Importance Of Industry Analysis
Stock selection and industry analysis go hand-in-hand. Thorough industry analysis can provide investors with a distinct advantage and may help investors beat the markets consistently. Geyatee Deshpande discusses the contours of industry analysis and explains the key focus area while conducting an industry analysis
Stock selection is a critical aspect of portfolio management. In finance theory there is lot of emphasis given on the stock selection process that focuses on two different approaches: top-down investment approach and bottom-up investment approach. Industry analysis is an integral part for most investors looking to create wealth in the equity markets. Says Chetan Bhosale, an investor who adopts the top-down investing approach: “Industry analysis is extremely crucial to beat markets and safeguard your money in the equity markets. There is no point in investing in an excellent company with great management and healthy balance-sheet if the industry it operates in is struggling.”
“I would prefer to invest in a quality company that is operational in an industry that is in the growth stage and not in a company with great management and track record operational in a struggling industry. I have seen many investors being clingy to stocks that are operational in a struggling industry. For example power, telecom and automotive about three years back. I have no doubt that industry analysis is as important as stock analysis, if not more. Once you get your industry analysis correct, it can open a Pandora’s box of opportunities for investors,” he adds. It makes sense to target investments where the industry prospects are bright and the demand supply situation is in favour of the industry players.
For instance, there is no point in buying stocks of an airline company with a great track record if the whole industry is on the verge of collapsing. There are several ways to identify industry prospects and trends which may help investors take profitable investment decisions. One of the best ways to gauge the attractiveness of any industry is to study the revenue growth and growth in profits of the listed players in any particular industry. The table below highlights how with the best growth in sales reported over the past three to five years, chemicals, FMCG and healthcare have remained attractive. The data reveals that a maximum number of multibaggers in the past three to five years have been from these three sectors, especially healthcare and chemicals.
1) Embryonic Stage
✓The industry has just started.
✓Slow growth is common even as customers are unfamiliar with the products.
✓ As there is no mass production and the necessary volumes for achieving the economies of scale have not been achieved, the product prices are usually high.
✓ Most companies in the industry at an embryonic stage require large investments to develop the products and expand.
✓As the products and services offered are relatively novel, there is high risk of failure for companies operating in industries which are in an embryonic stage.
2) Growth Stage
✓ Overall growth is rapid even as new customers discover the products.
✓ There is limited competitive pressure and the threat of new players coming into the markets usually peaks during the growth phase of any industry. Rapid growth allows the new entrant and existing players to grow profitably. There is no price war and hence the profit margins are healthy and the economies of scale are more or less achieved by the leading companies in the industry, thus creating a win-win situation for all the industry players and the consumers.
3) Mature Stage
✓ In this stage the overall growth slows for the industry and there is lot of consolidation that can be expected in the industry. Usually in the mature stage of the industry the entry barriers are high and the product pricing is stable.
✓ A mature industry is usually characterized by superior companies gaining market share and dominating the markets.
4 ) Declining Stage
✓In the declining stage the industry growth is negative even as the product prices see a declining trend on account of intense competition.
✓ High consolidation is visible in such industries as several failing firms are expected to exit the markets or are expected to merge with more profitable ones.
Important Elements of Industry Analysis
Most investors know and understand the importance of industry analysis; however, many lack the knowledge and will to conduct a thorough analysis. Here is a quick checklist of the various aspects to remember while studying the financial attractiveness of any industry:
✓It is crucial to evaluate the relationship between macroeconomic variables and industry trends. For example, cut in interest rates may be more profitable for interest rate-sensitive sectors such as automotive and financials.
✓ A thorough industry analysis should include estimates on industry variables using different approaches and scenarios.
✓Study and observe the comments of market experts on the prospects of any industry. Broker reports, analysts’ comments, fund managers’ views and financial advisors’ comments can help the investors to assess the industry situation more accurately.
✓ It is essential that investors study the relative valuation of different industries. For example, studying and observing the PE ratios of sectoral indices can help us compare the relative valuation across sectors to start with.
✓ Classify, if possible, based on available data, the industry by lifecycle stage – whether it is in a growth stage, declining stage or mature stage. ✓Try to focus and understand the factors that affect various industries such as demographics, government, social and technological influences. For example, factors like the emergence of e-commerce and frequent lockdowns have been a boon for certain industries. Similarly, Production Linked Incentive (PLI) scheme launched by the government is a boon for manufacturing and rise in infrastructure spend is a positive for the cement industry.
✓Understand the competitiveness of the industry players. Can all the players complete without price-cutting? If yes, it’s healthy for investments. If no, then there will be pressure in margins which may eventually lead to less profitability, thus making investment prospects less attractive. For example, two years ago the two-wheeler automotive manufacturers resorted to aggressive market share capture strategies by cutting product prices. It was clear that each of the players in the industry wanted to penetrate the markets, which looked like a good strategy but the quarterly results showed a steady decline in net profits margins in the wake of this aggressive discounting strategy. Such an ultra-competitive environment does not often translate into wealth-creating opportunities. The same can be said about the telecom players in India.
Conclusion
Industry analysis has to be an important component of security analysis and should be inculcated in investment studies before exploring investment opportunities. Apart from studying the sales and profit trends in the industry, the study of competitiveness of the industry is extremely crucial. To study industry competitiveness, traditionally fives forces are analyzed: rivalry amongst the existing competitors, threat of new entrants, threat of substitute products, the bargaining power of buyers and the bargaining power of suppliers. Usually those industries are profitable that showcase less rivalry amongst the existing industry firms, less threat of new entrants, less threat of substitute products, less bargaining power of buyers and less bargaining power of suppliers.
Looking at the current market conditions there is no doubt about the prospects of such sectors as healthcare, FMCG, cement, chemical and IT. These are the industries or sectors that are showing superlative growth in profits and revenues. They are also the sectors where the leading affiliated companies are showing increasing demand for their products with high profit margins and above average return on equity. One of the important data points that investors need to track is the number of stocks from growth-oriented industries making fresh 52-week highs and trading close to their lifetime highs. You will find several IT, pharmaceutical, chemical stocks and cement counters making fresh highs for themselves in 2021 even when the rest of the industries and the Sensex have been in the midst of a healthy correction.
As investors it is always a good idea to remain bullish on the stock where its competitors are also doing well. By this simple confirmation, investors can ascertain if the overall industry is doing well or not. If in case you have only one or two stocks in the industry doing well on the bourses while the other companies are bleeding, investors have to be careful as these could be signs of worsening industry prospects. The leaders in the industry pack may not be able to stay in the green when the industry itself is struggling to remain in a growth trajectory. Industry analysis is thus essential in security analysis and stock selection. A proper and detailed industry analysis will help investors identify a bucket of investing opportunities that can beat markets.