In my last article, I covered how to predict the earnings of a company and today I am going to write about how to do industry analysis.
The Need for Industry Analysis
Industry analysis is an essential responsibility for an equity research analyst.
As an equity research analyst, you need to analyze a particular industry, see its past trends, demand-supply mechanics, and future outlook.
The industry analysis report sheds light on the economic health of the company, underlining the understanding of whether it will be beneficial for the stakeholders to invest in such a company and offering recommendations and/or corrective actions to take in case of any untoward developments in the company.
As an equity research analyst, you might work on industries like Oil and Gas, Metal, Information Technology, Automobile, Financial Services, Infrastructure, Pharmaceuticals, and Consumer durables.
In some companies, there is a dedicated industry analyst who will work in the assigned industry and provide the analysis.
However, as an analyst, you should be aware of industry dynamics and hence, it is important to know how to do industry analysis.
How to do Industry Analysis?
Industry analysis is a complicated and time-consuming process.
If any of the dimensions are missed, the whole analysis becomes faulty.
Therefore, in this section, I have highlighted all the necessary steps telling you how to do industry analysis.
Use these steps and apply them in your analysis.
What are the steps? Here you go:
1. Review available reports
Read all the available but relevant industry reports and statistics to see whether it makes sense to dig deeper.
Some of the reports you will find already contain in-depth information that the need for new industry analysis is eliminated.
However, it is unwise to depend on existing analysis reports as the market is always volatile and industry factors change constantly.
Therefore, pick up a current report and envisage its relevancy in the current market.
2. Approach the correct industry
An industry has sub-parts.
For example, if you look at the chemical industry, you will find sub-industries like Fertilizers, Pesticides, Paints and Varnishes, Organic chemicals.
Therefore, it is important to focus on the relevant industry.
Without this, it will be impossible to draw an accurate industry analysis report.
So, take up an industry and find out the sub-industries. Select the one which suits the company’s purpose.
Moreover, it is worthwhile to look at the different market segments in a particular industry.
3. Demand & supply scenario
As any economist will know, demand and supply are the primary factors governing any market.
Hence, it becomes relevant to look into the demand-supply scenario for a particular product or industry by studying its past trends and forecasting future outlook.
You can do a comparative analysis with other companies competing, in the same manner, to find out the economic health of the company under consideration.
Future demand and supply forecasting help investors understand the viability of future investments in terms of profits and losses.
4. Competitive scenario
This is the most important step in any industry analysis.
In this, you need to study the competitive advantage scenario using Porter’s Five Forces Model.
The model acts as the framework for industry analysis.
Michael Porter, a famous strategist, and author, first came up with this model.
In this model, five parameters are analyzed to see the competitive landscape.
- Barriers to Entry
- Supplier Power
- Threat of Substitutes
- Buyer Power
- Degree of Rivalry
Porter’s five forces model and competitive forces are extensively used while analyzing any industry.
5. Recent developments
Any industry analysis report isn’t just about studying a particular industry on a micro-level.
The analyst needs to incorporate influencing factors at the macro-level.
These macro-level factors include recent industrial developments, innovation in your industry analysis report, sector valuations and global comparative valuation.
6. Focus on industry dynamics
The industry analysis should be specific to a particular industry and thus, it is important to focus and understand the industry dynamics.
Your industry analysis should be in-depth and to-the-point.
For example, if you are tracking the aluminium industry, you should know the per capita consumption in the country.
In India, the per capita consumption of aluminium is 1 Kg, in the USA, it is 25 to 30 Kgs, in Japan, it is 15 Kgs and in Taiwan, it is 10 Kgs.
Apart from consumption, you should also know the production of aluminium worldwide.
The above six steps are important and you, as an analyst, should follow them.
The analysts in private equity, investments banks, equity research firms, investment research firms need this skill and if you know how to do industry analysis, you are ahead of 80% of the aspirants as this will not only impress your interviewer but also add immense value to you and the business owners hiring you.
How to Write an Industry Analysis?
In the last section, we learned how to do industry analysis and in this, we will see how to write one.
Writing is also a required skill as you need to present all the findings within a written report in a concise and clear manner.
Begin by writing a concise overview of the industry.
Mention historical data and the nature of the industry, including its growth potential.
State the influencing economical factors, competitive strategy, SWOT (Strengths, Weaknesses, Opportunities, and Threats) Analysis, new competitors, business plan, competitive forces, and most importantly, don’t forget to mention the purpose of your industry analysis.
