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CHAPTER 9

INTRODUCTION TO INDUSTRY AND COMPANY ANALYSIS

Patrick W. Dorsey, CFA

Chicago, IL, U.S.A.

Anthony M. Fiore, CFA

New York City, NY, U.S.A.

Ian Rossa O’Reilly, CFA

Toronto, Canada

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• Explain the uses of industry analysis and the relation of industry analysis to company analysis.
• Compare and contrast the methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system.
• Explain the factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descriptors such as “growth,” “defensive,” and “cyclical.”
• Explain the relation of “peer group,” as used in equity valuation, to a company’s industry classification.
• Discuss the elements that need to be covered in a thorough industry analysis.
• Illustrate demographic, governmental, social, and technological influences on industry growth, profitability, and risk.
• Describe product and industry life-cycle models, classify an industry as to life-cycle phase (e.g., embryonic, growth, shakeout, maturity, or decline) based on a description of it, and discuss the limitations of the life-cycle concept in forecasting industry performance.
• Explain the effects of industry concentration, ease of entry, and capacity on return on invested capital and pricing power.
• Discuss the principles of strategic analysis of an industry.
• Compare and contrast the characteristics of representative industries from the various economic sectors.
• Describe the elements that should be covered in a thorough company analysis.

1. INTRODUCTION

Industry analysis is the analysis of a specific branch of manufacturing, service, or trade. Understanding the industry in which a company operates provides an essential framework for the analysis of the individual company—that is, company analysis. Equity analysis and credit analysis are often conducted by analysts who concentrate on one or several industries, which results in synergies and efficiencies in gathering and interpreting information.

Among the questions we address in this chapter are the following:

• What are the similarities and differences among industry classification systems?
• How does an analyst go about choosing a peer group of companies?
• What are the key factors to consider when analyzing an industry?
• What advantages are enjoyed by companies in strategically well-positioned industries?

After discussing the uses of industry analysis in the next section, Sections 3 and 4 discuss, respectively, approaches to identifying similar companies and industry classification systems. Section 5 covers the description and analysis of industries. Also, Section 5, which includes an introduction to competitive analysis, provides a background to Section 6, which introduces company analysis. Section 7 contains conclusions and a summary. Practice problems follow the text.

2. USES OF INDUSTRY ANALYSIS

Industry analysis is useful in a number of investment applications that make use of fundamental analysis. Its uses include the following:

• Understanding a company’s business and business environment. Industry analysis is often a critical early step in stock selection and valuation because it provides insights into the issuer’s growth opportunities, competitive dynamics, and business risks. For a credit analyst, industry analysis provides insights into the appropriateness of a company’s use of debt financing and into its ability to meet its promised payments during economic contractions.
• Identifying active equity investment opportunities. Investors taking a top-down investing approach use industry analysis to identify industries with positive, neutral, or negative outlooks for profitability and growth. Generally, investors will then overweight, market weight, or underweight those industries (as appropriate to their outlooks) relative to the investor’s benchmark if the investor judges that the industry’s perceived prospects are not fully incorporated in market prices. Apart from security selection, some investors attempt to outperform their benchmarks by industry or sector rotation—that is, timing investments in industries in relation to an analysis of industry fundamentals and/or business-cycle conditions (technical analysis may also play a role in such strategies). Several studies have underscored the importance of industry analysis by suggesting that the industry factor in stock returns is at least as important as the country factor (e.g., Cavaglia, Diermeier, Moroz, and De Zordo, 2004). In addition, industry membership has been found to account for about 20 percent of the variability of a company’s profitability in the United States (McGahan and Porter 1995).
• Portfolio performance attribution. Performance attribution, which addresses the sources of a portfolio’s returns, usually in relation to the portfolio’s benchmark, includes industry or sector selection. Industry classification schemes play a role in such performance attribution.

Later in this chapter we explore the considerations involved in understanding a company’s business and business environment. The next section addresses how companies may be grouped into industries.

3. APPROACHES TO IDENTIFYING SIMILAR COMPANIES

Industry classification attempts to place companies into groups on the basis of commonalities. In the following sections, we discuss the three major approaches to industry classification:

• Products and/or services supplied.
• Business-cycle sensitivities.
• Statistical similarities.

3.1. Products and/or Services Supplied

Modern classification schemes are most commonly based on grouping companies by similar products and/or services. According to this perspective, an industry is defined as a group of companies offering similar products and/or services. For example, major companies in the global heavy truck industry include Volvo, Daimler AG, Paccar, and Navistar, all of which make large commercial vehicles for the on-highway truck market. Similarly, some of the large players in the global automobile industry are Toyota, General Motors, Volkswagen, Ford, Honda, Nissan, PSA Peugeot Citroën, and Hyundai, all of which produce light vehicles that are close substitutes for one another.

Industry classification schemes typically provide multiple levels of aggregation. The term sector is often used to refer to a group of related industries. The health care sector, for example, consists of a number of related industries, including the pharmaceutical, biotechnology, medical device, medical supply, hospital, and managed care industries.

These classification schemes typically place a company in an industry on the basis of a determination of its principal business activity. A company’s principal business activity is the source from which the company derives a majority of its revenues and/or earnings. For example, companies that derive a majority of their revenues from the sale of pharmaceuticals include Novartis AG, Pfizer Inc., Roche Holding AG, GlaxoSmithKline, and Sanofi-aventis S.A., all of which could be grouped together as part of the global pharmaceutical industry. Companies that engage in more than one significant business activity usually report the revenues (and, in many cases, operating profits) of the different business segments in their financial statements.1

Examples of classification systems based on products and/or services include the commercial classification systems that will be discussed later, namely, the Global Industry Classification Standard (GICS), Russell Global Sectors (RGS), and Industry Classification Benchmark. In addition to grouping companies by product and/or service, some of the major classification systems, including GICS and RGS, group consumer-related companies into cyclical and noncyclical categories depending on the company’s sensitivity to the business cycle. The next section addresses how companies can be categorized on the basis of economic sensitivity.

3.2. Business-Cycle Sensitivities

Companies are sometimes grouped on the basis of their relative sensitivity to the business cycle. This method often results in two broad groupings of companies—cyclical and noncyclical.

A cyclical company is one whose profits are strongly correlated with the strength of the overall economy. Such companies experience wider-than-average fluctuations in demand—high demand during periods of economic expansion and low demand during periods of economic contraction—and/or are subject to greater-than-average profit variability related to high operating leverage (i.e., high fixed costs). Concerning demand, cyclical products and services are often relatively expensive and/or represent purchases that can be delayed if necessary (e.g., because of declining disposable income). Examples of cyclical industries are autos, housing, basic materials, industrials, and technology. A noncyclical company is one whose performance is largely independent of the business cycle. Noncyclical companies produce goods or services for which demand remains relatively stable throughout the business cycle. Examples of noncyclical industries are food and beverage, household and personal care products, health care, and utilities.

Although the classification systems we will discuss do not label their categories as cyclical or noncyclical, certain sectors tend to experience greater economic sensitivity than others. Sectors that tend to exhibit a relatively high degree of economic sensitivity include consumer discretionary, energy, financials, industrials, technology, and materials. In contrast, sectors that exhibit relatively less economic sensitivity include consumer staples, health care, telecommunications, and utilities.

