It is usually prudent for investors to determine the financial and economic prospects of the sector first before finishing the market assessment for any investment-related decisions. It provides an overview of how well a group of companies can do as a whole in a specific sector. This evaluation helps investors to make decisions on investments and to accomplish future benefits. So, let us understand more about sector analysis.
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What is Sector Analysis?
Sector Analysis is a statistical assessment of the economic and financial prospects and conditions for a given sector of the economy. It is an analysis of several dimensions such as size, demographic, pricing, competitive, and other dimensions for a particular sector. Sector Analysis helps the investors to assess the economic and financial prospects of that sector of the economy. As different sectors of the economy perform better at different stages of the business cycle, sector analysis can help them identifying sectors that are profitable for investment.
How does it Work?
Sector Analysis is based on a presumption that certain sectors of the economy perform better during different stages of the business cycle. The business cycle refers to cyclical upswings and downswing which occur in the broad measures of the economic activities over time. This means the business cycle consists of the Expansion phase i.e. economic growth phase and the Contraction Phase i.e. economic decline phase.
During the phase of expansion, when interest rates are lower and growth is faster, investors and analysts performing sector analysis would focus their research on companies that can benefit from lower interest rates and increased borrowings. It is because these companies are believed to perform well during the economic growth phase. These include companies in the financial and consumer discretionary sectors.
When an economy is in the contraction stage, the economy grows slowly. At that time, investors and analyst performing sector analysis tend to focus on the sectors which can perform better in economic downturns. These include utility and telecommunication services.
Approaches used for Sector Analysis:
There are two common approaches that are used:
- Top-Down Approach
- Sector Rotation Approach
A top-down approach is an approach of sector analysis that first focuses on macroeconomic factors that influence an economy, such as unemployment and inflation, in their search for companies that have the potential to outperform. According to this approach, the analyst starts by looking at those macroeconomic factors which have the biggest impact on the largest part of the population and economy. They then drill down to find the sectors which perform better during the prevailing economic condition. At last, they analyze the fundamentals of the companies within those sectors to identify the best potential stock.
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Sector Rotation Approach:
Investors using the sector rotation approach actively shift their investments from one sector to another, depending upon market cycles and trends that impact the potential profitability of various sectors. This approach includes the rotation of their investment in and out of various sectors of the economy.
The market cycles might be seasonal. Investors buy and sell depending on market cycles and trends which impact the profitability of some sectors over other sectors. Thus, investors might rotate in and out of cyclical stocks and defensive stocks depending on where in the business cycle the economy is headed.
Sector analysis is important as investors, before taking certain investment decisions, carry out it in order to have overall knowledge about the sector. Because certain economic sectors perform best at various stages of the business cycle, this can help to assess profitable investments in these sectors. Ultimately, performing sector analysis helps in maximizing profitability to investors.
Author: Hetvi Shah
About the Author: Hetvi is a BBA(Finance) graduate. She is currently pursuing an MBA with Finance specialization. She has a keen interest in Financial Market, Financial Management, and Financial Analysis.