Fundamentals of Industry Analysis

In this section, we will understand the first step of equity analysis – Industry analysis.

Industry analysis is concerned with the scrutiny of all factors that make up the industry in which a company operates. It includes an analysis of the competitive environment, regulatory policies and nature of suppliers and customers, among others. Industry environment is important because it helps shape up the strategies and policies of a business. The success of a business depends on the extent to which it is able to exploit the opportunities and circumvent the challenges presented by its environment.

In this section, we will first start with a look at the components of an industry. We then move on to an explanation of various types of market competition, before closing with the significance of industry analysis.

Understanding the key components of an industry: Customers, Competition, Regulators, Suppliers

An industry consists of many stakeholders. A company has to interact with them on a daily basis. Here, we look at the specific roles they play in the industry and the ways in which they influence the working of companies.

  • Customers :

    This is perhaps the most important category of market participants for a company. Its revenues are a direct function of the extent to which it can satisfy its customers. Thus, it must commit itself to first understanding what its customers need, and then catering to these needs as best as it can. Who one’s customers are depends on the nature of one’s business. In some cases, they are final consumers like us, who use their products for self-consumption. In others, they are companies from other industries, who use their products for further production of goods and services. Customers can be further divided on the basis of their age-group, gender, profession, income etc. While analyzing customer dynamics, you should look at the existing categories of customers as well as the new categories of customers that can enter the market.

    The ability to influence the price and nature of the offering in an industry is called bargaining power. It is critical to understand who the bargaining power lies with in an industry – customers or producers. Companies will do well only if bargaining power rests with them. If customers have greater bargaining power, they’ll be able to dictate the price of goods, as well as their quality, quantity and other specifications. This will adversely affect the industry’s profits. Bargaining power will lie with customers if there are multiple vendors offering similar goods in the industry. In such cases, if customers don’t get a good deal with one seller, they can easily go to another. Other factors that give customers bargaining power are a small number of buyers in the market, large quantities purchased by individual buyers and the ability of customers to integrate backwards. Backward integration takes place when customers are able to start producing a product themselves, instead of buying it from the market.

    This marginalizes the producers, who are slowly forced to either shut down their operations or move to other industries. Evaluating these factors is critical to industry analysis.

  • Regulators :

    In most industries, there is a body designated by the government to frame and enforce rules of participation. These are formulated with a view of protecting customers, competitors, suppliers and shareholders from malpractices of companies. Understanding the regulatory framework is important for investors like you, because it imposes certain restrictions on the activities of companies. The future growth potential of the industry must be viewed in this context. As a general rule, you should stay away from industries that are very highly regulated or little regulated.

    This is because excessive regulation strangles industry growth while under-regulation offers little protection to shareholders from the inconsiderate actions of companies. High regulation also imposes high entry barriers for new entrants into the industry. New companies find it hard to keep up with regulatory requirements and don’t survive for long. Whereas most regulations are formed specifically for each industry sector, some regulations are common for all sectors.

    One such category of regulations is antitrust regulations. They seek to prevent companies from stifling competition by unfairly cornering an unduly large market share. This adversely affects fellow competitors and customers.

  • Competition :

    Actions of other companies in an industry also influences a company’s prospects. Successful companies are able to meet the needs of their customers better than other competitors. There are three degrees of competition that are possible in a market – perfect competition, oligopoly and monopoly. Out of these, perfect competition is the most competitive and monopoly is the least competitive. Perfect competition refers to a situation where there are many producers of the same product in the industry.

    This limits a companies’ ability to change prices and product specifications without losing out to other competitors. Success of a company depends on its ability to differentiate its products, diversify into new products (within the same umbrella) and making operational changes that reduce its production cost. For such companies, advertising costs are generally high as they have to present their products differently from their rivals.

    You would like to invest in companies that operate in industries with low competition. Such companies generally exist in industries where entry barriers are high and the nature of product is specialized or only meant for a niche customer class. We will look at the different types of competition later in the piece.

  • Suppliers :

    Understanding the supply situation in an industry is important because unless a steady, cost-effective supply of inputs is ensured, it is impossible for producers to consistently churn out products of the same quality and price. The supply situation in an industry is satisfactory when there is an abundance of suppliers supplying similar inputs and there is no overdependence on a few suppliers. If this case, companies have more influence over price of inputs. In the contrary situation, the bargaining power rests with suppliers.

    They are able to develop a clout whereby, they deliver supplies based on their own specifications and prices. Like customers, suppliers too have the ability to integrate. They may move to the next level of the value chain and instead of selling their output to the industry, start using it themselves to produce the same goods.

