Industry Analysis — the middle layer of fundamental analysis

Where this chapter sits

Fundamental analysis works from the outside in. Economic analysis tells you whether the economy in general is likely to grow or decline. Industry analysis tells you how each industry would be impacted under those economic conditions. Company analysis comes after.

Industry analysis also asks a second question that economics cannot answer: how will the various players connected to this industry — competitors, customers, suppliers, regulators — react, and how will that reaction change the industry's prospects?

Three words the exam deliberately confuses

The workbook admits these three are "a source of confusion due to their lose usage". Learn them as written:

So banking is an industry; financial services is a business sector; services is an economic sector. Widest of the three is the economic sector.

The seven questions industry analysis must answer

The workbook lists them, and they are the skeleton of the whole chapter:

1. What is the industry in which the company operates?
2. How much does it get impacted by cyclical trends in the economy?
3. What is the potential industry size?
4. How has the industry performed in the past, and what drove that performance?
5. What is the level of competition, and how does it affect the pricing power of the players?
6. What secular trends affect the industry, and are they causing value migration?
7. Are there regulatory headwinds or tailwinds?

Step one: define the industry — and it is not easy

The first step is to define the industry. Standard classification systems exist — National Industry Classification (NIC) in India, the Global Industry Classification Standard (GICS), and the North American Industry Classification System (NAICS) in the US — but the workbook's warning is blunt: they "may not necessarily capture the substance of the industry."

NIC, for example, has a single classification for manufacture of passenger cars. An entry-level compact car maker and a luxury car maker sit in the same box, even though their dynamics are completely different. An analyst may reasonably treat them as two industries.

The problem gets worse when a company competes in several industries at once. The workbook's example is PVR Limited. PVR Cinemas competes with satellite channels and Over the Top (OTT) platforms such as Netflix and Hotstar for audience. It also competes with live theatre, live performances and sporting leagues.

• Define it narrowly as "cinema exhibitors" and you overlook real competitors.
• Define it broadly and you must choose between entertainment media and Out of Home (OOH) entertainment.
• Go broader still — "media and entertainment" — and each segment inside has its own idiosyncrasies and is not strictly comparable.

That matters enormously later, because peer selection drives financial comparison and valuation.

Camera manufacturing makes the same point. Two decades ago cameras were a standalone product. Mobile phones with built-in cameras killed entry-level digital cameras, and high-end phones are now eating mid-tier cameras too. Treat cameras as a standalone industry and you simply do not see the competition.

The workbook's rule: classify a company into the industry group that shares its common driving factors. If PVR's business is driven by people's propensity to spend time outside the home, it belongs to out-of-home entertainment. If it is driven by people's propensity to consume movie content, it belongs to entertainment media.

GICS, widely used by global investors, is a four-tiered hierarchical system: Sectors, Industry Groups, Industries and Sub-Industries — 11 sectors, 25 industry groups, 74 industries and 163 sub-industries (source: MSCI, March 2023).

Industry cyclicality — three buckets

Economic cycles affect all businesses, but not equally.

Market sizing and trend analysis

Underpenetrated industries have headroom — high growth potential. As industries mature, new growth avenues decline and growth rates come down. So you must study both the current size and the potential size of the market.

Both are hard. Current size is difficult to measure when there are many unorganised players or private companies whose data is not public. Potential size requires assumptions, which can go wrong. Studying past trends supplements the analysis, shows what drove growth, and reveals the underlying secular trends.

Two approaches, and the exam will ask you to tell them apart:

• Top-down: start from macro-economic factors and work down to the industry. For a particular therapy — (i) how many patients underwent the therapy, (ii) average expenditure per patient, (iii) multiply the two to get revenue.
• Bottom-up: look at individual companies and aggregate their data. Take the revenue of all hospitals providing the therapy, find what proportion of each one's revenue came from it, and add up.

Secular trends — five drivers

Secular trends are long-term trends that cause displacement in production or consumption of goods and services.

