How To Do Industry Analysis For Investment

Industry Analysis

Analyzing about the Industry is very crucial step in the in the equity analysis because most of the growth in profitability of an individual company is dependent on the industry in which it lies. If industry is experiencing headwind the company is also not going to do well most of the time. Like Indian pharma industry in got competitive advantage this decade because of the generic drug market in USA and almost all companies show huge rise in profitability. When there is wave most of the companies flare in such instances. Companies with serious business problems also do good.

Industry analysis is important to know how much tailwind company got. Having checklist is the best approach in stock market so here is the checklist for analyzing any industry.

Nature of Industry : Cyclical or Non-cyclical

All industries experience up and down in their earnings with changing economic condition but the extent of volatility in earning is different for different industries.

When earnings react too much to economic conditions then a patterns of uptrend followed by downtrend is formed and repeats after several interval to time this pattern is called as cycles.

So industries which have more volatile earnings are called as cyclical industry.

industry analysis

Take an example of Airlines.

When economy slows down a bit or goes into recession then airlines are most affected by it more than half of the companies experience loss. On the other hand industries like technology and Pharma remains unaffected to the most extent.

When economy recovers Airlines are the ones who show most growth in their earnings compared to other stable industries like Pharma and technology.

Both type of Industries has different methods of analysis and have different strategies of making investments.

Cyclical companies cannot be chosen for long term investment that will not give extraordinary results as overall growth rate of all these industries are very low. But cyclical can be fabulous investment for short term. We all know that if not today then tomorrow downtrend phase in cycle will range its direction so betting on recovery will good strategy.

Investor who understand cyclical we can make can make 100-300% in matter of one or two years.

But of investor want to see magic of compounding then consistent growers are the best. Say you buy company growing at 30 % each ear and hold it for twenty years then your return will be staggering 190 times or 19000%.

Knowing type of industry will tell you which kind of bet is more suitable.

Growth stage

Like human beings industries also have life cycles this life cycle is divided into four parts they are startup growth, maturity and decline.

industry analysis

Startup

New breed of companies emerge when new technological innovation happens. At this sales is very less because most of the people are unaware of the potential and merits of products that startup sells. Competition is also low as there are very less number of companies and that too with limited capacity.

If such startups managed well then they can surely gain advantage of starting first. Percentile growth rate in initial stage of industry cycle is tremendous. Such companies may grow 20-40% per month.

Identifying companies that have future potential to grow is very hard at this stage as success is totally dependent on founders, applied business strategies and faster adaptation to technological change. If there are 100 startups then 90 of them will fell and only 2 out of rest of the 10 will extraordinarily great corporation.

There is very little room for retail investors to make money as there are almost no company listed. If there are then betting on then can be little risky as they have not properly proved themselves yet.

Very little competition and exceptionally high growth is identification factor of this phase.

Next Phase is Growth

When people at large starts to understand and adapt new technologies then growth phase in industry come. More adaption by people means more revenue for existing companies. This extraordinary revenue attracts new competition. So although growth is high competition is also very high.

This phase is most favorable to make profitable investments for several reasons. First most of investments in startups are done by angel investors or venture capitalist so there is opportunity for common investors. At this phase weak and noncompetitive startups get wiped out. Investors now have enough data and understanding of company and people running it to do proper analysis.

Growth phase also lasts for more time than startup and decline phase. If there is constant innovation to existing product then it can last longer.

Growth rate or some leaders  20- 50 percent per annum. Because of such high growth there is market value these stocks are very high multiples to earning which create illusion of expensiveness. Although stock look expensive but they get more expensive every passing year of business is done is good way.

Growth phase of industry is marked by High growth and high competition.

Maturity

When product and services that industry serves are adapted by almost all the potential customers then growth phase stops and maturity phase starts. Revenue growth and profit growth slows and eventually comes more or less down to growth rate of overall economy.

Most prominent examples of such Industries are Infrastructure, power, mining, oil extraction. These sectors are never going to grow at 15-20 percent per annum because there is no more consumption capacity for them.  

At this stage industry has well recognized leaders who has most of the market share. These companies are huge and are very consistent in their revenue and profits.

This phase is not so good for the growth investor but best for the value investors. Most of companies in such sectors are unfavorable one. Investors reluctance to even take a look at then drives their stock price deep down. Herd behavior of market causes stock to fall way below intrinsic value.

Industry growing nearly at the pace of economy having large established companies giving good dividend yield is trait of this phase.

Decline

No one can deny death. No matter how good industry is in present condition is not going to last forever.

Technology time to time creates value migration. Jobs, companies or sometimes whole industry with outdated technology get wiped out and new industry emerges which create more jobs, more capital investment opportunity and more life easing products and services .

