The industry analysis process is similar to economy analysis-first is a macroanalysis of the industry to determine how this industry relates to the business cycle and what economic variables drive this industry. This macroanalysis will make the microvaluation easier when we use the several valuation techniques introduced in fundamental analysis (Advanced module)
As noted, macroanalysis of the industry will make the estimation of the major valuation inputs (a discount rate and the expected growth for earnings and cash flows) easier and more accurate. The specific macroanalysis topics are:
The business cycle and industry sectors
Structural economic changes and alternative industries
Evaluating an industry's life cycle
Analysis of the competitive environment in an industry
7.2. The Business Cycle and Industry Sector
Economic trends can and do affect industry performance. The objective is to monitor the economy and gauge how any new information on our economic outlook will impact the short-run and long-run valuation of our industry.
Economic trends can take two basic forms: cyclical changes that arise from the ups and downs of the business cycle, and structural changes that occur when the economy is undergoing a major change in how it functions. For example, excess labor or capital may exist in some sectors, whereas shortages of labor and capital exist elsewhere. The "downsizing" of corporate America during the 1990s, transitions from socialist to market economies in Eastern Europe, and the transition in the United States from a manufacturing to a service economy are all examples of structural change. Industry analysts must examine structural economic changes for the implications they have for an industry under review.
While industry performance is related to the stage of the business cycle, the real challenge is that every business cycle is different and those who look only at history miss the evolving trends that will determine future market and industry performance.
Switching industry groups over the course of a business cycle is known as a rotation strategy. When trying to determine which industry groups will benefit from the next stage of the business cycle, investors need to monitor economic trends and changes in industry characteristics.
The chart above presents a stylized graphic of which industry groups typically perform well in the different stages of the business cycle. For example, toward the end of a recession, financial stocks rise in value because investors anticipate that banks' earnings will rise as both the economy and loan demand recover. Brokerage houses become attractive investments because their sales and earnings are expected to rise as investors trade securities, businesses sell debt and equity, and there are more mergers during the economic recovery. These industry expectations assume that when the recession ends there will be an increase in loan demand, housing construction, and security offerings.
Traditionally, toward the business cycle peak, inflation increases as demand starts to outstrip supply. Basic materials industries such as oil, metals, and timber, which transform raw materials into finished products, become investor favorites. Because inflation has little influence on the cost of extracting these products and the firms in these industries can increase prices, these industries experience higher profit margins
During a recession, some industries do better than others. Consumer staples, such as pharmaceuticals, food, and beverages, outperform other sectors during a recession because, although overall spending may decline, people still spend money on necessities so these "defensive" industries generally maintain their values–that is, they will experience minimal declines. Similarly, if a weak domestic economy causes a weak currency, industries that export to growing economies benefit because their goods become more cost competitive.
7.3. Structural Economic Changes and Alternative Industries
Influences other than the economy are part of the business environment. Demographics, changes in technology, and political and regulatory environments also can have a significant effect on the cash flow and risk prospects of different industries.
India now has more than 50% of its population with a age of 25 years and above. There is a continuous increase in the number of working age population in India. This increase have had a large impact on India's consumption, from advertising strategies to house construction to concerns over social security and health care. The study of demographics includes much more than population growth and age distributions. Demographics also includes the geographical distribution of people, the changing ethnic mix in a society, and changes in income distribution.
Therefore, industry analysts need to carefully study demographic trends and project their effect on different industries. The changing age profile of the citizens has implications for resource availability, like in India- growing working age population means a high availability of entry-level workers leading to a lower labour costs and ease in finding persons to do the job.
In US, the aging population affects U.S. savings patterns, because people in the 40 to 60 age bracket usually save more than younger people. This is good for the financial services industry, which offers assistance to those who want to invest their savings. Alternatively, fewer younger workers and more "saving seniors" may have a negative impact on some industries, such as the retailing industry.
This deal with how people live, work, form households, consume, enjoy leisure, and educate themselves. Consumer behavior is affected by trends and fads. The rise and fall of designer jeans, chinos, and other styles in clothes illustrate the sensitivity of some markets to changes in consumer tastes. The increase in divorce rates, dual-career families, population shifts away from cities, and computer-based education and entertainment have influenced numerous industries, including housing, restaurants, automobiles, catalog shopping, services, and home entertainment. From an international perspective, some Indian brand goods-have a high demand overseas. They are perceived to be more in style and perhaps higher quality than items produced domestically. Several industries have benefited from this positive brand reputation.