One limitation of the cyclical/noncyclical classification is that business-cycle sensitivity is a continuous spectrum rather than an “either/or” issue, so placement of companies in one of the two major groups is somewhat arbitrary. The impact of severe recessions usually reaches all parts of the economy, so noncyclical is better understood as a relative term.

Another limitation of a business-cycle classification for global investing is that different countries and regions of the world frequently progress through the various stages of the business cycle at different times. While one region of the world may be experiencing economic expansion, other regions or countries may be in recession, which complicates the application of a business-cycle approach to industry analysis. For example, a jewelry retailer (i.e., a cyclical company) that is selling domestically into a weak economy will exhibit markedly different fundamental performance relative to a jewelry company operating in an environment where demand is robust. Comparing these two companies—that is, similar companies that are currently exposed to different demand environments—could suggest investment opportunities. Combining fundamental data from such companies, however, to establish industry benchmark values would be misleading.

3.3. Statistical Similarities

Statistical approaches to grouping companies are typically based on the correlations of past securities’ returns. For example, using the technique known as cluster analysis, companies are separated (on the basis of historical correlations of stock returns) into groups in which correlations are relatively high but between which correlations are relatively low. This method of aggregation often results in nonintuitive groups of companies, and the composition of the groups may vary significantly by time period and region of the world. Moreover, statistical approaches rely on historical data, but analysts have no guarantee that past correlation values will continue in the future. In addition, such approaches carry the inherent dangers of all statistical methods, namely, (1) falsely indicating a relationship that arose because of chance or (2) falsely excluding a relationship that actually is significant.

4. INDUSTRY CLASSIFICATION SYSTEMS

A well-designed classification system often serves as a useful starting point for industry analysis. It allows analysts to compare industry trends and relative valuations among companies in a group. Classification systems that take a global perspective enable portfolio managers and research analysts to make global comparisons of companies in the same industry. For example, given the global nature of the automobile industry, a thorough analysis of the industry would include auto companies from many different countries and regions of the world.

4.1. Commercial Industry Classification Systems

Major index providers, including Standard & Poor’s, MSCI Barra, Russell Investments, Dow Jones, and FTSE, classify companies in their equity indices into industry groupings. Most classification schemes used by these index providers contain multiple levels of classification that start at the broadest level with a general sector grouping, then, in several further steps, subdivide or disaggregate the sectors into more “granular” (i.e., more narrowly defined) subindustry groups.

4.1.1. Global Industry Classification Standard

GICS was jointly developed by Standard & Poor’s and MSCI Barra, two of the largest providers of global equity indices, in 1999. As the name implies, GICS was designed to facilitate global comparisons of industries, and it classifies companies in both developed and developing economies. Each company is assigned to a subindustry according to its principal business activity. Each subindustry belongs to a particular industry; each industry belongs to an industry group; and each group belongs to a sector. In June 2009, the GICS classification structure comprised four levels of detail consisting of 154 subindustries, 68 industries, 24 industry groups, and 10 sectors. The composition of GICS has historically been adjusted over time to reflect changes in the global equity markets.

4.1.2. Russell Global Sectors

The RGS classification system uses a three-tier structure to classify companies globally on the basis of the products or services a company produces. In June 2009, the RGS classification system consisted of 9 sectors, 32 subsectors, and 141 industries. Besides the number of tiers, another difference between the RGS and GICS classification systems is that the RGS system contains 9 sectors, whereas GICS consists of 10. For example, the RGS system does not provide a separate sector for telecommunication service companies. Many companies that GICS classifies as “Telecommunication Services,” including China Mobile Ltd., AT&T, and Telefonica, are assigned by RGS to its more broadly defined “Utilities” sector.

4.1.3. Industry Classification Benchmark

The Industry Classification Benchmark (ICB), which was jointly developed by Dow Jones and FTSE, uses a four-tier structure to categorize companies globally on the basis of the source from which a company derives the majority of its revenue. In June 2009, the ICB classification system consisted of 10 industries, 19 supersectors, 41 sectors, and 114 subsectors. Although the ICB is similar to GICS in the number of tiers and the method by which companies are assigned to particular groups, the two systems use significantly different nomenclature. For example, whereas GICS uses the term “sector” to describe its broadest grouping of companies, ICB uses the term “industry.” Another difference between the two systems is that ICB distinguishes between consumer goods and consumer services companies, whereas both GICS and the RGS systems group consumer products companies and consumer services companies together into sectors on the basis of economic sensitivity. These stylistic distinctions tend to be less obvious at the more granular levels of the different hierarchies.

Despite these subtle differences, the three commercial classification systems use common methodologies for assigning companies to groups. Also, the broadest level of grouping for all three systems is quite similar. Specifically, GICS, the RGS, and the ICB each identify 9 or 10 broad groupings below which all other categories reside. Next, we describe sectors that are fairly representative of how the broadest level of industry classification is viewed by GICS, RGS, and ICB.

4.1.4. Description of Representative Sectors

To classify a company accurately in a particular classification scheme requires definitions of the classification categories, a statement about the criteria used in classification, and detailed information about the subject company. Example 9-2 introduces an exercise in such classification. In addressing the question, the reader can make use of the widely applicable sector descriptions just given and familiarity with available business products and services.

Example 9-3 reviews some major concepts in industry classification.

4.2. Governmental Industry Classification Systems

A number of classification systems in use by various governmental agencies today organize statistical data according to type of industrial or economic activity. A common goal of each government classification system is to facilitate the comparison of data—both over time and among countries that use the same system. Continuity of the data is critical to the measurement and evaluation of economic performance over time.

4.2.1. International Standard Industrial Classification of All Economic Activities

The International Standard Industrial Classification of All Economic Activities (ISIC) was adopted by the United Nations in 1948 to address the need for international comparability of economic statistics. ISIC classifies entities into various categories on the basis of the principal type of economic activity the entity performs. ISIC is organized into 11 categories, 21 sections, 88 divisions, 233 groups, and more than 400 classes. According to the United Nations, a majority of the countries around the world have either used ISIC as their national activity classification system or have developed national classifications derived from ISIC. Some of the organizations currently using the ISIC are the UN and its specialized agencies, the International Monetary Fund, the World Bank, and other international bodies.

4.2.2. Statistical Classification of Economic Activities in the European Community

Often regarded as the European version of ISIC, Statistical Classification of Economic Activities in the European Community (NACE) is the classification of economic activities that correspond to ISIC at the European level. Similar to ISIC, NACE classification is organized according to economic activity. NACE is composed of four levels—namely, sections (identified by alphabetical letters A through U), divisions (identified by two-digit numerical codes 01 through 99), groups (identified by three-digit numerical codes 01.1 through 99.0), and classes (identified by four-digit numerical codes 01.11 through 99.00).

4.2.3. Australian and New Zealand Standard Industrial Classification

The Australian and New Zealand Standard Industrial Classification (ANZSIC) was jointly developed by the Australian Bureau of Statistics and Statistics New Zealand in 1993 to facilitate the comparison of industry statistics of the two countries and comparisons with the rest of the world. International comparability was achieved by aligning ANZSIC with the international standards used by ISIC. ANZSIC has a structure comprising five levels—namely, divisions (the broadest level), subdivisions, groups, classes, and at the most granular level, subclasses (New Zealand only).

