Why Sector Research Is Often Overlooked but Essential in Investing
Introduction
Typically, the focus of finance and investing is on stock analysis and valuation, as well as the volatility of the stock market. While sectoral research is an equally important aspect of creating sound finance and investment decisions, it receives significantly less attention overall. Most students and entry level analysts, and even experienced analysts, spend very little time studying the sectors that companies operate in when they start evaluating a particular company. Ironically, while analysts routinely fail to incorporate sectoral research in their ongoing analysis, it is one of the most respected and valuable skills of experienced equity analysts, fund managers and institutional investors.
The discrepancy in the perceived value of sectoral research arises from the learning process; essentially, the advantages of conducting sectoral research become apparent only after gaining experience. For this reason, it is helpful to provide insight into the definition of sectoral research, the typical reasons why it is commonly overlooked, and the ways in which it can enhance long-term analytical decision making.
What is Sector Research?
Sectoral research is the analysis of an entire industry, as opposed to the analysis of an individual company. Sectoral research reviews the macroeconomic impacts on an entire industry, as well as the macroeconomic factors impacting companies in that industry. Factors that will have a significant impact on all companies in the sector include demand and supply fluctuations, the impact of government regulations, the cost structure of the industry, breakthroughs in technology, competitive intensity, and the general macroeconomic environment.
While someone might assess the success of a single company, sector research seeks explanations for the profitability of an entire industry, as well as for identifying common risks, understanding current market dynamics and anticipating changes to the structure of an industry, and determining which business models can expect to be profitable and sustainable over the long term. These factors all help create the context in which financial performance of individual organisations can be evaluated.
The Main Causes Why there is a Lack of Interest in Sector Research
Immediate Results:
One of the main reasons why many analysts do not pay attention to sector research is that it is not a quick source of visible information. For example, financial models will produce numerical data and will create ratios that are much easier to compare than the accumulation of sector research over time. The most common use of sector research will generally develop an understanding of the market, but will not give you immediate guidance or conclusions regarding where to invest. Since the impacts of sector research are typically delayed and gradual, many analysts do not account for this in favour of the tools that result in visible and concrete outputs.
The Educational System Concentrates on Company Analysis:
The majority of university and continuous education programs emphasise financial statements, valuation methodologies and ratio analysis. Sector analysis is seen primarily as background information for financial analysis rather than a method that should be incorporated into one's process for completing a financial analysis. Many students and younger professionals will thus view that sector research will not be an integral part of performing high-quality analysis.
Qualitative Challenge of Sector Research:
In contrast between financial modeling and sector research, sector research lacks the fixed structure and process as do financial models. It is essentially a qualitative process that relies on the individual judgment of each market analyst and requires combining the various types of information found in sector databases (economic indicators), regulatory changes, industry standards, changing customer needs (influenced by technological changes), and innovative business practices, to create a complete view of the industry in question.
Focus on Short-Term Performance
Modern financial markets focus on being fast and making quick decisions. A good example of this is a company's quarterly earnings report, together with other types of information, such as daily news stories. These types of information will allow an analyst to quickly determine how well or poorly a company's overall performance is. In contrast to the focus of financial markets, on a short-term basis, sector research generally involves looking at longer time horizons and identifying trends or changes in the structure of the industry.
Reasons for Respect for Sector Research by Other Experienced Industry Professionals
While many view sector research as a source of significant value, they are missing an important aspect of it. The fundamental importance of sector research is that it improves an investor's judgment capabilities and decreases an investor's ability to miss out on significant opportunities in their market of interest.
1. Drivers Behind the Numbers
While financial statements represent the outputs of a company, the inputs to those outputs can be attributed to sector research. Financial performance metrics (margins, growth, and/or leverage) related to the performance of a company can sometimes be explained through information and trends across the entire sector.
For example, the losses reported by many firms might represent a decrease in profits because of government regulation or rising input costs; not necessarily because their managers made bad decisions.
