this wheel, would repeat itself. Now the key is to determine when, at what point we are at a peak. Now we know that after the fact. The key is to know this here, not know it here or here. The key is to know ahead of time, when did we reach the peak in the economy, because if we know we reached a peak, then we have a sector rotation. You would start to sell the energy, the industrial, the consumer discretionary, and you will start to buy defensive, and you will do the opposite at the trough level. Now we have what's called the industry life cycle. Each industry goes through a life cycle, and there are the, there are the four life cycles, startup, consolidation, maturity, and relative decline. And we're going to take a look at them and explain them in terms of how, what's their sales? Because what's important is this, you make sales eventually, hopefully you will make, it doesn't mean you're going to make profit, but the assumption is you make profit. So the more sales you make, the more profit you make, the more the higher is your stock. So what happened in the startup stage? What is a startup stage? The early stages of an industry are often characterized by new technology or product. Think of the desktop personal computers in the 80s or the cell phone in the 1990s or the large-screen smartphone introduced in 2007. So let's talk about PCs. In the 80s, PCs were in the startup stage. What do we experience through the startup stage? At this stage, it's difficult to predict which firm would emerge a leader because you're going to have many firms competing for the same technology. Some firms will turn out to be wildly successful and others will fail together, just like with Wender.com. We had so many companies like Amazon, like Yahoo. Well, Yahoo is not really a successful story nor eBay, but Amazon. Amazon was, was in the startup stages in 99, 2000, but you don't know whether Amazon's going to survive or not. But if you did buy Amazon, well, people made a lot of money buying Amazon. Therefore, there's a considerable risk in selecting one particular firm within the industry or think of Tesla these days. This is where Tesla is. It's basically a startup, startup. For example, in the smartphone industry, there continues to be a battle among competing technologies such as androids and the iPhone. I would say they're no longer in a startup stage, I would say, but you can, you know, depending on how you look at it, maybe they're at the end of the startup stage or they're in a stable growth. It's up, it's up to you how you define it. At the industry level, it's clear that sales and earning will grow at an extremely rapid rate when the new product has not yet saturated the market. So think about it when not everybody had a phone. For example, in 2000, very few households had smartphone altogether, not even, you know, but now it's, it's totally different. The potential market for the product was huge because eventually you would assume everyone will have a smartphone. Just like if you think Tesla, if you think everybody's going to be driving a Tesla 15 years from now, it's time to buy Tesla. That's what you believe, but we're going to look at other factors. In contrast, consider the market for mature product like refrigerator. Well, practically, not practically, every year's household has a refrigerator. Okay, almost all in the US already have refrigerator. So the market for this good is primarily composed of household replacing old ones, which has obviously limited the potential of growth. Okay, so this is in the rapid increasing growth. Then we move to the stable growth after a product becomes established, industry leader began to emerge. You know, for example, in 2015, Apple and Samsung, basically they combine, they, they, they, they control this, they control the, the smartphone market. So the survival from the startup stages are more stable. Some people don't make it through the, through the, through the stable, stable growth. Here, what we have is consolidation. Here, what we have is consolidation and the performance of the surviving company will more likely track the performance of the overall industry here. What they do is consolidation means they will start to buy each other. They will start to buy smaller, smaller firms that could not compete or it's easy to buy them to get them out of the competition. The industry will still grow faster than the rest of the economy as the product penetrate the market and becomes more commonly used. You still have growth in this, in this, in this stage in the consolidation stage. In the maturity stage now the, the, the growth will start to slow down. The product has reached its potential for use by customers. Practically now, not practically. The majority of people have smartphone. I still know people that still have flip phones, but the majority of people will have a smartphone. Further growth might merely track growth in the general economy. Now you're just basically, you're going to do as good as the economy. The product has become far more standardized and the producer are forced to compete to a greater extent on the basis of price. Now the timeframe, the timeframe, this is for each company and for each industry is, is different. For example, this could be three years. This could stage, could be five years. This could be two years. This could be five years. Slowing growth could be 10 years, could be 15 years. So there's no time limit. You don't, we don't know that until after the fact. And because you're competing on price, you'll start to make lower profit and further pressure on the profit. You have put pressure on the profit. Firm at this stage sometimes are characterized as cash cows. They're bringing the cash and now they can pay out to their shareholders and bound holders, providing reasonably stable cash, but offering little opportunity for profit expansion. The cash flow is best milled from rather than reinvested in the company. So basically now the investors want their money. They want the dividend. Why? Unless you have a new product, we'll go back to here. I'm better off having the money in my pocket. So that's why it's called cash cow. Okay. For example, personal computers by the mid 1990s. It was a mature industry with a high market penetration, considerable price competition, low profit margin and slowing sales. Just another example, Microsoft, it did not pay dividend until 2005. Why? Because from the year 2000 to the year 2005, they reach this stage here and investors started to demand like, look, you have a lot of cash on hand, you really don't have a new product start to pay us dividend. At this stage, the company will be a cash cow. Cash cow means milk the cash out of it in terms of dividend. By the mid 1990s, desktops were progressively given up, given up the laptops, indeed, which were in their early startup stages. Then what happened to laptop? Within a dozen of years, laptop had in turn entered a maturity stage. Again, low profit margin and new competition from tablets and large screen smartphone. Then eventually something's going to come and replace tablet and large screen smartphones. So notice, we have this cycle again and again and again, one product replacing the other one or one product within the industry replacing each other. And once we get to the relative decline in this stage, the industry might grow at a less than the over on the rate of the overall economy or it might even start to shrink. Again, how long it takes? This could take 20 years. This could take three years, but definitely the industry life cycle is getting shorter and shorter because of technology, because of technology. This could be due to obsolescence of the product, competition from new product or competition from new low cost supplier. Consider, for example, again, the displacement of desktop by laptop. It happened very quickly. Then laptops are technically not absolute, but they're being replaced by tablets and smartphones. So the question is at which stage in life cycle are investments in industry more attractive? So what do you think? That's the question. Some people think it's at the startup stage. Well, if it's at the startup stage, there's a risk you may not make it to the consolidation stage. Or once you know you are in the stable growth, well, you missed all this growth and you don't know what's going to happen, how much slower the growth is going to be. And if you're in the slowing growth, you missed all of these, but now you are more secure. So it all depends on your risk tolerance. So think of Tesla. Think of Tesla. What do you think Tesla is? Do you think it's still here? Do you think Tesla here? Or do you think Tesla in this stage is at startup, consolidation or maturity? Okay, it's definitely not in relative decline. But think of Tesla also, the technology could change very fast because Tesla has competition. They did not really started to produce as a lot at our scales, but all auto industries that are going into this industry. Also, who knows, we might have some new technology fuel cell or I'm not sure some technology we don't we never heard of it's more efficient, cheaper, and better than what we have right now, better than the battery. So we don't know. But the point is you're taking the risk at any stage you invest, you just need to understand your risk and how much risk you are willing to bear. And as always, I would like to remind you to like this recording, share it and visit please visit my website for head lectures dot com for additional resources. Good luck. Stay safe and study hard.