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Passenger cars
60 1994 and www.nada.org.
Cigarette sales: Department of
40 Alcohol, Tobacco, and
Firearms Statistical
20 Releases and Statistical
Abstract of the U.S.
1963 1967 1971 1975 1979 1983 1987 1991 1995 1999

Auto production by contrast is highly volatile. In recessions, consumers can try to prolong
the lives of their cars until their income is higher. For example, the worst year for auto pro-
duction, according to Figure 11.10, was 1982. This was also a year of deep recession, with the
unemployment rate at 9.5%.
Three factors will determine the sensitivity of a firm™s earnings to the business cycle. First
is the sensitivity of sales. Necessities will show little sensitivity to business conditions. Ex-
amples of industries in this group are food, drugs, and medical services. Other industries with
low sensitivity are those for which income is not a crucial determinant of demand. As we
noted, tobacco products are examples of this type of industry. Another industry in this group
is movies, because consumers tend to substitute movies for more expensive sources of enter-
tainment when income levels are low. In contrast, firms in industries such as machine tools,
steel, autos, and transportation are highly sensitive to the state of the economy.
The second factor determining business cycle sensitivity is operating leverage, which refers
to the division between fixed and variable costs. (Fixed costs are those the firm incurs regardless
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400 Part FOUR Security Analysis

of its production levels. Variable costs are those that rise or fall as the firm produces more or less
product.) Firms with greater amounts of variable as opposed to fixed costs will be less sensitive
to business conditions. This is because, in economic downturns, these firms can reduce costs as
output falls in response to falling sales. Profits for firms with high fixed costs will swing more
widely with sales because costs do not move to offset revenue variability. Firms with high fixed
costs are said to have high operating leverage, as small swings in business conditions can have
large impacts on profitability.
The third factor influencing business cycle sensitivity is financial leverage, which is the use
of borrowing. Interest payments on debt must be paid regardless of sales. They are fixed costs
that also increase the sensitivity of profits to business conditions. We will have more to say
about financial leverage in Chapter 13.
Investors should not always prefer industries with lower sensitivity to the business cycle.
Firms in sensitive industries will have high-beta stocks and are riskier. But while they swing
lower in downturns, they also swing higher in upturns. As always, the issue you need to ad-
dress is whether the expected return on the investment is fair compensation for the risks borne.

Sector Rotation
One way that many analysts think about the relationship between industry analysis and the
business cycle is the notion of sector rotation. The idea is to shift the portfolio more heavily
sector rotation
into industry or sector groups that are expected to outperform based on one™s assessment of
An investment
the state of the business cycle.
strategy that entails
Figure 11.11 is a stylized depiction of the business cycle. Near the peak of the business cy-
shifting the portfolio
into industry sectors cle, the economy might be overheated with high inflation and interest rates, and price pres-
that are expected to sures on basic commodities. This might be a good time to invest in firms engaged in natural
outperform others
resource extraction and processing such as minerals or petroleum.
based on
Following a peak, when the economy enters a contraction or recession, one would expect
defensive industries that are less sensitive to economic conditions, for example, pharmaceuti-
cals, food, and other necessities, to be the best performers. At the height of the contraction, fi-
nancial firms will be hurt by shrinking loan volume and higher default rates. Toward the end

F I G U R E 11.11 Economic activity
A stylized depiction of
the business cycle

Peak Peak



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11 Macroeconomic and Industry Analysis

of the recession, however, contractions induce lower inflation and interest rates, which favor
financial firms.
At the trough of a recession, the economy is posed for recovery and subsequent expansion.
Firms might thus be spending on purchases of new equipment to meet anticipated increases in
demand. This, then, would be a good time to invest in capital goods industries, such as equip-
ment, transportation, or construction.
Finally, in an expansion, the economy is growing rapidly. Cyclical industries such as con-
sumer durables and luxury items will be most profitable in this stage of the cycle. Banks might
also do well in expansions, since loan volume will be high and default exposure low when the
economy is growing rapidly.
Let us emphasize again that sector rotation, like any other form of market timing, will be
successful only if one anticipates the next stage of the business cycle better than other in-
vestors. The business cycle depicted in Figure 11.11 is highly stylized. In real life, it is never
as clear how long each phase of the cycle will last, nor how extreme it will be. These forecasts
are where analysts need to earn their keep.

4. In which phase of the business cycle would you expect the following industries to Concept
enjoy their best performance?
(a) Newspapers (b) Machine tools (c) Beverages (d) Timber.

