Table of Contents:-
- What is Industry Analysis?
- Types of Industries
- Industry Life Cycle
- Investment Implications Across Industrial Life Cycle Stages
- Features of Industry Analysis
- Techniques of Industry Analysis
What is Industry Analysis?
Webster’s Dictionary defines an industry as “A department or branch of a craft, art, business, or manufacture.”
More specifically, it is stated as follows:
“A group of productive or profit-making enterprises or organizations that have a similar technological structure of production and that produce income, supply technically substitutable goods, services, or sources of.”
Industry analysis attempts to gain insights into the following:
1) The key sectors of the economy that influence industries in particular, and
2) The relative strengths and weaknesses of a particular industry.
The information developed from economic analysis and forecasts will help the analyst visualize the growth patterns and opportunities in various industries.
After analysing the economy and identifying the likely direction it will take in the short, intermediate, and long term, the analyst must examine various sectors of the economy in terms of different industries. An industry is a homogeneous group of companies, meaning companies with similar characteristics can be grouped. There are many other bases on which companies can be grouped. For example, traditional classification is generally based on products, such as pharmaceuticals, cotton, textiles, synthetic fibre industry, etc. While such a classification is functional, it provides little assistance in making investment decisions.
Types of Industries
Some of the more valuable bases for classifying industries from the investment decision point of view are as follows:
- Growth industry
- Cyclical industry
- Defensive industry
- Declining industry
1. Growth industry: This is expected to grow persistently, with its growth likely to exceed the economy’s average growth.
2. Cyclical industry: In this category, the firms included are those that closely follow the rate of industrial growth in the economy and fluctuate cyclically as the economy fluctuates.
3. Defensive industry: This grouping includes firms that move steadily with the economy and experience declines less than the average downturn in a cyclical downturn.
4. Declining industry: This category comprises firms that either generally decline absolutely or grow less than the economy’s average growth.
Another valuable criterion for classifying industries is the various stages of their development. Industries at different stages of their life cycle exhibit other characteristics. Each development stage is unique. Grouping firms with similar developmental characteristics helps investors properly evaluate various company investment opportunities.
Industry Life Cycle
Based on the stage in the life cycle, industries may be classified as follows:
This marks the initial phase in the industrial life cycle of a new industry. As the first stage, the technology and its products are relatively novel and have yet to reach a state of perfection. Experimentation is prevalent in both product development and technology. Despite the ongoing investigation, there is a market demand for these products, providing ample profit opportunities. This stage attracts significant interest from venture capitalists who often enter the industry and may even organize businesses.
The risk of firms exiting the industry during this stage is high, resulting in a substantial mortality rate. Consequently, if one sector successfully navigates the risk of market exit, investors stand to reap tangible rewards; otherwise, there is a significant risk of investment loss.
A pertinent example of this stage in the Indian context was the leasing industry emerging in the mid-eighties. During this period, many companies sprouted, and hundreds entered the market. Initially, these companies charged high lease rentals. However, as competition intensified, lease rentals decreased, reaching a level where survival became challenging for many companies—this period witnessed the demise of numerous companies unable to withstand the onslaught of competition. Only those resilient enough to endure the price war remained in the industry. Presently, the leasing industry in India is much more streamlined compared to the mid-eighties.
This represents the second phase when the chaotic competition and growth, characteristic of the first stage, have more or less subsided. Firms that could not withstand this initial onslaught have already faded away. The surviving larger firms now dominate the industry. The demand for their products continues to increase in the market, which results in an increased profit for the companies. This stage is characterized by orderly and fast growth, which presents a good investment opportunity for investors. As companies in this developmental stage experience accelerated growth, they sometimes set records in various areas, such as dividend payments, making them attractive for investments.
