Industry Analysis and Top-down investing
The Business Cycle and Investing

Top-down investing involves looking at trends in the general economy and then selecting companies likely to benefit from those trends.


Look at the case of the countries in the Asian debt crisis (see M. Freddie Reiss, "Asian Markets" in Dominic DiNapoli, ed. (1999) "Workouts and Turnarounds II," 279ff.).  Look at the case of Enron, or at the case of other companies that have "inexplicably" crumbled.  In many of these cases, it is clear that the fundamentals were not reflected in the prices.  This suggests that if one had looked at the fundamentals, one could have sold out in time.   Of course, this represents a certain sort of market inefficiency.  But this is a market inefficiency that favors fundamental analysis.  If we can assume that the same applies for the upside as well (that is, by looking at fundamentals, we can find stocks/sectors that are under-priced), we should look at the fundamentals.

In order to reduce the order of difficulty of our problem, let us divide our approach into two parts -- one, finding a sector/industry that is under-priced, and then select stocks within those "under-priced" sectors that are underpriced relative to the sector and relative to other stocks, as a whole.

Sector Selection:

How can we select sectors?  In principle, there is no reason why our approach to sector selection should be different from our principle to stock selection.  Although we are yet to discuss stock valuation and stock selection, there are some basic principles that apply in both stock selection, as well as sector selection.  We could use those same principles to select sectors.  However, the difficulty with this approach -- one, we would need to get a lot of information on cashflows, since the basic stock valuation approach that we will use is cashflow based; and we will need a lot of detail.  Hence I will suggest an alternative approach.

We know that the economy is down quite a bit -- most of the statistics are pretty bad.  If we can agree that the economy is not likely to keep going down in the medium term (in the short term, maybe), then, even if we do not know when the upturn will occur, the sectors that will do well, when the upturn does occur will be sectors that have the flexibility to capitalize on the new opportunities.  (And, actually, many of the measures of flexibility that we will look at, will not hurt firms even if the economy continues going down.)

What aspects characterize a flexible firm?  I can think of two -- one, a low debt-equity ratio; and two, lots of free cashflow that are available to make NPV>0 investments.

Cash flows:

 Let's look at cash flows; let's see if there are industries that have a high level of free cash flow.  Whereas when the economy is flush, an excess of free cash flow might lead firms to make bad investments, at times like these, an availability of free cash flow is advantageous -- the firm/industry will have cash when good investments become available.  (Read article on dividends from the Economist.).

In fact, we might refine this approach further.  Perhaps there are industries that already have investment opportunities -- admittedly, there are not going to be many of these, but we can look!  If such industries exist, then their capital expenditures may very well be rising.  Of course, if these industries are already investing in profitable opportunities, why would the market not reflect that in their prices already?  After all, even if we are positing a certain level of market inefficiency, let's not assume gross inefficiency!  On the other hand, it would not hurt to use this factor as a secondary selection criterion.  If we have sectors that are making investments, this suggests that their free cashflow is probably not increasing.  In fact, if free cashflow is increasing, that might very well indicate that the sector is experiencing accelerating problems.  

So let's look at industries where capital expenditures are increasing and/or high as well as industries where free cash flow is high and decreasing (indicating, usage).


Firms with high leverage have to worry about paying off their debt or at least servicing it.  This does not give them much flexibility to capture investment opportunities.  Furthermore, debt, in general, and in these times, in particular, is probably laden with restrictions and covenants.  Hence, if we want flexible sectors, we want sectors with relatively low leverage ratios; industries with low debt/equity ratios (relatively) or industries where debt-equity ratios have not increased relative to their historic averages, or at least where they have not trended up.

Of course, we would need to look at debt levels/leverage relative to other industries.  Of course, since it's not possible to simply compare leverage across industries -- the fundamentals are different, we need to do a cross-sectional regression of leverage ratios.  Perhaps use Damodaran's cross-sectional regression model -- let's see if, perhaps there are industries that tend to have below average leverage.  Again, low relative leverage suggests the ability to survive, as well as to the flexibility to raise funds if necessary.  

