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The first three analysis tools dealt with abstract numbers such as
earnings forecasts and P/E ratios and the like without regard to the company’s
business. Given the same numbers, your conclusions would have
been identical whether you were analyzing a maker of chewing gum,
buggy whips, guided missiles, or computer chips.
Now it’s time to learn about your candidate’s business, its industry,
and its competition.
The Business
Your first step is to determine what the company does, that is,
the products and services that it sells. That’s a no-brainer if you’re talking
about Wal-Mart, but how many investors know what Lucent Technology
or Network Appliance do for a living?
Surprisingly, few investing sites do a good job of providing that
information. One that does, however, is Multex Investor. Its Company
Overview page offers a concise but readable paragraph describing a
company’s products and services.
Multex’s Business Description page goes into more depth than
the overview, describing each of the company’s major products and services,
probably in more detail than you’ll want to know at this stage of
your research, but you’ll need it later.
Morningstar also offers a concise company overview on its
Snapshot page, which is different, although not necessarily better than
Multex’s. I suggest reading both to gain a better understanding of the
company’s business.
Morningstar also offers a longer review, written by a Morningstar
analyst, for many, but not all stocks. The review gives you the analysts’
take on the company’s business plan, and on its competitive position.
Morningstar’s analyst review is concise, doesn't go into much depth, and
you must be a paid subscriber to see it. Still, it’s a worthwhile read, usually
giving you a better perspective on the company’s operations than
you’d otherwise have. It’s worth paying the $12 or so monthly fee.
Industry Growth Outlook
Once you understand a company’s line of business, your next
step is to research its industry, starting with growth prospects.
Why? If you’re a growth investor, you want growing companies,
and you’ll find them mostly in growing industries. Otherwise, your
picks will have to grow earnings by cutting costs, by taking market share
from competitors, or by acquiring other industry players. Although
many firms have successfully practiced these strategies, they are inherently
riskier than participating in a growth industry.
The competition is less intense in a fast-growing market because
there is plenty of business for all contenders. As an industry matures,
and growth slows, companies change their focus to increasing market
share. That usually translates to price-cutting, which leads to eroding
margins and reduced earnings.
Value investors, although satisfied with a slower pace than
growth investors, should still be concerned about their candidate’s industry
growth prospects. It’s tough, even for value investors, to make money
holding companies that are battling to survive in a declining industry.
Industry growth means sales growth, but industry sales growth
forecasts are hard to find. However, analysts consensus earnings growth
forecasts are readily available for most industries. So we’ll start with industry
earnings growth forecasts, and then convert the earnings growth
numbers to sales growth.
Analysts’ Forecasts Are Good Enough
Why would you want to rely on analysts’ forecasts when few
trust their buy/sell ratings?
For starters, although analysts may have conflicted interests,
most try to come up with accurate earnings growth forecasts. The industry
growth forecasts are compiled from consensus long-term earnings
growth forecasts for all the companies making up each industry. Since
the industry forecasts are the average of many individual forecasts, they
are probably more accurate than the individual company forecasts.
Secondly, predicting long-term growth is easier said than done,
and despite their failings, analysts’ forecasts are probably as good as
anyone’s. Besides, you need ballpark figures, not precise estimates. Despite
their other shortcomings, analysts’ growth forecasts are good
enough for this purpose.
MSN Money’s Earnings Estimates page is a good
place to find the industry earnings growth forecasts. I’ll use network
storage device maker Network Appliance to demonstrate the process.
MSN Money reported analysts consensus 5-year average annual
growth forecasts of 24 percent for Network Appliance and 21 percent
for its industry, computer storage devices.
Convert Earnings Growth to Sales Growth
Once you have the industry forecast, you can convert the earnings
growth forecast to sales growth. By analyzing historical data, I’ve
found that on average, long-term industry earnings growth typically outruns
sales growth by 15 percent or so. Also, analysts’ long-term forecasts
usually run high, probably by 10 percent to 15 percent.
Taking those two factors, together, I figure that discounting
long-term earnings forecasts by 30 percent is a reasonable rule of thumb
for estimating industry sales growth. Sure, this method is based on all
kinds of assumptions, but so are everybody’s forecasts. In reality, it’s all
guesswork, and this technique is probably as close as anyone’s.
Applying the 30 percent discount factor, I estimated 15 percent
annual sales growth for computer storage, Network Appliance’s industry.
Is 15 percent good or bad? It depends.
The moderate 10 percent to 15 percent growth range is a favorite
for many value investors, because to them, 15 percent is high, and they
think it’s unrealistic to expect more. Moderate growth industries are
suitable for growth investors, but only if they can pinpoint firms growing
faster than their peers.
Growth investors generally need faster growth than value investors
and find their best prospects in industries growing between 15 percent
and 25 percent annually. The best performing companies in these
industries could score 30 percent to 50 percent, or even higher annual
sales gains. Value investors, although unbelievers, may still find beaten
up value candidates left for dead by the growth crowd after the company
tripped up.
Look at high industry growth forecasts skeptically, since analysts
sometimes get carried away. That’s especially true when an industry
is experiencing super-heated growth, such as the telecommunications
industry saw in the late-1990s.
Here are five industries considered by many analysts as having
the best long-term growth prospects.
Financial Services
Health Care
Entertainment Products
Consumer products for a healthy lifestyle
Technology | 
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