Maturity and Stabilisation Stage
This is the third stage, where industries grow roughly at the economy’s rate and fully develop, reaching a stabilisation stage. Viewed differently, this is a stage where the industry’s ability to succeed appears to have more or less diminished. Compared to competitive industries, the industry’s growth rate could be faster. Sales may still be increasing but at a lower rate. At this stage, the industry faces the challenge of what Grodinsky called “latent obsolescence,” a term used to describe a situation where the earliest signs of decline have emerged. Investors must exercise caution and carefully examine and interpret these signs before it is too late.
Relative Decline Stage
The fourth stage of industrial life cycle development is the close decline stage. The industry at this stage has aged, with new products and technologies entering the market. Customers have altered their habits, styles, preferences, etc. The demand for its products is lower than in the earlier stages. Nevertheless, the industry can continue to exist for some more time. Consequently, the industry would experience growth less than the economy’s average growth during the best of times. However, as anticipated, the industry would decline much faster than the overall economic decline in the worst times.
Investment Implications Across Industrial Life Cycle Stages
The specific characteristics of different stages of the life cycle development of industries have several implications for investment decisions. For example, the Pioneering step could be more precise. Risk and returns are positively correlated, and investment at this stage is quite rewarding. However, an investor looking for steady long-term returns with risk aversion should avoid investing at this stage. These are good for venture capitalists. But if he is still keen to support, he should try to diversify or disperse his investment in companies in the second stage of development, i.e., fast growth. This explains the prevalent higher stock prices of the companies in this industry.
From the investment point of view, selecting the industries at the third stage of development is crucial as the industry’s future growth is relevant and not its past performance. There are several examples where companies’ share prices in a declining sector have been artificially hiked up in the market. This is justified based on a good record of its performance. But the fact of the matter is that a company in a declining industry would sooner or later feel the pinch of its features, and an investor investing in companies at this stage would experience a reduction in the value of his investment in due course.
Features of Industry Analysis
After discussing various investment implications, one should be careful using this classification. The above discussion assumes that the investor can identify multiple stages in the industry life cycle. In practice, it isn’t easy to detect which stage of development an industry is at a given time. It is only a general framework presented above, and he can use it for meaningful analysis with suitable modifications. To strengthen the research further, it is essential to study the features of the industry in detail. Due to its unique characteristics, it will be easy to form an opinion for profitable investment opportunities if the specific sector is studied correctly and in-depth. Given below are some features that could be considered for a detailed investigation while selecting an industry for investment.
These features broadly relate to the structural and operational aspects of the industry.
i) State of Competition in the industry
Competition is a way of life that increases as barriers to entering the industry are loosened/ removed. It is an essential input in investment decision making. Therefore, knowing about competition in a particular sector is a must. Questions that are relevant in this context are:
- Which firm in the industry plays a leadership role, and how do firms compete among themselves?
- How does competition unfold among domestic and foreign firms in both the domestic and foreign markets, and how do domestic firms perform in those markets?
- What types of products are manufactured in this industry?
- Are these products homogeneous or highly differentiated?
- What is the nature and outlook for demand in the industry?
This may also incorporate the analysis of classifying significant markets of its products:
- Customer-wise and geographical area-wise
- Identifying various determinants of the needs of its products
- Assessing the likely demand scenarios in the intermediate, short and long run.
Which type of industry is it: cyclical, growth, defensive, or relative decline?
ii) Cost conditions and profitability
The value of a share depends on its return, and the recovery depends on the company’s profitability. Interestingly, growth is essential, but its mere presence does not guarantee profitability. Profitability relies on the state of competition prevalent in the industry, cost control measures adopted by its constituent units, and the growth in demand for its products. When analyzing the point of view of cost and profitability, some relevant aspects to be investigated are:
- How is the cost allocation among various heads, like raw materials, wages, and overheads?
- Knowledge about the distribution of costs under various heads is essential, as this gives investors an idea about the controllability of costs. Some industries have overhead costs that are much higher than others. Likewise, labour cost is another area that requires scrutiny. Ultimately, whether labour is cheap or expensive depends on the wage level, and labour productivity is considered.
