Page 127 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes 1. There is competition among domestic and foreign firms, both in the domestic and the
foreign markets. How do firms perform here?
2. Many types of products are manufactured in this industry. Are these homogenous in
nature or highly heterogeneous?
3. What is the nature and prospect of demand for the industry? Are these homogenous in
nature or highly heterogeneous?
4. This may also incorporate the analysis of the markets of its products, customer-wise and
geographical area-wise, identifying various determinants of this type of industry its
growth, cyclical, defensive or relative decline industry.

4.2.1 Importance of Industry Analysis

Why should a security analyst carry out industry analysis?
To answer this question, logically, two arguments are presented:
1. Firms in each different industry typically experience similar levels of risk and similar
rates of return. As such, industry analysis can also be useful in knowing the investment-
Worthiness of a firm.
2. Mediocre stocks in a growth industry usually outperform the best stocks in a stagnant
industry. This points out the need for knowing not only company prospects but also
industry prospects.
Risk-return patterns: Economic theory points out that competitive firms in an industry try to
maximize their profits by adopting fairly similar policies with respect to the following:

1. The labour-capital ratio utilized by each firm.
2. Mark ups, profit margins and selling prices.
3. Advertising and promotional programmes.

4. Research and development expenditures.
5. Protective measures of the government.
At such, they have the same risk level as well as rates of return, on an average. Empirical
evidence shown by research done by Fabozzi and Francis supports this argument.
Growth Factor: All industries do not have equally good or equally bad experiences and
expectations; their fortunes keep on changing. It implies that the past is not a good indicator of
the future – if one looks very far into the future.
This view is well supported by research. Researchers have ranked the performance of different
industries over a period of one year and then ranked the performance of the same industries
over subsequent periods of years. They compared the ranking and obtained near zero correlations.
It implies that an industry that was good during one period of time cannot continue to be good
in all periods.
Another observation is every industry passes through four distinct phases of the life cycle. The
stages may be termed as pioneering, expansion, stagnation and decline. Different industries
may be in different stages. Consequently their prospects vary. As such, separate industry analysis
is essential.

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