What it means
Instead of starting with one company, sector analysis starts with the group it belongs to. The analyst asks whether the sector is growing, how profitable it is, how crowded the competition is and what could change the picture.
Only then does the focus move down to individual firms. Common tools include looking at the sector's growth rate, profit margins, return on capital and valuation compared with its history.
Analysts also study the main drivers, such as commodity prices for energy, interest rates for banks, or consumer confidence for retail. Porter's Five Forces, a framework that looks at rivalry, new entrants, substitutes and the power of buyers and suppliers, is a popular way to assess competition.
The economic cycle shapes much of the work. Some sectors lead the economy out of a downturn, such as consumer discretionary or financials, while others, such as utilities and health care, hold steadier.
Analysts try to judge where the economy is in its cycle and which sectors tend to do well at that stage. Relative strength is another useful measure.
It compares the sector's return with the wider market over the same period, showing whether money is flowing into or out of the group. A sector that keeps beating the market may be attracting investors, although the trend can reverse.
Businesses use the same method for their own planning. A manager considering a new product line or acquisition studies the sector's growth and competition first.
The limits are that sector forecasts can be wrong, and a good sector does not guarantee that a particular company will succeed. A typical process works from the top down.
The analyst first views the economy, then picks the most promising sectors, and only then chooses individual companies within them. Some investors prefer the opposite, bottom-up approach, but many use both to cross-check their conclusions.
In practice
Real-world examples.
Example
An analyst at an investment firm studies the renewable energy sector. She finds that demand is growing at 15% a year but profit margins are thin because of heavy competition. She recommends a small allocation rather than a large bet, and suggests reviewing the position again in six months when new data on margins is available.
Example
A food company's strategy team studies the packaged snacks sector before launching a new product. They find that the sector's growth is slowing and that retailers have strong bargaining power. They choose to focus on a niche segment with higher margins.
Example
A lender reviews its loan book and examines the construction sector, where interest rates and building activity are both weak. It decides to tighten lending standards for new construction loans. This reduces its exposure to a sector under strain.
Formula
Calculation
Relative performance = sector return - market return
Over the past year a sector index rose from 1,000 to 1,120, a return of (1,120 - 1,000) / 1,000 = 12%. The wider market index rose by 8% over the same year. The sector's relative performance is 12% - 8% = 4 percentage points, so the sector outperformed the market by 4 points.Case study
Seen in the real world.
Summit Ridge Capital is a fictional investment firm that was deciding where to place $20,000,000 of new client money. Its analysts, led by Omar, built a comparison of five sectors using growth, margins, valuation and relative strength.
The work showed that health care had steady growth and fair valuation, while technology had strong growth but a very high valuation. This is an illustrative case, but the process is realistic. Omar's team put $8,000,000 into health care and $5,000,000 into technology, and kept the rest in other sectors so that no single view dominated the portfolio.
Omar reviewed the figures every quarter and set triggers for change. If a sector's relative performance fell more than 10 percentage points below the market or its valuation climbed far above its history, the team would meet to decide whether to cut the position.
Watch out
Common mistakes.
- Assuming a strong sector guarantees a strong company. Weak firms can still fail in a booming sector.
- Using only past performance. A sector's past returns do not guarantee that the trend will continue.
- Ignoring valuation. A growing sector can still be a poor investment if prices are already too high.
Questions
People also ask.
What is the difference between sector analysis and company analysis?
Sector analysis looks at the whole group of companies and its conditions, while company analysis examines one firm in detail.
What is sector rotation?
It is the practice of moving money between sectors as the economy moves through its cycle.
How do I measure whether a sector is strong?
Compare its return, growth and profit margins with the wider market and with its own history.
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