1. Technological advancement. Horizontal drilling enabled shale gas exploration, which caused a significant decline in the long-term average price of hydrocarbons. Digital cameras made film rolls obsolete; mobile cameras made entry-level digital cameras obsolete. Better batteries are pushing electric vehicles ahead of fossil-fuel vehicles.
2. Change in income levels. As disposable income rises, people move from cheaper alternatives to premium products.
3. Demographic changes. Age, gender and ethnicity composition shifts consumption. Ageing Japan has seen per-capita beer consumption fall.
4. Change in culture, tastes and preferences. Usually gradual, sometimes sudden — driven by revolution, insurgency or a societal response to a pandemic. Western influence in Asian societies raised demand for western clothing.
5. Changes in regulation or government policy. GST created efficiencies in the logistics industry, which in turn reduced demand for new commercial vehicles.

When a secular trend emerges it causes value migration, and often creates an inflection point in the business cycle of the affected industries.

Value migration — four directions

Value migration happens when a phenomenon creates a long-term advantage for one or more entities at the cost of others. The gainer's shareholder value rises; the loser's falls. The winner is typically whoever adopts the new technology, captures the changing customer need, or creates a disruptive innovation.

Note the workbook's own qualifier: migration between competitors within the same industry happens to a lesser extent than the other three.

The business life cycle — five stages

1. Pioneering — the industry is just taking shape; the concept is still being proven or has just been proven; adoption is not widespread.
2. Growth — the concept is found viable, customers adopt in numbers, the industry grows steeply.
3. Matured — most customers who can use the product already do; few new potential customers remain.
4. Declining — changed preference or new technology replaces the product; the industry loses out to alternatives.
5. Reinvention and revival — very rare: the goods or services find a new use in a different application and a new cycle begins.

The Indian example is call taxis. They took shape at the end of the 20th and start of the 21st century, grew tremendously on rising telephone penetration and consumer income, then declined sharply once app-based taxi aggregators arrived.

Every industry going through this cycle causes displacement in the economy — the workforce must reskill or leave, and capacity must be redirected to a different use.

One nuance worth marking: not every secular trend follows a life cycle. Shale gas brought a long-term decline in crude prices without displacing the goods being consumed. Secular trends tell you the long-term trajectory; cyclical trends tell you the medium and short term.

Understanding the industry landscape

Industry landscaping means studying all the players and their interaction — competitors, customers, suppliers, regulators and emerging technologies — plus the differentiating factors between competitors and what customers prefer.

The pay-off is predicting reaction to external events. Where competition intensity is low, companies can pass an input-cost rise on to customers, so margins stay intact. Where competition intensity is high, pricing pressure builds and profits fall.

Four established frameworks: Porter's Five Force Model, PESTLE analysis, BCG Matrix, SCP analysis.

Porter's Five Forces — get the split exactly right

Developed by Dr. Michael Porter in 1979. Five forces, split into three horizontal and two vertical. Candidates lose marks here, so memorise the split:

Some industry structures make it very hard to earn profits for owners. The workbook names aviation, telecom, retail, textile, sugar and power as sectors where these forces keep profits low — unattractive from the owners' perspective. It names Education, FMCG, Healthcare and IT as enjoying huge margins over long periods because the forces are not so strong — attractive for shareholders.

Two Warren Buffett quotes the workbook uses:

The message: if the economics of the business are bad, great management will not rescue it — move your money to a different industry.

1. Industry rivalry

High rivalry means lower pricing power and lower incomes for participants. Innovation and customer engagement become essential. A strong competitor with deep pockets can dump products below cost to drive others out, and not everyone can sustain losses for long.

Rivalry is high if:

1. Many companies exist in the segment
2. Similar products or services with little or no differentiation
3. Everyone chases customers with the same strategies — lower prices or longer credit
4. Switching cost for customers is low or nil

Indian telecom is the standing example: many players per circle, a high pre-paid component in revenue, and price-sensitive subscribers who migrate the moment a rival cuts prices. Charlie Munger: "If only basis of competition in an industry is pricing, it is a self-defeating business."

How does a company still deliver returns in such an industry? Internally — efficient operations, less working capital, faster turnaround, cheaper capital. Externally — differentiated products, strong brands, unique positioning. Micromax captured a 10% market share in just three years of launch by offering special features at competitive prices.

2. Threat of substitutes

Telegram vanished when SMS arrived. Cement pipes lost out to steel and plastic pipes. Typewriters were totally substituted by computers. iPods and mobiles finished off radios and two-in-ones. The famous case is Kodak — its own engineers invented the first digital camera, but the company would not move to it in order to protect the existing business, did not see the threat, and eventually filed for bankruptcy.

