Investors sometimes decide that they wish to invest in a particular sector of the market – for example, retailers or health care. Their particular choice might have been influenced by familiarity with a specific industry, possibly as an employee or former employee, or even as a consumer. It might have been inspired by a stockbroker or a newspaper article.
This is all very rational, but if the exercise is to identify the best investment opportunity in the selected sector then it is necessary, as always, to compare like with like.
To illustrate, all retailers have certain similarities, but those listed on the stock exchange vary enormously from each other. Consider the following:
Wesfarmers (WES) is a conventional retailer in respect of Coles supermarkets, Officeworks, Target and Bunnings, but it also has operations in coal, LPG, fertilisers, chemicals and general insurance. Woolworths (WOW) runs supermarkets, but it also has interests in liquor and fuel. Harvey Norman (HVN) is strong on selling electrical and electronic appliances, but it also earns revenue from providing services to franchisees and investing in property. JB Hi Fi (JBH) is a specialist discounter of consumer electronics, car sound systems, DVDs and white goods. Just Group (JST) is an apparel retailer best known for its range of jeans and similar garments.
Some retailers operate only or mainly in Australia, while others are also active overseas. Some rely heavily on discretionary spending, while others focus mainly on staples.
All this means that companies that are classified as “retailers” are anything but a homogeneous group and comparing like with like is an impossibility.
In the same way, the term “health care” also embraces some rather different enterprises.
For example, Australian Pharmaceutical Industries (API) is a pharmaceutical wholesaler and a retailer of health and beauty products. Blackmores (BKL) is a naturopath and specialist health food chain. Healthscope (HSP) is an operator of hospitals, day surgeries, pathology collection centres and laboratories. Ramsay Health Care (RHC) runs about 70 private hospitals. Sigma Pharmaceuticals (SIP) is active as a distributor of prescription and over-the-counter drugs and as a manufacturer of pharmaceuticals for sale both locally and by way of exports.
Once again, comparing like with like is a virtual impossibility. Similar remarks apply to most other popular sectors of the market, from banks to energy and from resources to technology.
In theory one could compare similar divisions in different companies, but, quite apart from the practical difficulties in getting the relevant data, this would not provide much useful information to investors. A division of a listed company cannot be purchased separately from the rest of the business.
Another problem arises because the various companies in any industry vary enormously in size from each other. Large companies benefit from economies of scale, greater bargaining power with suppliers, lower borrowing costs and greater institutional interest (especially if their market capitalisation is large enough to move them into one of the leading indices).
On the other hand, investors in smaller companies have a much greater chance of doubling or trebling their money. Such companies also offer a greater prospect of being taken over at an attractive price.
In some cases a company may be a potential bidder is well as a potential target. While takeovers are usually good for the target company they are often bad for the bidding company – notwithstanding the economies of scale which a merger might achieve and the benefits from removing a competitor.
However, in practice it is not all that easy to spot takeovers before that they place. An astute investor might make a list of 40 or so likely prospects, only to find that perhaps only one of these might actually be acquired within the next five years or so. Equally, other takeovers might occur involving companies that were not included in the investor’s carefully compiled list.
Companies in any specific industry may also differ from each other in other less tangible ways. Thus, for example, a company which is run by a single individual as both its chairman and its chief executive officer poses certain dangers, particularly if that person was also its founder.
The combined office reduces the checks and balances. There are also questions such as what would happen if that person died suddenly? Has that person’s strong personality allowed a professional team of successors to be stgeloped?
Can statistics help investors to pick the best buy in any sector? The ratio of earnings before interest and tax (EBIT) to total assets can easily be calculated. For analytical purposes this can usefully be dissected into two components or factors, namely, EBIT as a percentage of turnover (the profit margin) and turnover as a proportion of total assets. (The two components multiplied together give the original ratio.)
Both factors measure different aspects of efficiency; the second factor can also give an indication of the likely future capital requirements if physical expansion and/or inflation is expected.
For some companies another measure of efficiency is obtainable from the ratio of stock on hand to turnover. This indicates how long on average a company took to make a sale.
Two yardsticks of a different type are given by the turnover per employee and per dollar of wages.
Ratios such as these do not mean all that much in isolation, but an examination of the trend over time and comparisons between a company and its competitors can give a useful insight.