4.2.4. North American Industry Classification System

Jointly developed by the United States, Canada, and Mexico, the North American Industry Classification System (NAICS) replaced the Standard Industrial Classification (SIC) system in 1997. NAICS distinguishes between establishments and enterprises. NAICS classifies establishments into industries according to the primary business activity of the establishment. In the NAICS system, an establishment is defined as “a single physical location where business is conducted or where services or industrial operations are performed” (e.g., factory, store, hotel, movie theater, farm, office). An enterprise may consist of more than one location performing the same or different types of economic activities. Each establishment of that enterprise is assigned a NAICS code on the basis of its own primary business activity.4

NAICS uses a two-digit through six-digit code to structure its categories into five levels of detail. The greater the number of digits in the code, the more narrowly defined the category. The five levels of categories, from broadest to narrowest, are sector (signified by the first two digits of the code), subsector (third digit of the code), industry group (fourth digit), NAICS industry (fifth digit), and national industry (sixth digit). The five-digit code is the level of greatest amount of comparability among countries; a six-digit code provides for more country-specific detail.

Although differences exist, the structures of ISIC, NACE, ANZSIC, and NAICS are similar enough that many of the categories from each of the different classification systems are compatible with one another. The U.S. Census Bureau has published tables showing how the various categories of the classification systems relate to one another.5

4.3. Strengths and Weaknesses of Current Systems

Unlike commercial classification systems, most government systems do not disclose information about a specific business or company, so an analyst cannot know all of the constituents of a particular category. For example, in the United States, federal law prohibits the Census Bureau from disclosing individual company activities, so their NAICS and SIC codes are unknown.

Most government and commercial classification systems are reviewed and, if necessary, updated from time to time. Generally, commercial classification systems are adjusted more frequently than government classification systems, which may be updated only every five years or so. NAICS, for example, is reviewed for potential revisions every five years.

Government classification systems generally do not distinguish between small and large businesses, between for-profit and not-for-profit organizations, or between public and private companies. Many commercial classification systems have the ability to distinguish between large and small companies by virtue of association with a particular equity index, and these systems include only for-profit and publicly traded organizations.

Another limitation of current systems is that the narrowest classification unit assigned to a company generally cannot be assumed to be its peer group for the purposes of detailed fundamental comparisons or valuation. A peer group is a group of companies engaged in similar business activities whose economics and valuation are influenced by closely related factors. Comparisons of a company in relation to a well-defined peer group can provide valuable insights into the company’s performance and its relative valuation.

4.4. Constructing a Peer Group

The construction of a peer group is a subjective process; the result often differs significantly from even the most narrowly defined categories given by the commercial classification systems. However, commercial classification systems do provide a starting point for the construction of a relevant peer group because, by using such systems, an analyst can quickly discover the public companies operating in the chosen industry.

In fact, one approach to constructing a peer group is to start by identifying other companies operating in the same industry. Analysts who subscribe to one or more of the commercial classification systems that were discussed in Section 4.1 can quickly generate a list of other companies in the industry in which the company operates according to that particular service provider’s definition of the industry. An analyst can then investigate the business activities of these companies and make adjustments as necessary to ensure that the businesses truly are comparable. The following lists of suggested steps and questions are given as practical aids to analysts in identifying peer companies.

Steps in constructing a preliminary list of peer companies:

• Examine commercial classification systems, if available to the analyst. These systems often provide a useful starting point for identifying companies operating in the same industry.
• Review the subject company’s annual report for a discussion of the competitive environment. Companies frequently cite specific competitors.
• Review competitors’ annual reports to identify other potential comparable companies.
• Review industry trade publications to identify comparable companies.
• Confirm that each comparable company derives a significant portion of its revenue and operating profit from a business activity similar to the primary business of the subject company.

Questions that may improve the list of peer companies:

• What proportion of revenue and operating profit is derived from business activities similar to those of the subject company? In general, a higher percentage results in a more meaningful comparison.
• Does a potential peer company face a demand environment similar to that of the subject company? For example, a comparison of growth rates, margins, and valuations may be of limited value when comparing companies that are exposed to different stages of the business cycle. (As mentioned, such differences may be the result of conducting business in geographically different markets.)
• Does a potential company have a finance subsidiary? Some companies operate a finance division to facilitate the sale of their products (e.g., Caterpillar Inc. and John Deere). To make a meaningful comparison of companies, the analyst should make adjustments to the financial statements to lessen the impact that the finance subsidiaries have on the various financial metrics being compared.

Example 9-4 illustrates the process of identifying a peer group of companies and shows some of the practical hurdles to determining a peer group.

Although companies with limited lines of business may neatly be categorized into a single peer group, companies with multiple divisions may be included in more than one category. For example, Belgium-based Anheuser-Busch InBev primarily makes and sells various brands of beer. It can easily be grouped together with other beverage companies (the theme park business constitutes a relatively immaterial part of total revenue). However, U.S.-based Hewlett-Packard Company (HP), a global provider of technology and software solutions, might reasonably be included in more than one category. Investors interested in the personal computer (PC) industry, for example, would probably include HP in their peer group, but investors constructing a peer group of providers of information technology services would probably include HP in that group also.

In summary, analysts must distinguish between a company’s industry—as defined by one or more of the various classification systems—and its peer group. A company’s peer group should consist of companies with similar business activities whose economic activity depends on similar drivers of demand and similar factors related to cost structure and access to financial capital. In practice, these necessities frequently result in a smaller group (even a different group) of companies than the most narrowly defined categories used by the common commercial classification systems. Example 9-5 illustrates various aspects of developing and using peer groups.

The next section addresses fundamental skills in describing and analyzing an industry.

5. DESCRIBING AND ANALYZING AN INDUSTRY

In their work, analysts study statistical relationships between industry trends and a range of economic and business variables. Analysts use economic, industry, and business publications and Internet resources as sources of information. They also seek information from industry associations, from the individual subject companies they are analyzing, and from these companies’ competitors, suppliers, and customers. An analyst with a superior knowledge about an industry’s characteristics, conditions, and trends has a competitive edge in evaluating the investment merits of the companies in the industry.

Analysts attempt to develop practical, reliable industry forecasts by using various approaches to forecasting. They often estimate a range of projections for a variable reflecting various possible scenarios. Analysts may seek to compare their projections with the projections of other analysts, partly to study differences in methodology and conclusions but also to identify differences between their forecasts and consensus forecasts. These latter differences are extremely important for uncovering investment opportunities because, to be the basis for superior investment performance, the forecast for a value-relevant variable must be both correct and sufficiently different from the consensus reflected in the price of publicly traded securities. Note that, although some information on analysts’ revenue projections, EPS estimates, and ratings are accessible in some markets, analysts may have limited access to details about other analysts’ work and assumptions because such details are kept confidential for competitive reasons.

