Equity Investment analysis-CIFA SECTION 4

CHAPTER TWO

INDUSTRY AND COMPANY ANALYSIS

Introduction

Industry analysis is a type of investment research that begins by focusing on the status of an industry or an industrial sector.

Why is this important? Each industry is different, and using one cookie-cutter approach to analysis is sure to create problems. Imagine, for example, comparing the P/E ratio of a tech company to that of a utility. Because you are, in effect, comparing apples to oranges, the analysis is next to useless.

In each section we'll take an in-depth look at the different valuation techniques and buzz words used in a particular industry, complete a 5-forces analysis on the state of the market and point you in the direction of industry-specific resources.

Porter's 5 Forces Analysis

If you are not familiar with the five competitive forces model, here is a brief background on who developed it, and why it is useful.

The model originated from Michael E. Porter's 1980 book "Competitive Strategy: Techniques for Analyzing Industries and Competitors." Since then, it has become a frequently used tool for analyzing a company's industry structure and its corporate strategy.

In his book, Porter identified five competitive forces that shape every single industry and market. These forces help us to analyze everything from the intensity of competition to the profitability and attractiveness of an industry. Figure 1 shows the relationship between the different competitive forces.

1. Threat of New Entrants - The easier it is for new companies to enter the industry, the more cutthroat competition there will be. Factors that can limit the threat of new entrants are known as barriers to entry.
2. Power of Suppliers - This is how much pressure suppliers can place on a business. If one supplier has a large enough impact to affect a company's margins and volumes, then it holds substantial power. Here are a few reasons that suppliers might have power:

·         Existing loyalty to major brands

·         Incentives for using a particular buyer (such as frequent shopper programs)

·         High fixed costs

·         Scarcity of resources

·         High costs of switching companies

·         Government restrictions or legislation

3. Power of Buyers - This is how much pressure customers can place on a business. If one customer has a large enough impact to affect a company's margins and volumes, then the customer hold substantial power. Here are a few reasons that customers might have power:

·         There are very few suppliers of a particular product

·         There are no substitutes

·         Switching to another (competitive) product is very costly

·         The product is extremely important to buyers - can\'t do without it

·         The supplying industry has a higher profitability than the buying industry

4. Availability of Substitutes - What is the likelihood that someone will switch to a competitive product or service? If the cost of switching is low, then this poses a serious threat. Here are a few factors that can affect the threat of substitutes:

·         Small number of buyers

·         Purchases large volumes

·         Switching to another (competitive) product is simple

·         The product is not extremely important to buyers; they can do without the product for a period of time

·         Customers are price sensitive

5. Competitive Rivalry - This describes the intensity of competition between existing firms in an industry. Highly competitive industries generally earn low returns because the cost of competition is high. A highly competitive market might result from:

·         The main issue is the similarity of substitutes. For example, if the price of coffee rises substantially, a coffee drinker may switch over to a beverage like tea.

·         If substitutes are similar, it can be viewed in the same light as a new entrant.

USES OF INDUSTRY ANALYSIS

Company analysis and industry analysis are closely interrelated. Company and industry analysis together can provide insight into sources of industry revenue growth and competitors' market shares and thus the future of an individual company's top-line growth and bottom-lin profitability.

Industry analysis is useful for:

·         Understanding a company's business and business environment

·         Identifying active equity investment opportunities.

·         Formulating an industry or sector rotation strategy.

·         Portfolio performance attribution.

There are three main approaches to classifying companies:

1. Products and/or service supplied.

This is the main approach to industry classification. Companies are categorized based on
the products and/or services they offer. The term sector is used to refer to a group of related industries.

2. Business-cycle sensitivities.

A cyclical industry is sensitive to business cycles. Its revenues are generally higher in periods of economic prosperity and lower in periods of economic downturn. The performance of a non-cyclical industry is independent of the business cycle.

Non-cyclical industries can be further sorted into two categories:

-          A defensive (or stable ) industry demonstrates stable performance during both economic expansion and contraction.

-          Companies in a growth industry achieve above-normal growth rate and profitability at any stage of the general business
cycle.

However, there are limitations when using these industry descriptors. For example, some industries may include both growth companies and defensive companies.

Note two things:

-          Business-cycle sensitivity is a continuous
spectrum.

-          A global company can experience economic expansion in one part of  the world while experiencing recession in another part.

3. Statistical similarities

 Statistical cluster analysis is defined as the art of finding groups in data such that the degree of natural association is high among members within the same class (internal cohesion) and low between members of different categories (external isolation. This technique can
be used to categorize companies into different industries.

