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by Jason Van Bergen

It is no accident that companies within a particular industry move in lock-step with one another. Companies in a single industry are forever bound by the type of product or service that they provide, and they are constantly competing with one another for market share, consumer acceptance and technological leadership in their particular sub-sectors. These competitive and consumer forces shape an industry’s corporations and determine the status of the industry as a whole. These forces have followed roughly the same patterns over time. Here we take a look at these stages and how they affect the companies that follow them.

Initial Growth / Emerging Industries
All companies have to start somewhere, and it takes only a single company or small group of companies to jumpstart an entire industry. Looking back in time, we see that it was not even a company but an individual by the name of Alexander Graham Bell who, with the invention of the telephone, started the entire industry of telecommunications. More recently, companies like Texas Instruments and Fairchild Semiconductor Corporation pioneered the semiconductor industry with the invention of the microchip, the central component of all computers and most high-tech electronics gear.

What returns can we expect from the stock market?
As of today, the Total Market Index is at $ 12133 billion, which is about 83.9% of the last reported GDP. The US stock market is positioned for an average annualized return of 3.4%, estimated from the historical valuations of the stock market. This includes the returns from the dividends, currently yielding at 0%.

As pointed by Warren Buffett, the percentage of total market cap (TMC) relative to the US GNP is “probably the best single measure of where valuations stand at any given moment.”

Over the long term, the returns from stock market are determined by these factors:

1. Interest rate

Total Market Cap and US GDP

Interest rates “act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.”—Warren Buffett

Warren Buffett’s Magic Formula In 1965?

I recently read through Buffett’s Partnership Letters again. This time I paid particular attention to one of the strategies he used to perform better than the market in down years. Buffett employed three such techniques from 1956-1965:

Generals – Private Owner – Large margin of safety was a cushion when markets fell.

Workouts – Special situations were not correlated to the market.
Controls – Accounting of “controls” typically outperformed the market in down years.
In his January 15, 1965 letter to partners, Buffett introduced a fourth category called:

4. Generals -Relatively Undervalued

“We have recently begun to implement a technique which gives promise of very substantially reducing the risk from an overall change in valuation standards; e.g., we buy something at 12 times earnings when comparable or poorer quality companies sell at 20 times earnings, but then a major revaluation takes place so the latter only sells at 10 times earnings. The risk has always bothered us enormously because of the helplessness position in which we be left compared to the “Generals -Private Owner” or “Workout” types. With this risk diminished, we think this category has a promising future.”

Complementing the balance sheet and income statement, the cash flow statement (CFS), a mandatory part of a company’s financial reports since 1987, records the amounts of cash and cash equivalents entering and leaving a company. The CFS allows investors to understand how a company’s operations are running, where its money is coming from, and how it is being spent. Here you will learn how the CFS is structured and how to use it as part of your analysis of a company.

The Structure of the CFS

The cash flow statement is distinct from the income statement and balance sheet because it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash is not the same as net income, which, on the income statement and balance sheet, includes cash sales and sales made on credit. (To learn more about the credit crisis, read Liquidity And Toxicity: Will TARP Fix The Financial System?)

Cash flow is determined by looking at three components by which cash enters and leaves a company: core operations, investing and financing,

Operations