LEVEL: BEGINNER
An industry risk analysis determines the financial risks of investing in a specific industry and the potential spillover of how risks in one industry can affect the performance of another. Industry risk affects the returns of a stock price of companies and is most appropriate for a top down approach to equity valuation.
Performing industry risk analysis involves evaluating events that could erode an industry and evaluating return performance of a sector analyzing any significant downward trends within an industry. A well-diversified portfolio can assist in avoiding the risk of ruin if one specific industry implodes and generates adverse returns for an investor.
Diversification
One way that an industry risk analysis can help an investor is by showing if the portfolio is too heavily skewed to a single industry. A portfolio that is biased toward one industry could face hard times if events occur that generate negative price action for all stocks within that industry. Diversification of a portfolio with stocks from various industries with different risk levels can help prevent a portfolio meltdown if an adverse price movement occurs.
Asset allocation is another strategy that can be used to reduce industry risk. This entails allocating capital to products other than stocks, and avoids purchasing products that have direct exposure to one industry. For example, an investor who allocates capital to corporate bonds should avoid purchasing bonds that have exposure to the same industry.
Investing Styles
A bottom up approach to investing examines a company and determines if that company is undervalued based on its own merits. Generally, this style ignores industry risk or macro risk as the basis for the investment decision is purely based on the merit of the company. A top down style incorporates macro factors and industry issues to determine if a stock is valued correctly. Both approaches are subject to industry risk, but it is more important for the bottom up investor to structure a diversified portfolio given the lack of attention to industry risk when making an investment decision.
Measuring Industry Risk
Industry risk plays an important part in explaining the environment in which a company participates. Most analysts make an industry-based adjustment in calculating a firm’s cost of equity, and the risk premium associated with that company. For example, analysts will place a higher measure of risk premium on a company that produces new technology, compared to a consumer staple company that producer tooth paste. Analysts will also employ a Capital Asset Pricing Model or evaluate industry risk though the beta or a stock.
The beta of a stock is the measurement of the returns relative to a benchmark. A beta of one means that the stock price returns move in tandem with the benchmark. A beta that is above one means that the stock price is more volatile than the benchmark and can produce returns that are much higher or lower than the benchmark. A beta that is less than one means that the stock’s returns are less than the benchmark.
Beta is calculated using regression analysis, and you can think of beta as the tendency of a security’s returns to respond to changes in the benchmark.
Consumer demand changes can be sudden and unexpected, which can create extreme volatility within an industry. For example, during the 2008 financial crisis the demand for banking products were reduced considerably over a short period of time leading to a quick adverse movement in financial stocks.
Direct and Indirect risks
Generally industry risk applies to companies that participate in a specific business line. For example, the energy industry includes upstream producers, downstream refiners, service oil and gas drilling companies as well as many other companies that assist in the petroleum process. These types of companies have direct risk to the energy industry, but there are a number of companies that have an indirect risk to energy. For example, a transportation company has indirect exposure to energy prices and should be considered a prime example of how companies can be affected by specific costs.
Summary
Industry risk can has a direct effect on the returns of a portfolio as investors sentiment can change rapidly based on adverse news. A dynamic change in a particular sector can quickly change the way investor view a specific industry driving down the price of stocks within that industry despite the underlying fundamentals of the company. Investor should be cognizant of the risks associated with an industry and diversify their portfolios to product against a market meltdown.