What’s in an industry?

If you tell someone in Los Angeles you’re in “the industry” they might assume you’re in the movie business and try to get you to look at their script. In Detroit, people in the Motor City industry are involved in making cars.

But when it comes to fundamental analysis, the term industry has a pretty precise meaning. At its most basic level, a company’s industry is the line of business it’s in. But that’s not a scientific enough definition for fundamental analysts; they’re pretty precise folks, if you haven’t noticed already.

Instead of just saying, for instance, Ford is in the auto industry, fundamental analysts break things down into more detail. Most fundamental analysts use a classification standard called the Global Industry Classification Standard, or GICS, to put companies into their places. GICS puts every industry into a sector, industry group, industry, and subindustry. GICS was cocreated by Standard & Poor’s and MSCI, two companies that specialize in creating ways to classify companies.

If you’ve ever seen Russian nesting dolls, or matryoshka dolls, you know exactly how GICS works. The sector is the largest classification, inside of which fit the industry group, industry, and subindustry. Just as you open the largest Russian nesting doll and find a smaller one and so forth, the same goes with GICS. Once you see what sector a company is in, you can then see which industry group, industry, and subindustry it’s in. All these classifications fit neatly inside of each other.

Ford is a good example of how all this GICS stuff works. The company falls into the consumer discretionary sector, which contains all sorts of industry groups that make big-ticket items consumers buy, such as consumer durables. Digging further, you find Ford goes into the automobiles & components industry group, which contains the auto components and automaking industries. Next, Ford fits into the automobiles industry, which includes two subindustries: automobile manufacturers and motorcycle manufacturers. And Ford makes cars and trucks, so it goes into the automobile manufacturers subindustry.

The GICS system is pretty comprehensive. Table 16-1 shows you how many sectors, industry groups, industries and subindustries there are.

Just as scientists periodically change their classifications to make room for new developments regarding heavenly bodies, the same goes for industries. I’m still shocked scientists stripped away the planet title from Pluto. The GICS changes a little over time, too. Sometimes industries, for instance, are added, deleted, or merged to reflect changes in the economy. Sometimes individual companies, too, are moved from different industries or subindustries. Real estate joined the GICS as a sector of its own in September 2016. And the communication services sector replaced the telecommunication services sector in September 2018.

It’s probably easiest to see how all these GICS sectors, industry groups, industries, and subindustries fit together by looking at a table. There are literally thousands of subindustries, but Table 16-2 gives you a very small summary of what the basic structure of the GICS looks like.

Following the ups and downs of industries

Just as the economy expands and contracts along with the business cycle as discussed in Chapter 15, industries also have their ups and downs. Some sectors, for instance, tend to see their business rise and fall along with the economy. These are called cyclical companies, and include industries such as the automakers. Then there are sectors that tend to be noncyclical, meaning that their performance tends to not be all that connected to the economy’s shape. The health care industry is a good example of a sector that’s usually noncyclical. You’re not going to cancel your doctor’s appointment just because the economy has slowed a little, are you?

Some fundamental analysts use industry analysis to clue into what point of the business cycle the economy is in. By paying attention to which industries (or sectors) are posting the best results, or the strongest stock prices, you can get a hint as to where the economy is headed.

You can see how different sectors and stocks tend to outperform during the different parts of the business cycle in Table 16-3.

You can review the different phases of the business cycle in Chapter 15.

Keeping tabs on a sectors’ fundamentals

There’s nothing to stop you from measuring the revenue and earnings of a group of companies in an industry. If you really wanted to tally up how companies in a sector are doing, you could, in theory, do it by hand. You could get a list of all the companies in a sector and open each company’s financial statements and add everything up. But, man, that would be a great deal of work you can avoid.

It’s much easier to get fundamental data on sectors from companies that track these types of things very closely. S&P is one of the companies with massive databases dedicated to tracking all the earnings reported by companies and compiling them into a resource you, as a fundamental analyst, may use. All the earnings for the companies in all 11 sectors are compiled and provided to you at http://us.spindices.com/indices/equity/sp-500. From this website, scroll down a bit and, under the Documents heading, click the Additional Info button and choose the Index Earnings. A spreadsheet will pop up on your screen that will blow you away with all sorts of industry data.

