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NEXT STEPS: CONSUMER DISCRETIONARY DETAILS
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4
CONSUMER DISCRETIONARY SECTOR LANDSCAPE
Now youāve got the basics of how the Consumer Discretionary sector works, an understanding of its history, and its high-level drivers. Just like the economy, sectors are made of many distinct partsāsome relatively similar to others and some quite unique. To better understand the whole, you must understand the parts.
Chapter 1 covered the basic types of the Consumer Discretionary sectorās stocks: Media, Retailing, Automobiles & Components, Consumer Durables & Apparel, and Consumer Services. But within those classifications, there are numerous types of firms with very different product lines, end markets, and drivers. While an understanding of every company isnāt necessary, a firm grasp on the major industries is vital before making any sector-related portfolio decisions. This chapter explores the sectorās industries and how an investor can begin forming opinions on each.
GLOBAL INDUSTRY CLASSIFICATION STANDARD (GICS)
Before beginning, some definitions: The Global Industry Classification Standard (GICS) is a widely accepted framework for classifying companies into groups based on similarities. The GICS structure consists of 10 sectors, 24 industry groups, 68 industries, and 154 sub-industries. This structure offers four levels of hierarchy, ranging from the most general sector to the most specialized sub-industry:
ā¢ Sector
ā¢ Industry group
ā¢ Industry
ā¢ Sub-industry
Letās start by breaking down the Consumer Discretionary sector into its different components. According to GICS, the Consumer Discretionary sector consists of 5 industry groups, 12 industries, and 36 sub-industries. Following are the industry groups and corresponding industries for the sector.
Industry Group: Automobiles & Components ā¢ Automobiles
ā¢ Auto Components
Industry Group: Retailing ā¢ Specialty Retail
ā¢ Multiline Retail
ā¢ Internet & Catalogue Retail
ā¢ Distributors
Industry Group: Media ā¢ Movies & Entertainment
ā¢ Cable & Satellite
ā¢ Publishing, Broadcasting & Advertising
Industry Group: Consumer Durables & Apparel ā¢ Household Durables
ā¢ Textiles, Apparel & Luxury Goods
ā¢ Leisure Equipment & Products
Industry Group: Consumer Services ā¢ Restaurants
ā¢ Hotels, Resorts & Cruise Lines
ā¢ Casinos, Gaming & Leisure Facilities
ā¢ Diversified Consumer Services
GLOBAL CONSUMER DISCRETIONARY BENCHMARKS
Whatās a benchmark? What does it do, and why is it necessary? A benchmark is your guide for building a stock portfolio. You can use any well-constructed index as a benchmarkāexamples are in Table 4.1. By studying a benchmarkās makeup, investors can assign expected risk and return to make underweight and overweight decisions for each industry. This is just as true for a sector as it is for the broader stock market, and there are many potential Consumer Discretionary sector benchmarks to choose from. (Benchmarks will be further explored with the top-down method in Chapter 7.)
Differences in Benchmarks
What does the Consumer Discretionary investment universe look like? It depends on the benchmark, so choose carefully. The US Consumer Discretionary sector looks very different from that of Europe, Japan, and emerging markets (EM). Table 4.1 shows major domestic and international benchmark indexes and the percentage weight of each sector.
Sector weights show each sectorās relative importance in driving overall index performance. For example, while the Consumer Discretionary sector represents 13 percent of the Russell 2000, it is just 5 percent of the MSCI EM Index. Since many emerging markets economies have yet to build a robust middle class, consumer-related companies are understandably smaller than resource- or industrial-focused segments. The large Consumer Discretionary weight in the Russell 2000 is also due to the nature of the index itself. As a small cap index, Energy and Consumer Staples firms are relatively underrepresented because firms in these sectors often rely on size to generate economies of scale. The remaining eight sectors end up looking especially large relative to the other indexes. Understanding these differences in benchmark weights is key to building a balanced, risk managed portfolio.
Table 4.1 Benchmark Differences
Source: Thomson Reuters, MSCI, Inc.1 as of 6/30/2009.
Wide sector weight deviations can also occur from country to country, as shown in Table 4.2, which includes selected countries from the MSCI All Country World Index. US firms clearly have the most influence on the sectorāover double the size of Japan, who has the next largest representation.
Table 4.2 MSCI ACWI Consumer Discretionary Index Weights by Country
Source: Thomson Reuters, MSCI, Inc.2 as of 6/30/2009.
| Country | Weight |
|---|
| US | 44.6% |
| Japan | 22.0% |
| France | 6.5% |
| Germany | 5.6% |
| UK | 5.2% |
| Korea | 1.9% |
| Sweden | 1.8% |
| Canada | 1.5% |
| South Africa | 1.0% |
| China | 1.0% |
| Hong Kong | 1.0% |
| Switzerland | 1.0% |
| Italy | 0.9% |
| Rest of the World | 6.0% |
Table 4.3 Consumer Discretionary Industry Group and Industry Weights
Source: Thomson Reuters, LSCI, Inc.3 as of 6/30/2009.
Industry Weights
Not only can sector weights vary, but so can industry weightsāsometimes greatly, depending on the chosen benchmark. Table 4.3 shows the weight of each Consumer Discretionary industry group and industry within each benchmark.
