Industry analysis refers to the assessment of different industries by using strategy in order to find out the potential and most profitable industry for the purpose of making investment in it. It is good to conduct economic analysis before starting industry analysis so that it can be performed in the light of the economic analysis. This will provide better results.
Mostly industries try to react to the movements in the general market but the degree of reaction can change importantly. Significant movements are exhibited by the companies over both relatively long term periods and relatively short term periods. The recessions & expansion influence the industries to a great extent. For example heavy good industries are seriously influenced by the recession. During contractionary period, consumer goods will likely to be less affected. The utilities industries are seriously affected during the strong inflationary period of later 1970’s & early 1980’s due to their inability to pass along all price increases. Besides this, industries like genetic engineering & synthetic fuel enjoys speculative growth from time to time.
How to do Industry Analysis
For doing industry analysis, you need to learn all the basics of industry, like how to classify the industry, how to analyze the industry, etc.
Analysts and investors require methods for the classification of industries. One popular classification system of the industries is Standard Industrial Classification (SIC) System which is based on the census date and is built to classify companies on the basis of their products. 11 divisions are represented by SIC codes and there are many major industrial groups within each division and represented by a two digit code. Further classification of industries is made within each major industry group representing the subdivided three, four and five digits SIC codes. The breakdown becomes more specific as the number of digits in the SIC system increases. SIC codes have provided consistent and orderly basis for the classification of the industries and companies. Besides the SIC system, there are certain other systems of classification of industries too like Standard and Poor Corporation classification system in which there are 11 sectors and approximately 115 industry group for a long time.
The study of wide range of data provides the basis for making analysis of the industry, company and economy like data on sales, capital structure, earnings, dividends, regulations, product lines, innovations etc. Brokerage firms and other institutional investors hire the services of professional industry analysts to perform such kind of analysis.
The first important step in analyzing industries is to ascertain their life cycle stage. By doing so overall health and current position of the industry is accessed. In the second step the future prospects of the industry are accessed for the assistance of the investors by analyzing the characteristics of industry in the shape of qualitative analysis.
The life Cycle of Industry
The life cycle of industries has the following four stages
- Pioneering Stage
- Expansion Stage
- Stabilization Stage
- Declining Stage
The idea of life cycle of industry can also be applied to the product lines within the industries and help a lot put the industry analysis process on the right track.
- Pioneering Stage:
The speedy growth in the demand occurs in the pioneering stage. A number of companies fail at this stage because of the competitive pressure is not tolerated by them. There is increasing growth in the sales & earnings. Many venture capitalists are attracted towards the available opportunities. High risk is associated with the companies at pioneering stage of the life cycle of industry but the expected returns are also higher which come into reality when the company acquires success in future. The profit margins are very low and in some cases they are negative. It is hard by the investors to point out the likely survivors or the future strong performers at this stage.
A good example of the companies at pioneering stage is the industry of microcomputers in the early 1980’s.
- Expansion Stage:
The survivors from the pioneering stage are identified in the second stage of the industry life cycle which is the expansion stage. The growth still proceeds in this stage but with a moderate rate and the companies face prosperity. These companies make improvements in their products and also lower the prices of their products. Most of the potential investors are attracted to invest in these companies because of their solid and stable conditions which reflect the decrease in their risk of failure.
At this stage financial policies are developed firmly. Capital base is increased. There are very high profit margins and mostly dividends become payable which attract the additional investors towards the companies.
- Stabilization Stage:
After passing through expansion stage, the stabilization stage starts where growth started to moderate. This stage is also referred to as maturity stage and likely contains the longest part of the life cycle of industry. There are abundant of competitors in the marketplace and the products become less innovative & more standardized. The costs in this stage are stable instead of reducing through efficiency efforts. The companies strive to produce efficiency in order to enhance their individual profit margins. There is continuity in the growth of industries but growth rate of industry correspond the economy’s growth rate as a whole.
- Declining Stage:
New Products are developed and shifts in demand occur at this stage which results in the decline in the growth of sales. The profits start decreasing & any particular company may face loss too. Lower rate of return on invested capital is offered.
Qualitative Aspects of Industry Analysis
Industry is characterized by many important factors which must be considered by the investors. The analysis of certain industry become easy for the investors by considering these significant factors which also helps the investors to access the future prospects of the industry. These factors are
- The Historical Performance
- Government Effects
- Structural Changes
The Historical Performance:
It is clear that over as long period of time, some industries perform well while some perform poor. The track record of the industry should be considered although the future performance is not fully sure by analysis of past records. Records on the earnings growth, sales and price performance should be considered by the investors. Useful information is availed through this analysis which will be helpful for the investors to predict the future in a better way.
The future is better forecasted by analyzing the nature of competitive environment in the industry. The competition is analyzed from the perspective of the entrance of new competitors as a result of prohibitive costs of building plants, control of raw materials, the level of production required to operate profitably etc.
Michael Porter has provided very useful information in the development of effective competitive strategy which contains the competitive position search in the in an industry. The ability of industry to prolong above average returns is determined by the intensity of competition present in it. There are five basic factors that reflect the competitive position in the industry. These factors are
- Threat of new entrants
- Bargaining power of buyers
- Bargaining power of suppliers
- Threat of substitute products or services
- Rivalry between existing competitors
The profitability of the industry is determined by these five competitive forces which affect the components of return on investments. The function of the industry structure is based on the strength of each of these forces. The main consideration of the analysis of Porter is that the profitability of a company is a function of its structure. The investors should analyze the structure of the industry to ascertain the strength of these five competitive forces, which in turn ascertain the profitability of the industry.
Industries are significantly affected by the regulations & actions of the government. The investors should consider the consequences of the effects of these regulations on the industry. For example the breakup of AT&T in January 1, 1984 had directly affected the telecommunication industry.
A potential factor required to be considered by the investors is structural changes that happen in the economy. Major industries are affected by the transformation of the industrial society of the United States to an information-communication society. New industries are emerging with drastic potential while some traditional industries may never regain their previous positions like steel industry.
Evaluating Future Prospects of the Industry
The final and most important consideration of the investor in the process of learning how to do industry analysis is the expected future performance. The future estimation is the most difficult task which includes many errors but still it is better to make future forecasting.
In order to anticipate the performance of industry over the long run, following points should be considered by the investors
- The industries that are likely to grow and prosper in the next decade
- The industries that are affected by the transformation of the industrial economy of the United States to the information collection & processing economy.
Selection of Industries for the Next Year:
The expected earnings & expected multiplier for the industry are estimated by the investors for the short run. These are compound together to generate an estimate of value. This is difficult task and needs understanding of many relationships & estimates of many variables. The investors are provided with sufficient information in conducting industry analysis. The investors have to know the primary sources of the information about industries.
The investors should try to find out the industries that probably improve their earnings under the given conditions of the economy. This helps the investors to ascertain the performance of the industry for shorter period.
Business Cycle Analysis
The investor should also consider the industries on the basis of their operating ability in relation to the overall economy. They should be aware of relationships of the poorly performing industries and good performing during a recession time of the economy. This analysis of the relationship of performance of industry with the business cycle of economy provides the indication of following kinds of industries.
Growth Industry: Which have growth in its earnings even during the recession period
Defensive Industry: Which is least influenced by the economic adversity and recession
Cyclical Industry: Which performs exactly according to the prevailing business cycle in the economy
Sensitive Industry: Which is sensitive to the expectations about the interest rates change