49 - Introduction To Industry And Company Analysis

Elements of Industry Analysis

- Evaluate relationships between macroeconomic variables and industry - Estimate industry projections using different approaches and scenarios - Cross-check analysis against that from other analysts - Compare industry valuations across time to determine risk and rotation strategies - Analyze industry prospects using strategic groups (similar business or product delivery) - Classify industries within lifecycle stage - Position industry on an experience curve (cost per unit relative to cumulative output) - Consider demographic, macroeconomic, governmental, social, technological influences - Examine forces that determine industry competition

Company Analysis

- Firm overview - Industry characteristics - Product demand - Product costs - Pricing environment - Financial ratios - compare over time and competition - Projected financial statements and firm valuation - Competitive strategy - cost leadership (lowest costs of production, low prices, high volume), product differentiation (distinct types, features, quality, delivery)

Limitations of Life-Cycle Analysis

- Most useful during stable periods - 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

Porter's Five Forces of Strategic Analysis

- threat of substitute products - bargaining power of customers - bargaining power of suppliers - threat of new entrants - intensity of rivalry

Constructing a Peer Group

-Examine commercial classification systems -Review company's literature - often cite specific competitors -Review industry trade publications -Confirm that each comparable company derives a significant portion of its revenue and operating profit from business activity similar to the primary business of the subject company.

Porter's two strategies to be employed by a firm within an industry

1. A cost leadership (low-cost) strategy 2. A product or service differentiation strategy

Between a restaurant, steel producer, and legal services provider - which has the greatest ability to quickly increase its capacity?

A legal services provider. Capacity increases in providing legal services would not involve factors such as the need for substantial fixed capital investments (this would be a factor for steel producers), or outfitting rental or purchased space (this would be a factor for restaurants).

An important point on market share

Absolute market share may not matter as much as a firm's market share relative to its competitors. A firm may have a 50% market share, but if a single competitor has the other 50%, their 50% share would not result in a great degree of pricing power - Return on capital is limited by intense competitor between the two firms. Conversely, a firm that has a 10% market share when no competitor has more than 2% may have a good degree of pricing power and high return on capital.

Between commercial and government industry classification systems, which are updated more regularly?

Commercial classification systems. They are updated more frequently than government systems, and include only publically traded for-profit companies.

Industry Concentration

Concentration among a relatively small number of players often experience less price competition. Relative share may matter as much as absolute share. Fragmented industries tend to be highly competitive - difficult to monitor each member, small gains in market share can make a meaningful difference in profit, members think of themselves as individuals rather than members of a group.

Consumer Discretionary

Cyclical firms that sell goods and services in industries such as Automotive, Apparel, Hotels & Restaurants

Regarding the relationship between pricing power and ease of entry and exit, greater ease of entry...

Decreases pricing power and greater ease of exit increases pricing power. In industries with greater ease of entry, firms have little pricing power because new competitors can take away market share. High costs of exiting result in overcapacity and likely price wars. Greater ease of exit (i.e., low costs of exit) increases pricing power.

Industry Life Cycle

Embryonic - slow growth, high prices, large investment, high risk of failure. Growth - rapidly increasing demand, improving profitability, falling prices, low competition Shakeout - slowing growth, intense competition, declining profitability, increasing overcapacity Mature - little or no growth, industry consolidation, high barriers to entry Decline - negative growth, excess capacity leads to price competition, high production costs

Barriers to entry

If barriers low then industry is likely to be highly competitive because high returns on invested capital will quickly be competed away. If barriers high then incumbents may enjoy a more benign competitive environment. Pricing power may not exist among current members - strong competition; undifferentiated products; high barriers to exit.

The industry experience curve shows the cost per unit relative to...

Industry life-cycle stage. The experience curve shows the cost per unit relative to output. Unit cost declines at higher output volume because of increases in productivity and economies of scale, especially in industries with high fixed costs.

Consumer Staples

Less cyclical firms that sell goods and services in industries such as Food, Beverage, Tobacco & Personal Care Products

Industry Capacity

Limited capacity gives members more pricing power. Overcapacity leads to price cutting as excess supply chases demand. Generally, capacity is fixed in the short term and variable in the long term. Producers may overshoot future required capacity, especially in cyclical markets. Non-physical capacity can be reallocated more quickly.

Greater pricing power is most likely to result from greater...

Market concentration. Greater concentration (a small number of firms control a large part of the market) typically reduces competition and results in greater pricing power. Greater unused capacity in an industry, especially if chronic, results in greater price competition and less pricing power. Greater stability in market share is typically associated with greater pricing power.

Strengths and Weaknesses of Current Classification Systems

Most government systems do not disclose information about a specific business or company Commercial systems adjusted more frequently than government systems. Government systems do no distinguish between small and large business, between for-profit and not-for-profit organizations, or between public and private companies.

Industry rotation

Overweighting or underweighting industries based on the current phase of the business cycle.

Approaches to Industry Groupings

Products and Services - group by sector or principal business activity Business cycle sensitivities - cyclical companies are strongly correlated with the strength of the overall economy. Statistical groupings - correlations of past securities' returns, cluster analysis

Industry classification systems from commercial index providers typically classify firms by...

Products and services. The classification systems provided by S&P/MSCI Barra, Russell, and Dow Jones/FTSE classify firms according to the product or service they produce.

Market Share Stability

Stable market shares typically indicate less competitive industries. Unstable shares indicate highly competitive industries with limited pricing power. High switching costs contribute to market share stability.

Which industry classification system uses a three-tier classification system?

The Russell Global Sectors system. The Russell system uses three tiers, whereas the other two systems are based on four tiers or levels.

Economic Profits

The return on invested capital minus its cost. It's greater than 20% in some industries and negative in others.

Uses of Industry Analysis

Understanding a company's business and business environment - growth opportunities, competitive dynamics, business risks Identifying active equity investment opportunities - active management, portfolio weighting Portfolio performance attribution - address the sources of a portfolio's return