Radios are replaced by televisions and now televisions are slowly fading put because of devices like smartphone, tablets, laptops and computers.

Not good place to invest for long term but can present good opportunities for special situation investing like mergers and acquisition, leveraged buyout, turnaround and dissolution.

If any company make successful adaptation to new technology or change its business model or completely shifts towards more profitable business then this can create great turnaround opportunity.

This phase is characterized by growth rate below economic growth or degrowth with giant companies with declining market.

Growth Rate

Growth rate of whole industry gives rough idea of growth stage of the industry. One another factor that is crucial about growth is predictability.

If there are two companies with equal revenue profit growing at same pace say 10 %. Out of them one is crude oil refinery and other is technology company then surely investor will value refinery much more than technology company. Because demand for crude products is stable and can be predicted for longer period of time .

On the other hand there are thousands of technology company files for bankruptcy because they comes down very fast if they are not well up to date to technological innovation.

Future growth rate of an industry can be calculated based on the extent of market penetration of product or services that can happen in the market. A smartphone companies have experienced huge growth for last few years but success will not be copied in future as most of the market penetration is already happened.

At the time of valuation properly factoring predictability is also important more the predictability more the benefit can be taken from miracle of compounding of returns.

Competitive Advantage

United states have vast technological knowledge pool also they have culture of innovation this gave advantage to technology industry in America and thus some companies event touches trillion dollars of valuation.

If an industry have a competitive advantage of any king whether geographical skill or knowledge. Then it is going to earn above average returns for long period of time.

Some of the unique things India have is availability of cheap labors vast amount of natural resources large area of cultivable land. This things have helped many industries like cheap skilled workforce have helped pharma companies to capture large generic drug market in USA. Because of agriculture India’s cotton industry is second largest after China.

How this can help investor ?

Make a list of all competitive advantages that industry have and then find companies that are in most favorable position to gain benefit from it.

Crucial Factors

Ever industry has some unique factors or variable that affects profitability of companies lying in that industry most.

Each industry has such factors are each have unique set than the other.

Crucial factors are different than the competitive advantages .Competitive advantage increase profitability of whole industry and are always positive. On the other hand crucial factors brings volatility in industry growth and profitability. It can harm company if not managed properly also can give edge over other players in an industry.

Also Read | How to Analyse management of the company.

These factors can be one or more predictable or non fairly predictable or non predictable, controllable or non controllable.

When investor read reports about industry of analyze annual reports of companies in that sector then investor after gaining sufficient knowledge understand which variables are sensitive to industry.

Some places which gives understanding of crucial factors.

  • Management discussion and analysis section of Annual report.
  • Financial statements of company.
  • Industry reports.
  • Person working in that sector for multiple year like employee of company, dealer, supplier, etc.

Example :

Based on my analysis I have found some crucial factors for Artificial roofing and cement products industry.

  • Price of Asbestos( most important material for production).
  • Foreign Exchange Rates. As 100% asbestos is imported from countries like Brazil and European countries .
  • Environmental laws. Asbestos is considered as harmful for biological creatures so there is always threat that use of it may not be permitted in future.
  • Cement Price.
  • Steel price.
how to do industry analysis

Availability of sources of natural resources or government license to do particular business is also crucial factor for certain industries.

Also Read |An Economic Analysis of the Low-Cost Airline Industry

Types of Products

Products and services that companies sell can be divided into two types Commodity and Differentiated.

Differentiated product is one which has for most of the part similar to products of competitors but has certain features or characteristics which is unique. In differentiated each company in industry create unique product than other and each has different customer base. When there is differentiation in products and services then company gains pricing power. Hence companies selling differentiated products generally have high profit margins.

On the other hand there are commodity product. Where products and services are exactly same. In such cases customers are not bind to buy from particular company this gives them bargaining power.

Because of high bargaining power of customers and similarity in products competitions among such companies are very tough and only way to get edge is to sell cheap. Such price war hampers profit margins of all the companies in the industry.

Commodity Product IndustriesDifferentiated product Industries
AirlinesAutomobiles
PaperTechnology
Sugar MillsPaints
Cotton MillsPharma
Iron and SteelRetail Chanis
Cement companiesBiotechnology
Electricity suppliersBanks
Insurance
FMCG

While doing industry analysis many things have to be kept in mind at the same time while making decision. Each industry has different set of rules and different weight has to be given to each of the factor. But skipping industry analysis is huge mistake , it is vital part of fundamental analysis. I prefer to makes notes when I learn about any industry this helps when after period you came across company with same industry.

If notes of analysis is not made then every time we may have to start from scratch as many things get washed out of brain over the period of time.

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