The concise overview of the industry should include its competitors and its operations.
You can write this in the next section. Write about similar products and services.
Now, with the overview aside, move on to the detailed analytical presentation of the specific industry.
Highlight factors like geographical growth, consumer base, price fluctuations, past performances, and income projections.
Use existing financial data and industry understanding to forecast industry growth for the next five or ten years. You can use the statistical graph in this section.
The next sections should be about using Porter’s Five Forces model, competitive advantage, and a detailed write-up about its five factors, its use, and its repercussions in the industry.
Don’t forget to mention governmental regulations relevant to the industry.
Lastly, give long-term and short-term valuations impacting the industry such as any foreseeable problems impacting the business in a negative fashion and potential corrective measures.
Wind up the industry analysis report with a very three or four-line summarization.
Read this guide to know the importance of industry analysis in equity research careers.
Industry Life Cycle
Now, we will see, different stages in the industry life cycle.
There are stages in everybody’s life like childhood, adult, middle age and then old age.
Likewise, there are four stages in every industry’s life cycle.
If you observe the Gaming industry closely, you will find that there are many firms out there having high investment rates, high rates of return on investments and low rates of dividend payout.
The same observation can be conducted on the steel industry and you will find firms with low rates of investment, low rates of return and higher dividends payout. What could be the possible reason for this difference?
Let’s find out.
In Recent times, better opportunities have been created by available technologies for substantially profitable investment of resources.
Patents safeguard new products and there are high-profit margins.
Such rewarding opportunities allure the firms in putting all profits back into the firm and the growth of firms, on average, is speedy.
However, the growth must slow down in due course of time.
Looking at the high-profit rates, more and more firms are encouraged to enter into the industry.
As a result, the competition increases affecting the prices and profit rates.
Advanced and new technologies start becoming more obvious, the extent of risks decreases making the entry easier.
The degree of reinvestment in these firms reduces as the internal opportunities become less lucrative and the cash dividends become high.
Eventually, cash cows are noticed in a mature industry.
By cash cows I mean firms having consistent cash flows, dividends, and low-risk levels.
Growth rates may be analogous to that of the overall economy.
High risk and high returns on investments are offered by industries in the initial stages of their life cycles.
On the other hand, low risk and low returns are offered by mature industries.
Thus, from the above analysis we can say that an industry life cycle can be classified into 4 stages:
Industry life cycle stages
Start-up stage in which growth is extremely fast, consolidation stage in which growth is not as fast as start-up stage but is faster than the general economy, maturity stage in which growth is not faster than the general economy and the relative decline stage in which the growth rate is less than that of the general economy.
1. Start-Up Stage
New technologies like personal computers or wireless communication portray the initial stages of an industry life cycle.
At this stage, it is very difficult to anticipate which firms will succeed; some firms will be a total success while some might fail completely.
Hence, the risk involved in selecting any specific firm in the business is quite high at this stage.
However, at this stage, since the new product has not yet flooded its market, there will be rapid growth in sales and earnings at the industry level.
Like, for example, in the 1980s, personal computers were a part of very few houses, while on the other hand, products like fans or even refrigerators were part of almost every household.
So naturally, the growth rate of products like refrigerators will be much less.
2. Consolidation Stage
Once the product has proved itself in the market, several leaders in the industry start surfacing.
The start-up stage survivors become more stable and market share can be easily envisaged.
Thus, the performance of the industry, in general, will be more minutely tracked by the performance of the firms that have survived.
As the product breaks through the market place and is used commonly, the growth rate of the industry is still faster than the rest of the economy.
3. Maturity Stage
The product has attained the full aptitude to be consumed at this stage by the users.
So, any growth from this point just tracks the growth of the economy in general.
At this stage, as the product gets more and more standardized, it compels the producers to compete heavily on a price basis.
As a result, the profit margins are lowered and add to the pressure on profits.
Most often, firms at this stage are referred to as cash cows as their cash flows are quite consistent but offer very little opportunity for growth of profit.
Instead of reinvesting the cash flows in the company, they are best milked from.
4. Relative Decline
In this stage following features are identified.
- Costs become counter-optimal
- Sales volume decline or stabilize
- Prices, profitability diminishes
- Profit becomes more a challenge of production/distribution efficiency than increased sales.
Which industries do you think will give the highest returns in the next 2-3 years?
I am sure, you are now clear about the different stages in the industry life cycle.
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