2. Identifying Structural Strength & Weakness
Not all businesses will see the same growth level due to the overall growth of their industry, so sector research will help differentiate between firms with actual sustainable competitive advantages and those who are simply benefitting from a period of cyclical growth.
For example, in the fast-moving consumer goods (FMCG) industry, longer-term factors such as strength of the brand and distributor relationships will outweigh any immediate/short-term volume growth. In the banking industry, things such as asset quality and regulatory positioning typically outweigh headline profit figures.
By understanding the underlying structure of the business, analysts avoid being fooled by a short-term “performance surge” and thinking it is indicative of long-term strength.
3. Improving Forecast/Assumption Accuracy
When analysing the revenue, margin and cash flow forecasting numbers, it is important to note that the accuracy of those estimates improves when they are based on sector norms.
When many organizations are in the same sector, the demand cycles, cost pressures, regulatory changes, and capacity utilization cycles will impact a number of companies simultaneously. Therefore, analysts with a sound Knowledge of the sector will develop more realistic assumptions and avoid over-reliance on historical averages.
4. Guarding Against Overconfidence and Bias
Typically, when a Company is being managed by management, the Company is likely being told an overly optimistic story about its future. The Sector Research Process provides a method of verifying management's claims to determine the extent of alignment with current industry conditions on a worldwide basis.
When an entire sector is experiencing a reduction in demand or increasing competition, claims of an extraordinary level of growth should be considered with caution because there is a high likelihood that they are not substantiated. Sector Research will assist in differentiating genuine opportunities from inflated claims.
Investment Firms' and Research Houses' Focus on Sector Expertise
Why Institutions Emphasize Sector Expertise
Although both Institutional Investors and the world's largest Analysts/Researchers structure their Analysts into teams aligned to specific Sectors and sub-sectors, not necessarily by which Analyst performs what task analytically, by working in the same sector, Analysts develop an in-depth understanding of Industry Trends over time (e.g., Cycles, Regulation Changes, and Competition).
Sector Experts have the opportunity to develop their Body of Knowledge throughout all such cycles, thereby allowing them to identify the first signs of a Change in their Sector earlier than Generalists and accurately to assess risk for their Sector and others better than Generalists.
Accordingly, Sector Experts will be the most trusted when it comes to making Significant Investment Decisions and determining Long-Term Portfolio Objectives.
The Compounding Benefits of Sector Research
While Sector Research may not show any Immediate Value, over an Extended Time, its accumulated value will begin to show itself. Sector Research provides Conviction during periods of Market Volatility. Sector Research can help Experts avoid Value Traps. Sector Research can help Experts determine when Market Sentiment diverges from the Market Fundamentals.
Additionally, Professionals who repeatedly use Sector Level Thinking are typically less Exposé to Emotional Decisions and tend to develop and maintain a Disciplined Investment Philosophy. Therefore, as Professionals become more familiar with Sector Research, it is only natural that they will appreciate the Long-Term Advantages of Sector Research.
• The industry size and growth drivers.
• The competitive structure/entry barriers.
• The cost Dynamics and profitability Trends.
• The Regulatory/Policy Environment.
• The Technological and Consumer Behaviour Change.
• The Cyclicality and Key Risks.
It is important to maintain and update this framework so that sector research can become an applicable, decision support tool, instead of being viewed as a static research exercise.
Final Thoughts
Sector research is often overlooked, due to the qualitative nature of most sector research with many times being very time-consuming and as well not providing quick conclusions. The value of sector research is the improvement it brings to one's analytical judgment and accuracy of forecasts and the avoidance of expensive misinterpretations of sector research.
Most of the time, the best insights that finance professionals gain are not evident, and therefore insightful sector research provides the ability to build depth, clarity and, most importantly, long-term conviction. The difference between good analytical work and being able to utilize those insights for exceptional decision-making lies in one's ability to put time into the understanding of the various sectors in which one is eventually going to make an investment. As a professional gains more experience over the years, this advantage that they will have gained from understanding various sectors will become more and more apparent.