Implications of Market Efficiency for Capital Budgeting

Market Efficiency is usually assumed only for capital markets, because there is relatively free flow of information.  However, this is not assumed in the market for real assets/projects.  In other words, we assume that firms can pick NPV>0 projects, even though, in general, we do not make that assumption for (active) portfolio managers.  However, this does not mean that all projects will be NPV>0.  Alan Shapiro has the following insights (in an HBS article)

A project can be reliably identified as being positive NPV only if we can also identify the sources of that positive NPV. In general, the sources of such value enhancement represent some deviation from perfect competition in the product market, such as the existence of barriers to entry in the firm's industry, due to:

  1. the availability of economies of scale in production
    Lesson: Investments that are structured to exploit economies of scale are more likely to be successful than those that are not.
  2. the possibility of product differentiation
    Lesson: Investments designed to create a position at the high end of anything, including the high end of the low end, differentiated by a quality or service edge, will generally be profitable.
  3. cost advantages
    Lesson: Investments aimed at achieving the lowest delivered cost position in the industry, coupled with a pricing policy to expand market share, are likely to succeed, especially if the cost reductions are proprietary.
  4. monopolistic access to distribution channels
    Lesson: Investments devoted to gaining better product distribution often lead to higher profitability.
  5. protective government regulation
    Lesson: Investments in project protected from competition by government regulation can lead to extraordinary profitability. However, what the government gives, the government can take away!


The Business Cycle and Stock Selection (From Robert Arnott (Chap. 9) in Investment Management by Bernstein and Damodaran)
Leading Indicators also provide an interesting gauge.  If leading indicators have risen in the past year, typical of a recovery from a recession, we find that heavily leveraged companies and labor-intensive companies are likely to do well.  Typically, during the recession that precedes an upturn in leading indicators, most labor-intensive companies have already cut costs; they enter the new economic cycle lean and well-positioned for the ensuing economic recovery.  Also when leading indicators have risen in the past year, growth stocks have likely already made their move; accordingly, the value stocks (high earnings-to-price stocks) would tend to do particularly well.

In each of these cases, we are not looking at coincident relationships, but predictive relationships.  One might surmise that the market would already have incorporated this information into stock prices, but that seems not to be the case.


Sectors and the Business Cycle

Why a sector emphasis?

Practical Matters:

How do we define sectors?  We can do it in several ways -- one we use the S&P definition of sectors; two, we use the StockVal definition.  

S&P Sector Dynamics, Oct. 2001 from Fidelity 

Sector and Style Investing


Information in Different Textbooks:

Chapter 13 of Jones:

A detailed listing of business cycle contraction and expansion dates can be found at  Go to to find a set of nine important economic indicators, including data on sales, earnings, exports, prices, and jobs.  Monthly statistics on the leading indicators as well as other indicators can be found at  The Federal Reserve Banks have numerous details on various aspects of economic activity and all of them can be accessed through any of the regional banks, such as  A daily commentary on economic activity can be found in the "Research," "Economics," part of Lehman's website at

Chapter 17 from Bodie, Kane and Marcus

Key Variables describing the macroeconomy:

Classify shocks as demand shocks versus supply shocks.  Demand shocks are events that affect the demand for goods and services in the economy.  Positive demand shock examples are

Supply shocks are events that influence production capacity and costs.  Examples are:

Demand shocks are characterized by aggregate output moving in the same direction as interest rates and inflation, while supply shocks have the opposite effect.

Consider a given scenario and identify which industries/firms would be benefited by that scenario.

Section 17.5 on the Business Cycle.

Cyclical Industries have above-average sensitivity to the state of the economy; they would outperform the market when the economy is improving.  Examples are producers are producers of durable goods, such as automobiles or washing machines; other cyclical industries are producers of capital goods.

Defensive industries include food producers and processors, pharmaceutical firms and public utilities.  These industries will outperform others when the economy enters a recession.

Leading indicators from the Conference Board are:

  1. Average weekly hours of production workers (manufacturing)
  2. Initial claims for unemployment insurance
  3. Manufacturer's' new orders (consumer goods and materials industries)
  4. Vendor performance -- slower deliveries diffusion index.
  5. Contracts and orders for plant and equipment
  6. New private housing units authorized by local building permits
  7. Interest rate spread, 10 year Treasury minus federal funds rate
  8. Stock prices, 500 common stocks.
  9. Money supply
  10. Index of consumer expectations.