    This is called forward integration. It is harmful for the industry because it consolidates the operations of suppliers and allows them to provide the same product at a lower cost to the final customers. Further, if suppliers use all the inputs themselves, existing companies are starved of these, resulting in a shutdown of their operations.

Components of Industry by Kotak Securities

Types of industries: Perfect, oligopoly, monopoly

Different Types of Industries

  • Perfect :

    As described above, an industry is in perfect competition when there are multiple companies producing similar products. This is the most intensely competitive industry because products are so similar that consumers are indifferent between the offerings of different producers. As a result, companies have very little ability to change product prices and specifications.

    Any increase in price will lead to one’s customers changing over to a different producer. Similarly, an alteration in the quantity, quality and technical attributes of the product also inspires changeovers. Since no company can earn more revenue by making changes to its price or output, success of companies depends solely on how well they perform along certain other factors.

    Companies can increase their earnings by differentiating the product from others, optimizing processes to cut their cost of production and marketing their product differently. As an investor, you should look for a company’s exploits in these areas to determine how well it can be expected to perform in a highly competitive market in the future.

  • Oligopoly :

    This market structure also consists of a number of firms. However, it is dominated by only a handful of them. As a result, there is no single market leader but a small group of companies have an inordinately high market share. The remaining companies make up the remainder of the market share. It is perhaps the most realistic market structure of all.

  • Monopoly :

    Monopoly is a term used to describe a market where there is only one producer of a product. He caters to the entire market demand for the product and has complete control over its price and specifications. Customers in such a market are only price takers. They have no control over the price of the product and have to buy it at whatever price the monopolist sells it at.

    Monopolies tend to get established when there are high entry barriers in an industry. Sometimes, a company is able to establish such a dominant position in the market that it is able to produce and sell its output at a much lower cost than new companies can even imagine to. This keeps them out of the market. Further, they tend to suck-up the entire supply of raw materials in the industry. This also helps them perpetuate there position.

    These practices sound unfair. For this reason, regulators tend to prevent monopolies from getting established. Generally, companies are required to seek regulatory approval before going ahead with a merger. This is because mergers can result in a company that is too big for others in the industry to compete against. Sometimes, companies use ploys to sidestep the regulator and indulge in activities that give them an undue advantage in the industry. In such cases, regulators tend to initiate antitrust proceedings against them and prevent them from establishing such a hold on the market.

    As a result, monopoly is not a realistic concept any longer, other than in some cases where governments monopolize certain strategic sectors, such as railways in India.

Why industry growth, competition, regulation matter

Reasons to Understand Industry Growth, Competition, Regulation by Kotak Securities

  • Industry forces affect companies :

    We have established that a company’s current and future performance is to a very large extent affected by the industry environment it operates in. The objective of conducting industry analysis is to recognize the forces within the industry that have a significant bearing on a company and assessing their impact on the company’s future performance.

  • New products :

    Lastly, industries grow as a whole when new uses of their products are discovered. These are some of the factors you should consider while conducting an industry analysis. These products can then benefit or harm the company depending on its position. This is why it is important to monitor the industry dynamics too.

  • Competition matters :

    Industries expand, overall, when companies that constitute them find new, innovative ways to improve their products, streamline their operations, find new uses of the product, or in general do something that will attract more customers and expand their market share. These are actions that describe the competitive environment of an industry. Companies that excel in these areas will stay above their competition and expand their market share, whereas the rest will falter. For someone who is conducting an industry analysis, these are important points to consider.

  • Industry grows, company profits :

    If the industry grows as a whole, the size of the earnings pie will naturally expand. Even if a company is able to maintain a constant market share, its slice of the pie will expand similarly. For most industries, high growth is obtained when the economy as a whole is doing well. In such cases, the need for all kinds of goods and services increases.

    This is largely owing to the high government spending that such economies witness. Additionally, governments offer incentives to industries for the promotion of economic activity in general.

  • Identify links with different industries :

    Apart from this, industries grow at a high rate when there is a boom in the key sectors to which they cater. For example, if the housing sector does well, the cement sector too will do well. These links would be beneficial while we try to predict the company’s future performance.

  • Regulation matters :

    One constraint to competition is regulation. Companies do all they can to increase market share. However, some of their activities can unfairly affect others in the market. Regulators try to check such actions. An analysis of the regulatory framework of an industry is, therefore, essential. Not only do you want to see what regulations govern a market, you must also diligently look at the extent to which the regulator is able to impose himself on those who flout them and assess the loopholes in the regulatory system that diminish his effectiveness.

    A week regulator, after all is no better than no regulator at all!

What next?

Now that we have a better understanding of how the industry environment shapes up a company, we must examine specifics of the companies that we are interested in within an industry. In the next section, we will look at the intricacies of company analysis. click here.

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