Investing: Make future perfect

By: | Published: September 29, 2015 12:12 AM

It’s necessary to forecast important economic variables and estimate biz cycles before taking investment decisions

INVESTMENT practitioners analyse the current stage of a firm’s business cycle as it enables them to look at investment opportunities that have favourable risk-return characteristics. Can we spot trends in industries that can make good investments? Let us try to find answers to this question.

Business cycles and industry trends

Economic trends can affect industry performance. By identifying and monitoring key assumptions and variables, one can monitor the economy and gauge the implications of new information on our economic outlook and industry analysis. As most investors wish to ‘beat the market’ on a risk-adjusted basis, they should have forecast that differ from the market consensus and that must be correct more often than not. Economic trends can take two basic forms:

Cyclical changes that arise from the ups and downs of the business cycle, and structural changes that occur when the economy is undergoing a major change in how it functions. For instance, excess labour or capital may exist in some sectors whereas shortages of labour and capital exist elsewhere.

Rotation strategy

It is believed that industry performance is related to the stage of the business cycle. What makes industry analysis challenging is that every business cycle is different and those who look only at history miss the evolving trends that will determine future market performance. Switching from one industry group to another over the course of a business cycle is known as a rotation strategy. When trying to determine which industry groups will benefit from the next stage of the business cycle, investors need to identify and monitor key variables related to economic trends and industry characteristics.

Expected patterns

Towards the end of a recession, generally the financial sector shares rise in value because investors anticipate that banks’ earnings will rise as both the economy and loan demand recover. Brokerage houses become attractive investments because their sales and earnings are expected to rise as investors trade securities, businesses sell debt and equity, and there is an increase in mergers and acquisitions during the economic recovery. These industry selections assume that when the recession ends, there will be an increase in loan demand, housing construction and security offerings.

Once the economy begins its recovery, consumer durable firms that produce expensive consumer items, such as cars, personal computers, refrigerators, lawn tractors and snow blowers, become attractive investments because a reviving economy will increase consumer confidence and personal income. Once businesses recognise the economy is recovering, they begin to think about modernising, renovating, or purchasing new equipment to satisfy rising demand and reduce costs. Thus, capital goods industries, such as heavy equipment manufacturers, machine tool makers and airplane manufacturers, become attractive.

Behaviour of cyclical industries

Cyclical industries whose sales rise and fall along with general economic activity are attractive investments during the early stages of an economic recovery because of their high degree of operating leverage, which means that they benefit greatly from the sales that increases during an economic expansion.

Industries with high financial leverage likewise benefit from rising sales volume. Traditionally, toward the business cycle peak, the rate of inflation increases as demand starts to outstrip supply. Basic materials industries, such as oil, metals, and timber, which transform raw materials into finished products, become investor favourites. Because inflation has little influence on the cost of extracting these products and they can increase prices, these industries experience higher profit margins.

During a recession, some industries do better than others. Consumer staples such as pharmaceuticals, food and beverages outperform other sectors during a recession because, although overall spending may decline, people still spend money on necessities so these ‘defensive’ industries generally maintain their values. Similarly, if a weak domestic economy causes a weak currency, industries with large export components to growing economies may benefit because their goods become more cost competitive in overseas markets.

To conclude, we have identified certain industries that typically make attractive investments over the course of the business cycle. Generally, investors should not invest based upon the current economic environment and prevailing business cycle because the market generally incorporates current economic news into security prices. Rather, it is necessary to forecast important economic variables and estimate the business cycles, which are likely to occur six months to one year in the future, and invest accordingly.

* Investors should avoid investing based on current economic environment and prevailing business cycle
* This is because the market generally incorporates current economic news into security prices
* Certain industries typically make attractive investments over the course of business cycle; it’s crucial to identify these
* During recession, consumer staples such as pharmaceutical, food and beverages outperform other sectors
* Forecast important economic variables and estimate business cycles likely to occur six months to a year in the future and invest accordingly

The writer is associate professor, finance & accounting, IIM Shillong

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