INDUSTRY CLASSIFICATION SYSTEMS

Commercial industry classification systems include:

1. The Global Industry Classification Standard (GICS)

It is an industry taxonomy for use by the global financial community. It is used as a
basis for S&P and MSCI financial market indexes in which each company is assigned to a sub-industry, and to a corresponding industry, industry group and sector, according to the definition of its principal business activity.

2. The Russell Global Sectors classification system

It uses a three-tier structure to classify global companies based on the products or services a
company offers.

3. The Industry Classification Benchmark (ICB)

It categorizes individual companies into subsectors based primarily on a company's source of revenue or where it constitutes the majority of revenue.

Various governmental agencies use a number of classification systems to facilitate the comparison of data over time and among countries that use the same system. These systems include:

-          International Standard
Industrial Classification of All Economic Activities (ISIC) is used by the United Nations, its agencies and many countries in the world.

-          Statistical Classification of Economic Activities in the European Community (NACE) is the European version of ISIC.

-          Australian and New Zealand Standard Industrial Classification.

-          North American Industry Classification System.

The structures of these systems are very similar. The limitation of current classification system is that the narrowest classification unit assigned to a company generally cannot be assumed to constitute its peer group for the purpose of detailed fundamental comparisons or valuation.

Peer Group Analysis

It is the practice of comparing a firm's result to those of similar firms. Commercial industry classification systems often provide a starting point for constructing a peer group. Start with companies in the same industry, review the subject company and its competitors' annual reports, and confirm each comparable company's primary business activity is similar to that of the subject company.

Useful questions to ask are:

·         What proportion of revenue and operating profit is derived from business activities similar to those of the subject company?

·          Does a potential peer company face a demand environment similar to that of the subject company?

·         Does a potential company have a finance subsidiary?

 Principles of strategic analysis A business has to understand the dynamics of its industries and markets in order to compete effectively in the marketplace. Porter identifies five forces that dictate the rules of competition in each industry. These forces determine industry profitability because they influence the prices, costs and required investment of firms in an industry.

·         The threat of substitutes. Substitutes not only limit profits in normal times, they also reduce the bonanza an industry can reap in good times. The threat of a substitute is high if it offers an attractive price-performance trade-off to the industry's product, and/or the buyer's cost of switching to the substitute is low.

·         The bargaining power of customers. How strong is the position of buyers? Can they
work together in ordering large volumes? This force influences the prices that firms
can charge. It can also influence cost and investment
as powerful buyers demand costly service.

·         The bargaining power of suppliers. How strong is the position of sellers? Suppliers, if powerful, can exert an influence on the producing industry, such as selling raw materials at a high price to capture some of the industry's profits. In some cases, monopolist supplier can dictate its terms to entire industries. This force determines the cost of raw materials and other inputs.

·         The threat of new entrants. How easy or difficult is it for new entrants to start competing? Barriers to entry are unique industry characteristics that define the industry. Barriers reduce the rate of entry of new firms, thus maintaining a level of profits for those already in the industry. From a strategic perspective, barriers can be created or exploited to enhance a firm's competitive advantage.

·         The intensity of rivalry. Does a strong competition between the existing players exist? Is one player very dominant or are all equal in strength and size?

The elements of a thorough industry analysis include the following:

Barriers to Entry

In theory, any firm should be able to enter and exit a market, and if free entry and exit exists, then profits always should be nominal. In reality, however, industries possess characteristics that protect the high profit levels of firms in the market and inhibit additional rivals from entering the market. These are barriers to entry. They are advantages that incumbents have relative to new entrants.

The threat of entry in an industry depends on the height of entry barriers that are present. If entry barriers are low, the threat of entry is high and industry profitability is moderated.

Generally high barriers to entry can lead to better pricing and less competitive industry conditions. However, barriers to entry are not barriers to success, and high barriers to entry do not necessarily lead to good pricing power and attractive industry economics. Barriers to entry can also change over time.

Industry Concentration

Industry concentration is often, although not always, a sign that an industry may have pricing power and rational competition. Industry fragmentation is a much stronger signal, however, that the industry is competitive and pricing power is limited. Certainly there are important exceptions. There are industries that are concentrated with weak pricing power, and there are also industries that are fragmented with strong pricing power. The level of industry concentration is just a guideline.

Industry Capacity

Tight capacity > more pricing power

Overcapacity > price cutting

The analyst should think about not only current capacity conditions but also future changes in capacity levels: how long does it take for supply and demand to reach equilibrium? Are the tight supply conditions sustainable?

In general it takes longer to shift physical capacity than to shift financial and human capital to new uses.

Market Share Stability

Stable market shares > less competitive industries
Unstable market shares > highly competitive industries and limited
pricing power

Industry Life Cycle
The industry life cycle reflects the vitality of an industry over time.
Each industry develops along a similar cyclical path that includes the
following stages:

·         Embryonic: new products, slow growth, high price, weak revenue, high risk investments.