Look at for information from the Chief Economist, The Conference Board.

Also, look at Aaron Gottesman's notes (c:\class\smip\macroeconomy_ag.ppt)

How to analyze companies and industries: Sites and Sources

Data on the service-sector is provided by (ISM) Institute for Supply Management's manufacturing report

Business Cycle & Stock Performance (July 2, 2003)

Because sector funds have a narrow focus, the sector fund investor should be familiar with the factors that may affect the industry in question. Based on a comprehensive analysis of the relevant facts, the investor must arrive at a judgment as to what the industry's performance will be like going forward. One technique commonly used by sector fund investors is to monitor the business cycle for clues as to what may be happening in the market.

Business cycle basics

In its most classic form, the business cycle involves a recession giving way to modest growth, then stronger growth. Eventually, growth reaches a peak, and a slowdown begins, leading to recession and a completion of the cycle.

By examining empirical evidence, the investor can attempt to create a framework for viewing present and future events as they unfold. There are two key questions the investor may want to ask about historical empirical evidence. First, will the historic pattern hold, or will it be altered? To answer that, the investor needs to ascertain whether the factors driving today's market are fundamentally unchanged, or whether the situation has evolved incrementally or even been radically changed.

The second question is whether the market has already taken the anticipated future events into account. If the factors driving the industry are the traditional cyclical ones, the market usually will have taken them into account, because they are expected. If the factors represent a new element in the equation, then the market may not be expecting them and may not have adjusted accordingly.

Business cycle and relative stock performance
The following chart shows a typical business cycle and the points at which various economic sectors tend to outperform the broader market. Click on any number in the chart to learn about the cyclical characteristics of a particular industry. Please note that the chart should be used for illustrative purposes only. The chart is a historical representation of stock performance movements relative to the business cycle and is not intended to convey any current or future economic outlook.

Definition 1 Definiton 2 Definition 3 Definition 4 Definition 5 Definition 6 Definition 7 Definition 8 Definition 9 Definition 10 Definition 11 Definition 1 Definition 2 Definition 3 Definition 4 Definition 5a Definition 6 Definition 7 Definition 8 Definition 9 Definition 10 Definition 11 Definition 4

Past performance is no guarantee of future results.

The chart above shows a typical business cycle and the points at which various economic sectors tend to outperform the broader market. Please note that the chart should be used for illustrative purposes only. The chart is a historical representation of stock performance movements relative to the business cycle and is not intended to convey any current or future economic outlook. Choose a Sector for a detail description of its role in the business cycle.

Source: 2000, Standard and Poor's, a division of McGraw-Hill Companies, based on a study analyzing the differences in market returns of 90 Industries vs the S&P 500 during 10 complete economic cycles from December 1945 - December 1995.

