Justificación de la metodología

Industries can be broadly classified as either cyclical or defensive. Few, if any, industries are immune from the adverse effects of an overall downturn in the business cycle, but the term

cyclical applies to industries in which the effect on earnings is most pronounced.

CYCLICAL INDUSTRIES

Most cyclical S&P/TSX Composite Index companies are large international exporters of commodities such as lumber, nickel, copper or oil. These industries are sensitive to global economic conditions, swings in the prices of international commodities markets, and changes in the level of the Canadian dollar. When business conditions are improving, earnings tend to rise dramatically. Interest expenses on the debt of cyclical industries can accentuate these swings in earnings. In general, cyclical industries fall into three main groups:

• commodity basic cyclical, such as forest products, mining, and chemicals

• industrial cyclical, such as transportation, capital goods, and basic industries (steel, building

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• consumer cyclical, such as merchandising companies and automobiles

The energy and gold industries are also cyclical, but tend to demonstrate slightly different cyclical patterns.

Most cyclical industries benefit from a declining Canadian dollar, since this makes their exportable products cheaper for international buyers. However, the rate of expansion or contraction in the U.S. business cycle is still the single greatest influence in determining the profitability of cyclical Canadian companies. The currency is an important secondary factor. DEFENSIVE INDUSTRIES

These industries have relatively stable ROE. Since defensive industries tend to do relatively well during recessions, this category includes blue-chip and income stocks. These are actually overlapping categories. For example, the term blue-chip denotes shares of top investment quality companies, which maintain earnings and dividends through good times and bad. This record usually reflects a dominant market position, strong internal financing and effective management. In both the United States and Canada, some consumer stocks have generated such stable long- term growth that they are considered defensive. However, a blue-chip stock offers no guarantee of continued performance; company fortunes can and do change. For example, the U.S. publishing industry was once considered blue-chip until industry maturity led to a decline in stock prices. The utility industry, however, would be considered a defensive blue-chip industry.

Many investors consider shares of the major Canadian banks to be blue-chip industries. However, banks are also typically high-yielding stocks (that is, income stocks) and are sensitive to interest rates. As interest rates rise, banks must raise the rate they pay on deposits to attract funds. At the same time, a large part of their revenue is derived from mortgages with fixed interest rates. The result is a profit squeeze when interest rates rise. Bank stock prices are therefore sensitive to changes in the level of interest rates and particularly the level of long bond yields. Utility industry stocks also tend to be sensitive to interest rates, because they tend to carry large amounts of debt. SPECULATIVE INDUSTRIES

Although all investment in common shares involves some degree of risk because of ever-changing stock market values, the word speculative is usually applied to industries (or shares) in which the risk and uncertainty are unusually high due to a lack of definitive information.

Emerging industries are often considered speculative. The profit potential of a new product or service attracts many new companies and initial growth may be rapid. Inevitably, however, a shakeout occurs and many of the original participants are forced out of business as the

industry consolidates and a few companies emerge as the leaders. The success of these leaders in weathering the developmental period may result from better management, financial planning, products or services, or marketing. Only an experienced analyst should try to select the companies that will emerge as dominant forces in a fledgling industry.

The term speculative can also be used to describe any company, even a large one, if its shares are treated as speculative. For example, shares of growth companies can be bid up to high multiples of estimated earnings per share as investors anticipate continuing exceptional growth. If, for any reason, investors begin to doubt these expectations, the price of the stock will fall. In this case, investors are “speculating” on the likelihood of continued future growth which may, in fact, not materialize.

RETURN ON EQUITY (ROE)

To compare cyclical and defensive industries, it is important to understand the concept of return on equity (ROE). This ratio is important to shareholders because it reflects the profitability of their capital in the business. Return on total equity is calculated using the following formula:

Net earnings (before extraordinary items) Total equity ×100

To calculate return on common equity only, subtract preferred dividends from net earnings and divide by common equity.

Analysts often track the ROE of an industry in which they are interested, as well as the ROE of the S&P/TSX Composite Index, in order to establish benchmarks for the companies within the industry. As a rule, the ROE of a defensive industry typically varies by about a third during a single business cycle. For cyclical industries, if the ROE of the S&P/TSX Composite Index varies by about 55%, the ROE of a cyclical industry will vary by at least 100%.

The variability in S&P/TSX Composite Index ROE generally reflects the cyclical industries within the S&P/TSX Composite Index. During economic downturns, defensive industries also demonstrate falling ROE, but their ROE falls less dramatically than those of cyclical industries. During economic upturns and periods of prolonged economic growth, the ROE of defensive industries tends not to rise as much as that of cyclical industries.

Defensive industries tend to outperform cyclical industries during recessions. Because the ROE of a cyclical industry falls faster than the ROE of a defensive industry during recessions, cyclical stock prices also fall faster. Therefore, stocks with a stable ROE demonstrate defensive price characteristics. However, during periods of sustained economic growth, the superior growth in the ROE of cyclical industries tends to produce superior price performance in those industries. This is one of the basic factors influencing a pattern of alternating industry leadership during a business cycle. This pattern is referred to as industry rotation and the pattern is used by portfolio managers.