Threat of substitutes is high if:

1. Substitutes offer equal or better experience — quality, price, ease
2. Switching cost is low or nil

Some industries have no threat of substitutes at all — the workbook names power, healthcare and education. The mode of delivery may change; the product never goes out of business. And substitution can be slow: solar products and LED lights are cheaper to run but need upfront capex, which deters customers until the technology gets cheaper.

3. Bargaining power of buyers

Buyers dictate prices when there are many sellers with similar products. They matter far less when there are few sellers. It is a function of the number of buyers and sellers and the differentiation between products. The size and profile of the buyer matters too — the government as a buyer has real power.

Buyers' power is high if:

1. Competitive intensity in the industry is strong (continuous pricing pressure on participants)
2. Products or services are standardised with little or no differentiation
3. Close substitutes exist and switching cost is low or nil

4. Bargaining power of suppliers

You never bargain over hospital or school fees; you always bargain with the vegetable vendor. In the first case suppliers' bargaining power is absolute; in the second it is nil — unless he is the only vendor and the nearest substitute is far away.

The sugar industry depends on a cane price decided by the government after considering the views of the farmers — suppliers have strong bargaining power. Crude oil supply is virtually controlled by a few members of OPEC through output adjustment: OPEC has pricing power on oil.

Suppliers' power is high if:

1. The number of suppliers is limited and buyers are many
2. Suppliers supply critical inputs
3. Competitive intensity in the industry is low, with differentiation in products and services
4. The products or services do not have a threat of substitutes
5. Switching cost for the customers is high

Read points 3, 4 and 5 twice. They are the opposite of what most candidates guess, and the exam knows it.

5. Barriers to entry (threat of new entrants)

An industry that does not face the threat of new competitors is attractive for investors and owners. Barriers include licensing, required competence or skills (IT products), capital (oil and gas), distribution reach (banking and finance), and brand loyalty with existing participants (toothpaste, coffee).

This is Buffett's moat: "In business, I look for economic castles protected by unbreachable moats." Such businesses have pricing power — they can sell at a premium without fear of losing customers.

Entry barriers are high if:

1. Lots of licensing is required
2. Patents and copyrights prevent new entrants
3. Huge investments in specialised assets pose a challenge
4. Strong brands, strong distribution network, specialised execution capabilities and customer loyalty exist with the incumbents

The five features of an attractive industry

Memorise this list — it is the summary of the whole model:

1. Low competition
2. High barriers to entry
3. Weak suppliers' bargaining power
4. Weak buyers' bargaining power
5. Few substitutes

Such an industry has strong pricing power and high profit margins, and attracts investors.

The workbook works Education in India through all five: ample and increasing demand with very little bargaining power for students (weak buyers); largely protected from recession; multiple permissions needed to start an institute (high entry barriers); few quality institutions (low competition); teaching staff hired at salaries decided by management (weak suppliers); competing courses exist but do not inspire student confidence (few substitutes).

PESTLE analysis

Political, Economic, Socio-cultural, Technological, Legal, Environmental. Some models extend it with Ethics and Demographics, making the acronym STEEPLED.

Note the perspective the workbook specifies: PESTLE is done more from the point of view of a business looking to set up a unit offshore and analysing several countries to choose from. It analyses the external environmental factors that influence a business.

The closing caution: not all these factors affect all companies equally. Evaluating the impact and criticality of each factor for the particular business is itself a step.

BCG matrix

Developed by the Boston Consulting Group, this one is different in kind: it looks at different segments of a business unit on a portfolio basis, through the lenses of market growth and cash generation.

Navneet is the textbook cash cow: a predictable, steady-growing industry, strong brand, penetrated distribution, ready market and strong balance sheet — all it must do is change the content when a syllabus changes.

SCP analysis

Structure, Conduct, Performance. The workbook calls it an extension of Porter's model, where structure and conduct were "probably" already captured, but SCP adds the financial dimension.

