The need to carry research, analysis and/or investigation of the economy and sectors within the economy, when you are in the process of valuation of companies and shares one intends to invest into cannot be over emphasized. Such research and analysis, which then informs you whether you are about to pay the right price for a share you intend to buy, or not. In previous articles about similar topic, we indicated that one of the useful tools for analysing the outlook for an industry or sector is to use the Porter ‘five forces’ framework. We indicated that these forces identify the five underlying factors determining future profitability of the company you have invested into or are planning to invest into, these industry forces are:
- Threat of new entrants
- Threat of substitute products
- Bargaining power of suppliers (buyers)
- Rivalry among the existing competitors
- Bargaining power of suppliers
Let’s look a little closer at the questions we need to ask when investigating an industry.
Suppose that you have to bet your entire nest egg on a football game. All you need to do is select a winning team. These are your choices: Young Africans, Simba, Azam, Biashara United, Tanzania Prison, KMC, Ruvu Shooting, or any of the 16 participating clubs in the Tanzania Premier League, probably the obvious choice for most of us would be either Yanga, or Simba, or Azam, given the odds.
Fortunately, this is where the comparison between football (or other) sports and investing in shares ends.
You don’t have to choose the absolute winner in investing in shares because there are lots of winning shares in second place, too. The basic point is that you can increase your odds of winning when you choose a winning industry or sector in the economy as part of your investment strategy. In the race to build wealth, all you need to do is to pick decent shares in a decent industry and do so on a long-term basis in a disciplined manner. Remember that investing in shares should be a long-term value investment as opposed to short-term speculative motives.
As mentioned above, a successful long-term investor (a value investor) looks at the sector just as carefully as he looks at the individual share of a listed company that s/he intends to invest in.
The important questions to ask yourself when you are choosing shares of a sector you intend to invest in, are:
- Is the sector depicting the growing trend? – The saying “the trend is your friend” applies when choosing a sector in whose shares you intend to invest, as long as the trend is an upward one. If you look at three different shares that are equal in every significant way, but you find that share X is in a sector growing at 10 percent a year while the other two types of shares are in industries that have either little growth or are shrinking, which share would you choose? – Obviously the common wisdom, and other things being equal, will propel you to choose shares belonging to a growing sector.
- Are the sector’s products or services in demand? – Look at the products and services that the sector provides. Do they look like items that the society will continue to want and demand for a foreseeable future? Are there any products and services that are on the horizon that could replace them? Does the sector face a danger of going out of fashion?
- What does the sector’s growth rely on? – Does the sector rely on established historical trends, or on factors that are losing relevance?
- Is this sector dependent on another sector? When one sector suffers, you may find it helpful to understand which sectors will subsequently suffer. The company or shares that you intend to invest into may be in the sectors that will be affected by side effects.
- Who are the leading companies in the sector? – Once you have chosen the sector, you can choose from two basic companies, namely established leaders, which is a safe way to go or innovators, which have more potential.
- Is the sector a target of government action? – Intervention by policy makers and politicians can have an impact on a sector’s economic situation.
Which category does the industry fall into? – Most sectors normally fall into two categories, namely cyclical category and defensive category. This translates into what the society wants and what it needs. Society buys what it needs in both good and bad times. It buys what it wants when times are good and holds off when times are bad.
Cyclical industries are those whose fortunes rise and fall with the economy’s rise and fall.
Defensive industries are those that produce goods and services that are needed no matter what’s happening in the economy i.e., food, housing, clothing, medical and health services, education, transportation, etc.
Once understood where the economy/market/sector is situated, based on the research and analysis — then comes the hard decision – which company’s shares should you buy from the stock exchange? Although every part of the investment decision-making process is important, this part is equally crucial and critical because it is your share-selection that will ultimately determine your investment performance relative to the rest of the market.
A very common question is, ‘how many different companies’ shares should I have in my portfolio?’ The answer is, ‘As many as you like’ – provided you have the capability to acquire them and are also capable of keeping track of all your shares by following on their corporate performance, corporate announcement i.e., dividend payments, appointment of people to fill in key positions in the company, rights issues, bonus issues, etc) market movement and other investors’ sentiment on the particular company.
Research indicates that if you own shares on only one or two listed companies, your portfolio is likely to experience a relatively high level of volatility (up and down share price movement) relative to the rest of the shares in the market. The volatility declines steadily, however, as the number of companies to which you hold shares increases. But be careful – if you spread your investments too widely, the performance of your portfolio will begin to simulate that of the market index, which you should be hoping to outperform.