·         Growth: growing sales, significant profitability and lack of competition.

·         Shakeout: slowing growth, intense competition and
declining profitability.

Competitive strategy is very important at this stage, since above-average growth can be attained only by increasing the market share.

·         Mature: little or no growth, industry consolidation, and relatively high barriers to entry.

·         Decline: falling demand, sales and negative growth. Some companies fail, others exit the industry to compete in other lines of business. Companies that have the strongest
competitive advantages remain in the industry and fight for market share.

There are certainly limitations of industry life-cycle analysis. Demographics and changes in technology as well as political and regulatory environments all play a role in affecting the cash flow and risk prospects of different industries. Some stages may become longer or shorter than expected, and some stages may even be skipped altogether. Another limitation is that not all companies in an industry experience similar performances.

Price Competition
Price competition and thinking like a customer are important factors that are often overlooked when analyzing an industry. Whatever factors most influence customer purchasing decisions are also likely to be the focus of competitive rivalry in the industry. Broadly, industries for which price is a large factor in customer purchase decisions tend to be more competitive than industries in which customers value other attributes more highly.

EXTERNAL INFLUENCES ON INDUSTRY GROWTH, PROFITABILITY, AND RISK

These external influences include:

Macroeconomic Influences

 GDP, interest rates, inflation, the availability of credit, etc

Technological Influences

Established companies face the threat of technological obsolescence, while technological developments may also help established industries reinforce growth. Infant industries
face the threat of a new product not being accepted by the market place.

Demographic Influences
Broad shifts in population distribution, age, and income can have very marked effects on different industries. For example, a greater role of sports in lives of many Americans has increased demand for sports trauma orthopedics.

In most cases, demographic shifts are easy to identify, because they occur over a very long time period. However, it is much harder to quantify such trends and determine
their influence on a particular industry.

Governmental Influences
Government regulations, laws, and tax policies can have a marked influence on many industries. They may potentially increase or decrease an industry's prospects. In certain cases, government policies create new industries. For example, after the Firestone case, government required original auto manufacturers to submit all information about their cars, which created new auto business intelligence software industry.

Trade barriers established by governments support demand for specific domestic industries by
fending off foreign competition (an example would be the steel industry in the US).

Social Influences
Fashion changes tend to be short-term and less predictable. For example, new products in the cosmetics or film industries may enjoy a brief spark in demand, which will dissipate shortly. Lifestyle changes tend to be long- term and more predictable. For example, as a result of greater health consciousness, natural foods and nutritional products enjoyed a boom and hard liquor sales were depressed.

Industry Analysis

Top – down Approach

This is a 3 step approach to security valuation. Starts with a forecast of the direction of the general economy. Based on this economic forecast, project the attack for each industry under review.

Within each industry, select the firms most likely to perform the best given this economic and industry forecast. 

Economic analysis - industry analysis   -   Stock analysis

Step 1:  Forecast macroeconomic influences

Fiscal policy is a direct approach to affect aggregate demand in an attempt to manage the rate of economic growth.  Tax cuts encourage spending <demand> and speed up the economy.  Tax increases discourages spending – slowing down economic growth.

Government spending creates jobs increasing aggregate demand. Monetary policy is used by CB to manage economic growth decreasing money supply causes interest rate to rise putting upward pressure on costs and downward pressure of demand.  Increasing money supply reduces interest rates increases demand. Inflation can result from increasing money supply too fast.

Rising interest rates reduce demand for investment firms and rising consumer prices reduces product demand.

Step 2:  determine Industry Effects

Identify industries that should prosper or suffer from economic outlook identified in step 1.

Consider how these industries react to economic change. Consider global economic shifts, an industry prospects within global business environment determine how well or poorly individual firms in the industry will do for industry overtime.

Change in technology of transportation and communication has certainly had an effect on this industry both in terms of product and services consumed but also in their production and pricing Technological advances in comps and micro- processors in general have led to sweeping changes in how inventory is managed and how products are distributed in many industries particularly in retailing industry.

Politics and Regulation

Changes in political climate and changes in specific government regulations can also have significant effect on particular industries.  Imposition of tariffs on steel will lead to increased domestic production and profitability, the rise of terrorist activity has helped some industries and imposed cost on others such as airline and shipping industries.  Requirement of a minimum wage and wide spread expectation of employment benefits, packages have affected hiring practices and production methods, especially in labour intensive industries.

Life cycle analysis, Business Cycle

There are 5 primary stages of a business cycle.

(i)                  Recession

(ii)               Recovery

(iii)             Early expansion

(iv)             Late expansion

(v)               Slowing into recession.

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