Investment managers and analysts also examine industry performance (1) in relation to other industries to identify industries with superior/inferior returns and (2) to determine the degree of consistency, stability, and risk in the returns in the industry over time. The objective of this analysis is to identify industries that offer the highest potential for investment returns on a risk-adjusted basis. The investment time horizon can be either long or short, as is the case for a rotation strategy in which portfolios are rotated into the industry groups that are expected to benefit from the next stage in the business cycle.

Often, analysts examine strategic groups (groups sharing distinct business models or catering to specific market segments in an industry) almost as separate industries within industries. Criteria for selecting a strategic group might include the complexity of the product or service, its mode of delivery, and “barriers to entry.” For example, charter airlines form a strategic group among “airlines” that is quite distinct from scheduled airlines; full-service hotels form a strategic group that is separate from limited-service or budget hotels; and companies that sell proprietary drugs (which are protected by patents) would be in a separate group from companies that sell generic drugs (which do not have patent protection) partly because the two groups pursue different strategies and use different business models.

Analysts often consider and classify industries according to industry life-cycle stage. The analyst determines whether an industry is in the embryonic, growth, shakeout, mature, or declining stage of the industry life cycle. During the stages of the life cycle of a product or industry, its position on the experience curve is often analyzed. The experience curve shows direct cost per unit of good or service produced or delivered as a typically declining function of cumulative output. The curve declines (1) because as the utilization of capital equipment increases, fixed costs (administration, overhead, advertising, etc.) are spread over a larger number of units of production; (2) because of improvements in labor efficiency and management of facilities; and (3) because of advances in production methods and product design. Examples exist in virtually all industries, but the experience curve is especially important in industries with high fixed overhead costs and/or repetitive production operations, such as electronics and appliance, automobile, and aircraft manufacturing. The industry life cycle is discussed in depth later in this chapter.

Exhibit 9-2 provides a framework designed to help analysts check that they have considered the range of forces that may affect the evolution of an industry. It shows, at the macro level, macroeconomic, demographic, governmental, social, and technological influences affecting the industry. It then depicts how an industry is affected by the forces driving industry competition (threat of new entrants, substitution threats, customer and supplier bargaining forces), the competitive forces in the industry, life-cycle issues, business-cycle considerations, and position of the industry on the experience curve. Exhibit 9-2 summarizes and brings together pictorially topics and concepts discussed in this section.

5.1. Principles of Strategic Analysis

When analyzing an industry, the analyst must recognize that the economic fundamentals can vary markedly among industries. Some industries are highly competitive, with most players struggling to earn adequate returns on capital, whereas other industries have attractive characteristics that allow almost all industry participants to generate healthy profits. Exhibit 9-3 makes this point graphically. It shows the average spread between return on invested capital (ROIC) and the cost of capital for 54 industries from 2006 through 2008.6 Industries earning positive spreads appear to be earning economic profits, in the sense that they are achieving returns on investment above the opportunity cost of funds. This result should create value—that is, should increase the wealth of the investors, who are the providers of capital. In contrast, industries that are realizing negative spreads are destroying value. As can be seen, some industries struggled to generate positive economic returns (i.e., to create value) even during this period of synchronized global growth, while other industries did very well in earning such returns.

Differing competitive environments are often tied to the structural attributes of an industry, which is one reason industry analysis is a vital complement to company analysis. To thoroughly analyze a company itself, the analyst needs to understand the context in which the company operates. Needless to say, industry analysis must be forward looking. Many of the industries in Exhibit 9-3 were very different 10 or 15 years ago and would have been placed differently with respect to value creation; many will look very different 10 or 15 years from now. As analysts examine the competitive structure of an industry, they should always be thinking about what attributes could change in the future.

Analysis of the competitive environment with an emphasis on the implications of the environment for corporate strategy is known as strategic analysis. Michael Porter’s “five forces” framework is the classic starting point for strategic analysis;7 although it was originally aimed more at internal managers of businesses than at external security analysts, the framework is useful to both.8

Porter focused on five determinants of the intensity of competition in an industry:

• The threat of substitute products, which can negatively affect demand if customers choose other ways of satisfying their needs. For example, consumers may trade down from premium beers to discount brands during recessions. Low-priced brands may be close substitutes for premium brands, which, when consumer budgets are constrained, reduces the ability of premium brands to maintain or increase prices.
• The bargaining power of customers, which can affect the intensity of competition by exerting influence on suppliers regarding prices (and possibly other factors such as product quality). For example, auto parts companies generally sell to a small number of auto manufacturers, which allows those customers, the auto manufacturers, to be tough negotiators when it comes to setting prices.
• The bargaining power of suppliers, which may be able to raise prices or restrict the supply of key inputs to a company. For example, workers at a heavily unionized company may have greater bargaining power as suppliers of labor than workers at a comparable nonunionized company. Suppliers of scarce or limited parts or elements often possess significant pricing power.
• The threat of new entrants to the industry, which depends on barriers to entry, or how difficult it would be for new competitors to enter the industry. Industries that are easy to enter will generally be more competitive than industries with high barriers to entry.
• The intensity of rivalry among incumbent companies (i.e., the current companies in the industry), which is a function of the industry’s competitive structure. Industries that are fragmented among many small competitors, have high fixed costs, provide undifferentiated (commodity-like) products, or have high exit barriers usually experience more intense rivalry than industries without these characteristics.

Although all five of these forces merit attention, the fourth and fifth are particularly recommended as a first focus for analysis. The two factors are broadly applicable because all companies have competitors and must worry about new entrants to their industries. Also, in investigating these two forces, the analyst may become familiar in detail with an industry’s incumbents and potential entrants, and all these companies’ relative competitive prospects.

Addressing the following questions should help the analyst evaluate the threat of new entrants and the level of competition in an industry and thereby provide an effective base for describing and analyzing the industry:

• What are the barriers to entry? Is it difficult or easy for a new competitor to challenge incumbents? Relatively high (low) barriers to entry imply that the threat of new entrants is relatively low (high).
• How concentrated is the industry? Do a small number of companies control a relatively large share of the market, or does the industry have many players, each with a small market share?
• What are capacity levels? That is, based on existing investment, how much of the goods or services can be delivered in a given time frame? Does the industry suffer chronic over- or undercapacity, or do supply and demand tend to come into balance reasonably quickly in the industry?
• How stable are market shares? Do companies tend to rapidly gain or lose share, or is the industry stable?
• Where is the industry in its life cycle? Does it have meaningful growth prospects, or is demand stagnant/declining?
• How important is price to the customer’s purchase decision?

The answers to these questions are elements of any thorough industry analysis.

5.1.1. Barriers to Entry

When a company is earning economic profits, the chances that it will be able to sustain them through time are greater, all else being equal, if the industry has high barriers to entry. The ease with which new competitors can challenge incumbents is often an important factor in determining the competitive landscape of an industry. If new competitors can easily enter the industry, the industry is likely to be highly competitive because high returns on invested capital will quickly be competed away by new entrants eager to grab their share of economic profits. As a result, industries with low barriers to entry often have little pricing power because price increases that raise companies’ returns on capital will eventually attract new competitors to the industry.

