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The Rise and Fall of Industries

Is it possible that the ancient sentence "Change is the only constant in life" is relevant to stock markets? A recent Credit Suisse study explores the transformation of industries over the last 100 years and the answer is "yes, it is."

"What could be more palpably absurd than the prospect of locomotives traveling twice as fast as stagecoaches?" That is how "The Quarterly Review" had greeted rail transport in 1825. After that the rail industry shot to investment stardom and subsequently fell, to finally find its tiny share in the market. A similar fate was shared by other industries, and not always with a happy ending. Can history be a teacher for long-term investors? Is there a 'change-proof' investment strategy, or what can investors do to be more optimistic about the future?

Adapt or Die ‒ an Evolution of Industries

The Industrial Revolution was a turning point – the pace of change accelerated bringing many technological innovations. The following decades witnessed births and deaths of industries. Stagecoaches, canal boats, steam-powered machines, and many more had to leave the stage to make room for electricity, automobiles, and telecommunications, to name just a few. Some of them are still present in our everyday life, while some are long forgotten.

In their "Global Investors Returns Yearbook 2015", the authors Elroy Dimson, Paul Marsh and Mike Staunton analyzed and compared the industrial composition of listed companies on American and British markets in 1900 and in 2015. The findings reflect the evolution of the technological landscape.

The history of the rail industry is an eye-opening example. On the threshold of the 20th century, it was a dominating force, with a 63 percent share of the US stock market, while in 2015 its share is less than 1 percent. Over 115 years, the once thriving industry has found itself on the edge of stock market extinction.

Many other industries have either declined or are now extinct, changing the composition of the British and American economies and stock markets. Not all cases were a direct result of industry death. Textiles, iron, coal and steel vanished because they were moved to lower cost locations.

The industries that survived often had to undergo extensive alterations to adapt to new market and user expectations. For example, telecommunications: telegraphy in 1900 and smartphones in 2014, both high-tech solutions of their time, and both stemming from the same technology sector.

Another distinctive statistic in this comparison is the high percentage of brand new industries that were introduced after 1900 and, over the years, managed to take extensive shares in the American and British markets (62 percent and 47 percent respectively). Among them technology, health care, and oil and gas, which were virtually non-existent at the beginning of the 20th century. 

Railways Killed the Canal Star

With the Industrial Revolution came the requirement for modern and more efficient transport. Manufacturers ditched the usual horse-drawn carriages and wagons, and jumped on canal boats, as they were sixty times more efficient (measured in ton miles per day). Investors went mad for the canal companies and, in 1792, the London Stock Exchange saw a canal frenzy, followed by a crash the next year. It did not destroy the new industry though and, what 's more, between 1816 and 1824 canal stock prices rose by 140 percent.

However, this marked the end of the canal boom, as a faster and even more efficient mode of transportation was introduced – railways. The new era began and, over 25 years after the railway 's debut, the canal stocks fell by 70 percent.  Although railway mania hit the world, it was a rocky ride for investors. The stock exchange witnessed the same investor behavior and the same ups and downs as when canal stocks were introduced.

Alasdair Nairn, in the book "Engines that Move Markets", concludes that most innovations are greeted by markets with skepticism and rejection, followed by over-enthusiasm leading to stock market "bubbles". Only after investors ' emotions cool down comes the phase of rational assessment and stocks being valued correctly. However, the biggest beneficiaries of new technologies are usually not stock market investors, but the innovators, founders and society as a whole.

Triumph of Experience over Hope?

The natural question that comes to mind is whether investors should focus on new industries or maybe look for potential in old ones.

To find an answer, the Yearbook researchers analyzed the later years of rail transport, when it became declining industry, with its share of the transport market falling to below 1 percent. Its dominant position was shaken by newer means of transportation, such as airplanes and trucks. The 1950s and 1960s were especially challenging for the rail business. However, after hitting rock bottom in the 1970s, the rail transport industry started outperforming its competitors. That was possible thanks to stock prices being under-valued after all the negative events, but – to be fair – industry rationalization and increased productivity also helped to improve performance.

At the other end of the spectrum are new industries. The report presents studies of investing in S&P 500 companies and of backing IPOs.

Regarding S&P 500 companies, Jeremy Siegel 's study, "The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New", confirms that investors who had stuck to the original constituents of the index would have achieved higher returns than those investing in new joiners. Siegel explains: "Investors have a propensity to overpay for the "new" while ignoring the "old" […] growth is so avidly sought after that it lures investors into overpriced stocks in fast-changing and competitive industries, where the few big winners cannot compensate for the myriad of losers."

There is wide evidence confirming these findings to be true for IPOs as well. Investors hoping to discover a new Apple or Microsoft often ignore rational valuations and fall into a "gold rush" trap. Tim Loughran and Jay Ritter, who analyzed the IPOs phenomenon in the study "The New Issues Puzzle", claim that investors "seem to be systematically misestimating the probability of finding a big winner."

Does it mean investing in well-established industries is the solution for success? No, the report provides evidence that both new and old industries can either disappoint or bring satisfying returns. While new technologies are often welcomed with over-enthusiasm, old industries suffer from investors ' pessimism. Rational and carefully considered valuation is the key to success. 

Investors, Learn Your Lesson

Definitely 115 years of rising and falling industries provide a very interesting chronicle, but will not help to predict which industries will be profitable in another 100 years. What they offer is the evidence that industries can experience periods of over- and under-valuation. Credit Suisse 's report examined if this knowledge can be put to use and whether it is possible to exploit it via industry rotation. Two simulations were prepared (both covering data for years 1900–2014): one focused on momentum in past returns and the second on a value measure.

The latter proved useful, as it helps to avoid periods when stocks are over- or under-valued. But the former strategy appears to be more effective. The analysis of past returns established that there was no reversal effect over a one-year interval, while confirming the momentum effect – winners continued to win, while losers continued to lose. According to the three professors: "Buying last year's best performing industries while shorting the worst performers would, since 1900, have generated an annualized winner-minus-loser premium of 6.1 percent in the USA and 5.3 percent in the UK."

What is in store for 2015, assuming that the rotation strategies were to continue working? According to the authors, the favorites in the US would be utilities, insurance, transport and healthcare, while in the UK they would be utilities, tobacco, pharmaceuticals and life assurance.

This is just an illustration of a trend that has worked as well as failed (around one year in three) in the past. It is important to stress that past performance is no guarantee of future performance. However, the past success of these strategies may provide food for thought for patient, long-term investors.