Technology can affect numerous industry factors, including the product or service and how it is produced and delivered. There are numerous examples of changes due to technological innovations. For example, demand has fallen for carburetors on cars because of electronic fuel-injection technology. The engineering process has changed because of the advent of computer-aided design and manufacturing. Perpetual improvement of designs in the semiconductor and microprocessor industry has made that industry a difficult one to evaluate.
Innovations in process technology allowed steel minimills to grow at the expense of large steel producers. Advances in technology allow some plant sites and buildings to generate their own electricity, bypassing their need for power from the local electric utility. Trucks have reduced railroads' market share in the long-distance carrier industry. The information superhighway is becoming a reality and encouraging linkages between telecommunications and cable television systems. Changes in technology have spurred capital spending in technological equipment as a way for firms to gain competitive advantages. The future effects of the Internet will be astronomical.
The retailing industry is a wonderful example of how an industry can use new technology. Some forecasters envision relationship merchandising, in which customer databases will allow closer links between retail stores and customer needs. Rather than market research on aggregate consumer trends, specialized retailers offer products that consumers desire in preferred locations. Technology allows retailers to become more organizationally decentralized and geographically diversified. Major retailers use barcode scanning, which speeds the checkout process and allows the firm to track inventory and customer preferences. Credit cards allow firms to track customer purchases and send customized sales announcements. Electronic data interchange (EDI) allows the retailer to electronically communicate with suppliers to order new inventory and pay accounts payable. Electronic funds transfer allows retailers to move funds quickly and easily between local banks and headquarters.
Politics and Regulations-
Because political change reflects social values, today's social trend may be tomorrow's law, regulation, or tax. The industry analyst needs to project and assess political changes relevant to the industry under study. Some regulations and laws are based on economic reasoning. Due to utilities' positions as natural monopolies, their rates must be reviewed and approved by a regulatory body. Regulatory changes have affected numerous industries. An example is the numerous regulations and inspections introduced to protect against terrorist attacks. Changing regulations and technology are bringing participants in the financial services industry-banking, insurance, investment banking, and investment services-together. Regulations and laws affect international commerce. International tax laws, tariffs, quotas, embargoes, and other trade barriers have a significant effect on some industries and global commerce.
7.4 Life Cycle
An insightful analysis when predicting industry sales and trends in profitability is to view the industry over time and divide its development into stages similar to those that humans progress through: birth, adolescence, adulthood, middle age, old age. The number of stages in this industry life cycle analysis can vary based on how much detail you want.
A five-stage model would include:
Rapid accelerating growth
Stabilization and market maturity
Deceleration of growth and decline
The following is a brief description of how these stages affect sales growth and profits:
Pioneering development- During this start-up stage, the industry experiences modest sales growth and very small or negative profits. The market for the industry's product or service during this stage is small, and the firms incur major development costs.
Rapid accelerating growth- During this rapid growth stage, a market develops for the product or service and demand becomes substantial. The limited number of firms in the industry face little competition, and firms can experience substantial backlogs and very high profit margins. The industry builds its productive capacity as sales grow at an increasing rate and the industry attempts to meet excess demand. High sales growth and high profit margins that increase as firms become more efficient cause industry and firm profits to explode (i.e., profits can grow at over 100 percent a year because of the low earnings base and the rapid growth of sales and margins)
Mature growth- The success in Stage 2 has satisfied most of the demand for the industry goods or service. Thus, future sales growth may be above normal, but it no longer accelerates. For example, if the overall economy is growing at 8 percent, sales for this industry might grow at an above normal rate of 15 percent to 20 percent a year. Also, the rapid growth of sales and the high profit margins attract competitors to the industry, causing an increase in supply and lower prices, which means that the profit margins begin to decline to normal levels.
Stabilization and market maturity- During this stage, which is probably the longest phase, the industry growth rate declines to the growth rate of the aggregate economy or its industry segment. During this stage, investors can estimate growth easily because sales correlate highly with an economic series. Although sales grow in line with the economy, profit growth varies by industry because the competitive structure varies by industry, and by individual firms within the industry because the ability to control costs differs among companies. Competition produces tight profit margins, and the rates of return on capital (e.g., return on assets, return on equity) eventually become equal to or slightly below the competitive level.
Deceleration of growth and decline- At this stage of maturity, the industry's sales growth declines because of shifts in demand or growth of substitutes. Profit margins continue to be squeezed, and some firms experience low profits or even losses. Firms that remain profitable may show very low rates of return on capital. Finally, investors begin thinking about alternative uses for the capital tied up in this industry.