If incumbents are protected by barriers to entry, the threat of new entrants is lower, and incumbents may enjoy a more benign competitive environment. Often, these barriers to entry can lead to greater pricing power, because potential competitors would find it difficult to enter the industry and undercut incumbents’ prices. Of course, high barriers to entry do not guarantee pricing power, because incumbents may compete fiercely among each other.

A classic example of an industry with low barriers to entry is restaurants. Anyone with a modest amount of capital and some culinary skill can open a restaurant, and popular restaurants quickly attract competition. As a result, the industry is very competitive, and many restaurants fail in their first few years of business.

At the other end of the spectrum of barriers to entry are the global credit card networks such as MasterCard and Visa, both of which often post operating margins greater than 30 percent. Such high profits should attract competition, but the barriers to entry are extremely high. Capital costs are one hurdle; also, building a massive data-processing network would not be cheap. Imagine for a moment that a venture capitalist was willing to fund the construction of a network that would replicate the physical infrastructure of the incumbents. The new card-processing company would have to convince millions of consumers to use the new card and convince thousands of merchants to accept the card. Consumers would not want to use a card that merchants did not accept, and merchants would not want to accept a card that few consumers carried. This problem would be difficult to solve, which is why the barriers to entering this industry are quite high. The barriers help preserve the profitability of the incumbent players.

One way of understanding barriers to entry is simply by thinking about what it would take for new players to compete in an industry. How much money would they need to spend? What kind of intellectual capital would they need to acquire? How easy would it be to attract enough customers to become successful?

Another way to investigate the issue is by looking at historical data. How often have new companies tried to enter the industry? Is a list of industry participants today markedly different from what it was five or ten years ago? These kinds of data can be very helpful because the information is based on the real-world experience of many entrepreneurs and businesses making capital allocation decisions. If an industry has seen a flood of new entrants over the past several years, odds are good that the barriers are low; conversely, if the same ten companies that dominate an industry today dominated it ten years ago, barriers to entry are probably fairly high.

Do not confuse barriers to entry, however, with barriers to success. In some industries, entering may be easy but becoming successful enough to threaten the incumbents might be quite hard. For example, in the United States, starting a mutual fund requires a capital investment of perhaps US$150,000—not much of a barrier to an industry with historically high returns on capital. But once one has started a mutual fund, how does the company gather assets? Financial intermediaries are unlikely to sell a mutual fund with no track record. So, the fund may need to incur operational losses for a few years until it has established a good track record. Even with a track record, the fund will be competing in a crowded marketplace against companies with massive advertising budgets and well-paid salespeople. In this industry, good distribution can be even more valuable than good performance. So, although entering the asset management industry may be relatively easy, succeeding is another thing altogether.

Also, high barriers to entry do not automatically lead to good pricing power and attractive industry economics. Consider the cases of auto making, commercial aircraft manufacturing, and refining industries. Starting up a new company in any of these industries would be tremendously difficult. Aside from the massive capital costs, there would be significant other barriers to entry: A new automaker would need manufacturing expertise and a dealer network; an aircraft manufacturer would need a tremendous amount of intellectual capital; and a refiner would need process expertise and regulatory approvals.

Yet, all of these industries are quite competitive, with limited or nonexistent pricing power, and few industry participants reliably generate returns on capital in excess of their costs of capital. Among the reasons for this seeming paradox of high barriers to entry plus poor pricing power, two stand out.

• First, price is a large component of the customer’s purchase decision when buying from these companies in these industries. In some cases, the reason is that the companies (e.g., refiners) sell a commodity; in other cases, the product is expensive but has easily available substitutes. For example, most airlines choose between purchasing Boeing and Airbus airplanes not on brand but on cost-related considerations: Airlines need to transport people and cargo at the lowest possible cost per mile because the airlines have limited ability to pass along higher costs to customers. That consideration makes price a huge component of their purchase decision. Most airlines purchase whichever plane is the most cost efficient at any point in time. The result is that the Boeing Company and Airbus have limited ability to price their planes at a level that generates good returns on invested capital.9
• Second, these industries all have high barriers to exit, which means they are prone to overcapacity. A refinery or automobile plant cannot be used for anything other than, respectively, refining oil or producing cars, which makes it hard to redeploy the capital elsewhere and exit the industry if conditions become unprofitable. This barrier gives owners of these types of assets a strong incentive to attempt to keep those loss-making plants operating, which, of course, prolongs conditions of overcapacity.

A final consideration when analyzing barriers to entry is that they can change over time. Years ago, a potential new entrant to the semiconductor industry would have needed the capital and expertise to build a “fab” (the industry term for a semiconductor manufacturing plant). Chip fabs are hugely expensive and technologically complex, which deterred potential new entrants. Starting in the mid-1990s, however, the outsourcing of chip making to contract semiconductor manufacturers became feasible, which meant that designers of chips could challenge the manufacturers without the need to build their own plants. As a result, the industry became much more fragmented through the late 1990s and into the first decade of the twenty-first century.

So, in general, high barriers to entry can lead to better pricing and less competitive industry conditions, but important exceptions are worth bearing in mind.

5.1.2. Industry Concentration

Much like industries with barriers to entry, industries that are concentrated among a relatively small number of players often experience relatively less price competition. Again, there are important exceptions, so the reader should not automatically assume that concentrated industries always have pricing power or that fragmented industries do not.

An analysis of industry concentration should start with market share: What percentage of the market does each of the largest players have, and how large are those shares relative to each other and relative to the remainder of the market? Often, the relative market shares of competitors matter as much as their absolute market shares.

For example, the global market for long-haul commercial aircraft is extremely concentrated—only Boeing and Airbus manufacture these types of planes. The two companies have roughly similar market shares, however, and control essentially the entire market. Because neither enjoys a scale advantage relative to its competitor and because any business gained by one is lost by the other, competition tends to be fierce.

This situation contrasts with the market for home improvement products in the United States, which is dominated by Home Depot and Lowe’s. These two companies have 11 percent and 7 percent market share, respectively, which doesn’t sound very large. However, the next largest competitor has only 2 percent of the market, and most market participants are tiny with miniscule market shares. Both Home Depot and Lowe’s have historically posted high returns on invested capital, in part because they could profitably grow by targeting smaller competitors rather than engaging in fierce competition with each other.

Fragmented industries tend to be highly price competitive for several reasons. First, the large number of companies makes coordination difficult because there are too many competitors for each industry member to monitor effectively. Second, each player has such a small piece of the market that even a small gain in market share can make a meaningful difference to its fortunes, which increases the incentive of each company to undercut prices and attempt to steal share. Finally, the large number of players encourages industry members to think of themselves individualistically rather than as members of a larger group, which can lead to fierce competitive behavior.

In concentrated industries, in contrast, each player can relatively easily keep track of what its competitors are doing, which makes tacit coordination much more feasible. Also, leading industry members are large, which means they have more to lose—and proportionately less to gain—by destructive price behavior. Large companies are also more tied to the fortunes of the industry as a whole, making them more likely to consider the long-run effects of a price war on overall industry economics.