 Consumer Non-Cyclicals
Stocks in consumer non-cyclicals (food) and consumer growth industries (cosmetics, tobacco, beverages) tend to experience fairly steady demand and are less sensitive to changes in the business cycle. These stocks typically attract investors when the economic cycle or bull market has matured, or is in the early stages of contraction.
 Consumer Cyclicals (durable & non)
Stocks in this category include durables and non-durables that are sensitive to interest rates as well as the business cycle. Investors typically seek them out when the economy is in the late stages of contraction.
In general, stocks in this sector move similarly to consumer non-cyclicals. This sector is considered defensive, meaning companies in this sector are generally unaffected by economic fluctuations. The Healthcare industry consists of pharmaceutical firms, HMOs, biotechnology firms and medical equipment suppliers. Pharmaceutical companies are affected by competitive market shares, the pace of FDA approvals, patent lives, and the strength of the R&D pipelines. Many biotechnology firms are still in the development stage with their fortunes largely determined by investor perceptions of the relative merits of their R&D pipelines. With future new financing likely to be more difficult to obtain than in the past, strategic alliances between major drug companies and biotech firms are expected to increase.
Stocks in housing-related industries tend to respond well to falling interest rates and are often targeted by investors in the mid to late stages of an economic contraction. Non-mortgage-dependent banks are generally driven by commercial and consumer loan growth, and tend to be favored by investors during the middle of the cycle.
Technology stocks can be cyclical to the degree that they depend on capital spending and business or consumer demand. However, they may also have long-term growth potential as technological products find broader applications and as new technologies are developed. Technology stocks are usually popular during early to mid stages of an economic expansion.
 Basic Industry
Profits of basic industries are driven by high utilization of capacity and strong market demand for products. Therefore, their stocks tend to be popular with investors late in an economic expansion. For basic material companies, the global economic picture and supply/demand equation also affect stock price movements.
 Capital Goods
Capital spending tends to increase midway through the business cycle, as the economy is heating up and higher demand for products leads companies to expand their production capacity. Demand in global export markets is key for agricultural equipment, industrial machinery, and machine tools.
Railroads and other surface carriers tend to react early to a pickup in the economy. Airlines are subject to cyclical fuel costs, usage versus capacity, and competitive pressures on airfares.
This category includes large integrated international companies, domestic exploration companies, and energy services companies. Each industry has its own dynamics, but ultimately all are driven by the supply and demand picture for energy worldwide. Political events have historically had a major impact on these industries. Stocks tend to be popular with investors late in the business cycle.
Electric companies have historically been very sensitive to interest rates because of the large debt financing costs they must incur in order to build their infrastructures. These stocks tend to perform well in an environment of declining interest rates. Telephone companies may offer attractive long-term growth opportunities, as they diversify and compete in recently deregulated telecommunications markets.
 Precious Metals
Precious metals and the stocks of companies that mine and process them can be affected by industrial and consumer demand, but the largest factor contributing to volatility in this category is generally inflationary pressure. Investors often flock to this category late in the expansion cycle.

Signals to Look for During a Business Cycle

A business-cycle trough. The trough is usually characterized by low earnings and high unemployment. When inventories start to shrink, an upturn may be on the way.

A business-cycle peak. Typically, earnings are high and unemployment is low at a peak. When prices for raw materials rise and inventories start to increase, look for a downturn to follow.

A bull market. A bull market is characterized by rising price-to-earnings (p/e) ratios and falling yields. In its late stages, a bull market may see high initial public offering (IPO) activity, rampant speculative buying, and outperformance from small-cap stocks. A market that seems indifferent to good news and shows a strong concern over interest rates may be at its top. Because the stock market usually anticipates the business cycle, it may begin to slide even as good earnings are still being reported.

A bear market. A bear market is characterized by rising yields, falling p/e ratios, and sharp declines with heavy trading volumes. A market bottom, however, may be marked by indifference to bad news, sluggish performance, and widespread pessimism. Upturns are often gradual and imperceptible. If the market anticipates the business cycle, earnings may continue to be weak for some time.

Other factors

Factors outside the business cycle

In addition to evaluating sector performance relative to the business cycle, sector investors should also evaluate factors that are external to the business cycle, as they can also influence the short- or long-term behavior of various industries' stocks. Some of these factors include:

Government policies. Recent examples include high-tech antitrust cases such as Microsoft*, the auction of radio frequencies, the move to reform healthcare, and the approval or denial of biotech new product proposals.

International trade and competition. The increasing globalization of the economy means that foreign activities can affect American markets. For example, China's move toward acceptance as a member of the World Trade Organization could have a major impact on U.S. exports. Industries that are sensitive to imports or exports will also be affected by changes in currency values.

International exposure. When evaluating sector funds, it is also important to keep in mind that certain sector funds may invest in foreign securities. Similar to any mutual fund, a sector fund's exposure to international securities could magnify the overall risk of the fund. A good example would be foreign government regulation in the healthcare sector. While some drug companies have benefited by government deregulation, heavily regulated pricing and government bureaucracy has hampered others.

Consumer demand. While some aspects of demand are tied to the business cycle, demand can also follow changes in demographics, fashions, price levels, or cultural concerns. Strong holiday sales (or the expectation of them) can send retail stocks up. During the late 1990s, the emergence of the internet and the demand for access created new markets for internet service providers and on-line retailers.

Innovation. The introduction of new products and technologies can change the entire landscape of an industry. Examples include the booming trend toward wireless communication, and developments in biotechnology. While great investment opportunities abound, rapid product development can also lead to the obsolescence of established products.