Fundamental securities analysts (as opposed to technical securities analysts) look at particular industries to see which are likely to fare best as the economy proceeds along its upward or downward course. These types of analysts use earnings and dividend prospects of a company, expectations of future interest rates and risk evaluation of the firm to determine proper stock prices.
In addition, fundamental analysts look for industries that offer better-than-average long-term investment opportunities. Some industries are more affected by business cycles than others. Typically, analysts find it useful to distinguish between the four types of industries and investments: defensive, cyclical, growth and special situation.
Defensive industries: Defensive industries are those industries that are least affected by normal business cycles. Stock in companies in these defensive industries offers investors some protection against the inevitable downturns in the economy. Most defensive industries involve the production of nondurable consumer goods such as food, insurance, pharmaceuticals, tobacco and energy. Public consumption of such goods remains fairly steady throughout the business cycle, regardless of inflationary or deflationary economic factors.
During recessionary economic periods and bearish markets, stocks in defensive industries generally decline less than stocks in other industries. During inflationary periods and bull markets, defensive stocks show less growth and return. Investment in defensive industries tends to involve less risk and, consequently, less opportunity for a high return on investment.
Cyclical industries: Cyclical industries are in many ways the opposite of defensive industries – they are highly affected by business cycles and price changes. Most cyclical industries produce durables such as capital goods, raw materials (such as steel, cement, aluminum and paper) and heavy equipment. During periods of tight credit or high inflation, manufacturers postpone investing in new capital goods. Likewise, consumers postpone purchasing durable goods like automobiles, recreational vehicles, appliances and houses. From an investment perspective, such industries are considered cyclical.
During recessionary economic periods and bearish markets, stocks in cyclical industries generally decline as much or more than stocks in defensive industries. During inflationary periods and bull markets, cyclical stocks offer much higher returns and growth potential. Investments in cyclical industries tend to involve greater risks and greater opportunities for a high return on investment.
Growth industries: Every industry and product passes through four phases during its existence – introduction, growth, maturity and decline. An industry is considered in its growth phase if the industry is growing faster than the economy as a whole because of technological changes, new products or changing consumer tastes. Computers, soft drinks and bio-engineering have all been growth industries in the past. Because most companies in their growth phases retain nearly all of their earnings for expansion, stocks in these industries usually pay little or no dividends.
Special situation stocks: Special situation stocks are stocks of a company with unusual profit potential due to nonrecurring circumstances. Examples include an expected recovery under new management, the discovery of a valuable natural resource on corporate property or the introduction of a new product.
As you can tell, the above categories contain companies in different market sectors such as basic materials, conglomerates, consumer goods, financial, healthcare, industrial goods, service, transportation, technology and utilities.
Quote of the Week: “The market will fluctuate.” —JP Morgan
Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.