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Macro Factors for Stock Investing

Industry Analysis

What is Sector or Industry Analysis?

After economic analysis, we need to determine those industries or sectors which will prosper or suffer according to the economic outlook. 

 

Sector or Industry analysis is carried out by investors who use a top-down or sector rotation approach to investing. It has been empirically observed that specific sectors outperform during certain phases of the market cycles. During different stages of the business cycle, certain sectors perform better in comparison to others. 

 

The business cycle is comprised of expansions which are periods of economic growth, and contractions, which are periods of economic decline. During the expansion phase, investors normally focus their research on companies that benefit from low interest rates and increased Capex. During the periods of economic growth, performance of companies in the Financial and consumer discretionary sectors increase.

 

When the economy contracts and growth slows down, Investors focus shifts to defensive sectors, such as utilities and telecommunication services as these sectors often outperform during economic downturns.

 

We need to look into the industries which might be cyclical and counter cyclical considering the global shifts i.e., how well or poorly the individual firms in the industry will perform need to be analysed.

 

Example:

Let’s discuss 'Dabur Ltd' that belongs to the FMCG Sector.

 

Management & Discussion Analysis of Dabur Limited Annual Report 2020 states the following with respect to FMCG Sector Analysis

“The Fast-moving Consumer Goods (FMCG) sector is the 4th largest sector of the Indian economy. During FY 2019-20, the sector witnessed growth of 7.2% as per AC Nielsen, which is almost half of the 14% growth reported in FY2018-19”.

 

The sector saw a sharp slowdown during the year on account of various reasons:

 

  • Moderation in economic activity
  • Low farm incomes 
  • Weak rural wage growth
  • Liquidity crunch in the system
  • High unemployment levels 

By March 2020, the sectoral growth dropped to 3.3% in value terms and 0.5% in volume terms.

 

The Coronavirus pandemic has further impacted the sector since March 2020 due to restrictions on the movement of goods, supply side bottlenecks and impact on consumption.

 

Consumers have been stocking up essential products such as packaged foods, staples, tea, coffee, milk, detergents, and other products of daily usage.

 

During this phase, demand has also surged for health and hygiene products as these aspects came into sharp focus. There was a surge in demand for hygiene products like sanitizers and disinfectants in addition to immunity building OTC (Over- the-Counter) and healthcare products.

 

However, “discretionary and nonessential items have seen weak demand as the focus during the lockdown has been on food and hygiene.”

 

Inference:

From the above excerpt taken from the annual report of Dabur ltd, we get an idea about the particular sector growth and the future outlook of the particular sector. It gives a fair idea of the economic and financial prospects of a sector and industry of the economy. 

 

This analysis helps to identify the area where strategic changes will help to maximize profitability. It gives us knowledge of the untapped opportunities in the sector and economy.

 

We could conduct industry analysis using Michael Porter’s five force model. Porter is a Harvard Professor renowned for his work in developing a specialized industry analysis model. This is an appropriate way to assess the structure of an industry.

 

It is one of the ways to analyse whether the industry will prosper or suffer as the economy's outlook changes.

 

One of the simple but useful approaches would be to answer a set of questions-

 

1. Is this an appropriate industry to invest in?

 

2. Are there any quality players even if the industry is average?

 

3. What are the challenges and growth drivers for the industry?

 

4. Who are the dominant players and why are they dominant?

 

5. What are the factors which will shape an industry’s future?

 

Porter believes that the combined strength of these five forces shapes industry’s potential for value creation.

 

 

Threat of new Entrants: It refers to the threat which new competitors would pose to the existing competitors in the industry. The lower the barriers to entry, higher are the chances of new entrants in the market. The threat from new entrants affects the level of competition for the existing peer firms and also influences the ability of existing firms to achieve profitability.

 

Higher levels of competition would lead to decrease in market share and profitability of existing firms.

 

The factors that may affect the threat of new entrants are-

 

  • Government restriction
  • Higher switching cost
  • High fixed costs
  • Existing loyalty to major brands. 