- Price of the product of the industry.
- Capacity of production: installed, used, unused, etc.
- Level of capital expenditure required to increase or maintain the productive efficiency of the industry.
Profitability is another area that requires thorough analysis on the part of investors. This requires a detailed examination of the interests of investors. An industry can only survive in the long run if it makes profits. This necessitates a comprehensive investigation into various aspects of profitability. However, such an analysis can be done with a bird’s eye view.
In this context, the ratio has been helpful. Some of the essential ratios often used are:
- Gross Profit Margin ratio
- Operation Profit Margin ratio
- Rate of Return on Equity
- Rate of Return of Total Capital
Ratios are not an end in themselves but mean possible areas for further investigation.
iii) Technology and Research
Due to increased competition in general, technology and research play a crucial role in the growth and survival of a particular industry. However, technology is subject to change, sometimes very rapidly, leading to obsolescence. Therefore, only enterprises consistently updating themselves in technology can gain a competitive advantage over others regarding product quality, pricing, and more.
The relevant questions to be further investigated by the analyst in this respect could include the following:
- What is the type and nature of technology used in the industry?
- Are there any expected technological changes that may lead to introducing new products and increased sales?
- What is the relationship between capital expenditure and sales over time?
- Has an increase in capital expenditure correlated with an increase in sales?
- How much money is spent on the firm’s research and development activities?
- Does the expenditure on research and development in the industry correlate with its sustainability in the long run?
- How is this industry assessed in terms of its sales and profitability in the short, intermediate, and long run?
The impact of all these factors must be translated into the two most crucial numbers, namely sales and profitability, considering their level and expected rate of change during the short, intermediate, and long run.
Techniques of Industry Analysis
Until now, we have discussed various factors that must be considered while conducting industry analysis. Now, we will turn our attention to different techniques that help us evaluate the factors mentioned above:
End Use and Regression Analysis
It is the process whereby the analysis or investor attempts to diagnose the factors determining the industry’s output demand. This is also known as product-demand or end-use analysis. In this process, the investor hopes to uncover the factors that explain the market. Some elements found to be decisive in explaining the need for the industry are GNP, disposable income, per capita consumption, and price elasticity techniques like regression analysis and correlation, which have often been used. These help to identify the critical factors/variables. However, a person should be aware of his limitations.
Inputs Output Analysis
This analysis helps us understand demand analysis in greater detail. Input-output analysis is a beneficial technique that reflects the flow of goods and services through the economy. This analysis includes intermediate production steps as the good proceeds from the raw material stage through final consumption. This information in the input-output table reflects the consumption pattern at all stages- not just at the final stage of consumption of final goods. This is done to detect any changing patterns or trends that indicate the growth or decline of industries.
Industry Analysis Dynamics
Not all industries are equally influenced by economic changes, nor are they affected by business cycles at a single point in time. For example, in an international environment of peace treaties and the Cold War resolution, defence-related industries’ profits would decline. The upturn in the construction industry generally lags behind the overall economy. Similarly, a boom or expansion of the economy is not likely to benefit industries subject to foreign competition or product obsolescence. The equipment manufacturing sector tends to perform well towards the end of an economic cycle because buyer firms typically increase capital expenditure when operating at total capacity. On the other hand, cyclical industries such as steel and auto typically outperform the aggregate economy during expansion but suffer more during contractions. In contrast, non-cyclical sectors like food processing or drugs would neither show a substantial increase nor a substantial decline during economic expansion and contraction.
Generally, an industry’s prospects within a global business environment will determine how well or poorly an individual firm will fare. Thus, industry analysis should precede company analysis. A weak firm in a booming industry is more rewarding than a weak or declining industry leader. Of course, the investor would continuously go through a search process to identify the best firms in vital industries and narrow down the area of search for investment outlets. Industry analysis is also helpful for investors to allocate funds to different sectors, considering future potential and current valuation.