• Structure — competitive intensity (number of players), concentration, relationship among players, market size, growth rate, organised vs unorganised split, threats from substitutes, supplier–buyer equations, existing or possible backward/forward integration. This overlaps with Porter's Five Forces and SWOT. Structures include monopoly and oligopoly.
• Conduct — how the structure makes businesses behave on pricing and product innovation. Is the business cyclical, and if so driven by commodity prices, interest rates, currency or global factors? Is it specialised and skilled-labour dependent or low-skill? Is there enough talent? How do customers choose? How will technology change it? Is it heavily dependent on government policy? Umbrellas and raincoats are seasonal; FMCG and pharma are round-the-year. High interest rates deter purchases of real estate and four-wheelers, but two-wheelers are less affected. Mining is commoditised; FMCG and white goods sell on brand.
• Performance — the financials thrown off. Businesses with high return on capital or equity create wealth for owners in the long run. The metrics named are RoE, RoIC and WACC, covered in detail in the quantitative analysis unit.

Key industry drivers and industry KPIs

The KPI varies from industry to industry, and a metric suitable for one may be useless for another. Revenue per employee is very useful for a BPO — a labour-driven industry billing on head count — and far less valuable for capital-intensive manufacturing.

Where do KPIs come from? Most often, the companies themselves guide analysts. Reading annual reports and the Management Discussion and Analysis shows what industry players consider their KPIs. Beyond that, two guides:

(i) Unit of pricing — what the company treats as a unit when pricing. Simple in manufacturing (number of goods sold), tricky in services. For a café like Starbucks it looks like the quantity of beverage sold, but in substance pricing is driven by how much they expect to earn from one patron.

(ii) Key constraining factors — which may vary within an industry and change over time. Three categories: demand-side, supply-side and regulatory. Match the KPI to the constraint: a limited market size means watch the penetration rate; a capacity constraint means watch the capacity utilisation rate; a regulatory constraint means track the metrics the regulator follows.

KPIs sector by sector — the table to learn

Media earns from two sources — payments by users and advertisement revenue — and the majority comes from advertisement. Because airtime and page space are physically limited, media growth depends on attracting a larger audience so higher rates can be charged, which in turn depends on acquiring good content at a reasonable price.

Regulatory environment

"Industry analysis cannot be complete without adequate knowledge of the rules of the game. Even small changes in regulatory framework can have big impact on the businesses."

The workbook's examples: the long debate on FDI in multi-brand retail (how much back-end infrastructure, what counts as back-end, whether existing set-ups may be bought out, minimum purchases from Indian vendors); environment policy changes closing mines; cancellation of telecom licences; and the latest amendments to the Companies Act changing the landscape for doing business in India.

Taxation

Taxes raise revenue, but governments also use them to encourage or discourage particular businesses. Kerala introduced a fat tax in 2017 — an additional 14.5% on junk foods — specifically to discourage that industry. Similarly, India's GST slabs keep many essentials at nil or low rates while luxury products carry much higher rates.

Direct tax: the incidence and the liability are on the same person — whoever must bear the tax is also obliged to pay it to the government. Income tax is the common example.

Tax law also nudges behaviour. In India, to promote research and development, companies may claim an expense of 1.5 times the actual expenditure on certain scientific research. To discourage delay in paying interest owed to scheduled commercial banks, that interest is deductible only if it is actually paid. Such adjustments create a gap between book profit and taxable profit, shown as a Deferred Tax Asset (paying more tax today, less later) or Deferred Tax Liability (paying less today, more later).

Corporate income tax in India has four components:

Indirect tax: the person bearing the tax differs from the person liable to collect it and pay it over. GST is levied on the seller, who collects it from the customer and deposits it — so the end consumer bears it.

Other taxes and who they hit:

• Road tax — paid by purchasers of new automobiles, a lifetime tax paid upfront. It raises the acquisition cost of vehicles, hurting auto sales and, downstream, auto-ancillaries and general insurers writing motor policies.
• Stamp duty — payable whenever a document must be registered, usually on purchase or sale of an asset. Being upfront, it raises the buyer's cost of acquisition or reduces the seller's realisable value. It affects real estate, and investment management firms including stock broking firms and asset management companies.
• Securities Transaction Tax (STT) — paid at the time of sale of securities. Because it reduces the realisable value, it discourages short-term trading, affecting stock traders and in turn stock broking firms.

Sources of information for industry analysis

• Industry reports from various sources — industry journals and media reports
• Annual Reports of companies in the industry, especially the Management Discussion and Analysis section
• Associations / trade bodies publications
• Relevant ministry website / publications