As with barriers to entry, the level of industry concentration is a guideline rather than a hard and fast rule when thinking about the level of pricing power in an industry. For example, Exhibit 9-4 shows a rough classification of industries compiled by Morningstar after asking its equity analysts whether industries were characterized by strong or weak pricing power and whether those industries were concentrated or fragmented. Examples of companies in industries are included in parentheses. In the upper right quadrant (“concentrated with weak pricing power”), those industries that are capital intensive and sell commodity-like products are shown in boldface.

EXHIBIT 9-4 Two-Factor Analysis of Industries

Source: Morningstar Equity Research.

Concentrated with Strong Pricing Power	Concentrated with Weak Pricing Power
Soft drinks (Coca-Cola Co., PepsiCo) Orthopedic devices (Zimmer, Smith & Nephew) Laboratory services (Quest Diagnostics, LabCorp) Biotech (Amgen, Genzyme) Pharmaceuticals (Merck & Co., Novartis) Microprocessors (Intel, Advanced Micro Devices) Industrial gases (Praxair, Air Products and Chemicals) Enterprise storage (EMC) Enterprise networking (Cisco Systems) Integrated shippers (UPS, FedEx, DHL International) U.S. railroads (Burlington Northern) U.S. defense (General Dynamics) Heavy construction equipment (Caterpillar, Komatsu) Seaborne iron ore (Vale, Rio Tinto) Confections (Cadbury, Mars/Wrigley) Credit card networks (MasterCard, Visa) Custody and asset administration (BNY Mellon, State Street) Investment banking/mergers and acquisitions (Goldman Sachs, UBS) Futures exchanges (Chicago Mercantile Exchange, Intercontinental Exchange) Canadian banking (RBC Bank, TD Bank) Australian banking Tobacco (Philip Morris, British American Tobacco) Alcoholic beverages (Diageo, Pernod Ricard)	Commercial aircraft (Boeing, Airbus) Automobiles (General Motors, Toyota, Daimler) Memory (DRAM & Flash Product, Samsung, Hynix) Semiconductor equipment (Applied Materials, Tokyo Electron) Generic drugs (Teva Pharmaceutical Industries, Sandoz) Consumer electronics (Sony Electronics, Koninklijke Philips Electronics) PCs (Dell, Acer, Lenovo) Printers/office machines (HP, Lexmark) Refiners (Valero, Marathon Oil) Major integrated oil (BP, ExxonMobil) Equity exchanges (NYSE, Deutsche Börse Group)
Fragmented with Strong Pricing Power	Fragmented with Weak Pricing Power
Asset management (BlackRock, Fidelity) For-profit education (Apollo Group, DeVry University) Analog chips (Texas Instruments, STMicroelectronics) Industrial distribution (Fastenal, W.W. Grainger) Propane distribution (AmeriGas, Ferrellgas) Private banking (Northern Trust, Credit Suisse)	Consumer packaged goods (Procter & Gamble, Unilever) Retail (Wal-Mart, Carrefour Group) Marine transportation (Maersk Line, Frontline) Solar panels Homebuilding Airlines Mining (metals) Chemicals Engineering and construction Metal service centers Commercial printing Restaurants Radio broadcasting Oil services Life insurance Reinsurance Exploration and production (E&P) U.S. banking Specialty finance Property/casualty insurance Household and personal products

The industries in the top right quadrant defy the “concentration is good for pricing” guideline. We discussed the commercial aircraft manufacturing example in the preceding section, but many other industries are dominated by a small number of players yet have difficult competitive environments and limited pricing power.

When we examine these concentrated-yet-competitive industries, a clear theme emerges: Many industries in this quadrant (the boldface ones) are highly capital intensive and sell commodity-like products. As we saw in the discussion of exit barriers, capital-intensive industries can be prone to overcapacity, which mitigates the benefits of industry concentration. Also, if the industry sells a commodity product that is difficult—or impossible—to differentiate, the incentive to compete on price increases because a lower price frequently results in greater market share.10

The computer memory market is a perfect example of a concentrated-yet-competitive industry. Dynamic random access memory (DRAM) is widely used in PCs, and the industry is concentrated, with about three-quarters of global market share held by the top four companies. The industry is also highly capital intensive; a new fab costs upwards of US$3 billion. But one DRAM chip is much like another, and players in this market have a huge economic incentive to capture market share because of the large scale economies involved in running a semiconductor manufacturing plant. As a result, price competition tends to be extremely fierce and industry concentration is essentially a moot point in the face of these other competitive dynamics.

The global soft drink market is also highly concentrated, of course, but capital requirements are relatively low and industry participants sell a differentiated product. Pepsi and Coca-Cola do not own their own bottling facilities, so a drop in market share does not affect them as much as it would a memory-chip maker. Moreover, although memory-chip companies are assured of gaining market share and increasing sales volumes by cutting prices, a sizable proportion of consumers would not switch from Pepsi to Coke (or vice-versa) even if one cost much less than the other.

Generally, industry concentration is a good indicator that an industry has pricing power and rational competition, but other factors may override the importance of concentration. Industry fragmentation is a much stronger signal that the industry is competitive with limited pricing power. Notice how few fragmented industries are in the bottom left quadrant in Exhibit 9-4.

The industry characteristics discussed here are guidelines meant to steer the analyst in a particular direction, not rules that should cause the analyst to ignore other relevant analytical factors.

5.1.3. Industry Capacity

The effect on pricing of industry capacity (the maximum amount of a good or service that can be supplied in a given time period) is clear: Tight, or limited, capacity gives participants more pricing power as demand for the product or service exceeds supply, whereas overcapacity leads to price-cutting and a very competitive environment as excess supply chases demand. An analyst should think about not only current capacity conditions but future changes in capacity levels. How quickly can companies in the industry adjust to fluctuations in demand? How flexible is the industry in bringing supply and demand into balance? What will be the effect of that process on industry pricing power or on industry margins?

Generally, capacity is fixed in the short term and variable in the long term because capacity can be increased—for example, new factories can be built—if time is sufficient. What is considered “sufficient” time—and, therefore, the duration of the short term, in which capacity cannot be increased—may vary dramatically among industries. Sometimes, adding capacity takes years to complete, as in the case of the construction of a “greenfield” (new) manufacturing plant for pharmaceuticals or for paper, which is complex and subject to regulatory requirements (e.g., relating to the plant’s waste). In other situations, capacity may be added or reduced relatively quickly, as is the case with service industries, such as advertising. In cyclical markets, such as commercial paper and paperboard, capacity conditions can change rapidly. Strong demand in the early stages of an economic recovery can result in the addition of supply. Given the long lead times to build manufacturing plants, new supply may reach the market just as demand slows, rapidly changing capacity conditions from tight to loose. Such considerations underscore the importance of forecasting long-term industry demand in evaluating industry investments in capacity.

One of the more dramatic examples of this process in recent years occurred in the market for maritime dry-bulk shipping during the commodity boom of 2003–2008. Rapid industrialization in China—combined with synchronized global economic growth—increased demand for cargo ships that could transport iron ore, coal, grains, and other high-volume/low-value commodities. Given that the supply of cargo ships could not be increased very quickly (because ships take time to build and large commercial shipyards typically have multiyear backlogs), shippers naturally raised prices to take advantage of the tight global cargo capacity. In fact, the price to charter the largest type of dry-bulk vessel—a Capesize-class ship too big to fit through the Panama Canal—increased more than fivefold in only a year, from approximately US$30,000 per day in early 2006 to almost US$160,000 per day by late 2007.