You’ll be amazed at how quickly you can process the sector data from hundreds of companies using S&P Dow Jones Indices’ data. For instance, you can not only see how quickly earnings in the 11 sectors rose or fell in the past couple of years, but you can also monitor how rapidly analysts expect the sectors’ earnings to rise or fall in the future. S&P Dow Jones Indices also provides data showing the average price-to-earnings ratio of companies in the sector. You can review how to interpret the P-E ratio in Chapter 8. Some of the sector data you can obtain from S&P looks like what you see in Table 16-4.

This handy chart, which is updated regularly, shows you that in September 2022 investors were paying up most for real estate stocks, shown by the 35.1 P-E. But consumer discretionary was expected to be the biggest engine of growth.

When evaluating the profit and growth of individual companies, as discussed in Chapter 5, it’s a good idea to compare the results to that of the sector. This might help you identify companies that are pulling ahead of their peers.

Tracking the stock performances of sectors

Studying sectors’ fundamentals, such as earnings growth, is just one part of industry analysis. To get a full picture of how the sectors are faring, it’s important, too, to monitor their stock price changes.

The stock market can give you an early signal to where the economy is headed three to six months in the future, as shown in Chapter 15. You can apply the market’s same early-warning signal to industry analysis. When you start to see stocks in a sector rising or falling, for instance, that tells you investors think the sector’s fundamentals will follow.

If you really want to keep yourself busy an entire weekend, you could get price quotes for every stock in a sector. But why go to all that trouble if someone else makes it so easy? There are a few sources that provide helpful industry performance data, including:

• Summary of how the sectors have done over time: Standard & Poor’s provides the performance of all 11 of its sector indexes on a daily, monthly, quarterly, and year-to-date basis. You can download the data into a spreadsheet for further analysis. Return to the S&P Dow Jones Indices website here: http://us.spindices.com/indices/equity/sp-500. But this time after clicking the Additional Info button, click S&P 500 GICS Scorecard.
• Up-to-date daily industry information: Yahoo! Finance provides an industry analysis page that shows you which industries are doing the best or worst during a trading day. The data are available here: https://finance.yahoo.com/screener/predefined/ms_basic_materials/. Scroll through the various industries along the top of the page to see how stocks in the group performed.
• Graphical view of industry group data: If you’re looking for an easy way to see which industry groups are leading or lagging over time, Sector SPDRs provides an up-to-date graphical heat map: www.sectorspdr.com/sectorspdr/tools/sector-tracker/components. The chart lets you quickly find which industry groups are charging forward or falling behind. Sometimes there’s nothing like spreading out a map of the stock market on a screen in front of you.

Using exchange-traded funds to monitor sectors and industries

Exchange-traded funds, or ETFs, are one of the more exciting things to happen to the investment business. Investors who want to invest in a basket of stocks, for instance, can buy just one ETF and spread their money over dozens, hundreds, or even thousands of individual stocks.

But what do ETFs have to do with fundamental analysis? ETFs are excellent tools to get real-time information on industries and sectors. Because most ETFs track various stock indexes, or mathematical calculations that measure the value of a group of stocks, they can be tremendously useful when tracking industries, too.

The beauty of using ETFs as a way to see how a sector or industry is doing is that you can get real-time stock quotes on ETFs as you would with any stock. Just enter the ETF’s stock symbol into a financial website to get a price. The prices of ETFs show you how sectors are doing. Many financial websites will also provide fundamental details about the ETF, giving you a deeper look at how things are going in the industry. Table 16-5 lists some ETFs that track all 11 sectors. If you’re interested in learning more about ETFs, consider the book, Investing in ETFs For Dummies (Wiley).

Sizing up a company’s financials relative to its industry’s

Whenever you look up a piece of financial data, the first thing that should pop into your head as a fundamental analyst is, “What does this mean?”

Generally, no single piece of financial data is meaningful by itself. Financial ratios, covered in Chapter 8, are especially irrelevant by themselves. Traditionally, fundamental analysis requires you to either compare a company’s financial data with its historical results or against other companies in the sector or industry.