Industry Life Cycles
Examine the biotechnology industry and you will find many firms with high rates of invest-
ment, high rates of return on investment, and very low dividends as a percentage of profits. Do
the same for the electric utility industry and you will find lower rates of return, lower invest-
ment rates, and higher dividend payout rates. Why should this be?
The biotech industry is still new. Recently, available technologies have created opportuni-
ties for the highly profitable investment of resources. New products are protected by patents,

Investment and Sector Forecasts
Standard & Poor™s provides information on the overall investment environment and also
on particular segments of the environment on a routine basis. For example, go to
http://www.standardandpoors.com/NewsBriefs/index.html to access the Economic and
Investment Outlook for May 2002. The report contains information on overall earnings
and three sectors of the market.
After reading the investment outlook, address the following questions:
1. How much did earnings decline in 2001?
2. What was the projected growth in earnings for 2002?
3. The report suggested reducing the portfolio allocation to equity to 60% compared
to 65%. What factors or risks led to that lower suggested allocation?
4. What level of earnings growth were forecast for managed health care?
5. What was the outlook for the steel sector?
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402 Part FOUR Security Analysis

F I G U R E 11.12 Sales
The industry life cycle

Rapid and Stable Slowing Minimal or
increasing growth growth negative growth

Consol- Maturity Relative decline

and profit margins are high. With such lucrative investment opportunities, firms find it ad-
vantageous to put all profits back into the firm. The companies grow rapidly on average.
Eventually, however, growth must slow. The high profit rates will induce new firms to en-
ter the industry. Increasing competition will hold down prices and profit margins. New tech-
nologies become proven and more predictable, risk levels fall, and entry becomes even easier.
As internal investment opportunities become less attractive, a lower fraction of profits are
reinvested in the firm. Cash dividends increase.
Ultimately, in a mature industry, we observe “cash cows,” firms with stable dividends and
cash flows and little risk. Their growth rates might be similar to that of the overall economy.
Industries in early stages of their life cycles offer high-risk/high-potential-return investments.
Mature industries offer lower risk, lower return combinations.
This analysis suggests that a typical industry life cycle might be described by four stages:
industry life cycle
a start-up stage characterized by extremely rapid growth; a consolidation stage characterized
Stages through which
by growth that is less rapid but still faster than that of the general economy; a maturity stage
firms typically pass as
characterized by growth no faster than the general economy; and a stage of relative decline, in
they mature.
which the industry grows less rapidly than the rest of the economy, or actually shrinks. This
industry life cycle is illustrated in Figure 11.12. Let us turn to an elaboration of each of these

Start-up stage The early stages of an industry often are characterized by a new tech-
nology or product, such as VCRs or personal computers in the 1980s, cell phones in the
1990s,or bioengineering today. At this stage, it is difficult to predict which firms will
emerge as industry leaders. Some firms will turn out to be wildly successful, and others will
fail altogether. Therefore, there is considerable risk in selecting one particular firm within
the industry.
At the industry level, however, sales and earnings will grow at an extremely rapid rate since
the new product has not yet saturated its market. For example, in 1990 very few households
had cell phones. The potential market for the product therefore was huge. In contrast to this
situation, consider the market for a mature product like refrigerators. Almost all households in
the U.S. already have refrigerators, so the market for this good is primarily composed of
households replacing old refrigerators. Obviously, the growth rate in this market will be far
less than for cell phones.
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Consolidation stage After a product becomes established, industry leaders begin to
emerge. The survivors from the start-up stage are more stable, and market share is easier to
predict. Therefore, the performance of the surviving firms will more closely track the per-
formance of the overall industry. The industry still grows faster than the rest of the economy
as the product penetrates the marketplace and becomes more commonly used.

Maturity stage At this point, the product has reached its full potential for use by con-
sumers. Further growth might merely track growth in the general economy. The product has
become far more standardized, and producers are forced to compete to a greater extent on the
basis of price. This leads to narrower profit margins and further pressure on profits. Firms at
this stage sometimes are characterized as “cash cows,” firms with reasonably stable cash flow
but offering little opportunity for profitable expansion. The cash flow is best “milked from”
rather than reinvested in the company.
We pointed to VCRs as a start-up industry in the 1980s. By now, it is certainly a mature in-
dustry, with high market penetration, considerable price competition, low profit margins, and
slowing or even declining sales. In September of 2001, monthly sales of DVD players, which
seem to be the start-up product that will eventually replace VCRs, surpassed those of VCRs
for the first time.

Relative decline In this stage, the industry might grow at less than the rate of the over-
all economy, or it might even shrink. This could be due to obsolescence of the product, com-
petition from new products, or competition from new low-cost suppliers.
At which stage in the life cycle are investments in an industry most attractive? Conven-
tional wisdom is that investors should seek firms in high-growth industries. This recipe for
success is simplistic, however. If the security prices already reflect the likelihood for high
growth, then it is too late to make money from that knowledge. Moreover, high growth and fat
profits encourage competition from other producers. The exploitation of profit opportunities
brings about new sources of supply that eventually reduce prices, profits, investment returns,
and finally, growth. This is the dynamic behind the progression from one stage of the industry
life cycle to another. The famous portfolio manager Peter Lynch makes this point in One Up
on Wall Street. He says:
Many people prefer to invest in a high-growth industry, where there™s a lot of sound and fury. Not
me. I prefer to invest in a low-growth industry. . . . In a low-growth industry, especially one that™s
boring and upsets people [such as funeral homes or the oil-drum retrieval business], there™s no
problem with competition. You don™t have to protect your flanks from potential rivals . . . and this
gives you the leeway to continue to grow [page 131].

In fact, Lynch uses an industry classification system in a very similar spirit to the lifecycle
approach we have described. He places firms in the following six groups:
1. Slow Growers. Large and aging companies that will grow only slightly faster than the


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