As one would expect, orders for new dry-bulk carriers skyrocketed during this period as the industry scrambled to add shipping capacity to take advantage of seemingly insatiable demand and very favorable pricing. In early 2006, the number of dry-bulk carriers on order from shipyards represented approximately 20 percent of the worldwide fleet. By late 2008, the number of bulk ships on order represented almost 70 percent of the global bulk fleet.11 Of course, the prospect of this additional capacity, combined with a dramatic slump in aggregate global demand for commodities, caused a massive decline in shipping rates. Capesize charter rates plummeted from the US$160,000/day high of late 2007 to a low of under US$10,000 per day just one year later.

In this example, the conditions of tight supply that were driving strong dry-bulk pricing were quite clear, and these high prices drove attractive returns on capital—and share-price performance—for dry-bulk-shipping companies. However, the careful analyst would have looked at future additions to supply in the form of new ships on order and would have forecasted that the tight supply conditions were not sustainable and thus that the pricing power of dry-bulk shippers was short lived. These predictions are, in fact, precisely what occurred.

Note that capacity need not be physical. After Hurricane Katrina caused enormous damage to the southeastern United States in 2005, reinsurance rates quickly spiked as customers sought to increase their financial protection from future hurricanes. However, these high reinsurance rates enticed a flood of fresh capital into the reinsurance market, and a number of new reinsurance companies were founded, which brought rates back down.

Generally, if new capacity is physical—for example, an auto manufacturing plant or a massive cargo ship—it will take longer for new capacity to come on line to meet an increase in demand, resulting in a longer period of tight conditions. Unfortunately, capacity additions frequently overshoot long-run demand, and because physical capital is often hard to redeploy, industries reliant on physical capacity may get stuck in conditions of excess capacity and diminished pricing power for an extended period.

Financial and human capital, in contrast, can be quickly shifted to new uses. In the reinsurance example, for instance, financial capital was quick to enter the reinsurance market and take advantage of tight capacity conditions, but if too much capital had entered the market, some portion of that capital could easily have left to seek higher returns elsewhere. Money can be used for many things, but massive bulk cargo vessels are not useful for much more than transporting heavy goods across oceans.

5.1.4. Market Share Stability

Examining the stability of industry market shares over time is similar to thinking about barriers to entry and the frequency with which new players enter an industry. In fact, barriers to entry and the frequency of new product introductions, together with such factors as product differentiation, all affect market shares. Stable market shares typically indicate less competitive industries; unstable market shares often indicate highly competitive industries that have limited pricing power.

A comparison of two noncommodity markets in the health care sector illustrates this point. Over the past decade, the orthopedic device industry—mainly artificial hips and knees—has been a relatively stable global oligopoly. As Exhibit 9-5 indicates, five companies control about 95 percent of the worldwide market, and the market shares of those companies have changed by only small amounts over the past several years.

EXHIBIT 9-5 Market Share Stability in Global Orthopedic Devices (entries are market share)

Source: Company reports and Morningstar estimates.

In contrast, although the U.S. market for stents—small metal mesh devices used to prop open blocked arteries—is also controlled by a handful of companies, market shares recently have gone from being very stable to being marked by rapid change. Johnson & Johnson, which together with Boston Scientific, dominated the U.S. stent market for many years, went from having about half the market in 2007 to having only 15 percent in early 2009; over the same period, Abbott Laboratories increased its market share from zero to 25 percent. The reason for this change was the launch of new stents by Abbott and Medtronic, which took market share from Johnson & Johnson and Boston Scientific’s established stents.

Orthopedic device companies have experienced more stability in their market shares for two reasons. First, artificial hips and knees are complicated to implant, and each manufacturer’s products are slightly different. As a result, orthopedic surgeons become proficient at using one or several companies’ devices and may be reluctant to incur the time and cost of learning how to implant products from a competing company. The second reason is the relatively slow pace of innovation in the orthopedic device industry, which tends to be evolutionary rather than revolutionary, making the benefit of switching among product lines relatively low. In addition, the number of orthopedic device companies has remained fairly static over many years.

In contrast, the U.S. stent market has experienced rapid shifts in market shares because of several factors. First, interventional cardiologists seem to be more open than orthopedic surgeons to implanting stents from different manufacturers; that tendency may reflect lower switching costs for stents relative to orthopedic devices. More importantly, however, the pace of innovation in the stent market has become quite rapid, giving cardiologists added incentive to switch to newer stents, with potentially better patient outcomes, as they became available.

Low switching costs plus a relatively high benefit from switching caused market shares to change quickly in the stent market. High switching costs for orthopedic devices coupled with slow innovation resulted in a lower benefit from switching, which led to greater market share stability in orthopedic devices.

5.1.5. Industry Life Cycle

An industry’s life-cycle position often has a large impact on its competitive dynamics, making this position an important component of the strategic analysis of an industry.

5.1.5.1. Description of an Industry Life-Cycle Model

Industries, like individual companies, tend to evolve over time, and usually experience significant changes in the rate of growth and levels of profitability along the way. Just as an investment in an individual company requires careful monitoring, industry analysis is a continuous process to identify changes that may be occurring or be likely to occur. A useful framework for analyzing the evolution of an industry is an industry life-cycle model, which identifies the sequential stages that an industry typically goes through. The five stages of an industry life-cycle model are embryonic, growth, shakeout, mature, and decline. Each stage is characterized by different opportunities and threats.12 Exhibit 9-6 shows the model as a curve illustrating the level and growth rate of demand at each stage.

Embryonic

An embryonic industry is one that is just beginning to develop. For example, in the 1960s, the global semiconductor industry was in the embryonic stage (it has grown to become a US$249 billion industry in 2008)13 and in the early 1980s, the global mobile phone industry was in the embryonic stage (it now produces and sells more than a billion handsets annually). Characteristics of the embryonic stage include slow growth and high prices because customers tend to be unfamiliar with the industry’s product and volumes are not yet sufficient to achieve meaningful economies of scale. Increasing product awareness and developing distribution channels are key strategic initiatives of companies during this stage. Substantial investment is generally required, and the risk of failure is high. A majority of start-up companies do not succeed.

Growth

A growth industry tends to be characterized by rapidly increasing demand, improving profitability, falling prices, and relativity low competition among companies in the industry. Demand is fueled by new customers entering the market, and prices fall as economies of scale are achieved and as distribution channels develop. The threat of new competitors entering the industry is usually highest during the growth stage, when barriers to entry are relatively low. Competition tends to be relatively limited, however, because rapidly expanding demand provides companies with an opportunity to grow without needing to capture market share from competitors. Industry profitability improves as volumes rise and economies of scale are attained.

Shakeout

The shakeout stage is usually characterized by slowing growth, intense competition, and declining profitability. During the shakeout stage, demand approaches market saturation levels because few new customers are left to enter the market. Competition is intense as growth becomes increasingly dependent on market share gains. Excess industry capacity begins to develop as the rate at which companies continue to invest exceeds the overall growth of industry demand. In an effort to boost volumes to fill excess capacity, companies often cut prices, so industry profitability begins to decline. During the shakeout stage, companies increasingly focus on reducing their cost structure (restructuring) and building brand loyalty. Marginal companies may fail or merge with others.