Understanding these weights allows you to not only make better decisions about relative weights of various industries, but also focus on the most important components. For Consumer Discretionary, Automobiles & Components, Retailing, and Media make up the majority of the weight in most benchmarks and are therefore the focus of much of this chapter.
Concentrating on Bellwethers
Drilling down one more layer, itās important to understand the makeup of each industry at the stock level. Some industries are more concentrated than othersāin other words, one or two large stocks may make up the majority of an industry. When an industry is particularly concentrated, understanding what drives the largest stocksāthe bellwethersāis key.
Table 4.4 highlights industry concentration in the MSCI ACWI. The āIndustryā column represents the top five stocks (by market cap) as a percent of the overall industry. The higher the concentration, the more important it is to understand industry bellwethers.
Industry concentration is the result of many factors, including the importance of economies of scale, barriers to entry, and industry depth, among others. Automobiles, for example, is a highly concentrated industry. As a manufacturing-focused business, it is in the best interest of an automobile manufacturer to be large enough to capitalize on economies of scale. Conversely, the Hotels, Restaurants & Leisure industry is more fragmented due to minimal barriers to entry (e.g., it takes much less capital to open a restaurant than to start a car-manufacturing firm).
Diversified Consumer Services (which includes companies like tax preparer H&R Block and hair salon operator Regis Corp.), Distributors, and Leisure Equipment & Products are highly concentrated because there simply arenāt that many publicly traded hair salons or tax preparers out there. Indeed, there are only six Distributors in the MSCI ACWI Consumer Discretionary Index, and just five Diversified Consumer Services companies!
Table 4.4 Industry Concentration Ratios
Source: Thomson Reuters, MSCI, Inc.4 as of 6/30/2009.
| Industry | Top 5 Stocks |
|---|
| Diversified Consumer Services | 100.0% |
| Distributors | 94.6% |
| Internet & Catalogue Retail | 90.2% |
| Leisure Equipment & Products | 73.8% |
| Automobiles | 66.0% |
| Textiles, Apparel & Luxury Goods | 57.8% |
| Auto Components | 57.2% |
| Household Durables | 56.4% |
| Multiline Retail | 54.9% |
| Hotels, Restaurants & Leisure | 54.2% |
Understanding the composition of and differences in benchmarks and industries is the first step to building a diversified portfolio. Now, letās flesh out your understanding of each of the industry groups, starting with the largestāAutomobiles & Components.
AUTOMOBILES & COMPONENTS INDUSTRY GROUP
The Automobiles & Components industry group breaks down into the following industries:
ā¢ Automobiles
ā¢ Auto components
Automobiles
This industry includes firms engaged in the design, manufacture, and sale of automobiles and motorcycles. The industry is characterized by:
ā¢ Economic sensitivity
ā¢ Significant barriers to entry
ā¢ Heavy governmental regulation
Itās also the largest industry in the Consumer Discretionary sector.
Economically Sensitive Cyclical Demand In 2008, over 65 million cars were sold globally. The US is the largest market for automobiles, representing about 20 percent of global sales. China is the second largest at 13 percent, while other major economies like Japan, Germany, and the UK make up smaller portions at 7.6 percent, 4.7 percent, and 3.2 percent, respectively. As a durable good, demand for automobiles is impacted by economic factors like wages and disposable income, in addition to sentiment and government regulation (more on that later). Interest rates are another key consideration since most cars are financed.
Periods of steady economic growth are typically good for car sales. We purposely say āsteadyā rather than āpositiveā because economic growth may be volatile and even quite strong at turning points in the economy. Consumers may wait for several quarters of positive economic growth to make a commitment like buying a car or restrict purchases if they suspect the economy may weaken. Indeed, even though disposable income grew during much of the 2008 to 2009 bear market, automobile sales fell sharply as economic deterioration and acute consumer uncertainty contributed to declining durable goods spending. Conversely, the relative economic stability of the 1990s drove a golden decade for the US automobile industry, with unit volumes growing 9 out of 10 years despite the market being nearly 100 percent saturated.
Demand cyclicality is also impacted by the replacement cycle. During periods of weak economic growth, consumers may delay purchases of new cars. However, this is not a long-term solution. As the fleet of operating automobiles ages, consumers must invest to replace cars that canāt be repaired. While the exact number is difficult to forecast, the replacement cycle is responsible for about 10 million car sales in the US each yearāa significant percentage of overall sales considering US auto sales fluctuated between 15 and 17 million units annually between 1998 and 2008.5
Significant Barriers to Entry Significant barriers to entry keep established manufacturers in business and aspiring manufacturers on the sidelines. Manufacturing a single car is not profitable. Sometimes, manufacturing 10 million cars is not profitable. Manufacturing costs, high wages, raw materials expense, significant competition, and direct government ownership are just a few of the factors limiting new entrants in the automobile industry.
High wage and benefit costs are most frequently associated with US automakers, where decades of prosperity and pressure from unions resulted in significant benefits to their employees. For example, the United Auto Workers (UAW), one of the nationās largest unions, played a major role in increasing health care, pension, and pay benefits for its members. As a result, the hourly cost per employee at a General Motors plant is $81.18. Compare that to its Japanese competitors, where pay for comparable labor can be as lo...