Bargaining power of suppliers: This means how much pressure suppliers can put on a business. Suppliers of raw materials, components, labour, and services (such as expertise) to the firm can be a source of power over the firm, when there are few substitutes. 

 

If one of the suppliers has a large impact on the margin and volume of the company, it means the supplier has substantial bargaining power. A strong supplier can make an industry more competitive and decrease profit potential for the buyer.

 

The factors leading to supplier power are as follows: -

 

  • Presence of substitutes
  • Higher Switching Costs
  • Number of suppliers dealing in a product
  • Product is a necessity to the consumers.
  • Suppliers Switching Costs Relative to Firm Switching Costs
  • Supplier Concentration to Firm Concentration Ratio

Bargaining Power of Buyers: This means how much pressure a buyer can place on a business. It is described as the market of outputs: the ability of customers to put the firm under pressure, which also affects the customer's sensitivity to price changes. 

 

The more the buyer's concentration, the better is the impact they can create. Buyers increase the level of competition within an industry by bargaining for better services and reduced prices.

 

In order to assess the power of buyer, here are the conditions which you need to look into-

 

  • Concentration of buyers
  • Sensitivity of customers
  • Volume of transactions
  • Degree of Dependency upon Existing Channels of Distribution
  • Bargaining Leverage, Particularly in Industries with High Fixed Costs
  • Buyer Switching Costs Relative to Firm Switching Costs
  • Buyer Information Availability
  • Ability to Backward Integrate.

Threat of substitutes: Substitute goods are those goods that fulfill the same purpose and can be used in place of one another. For instance, tea & coffee, butter & jam, amongst others. 

 

The threat from a substitute in an industry affects the competitive environment for the firms in that industry and influences the firm’s profitability. 

 

The availability of a substitution threat affects the profitability of an industry because consumers can choose to purchase the substitute instead of the industry’s product.

 

The existence of products outside of the realm of the common product boundaries increase the propensity of customers to switch to alternatives.

 

The factors to be considered are:

 

  • Buyer's Propensity to Substitute
  • Relative Price Performance of Substitute
  • Buyer Switching Costs
  • Perceived Level of Product-Differentiation
  • Number of Substitutes Available
  • Ease of Substitution
  • Standard Product
  • Quality Depreciation

Competitive Rivalry among the Industry: It refers to the extent one firm exerts pressure on another firm within the industry and restricts each other’s profitability. If the level of competition is intense, competitors may try to eat away the profit and market share from one another.

 

Highly competitive industries generally earn a low return on capital. The factors which should be looked upon are:

 

  • Changing Prices
  • Improving Product Differentiation
  • Using Channels of Distribution
  • Exploiting Relationships with Suppliers

The intensity of rivalry is influenced by the following industry characteristics:

 

1. A larger number of firms increases rivalry because more firms must compete for the same customers and resources. The rivalry intensifies if the firms have similar market share, leading to a struggle for market leadership.

 

2. Slow market growth causes firms to fight for market share. In a growing market, firms are able to improve revenues simply because of the expanding market.

 

3. High fixed costs result in an economy of scale effect that increases rivalry. When total costs are mostly fixed costs, the firm must produce near capacity to attain the lowest unit costs. Since the firm must sell this large quantity of product, high levels of production lead to a fight for market share and result in increased rivalry.

 

4. High storage costs or highly perishable products cause a producer to sell goods as soon as possible. If other producers are attempting to unload at the same time, competition for customers intensifies.

 

5. Low switching costs increase rivalry. When a customer can freely switch from one product to another, there is a greater struggle to capture customers.

 

6. Low levels of product differentiation are associated with higher levels of rivalry. Brand identification, on the other hand, tends to constrain rivalry.

 

7. Strategic stakes are high when a firm is losing its market position or has potential for great gains. This intensified rivalry.

 

8. High exit barriers place a high cost on abandoning the product. The firm must compete. High exit barriers cause a firm to remain in an industry, even when the venture is not profitable. Competitive Rivalry among the Industry is an external factor, and the rest of Porter's forces are internal factors.

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