Virtually any piece of financial data you can extract from the financial statements can be compared against other companies in an industry. You can compare company data with industry data to get better insight about the company by:

• Putting companies in their place. Sizing up financial data to industry averages gives you a better idea of where a company stands in its respective field. Is the company the biggest player in an industry or the most valuable? Find out by comparing revenue to the industry’s total revenue or market value. Electric car maker Tesla, for instance, was the most valuable automobile manufacturer in mid-2022 with a market value of $951 billion. But General Motors was bigger by revenue.
• Sizing up a stock’s valuation. It’s one thing to know how much investors are paying for a stock. That’s simple enough by using valuation techniques in Chapter 8, under the “Getting a handle on a company’s valuation” section. But after you measure a stock’s P-E, you can then compare the P-E against the valuation of the industry or the stock market to get an idea of how richly valued a stock is.
• Trusting but verifying. You can evaluate statements made by a company’s management using industry analysis. Here’s an example: Struggling retailers love to blame the weather for a bad quarter. Using fundamental analysis, you can see if other retailers struggled, too. This extra step can tell you whether retailers are suffering from Mother Nature … or just making excuses.

Some companies, especially manufacturing companies, love to talk about how lean and mean they are. One way to verify a company’s efficiency is by comparing its inventory turnover in days, or how rapidly a company clears out inventory from its warehouses, to the industry. A more efficient production system would have a rapid turnover, so the inventory turnover in days should be a small number. The formula is:

Inventory turnover in days = Average inventory ÷ Cost of goods sold × 365

Let me show you using a real company: automaker Ford. To get Ford’s average inventory in 2021, add its inventory from the end of 2021 ($12,065 million) to its inventory at the end of 2020 ($10,808 million) and divide by two. For Ford, that is $11,437 million.

Now divide Ford’s average inventory by its cost of goods sold for 2021, which was $114,651 million. You should have gotten 0.10. Now, multiply that by the number of days in the year, or 365, and you get 36.4.

What’s all this mean? Ford in 2021 churned through its inventory every 36 days.

How does Ford’s inventory turnover in days compare with the industry? It’s better than General Motors, which turned over its inventory every 42 days in 2021. It’s also impressive among the consumer discretionary sector — which has an average inventory turnover of 88 days in 2021, according to S&P Global Market Intelligence.

You don’t have to calculate the financial ratios for all the companies in a sector to get a comparison basis. Ready Ratios provides industry data for you at https://www.readyratios.com/sec/industry/. All you need to do is enter the stock symbol of the company you’re studying, click the search button, click the name of the company, and then read the results.

One thing to keep in mind, though, is sometimes you need to convert industry ratios generated by systems like Ready Ratios to match your calculation method. For instance, Ready Ratios doesn’t convert some turnover data into days, as I did. To convert a turnover ratio into days, just divide 365 by the turnover ratio to convert the industry number into days.

Find out who a company’s competitors are

Sometimes you might find yourself getting interested in learning more about an industry or a sector. Perhaps you want to perform fundamental analysis on several companies that are competitors to one you’re looking into.

There are several ways fundamental analysts can get a list of the other companies in an industry, including the:

• The 10-K: Most companies will provide a list of all the companies they deem to be their archrivals in their 10-K, or the annual report required by regulators. Flip back to Chapter 12 to refresh your memory on where this information is located in the rather lengthy financial document.
• Web-based research tools: Several leading financial websites will give you a list of all the companies that compete with each other in a given industry. Enter any stock symbol at Yahoo! Finance, at finance.yahoo.com, and click the name of the company when it pops up. Next, scroll down and on the right side of the page you’ll find a list of some of the top rivals and some of their market data. Click on their symbols to get more fundamental information on them.

Considering industry-specific data

Financial ratios are among the favorite tools used by fundamental analysts. You can quickly determine whether or not a company has borrowed too much, wastes too much money, or isn’t growing very fast by studying financial ratios. Most of the popular ratios that will work most of the time are discussed in Chapter 8.

But, when performing industry analysis, sometimes the off-the-shelf ratios aren’t enough. Some industries might have unique characteristics, which require additional analysis.

Companies in the financial sector are an excellent example of how industry analysis may need to be tweaked to handle different industries. Most of the traditional free cash flow measures and cash burn techniques, discussed in Chapter 7, just don’t apply to financials. Banks and brokerages, often, have cash on deposit from their customers. That cash cannot be used to fund operations.

