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Reading 40: Introduction to Industry and Company analysis - Coggle Diagram
Reading 40: Introduction to Industry and Company analysis
Uses of Industry Analysis
Understand a firm's business environment: growth, competition, risks
Active management: industry analysis can be used to weight a portfolio and rotate money to invest among industries
Performance attribution: industry selection as a source of portfolio return
Industry analysis
Industry Groupings
By business cycle sensitivity:
High sensitivity (aka. Cyclical):
Example: Consumer discretionary, energy, financials, industrials, technology, materials
Earnings highly dependent on business cycle
Includes growth cyclical firms with strong long-term potential (example: IT firms)
Low sensitivity (aka. Non-cyclical):
Example: Consumer staples, health care, telecommunications, utilities
Earning largely independent of the business cycle
Types
Defensive: basic goods and service with relatively stable demand
Growth: Demand is so strong that the firm is largely unaffected by business cycle
By Products and Services:
Group by sector or primary business activity
By statistics
Groups of firms with highly correlated historical returns, low correlations between groups
Limitations
Historical correlations may not persist (in the future)
Firm groups can be non-intuitive (there maybe no similarity between firms)
Firm groups may change for different time periods and countries
Commercial Classification Systems
4 tiers
Sector > Industry Groups > Industries > Sub industries
Some sectors
Basic materials
Consumer Discretionary
Utilities
Consumer Staples
Energy
Financial Services
Health Care
Industrial Durables
Real Estate
Technology
Telecommunications
Government Classifications Systems
To facilitate comparison over time and across countries
North American Industry Classification
2 digits: sector
3 digits: subsector
4 digits: industry group
5 digits: industry
6 digits: country
Update less frequently than commercial systems
Does not distinguish between public vs. private, large vs. small. for-profit vs. non-profit
Peer groups
Start with narrowest commercial classification
Find specific competitors - annual reports
Find comparable companies - industry reports, management comments
Determine similar business model/ activity
Peer group companies should have similar business activities, demand drivers, cost structure drivers, and availability of capital
Elements
Estimate industry projections using different approaches and scenarios
Cross-check against analysis from other analysts
Compare industry valuations across time to determine risk and rotation strategies (going into different sectors at different point of business cycle)
Analyze industry prospects using strategic groups
Classify industries within life-cycle stage (Embryonic → Growth → Shakeout → Mature → Declining)
Position industry on experience curve (cost per unit (ATC) relative to output will fall as the industry develops)
Consider demographic, macroeconomic, governmental, social, and technological influences.
Examine forces that determine industry competition
Porter's 5 Forces
A. Rivalry among existing competitors
B. Threat of new entrants
C. Threat of substitute productsa
D. Bargaining power of buyers
E. Bargaining power of suppliers
Evaluate relationships between macroeconomic variables and industry
Barriers to entry
High barriers to entry limit new competitors
To determine ease of entry, examine industry composition over time
Barriers to entry may not imply pricing over if competition among existing firms is strong
Undifferentiated products
High barriers to exit (→ overcapacity)
Barriers to entry and competitive environment my change over time
Industry Concentration
High industry concentration does not necessarily imply pricing power
Absolute market share may not matter as much as relative market share (having larger share than next-largest competitor)
Low industry concentration (market fragmentation) usually results in strong competition, little pricing power
Industry Capacity
Under-capacity (demand > supply) often implies pricing power
Over-capacity can lead to strong price competition, especially when barriers to exit are high
Capacity is fixed in the short-run and variable in the long-run
Producers may overshoot future required capacity, especially in cyclical markets.
Non-physical capacity (e.g. capital, skills) can be reallocated more quickly to new industries than physical capacity
Physical capacity comes into production more slowly than non-physical capacity
If capacity is physical and specialized, there maybe over-capacity if producers overshoot
Market Share Stability
Highly variable market shares suggest competitive industry, firms with little pricing power
Stable market shares suggest less intense competition
High switching costs contribute to market share stability
Industry Life-cycle
Stages
Growth Stage:
Rapid demand growth, low competition, falling prices, increasing profitability
Shakeout Stage:
Slower growth, intense competition, increasing overcapacity, declining profitability, cost cutting, increased failure
Embryonic Stage:
Slow growth, high prices, large investment required, high risk of failure.
Mature Stage:
Slow growth, industry consolidation, high barriers to entry including brand loyalty and efficient cost structure.
Superior products lead to market share increases.
With stable demand, firms avoid price competition
During economic downturns, overcapacity can lead to intense price competition
Declining Stage
Negative growth, excess capacity leads to price competition, higher production costs as demand falls, weak companies emerge or exit
Reason for decline:
Technology
Example: Decline of print newspaper
Global Competition
Example: Decline of US Textile industry
Social / taste changes
Example: Falling beer sales in Germany
Limitation of Life-cycle Analysis
Most useful during stable period
Stages may not be as long as anticipated. or might be skipped altogether
Some firms will experience dissimilar growth and profits due to competitive position
Strategic Industry Analysis
Elements
Major firms
Barriers to entry / success
Industry concentration
Influence of industry capacity on pricing
Industry stability
Life cycle
Competition
Influences
Demographic
Governmental
Social
Technological
Whether industry is growth, defensive or cyclical
Growth, Probability, Risk
Macroeconomic factors: Economic output, interest rates, credit availability, inflation
Technology: new or improved products
Demographic: Age distribution, population
Social influences: How people conduct their lives and choose to spend their incomes
Government: Tax rates, business regulation, purchases
Company analysis
Firm overview
Industry characteristics
Product demand
Product costs
Pricing environment
Financial ratios
Projected financial statements and firm valuation
Firm's Competitive Strategy
Cost leadership (low cost)
Lowest costs of production, lowest prices
Sell enough volume to earn superior return
Product or service differentiation
Distinctive in terms of type, features, quality, or delivery
Achieve price premium