Reading 42: Industry Analysis

This reading was quite interesting. I used Schweser as a study guide to get a gist of the entire chapter and then used the Curriculum for my main reading. Took me about 2.5 hours, I guess. I worked out the concept checkers at the end of Schweser 2007.

Main points:

The model of an Industry Analysis should include-

Industry Classification

External Factors

Demand analysis

Supply Analysis

Profitability

International Competition and Markets (Not covered by the LOS).

Let’s discuss each of these parts in details now-

I. Industry Classification- Can be done either by Industry Life Cycle or Business Life Cycle.

a. Industry Life Cycle- Pioneer, Growth, Mature and Decline are the 4 stages.

Pioneer- 7/10 start up businesses fail to survive.

Growth- Even when the economy is doing poorly, growth industries can experience positive profits. They prosper independent of the business cycle.

Mature- Within a mature industry, there might be a couple of growth companies. They can achieve this by acquisition or improved quality/service.

Decline- Remaining participants consolidate. The better managed survivors anticipate this fate and avoid it by using cash flow to diversify into promising industries.

b. Business Life Cycle- Industry classified as either-

Growth -above normal rate of expansion and independent of the business cycle. Eg- Computer Software Industry).

Defensive- Stable performance throughout the business cycle. Egs- Utilities, food, cigarettes and beer industry and govt. contractors.

Cyclical- Produce discretionary products, the consumption of which depends upon the economic optimism. Egs- Auto industry, heavy equipment and machine tool producers. Certain cyclical firms experience earnings patterns that do not correlate well against the general economy, but trend against other economic variables. (Brokerage firms use the stock prices as their base and agricultural firms that are related to the crop price cycle).

Problems with Industry Classification-

a. Self-deception- placing all not all companies in a mature industry are mature companies.

II. External Factors-

There are five external factors:

Technology- For pioneer industries, the question is will the market accept the innovation? For mature industries, the question is- will the industry face obsolescence from competing technologies?

Govt- New regulations, changes etc. can impact an industry either positively or negatively. For eg- Tobacco industry facing problems.

Social changes- Either due to fashion or lifestyle changes. Fashion changes are of a shorter duration and more unpredictable. Eg- women’s clothing line. Lifestyle changes take place over long periods of time and easier to determine.

Demographics- Studying the vital stats of population, such as distribution, age and income. They are easier to identify and track compared to other external factors, but disagreement occures in sizing up its impact on relevant industries.

Foreign influences-Foreign policies and restrictions.

III. Demand Analysis- Can be achieved in three ways-

a. Top Down Economic Analysis when the revenues correlate strongly to one economic statistic.

b. Industry Life cycle- Categorizing the industry within its life cycle position.

c. External Factors

Customer Study- Segmenting the customers into submarkets (based on user type, type of business, geographic, sex, age etc.) to study a smaller number of factors that contribute to demand.

For established industries, the analyst should contact long time customers to figure what drives demand in each submarket.

For growth industries- the analyst considers new outlets for the industry’s products.

Untested industries- We need to determine if the new industry fulfills a need that exists and isn’t being met by another industry. Assuming a new is verified, analysts typically forecast new industry sales based on the experience of a similar industry.

Input/Output Analysis- A rising consumption of the finished product boosts demand for industries supplying the intermediate steps.

IV. Supply Analysis-

In the long term, it is appreopriate to assume that supply will equal demand. In the short term, there can be a shortfall in supply in case of -

a. Capacity intensive industries where the lead time is high, or

b. When capacity is diabled due to natural disasters.

The analyst should obtain data on the aggregate size of the potential supply of output from a given industry- incl. foreign industry- and compare this with projected demand for the industry output (called capital utilization data, which is equal to the total capacity divided by the total demand).

V. Profitability, Pricing and the Industry Study

A supply/demand forecast gives an indication of future profitability. A projected oversupply will retard investment since it augurs lower prices.

Factors contributing to pricing include:

a. Product segmentation- Most industries effectively segment their product offerings by brand name, reputation, or service, even when the products are quite similar.

b. Degree of industry concentration

c. Ease of industry entry

d. Price changes in key supply inputs

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I left out the pages that talked about International Competition and Markets because it’s not covered by any of the relevant LOSs.