Why Industry Dynamics Must Be Considered

Even if you bought a good company that has good potential, you may still have a dog on your hands. Prolonged “sector judgments” can be very costly to you if you don’t account for them.

The market loves to render companies “guilty by association.” Reams of research have clearly established that sector or industry dynamics have a greater impact on stock price than a company’s individual performance. Some reports go so far as to suggest that selecting individual companies is barely important. In most cases, you are buying into a sector first and a company second.

Context matters more than company particulars. Now, you might be asking, “Aren’t we looking for the next Microsoft or the next Amazon?” The real trick in finding that Microsoft or Amazon — if you look back in time — is to recognize the sizzling hot, emerging market that few people even think to consider in the first place.

For example, to have found Microsoft at its precious infancy, you would have had to first appreciate the enormous impact that the graphical user interface (GUI) was about to have on the world. (Remember when your computer was nothing more than a black screen and a command prompt?)

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When Microsoft was pushing Windows 3.0 over a decade ago, there were plenty of people in the industry who did not believe GUIs were going to amount to anything. If, at the time, you believed in the inevitable power of the GUI, Microsoft would have been a natural choice.

What does this mean for the individual investor? You can improve your odds by investing in solid macroeconomic themes, and you can hedge your bets by avoiding dicey sectors. Sure, maybe you could have made some money recently in younger and leaner airlines, but why would you have even taken the risk given the labor woes, the terrorism overhang, and the sad fundamentals in general (not to mention, the exceptional airline or two that was shockingly not well hedged against violently fluctuating fuel prices).

Another example is the sad saga of Canadian income trusts, which also must be considered first and foremost as assets that are sensitive to macroeconomic events. Now, the attraction of income trusts is understandable because these investments have directly benefited from a years-long favorable tax regime, resulting in huge income distributions.

But you don’t have to look any further than Jim Flaherty, Canada’s Finance Minister, to understand that we are headed into a “new tax regime” of higher taxes — a regime in which income trust distributions will suffer, while investor exodus sends trusts’ market prices into a nosedive. That’s not to say you should stay away from income trusts. Rather, tread carefully; it’s a different world out there!