Due to the special way fundamental analysis must be applied to certain industries, analysts often adopt unique methods. Such industry-specific financial measures can help you better analyze some of the oddities of certain industries.

Again, the financials are a great example. Many financial analysts know to truly see how strong a bank is financially, they must examine both its Tier 1 and Tier 2 capital. Tier 1 is considered to be a much more reliable measure of financial staying power than Tier 2 capital. Tier 1 capital includes common stock and cash reserves — what regulators consider to be the financial bedrock of a financial. Banks must disclose how much Tier 1 and Tier 2 capital they have, but getting that information requires digging into the footnotes to the financial statements.

Fundamental analysts who specialized on financial companies also study industry-specific measures such as a bank’s level of loans that are 90 days past due, loans that have been completely written off, and the level of reserves a bank has taken to cover loans if they go bad.

Some of the fundamental analysts who took the time to do industry-specific analysis saw that many of the banks were less solid than the traditional ratios implied.

Taking stock of raw material costs

Much of fundamental analysis dwells on the end result. You assess a company’s bottom line and see how many assets and liabilities it ends up with after selling goods and services to customers.

But industry analysis encourages you to examine a company, almost the way the executives running the firm would. That includes paying attention to how much a company must pay for its raw materials. As you know from analyzing income statements, the amount of money a company spends to buy raw materials used to make products is considered a direct cost, and is included in its cost of goods sold, or COGS. The more a company pays for raw materials, the higher its COGS, and the lower its profit.

Sometimes, increased demand for a commodity, such as energy or agricultural products, can drive the price of raw materials up. As a fundamental analyst, if you see the prices of raw ingredients rising, that might be a tip-off a company or industry that buys those ingredients might see its future profits fall.

Bloomberg keeps an up-to-date list of prices of many commodities companies use as raw materials. You can access this information at www.bloomberg.com/markets/commodities.

Remember, just because the prices of a commodity a company relies on are rising doesn’t mean profits will take a hit immediately. Many companies use hedging, or complex financial instruments that let them lock in raw material prices for many months, or even years. Airlines do this all the time with jet fuel. You can find out if, or how, a company is hedging the risk of higher commodity prices in the 10-K.

It’s mine! Paying attention to market share

One of the most dramatic ways of paying attention to what’s going on in a company’s industry is market share. Market share tells you how much of a certain line of business a company controls.

You can measure a company’s share of either large industries or smaller subsets of the industry. For instance, if you’re studying a technology company, you might want to find out what the company’s share of overall technology spending is. Or, you might drill down, and find out what percentage of the business or consumer software markets a company has.

While market share may be measured on very precise markets, that level of industry analysis usually requires analysis that goes beyond what’s available in the financial statements. Sometimes, you need to consult with specialized market research firms if you want to know what percentage of total sales of a product type a company has.

For instance, going back to the software example, some companies might not break down how much of their business is with consumers versus other companies. There are firms that estimate market share for this type of software, though.

Still, using routine fundamental analysis, you can get a pretty good idea when other companies are eating each other’s lunches, so to speak. You can use the financial statements to monitor changes in revenue, for instance, to see who is benefitting from the weakness of some of the players in the business.

Market share analysis demonstrates the counterintuitive fact a company may be able to increase profit, even in a tough economic environment, if it’s able to steal business from rivals.

Table 16-6 presents a simple demonstration on how you can see whether one company in an industry may be taking business away from other players. The table shows total revenue reported by three large retailers, Walmart, Target, and Amazon.com.

Examining this chart shows you how Amazon, which was a smaller retailer than the other two in 2010, may have profited by cutting into the overall business. But you’ll also see how the larger retailers are fighting back lately by upping their technology chops. Amazon’s slice of the total revenue generated by the big three retailers actually fell to 40 percent in 2021 from 2017. Walmart continues to surpass Amazon in revenue in 2021. Meanwhile, Target, too, is clawing back some of the market share it lost to Amazon, but it’s still relatively tiny.

Using total revenue to measure a company’s market share is kind of a blunt financial analysis instrument. Companies may generate revenue from many different businesses. The companies listed in Table 16-6, for instance, don’t sell exactly the same things. Amazon is primarily a retailer, but it also has a large business where it manages cloud and online operations for other companies. But the analysis can give you an idea of the shifts between the industry players and how this type of industry analysis is performed.