Mature

Characteristics of a mature industry include little or no growth, industry consolidation, and relatively high barriers to entry. Industry growth tends to be limited to replacement demand and population expansion because the market at this stage is completely saturated. As a result of the shakeout, mature industries often consolidate and become oligopolies. The surviving companies tend to have brand loyalty and relatively efficient cost structures, both of which are significant barriers to entry. During periods of stable demand, companies in mature industries tend to recognize their interdependence and try to avoid price wars. Periodic price wars do occur, however, most notably during periods of declining demand (such as during economic downturns). Companies with superior products or services are likely to gain market share and experience above-industry-average growth and profitability.

Decline

During the decline stage, industry growth turns negative, excess capacity develops, and competition increases. Industry demand at this stage may decline for a variety of reasons, including technological substitution (for example, the newspaper industry has been declining for years as more people turn to the Internet and 24-hour cable news networks for information), social changes, and global competition (for example, low-cost foreign manufacturers pushing the U.S. textile industry into decline). As demand falls, excess capacity in the industry forms and companies respond by cutting prices, which often leads to price wars. At this point, the weaker companies often exit the industry, merge, or redeploy capital into different products and services.

When overall demand for an industry’s products or services is declining, the opportunity for individual companies to earn above-average returns on invested capital tends to be less than when demand is stable or increasing, because of price-cutting and higher per-unit costs as production is cut back. Example 9-6 deals with industry life cycles.

5.1.5.2. Using an Industry Life-Cycle Model

In general, new industries tend to be more competitive (with lots of players entering and exiting) than mature industries, which often have stable competitive environments and players that are more interested in protecting what they have than in gaining lots of market share. However, as industries move from maturity to decline, competitive pressures may increase again as industry participants perceive a zero-sum environment and fight over pieces of an ever-shrinking pie.

An important point for the analyst to think about is whether a company is “acting its age” relative to where its industry sits in the life cycle. Companies in growth industries should be building customer loyalty as they introduce consumers to new products or services, building scale, and reinvesting heavily in their operations to capitalize on increasing demand. They are probably not focusing strongly on internal efficiency. These companies are rather like young adults, who are reinvesting their human and financial capital with the goal of becoming more successful in life. Growth companies typically reinvest their cash flows in new products and product platforms rather than returning cash flows to shareholders because these companies still have many opportunities to deploy their capital to make positive returns. Although this analogy to the human life cycle is a helpful way to think about the model, the analyst should also be aware that the analogy is not exact in detail. Long-established companies sometimes find a way to accelerate growth through innovation or by expansion into new markets. Humans cannot really move back to the days of youth. So, a more precise formulation may be “acting its stage” rather than acting its age.

Companies in mature industries are likely to be pursuing replacement demand rather than new buyers and are probably focused on extending successful product lines rather than introducing revolutionary new products. They are also probably focusing on cost rationalization and efficiency gains rather than on taking lots of market share. Importantly, these companies have fewer growth opportunities than in the previous stage, and thus more limited avenues for profitably reinvesting capital, but they often have strong cash flows. Given their strong cash flows and relatively limited reinvestment opportunities, such companies should be, according to a common perspective, returning capital to shareholders via share repurchases or dividends. These companies are rather like middle-aged adults who are harvesting the fruits of their success earlier in life.

What can be a concern is a middle-aged company acting like a young, growth company and pouring capital into projects with low ROIC prospects in an effort to pursue size for its own sake. Many companies have a difficult time managing the transition from growth to maturity, and their returns on capital—and shareholder returns—may suffer until management decides to allocate capital in a manner more appropriate to the company’s life-cycle stage.

For example, three large U.S. retailers—Wal-Mart, Home Depot, and McDonald’s—all went through the transition to maturity in the first decade of the twenty-first century. At various times between 2002 and 2005, these companies realized that their size and industry dominance meant that the days of double-digit growth that was driven largely by new store (restaurant) openings were a thing of the past. All three reallocated capital away from opening new stores to other areas—namely, increased inventory efficiency (Home Depot), improving the customer experience (McDonald’s), and increased dividends and share repurchases (all three). As a result, returns on capital for each improved, as did shareholder returns.

5.1.5.3. Limitations of Industry Life-Cycle Analysis

Although models can provide a useful framework for thinking about an industry, the evolution of an industry does not always follow a predictable pattern. Various external factors may significantly affect the shape of the pattern, causing some stages to be longer or shorter than expected and, in certain cases, causing some stages to be skipped altogether.

Technological changes may cause an industry to experience an abrupt shift from growth to decline, thus skipping the shakeout and mature stages. For example, transistors replaced vacuum tubes in the 1960s at a time when the vacuum tube industry was still in its growth stage; word processors replaced typewriters in the 1980s; and today the movie rental industry is experiencing rapid change as consumers increasingly turn to on-demand services such as downloading movies from the Internet or through their cable providers.

Regulatory changes can also have a profound impact on the structure of an industry. A prime example is the deregulation of the U.S. telecommunications industry in the 1990s, which transformed a monopolistic industry into an intensely competitive one. AT&T was broken into regional service providers, and many new long distance telephone service entrants, such as Sprint, emerged. The result was a wider range of product and service offerings and lower consumer prices. Changes in government reimbursement rates for health-care products and services may (and have) affected the profitability of companies in the health care industry globally.

Social changes also have the ability to affect the profile of an industry. The casual dining industry has benefited over the past 30 years from the increase in the number of dual-income families, who often have more income but less time to cook meals to eat at home.

Demographics also play an important role. As the Baby Boom generation ages, for instance, industry demand for health care services is likely to increase.

Thus, life-cycle models tend to be most useful for analyzing industries during periods of relative stability. They are less practical when the industry may be experiencing rapid change because of external or other special circumstances.

Another limiting factor of models is that not all companies in an industry experience similar performances. The key objective for the analyst is to identify the potential winners while avoiding potential losers. Highly profitable companies can exist in competitive industries with below-average profitability—and vice versa. For example, Nokia has historically been able to use its scale to generate levels of profitability that are well above average despite operating in a highly competitive industry. In contrast, despite the historically above-average growth and profitability of the software industry, countless examples exist of software companies that failed to ever generate a profit and eventually went out of business.

5.1.6. Price Competition

A highly useful tool for analyzing an industry is attempting to think like a customer of the industry. Whatever factor most influences customer purchase decisions is likely to also be the focus of competitive rivalry in the industry. In general, 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.

Although this depiction may sound like the description of a commodity industry versus a noncommodity industry, it is, in fact, a bit more subtle. Commercial aircraft and passenger cars are certainly more differentiated than lumps of coal or gallons of gasoline, but price nonetheless weighs heavily in the purchase decisions of buyers of aircraft and cars, because fairly good substitutes are easily available. If Airbus charges too much for an A320, an airline can buy a Boeing 737.14 If BMW’s price for a four-door luxury sedan rises too high, customers can switch to a Mercedes or other luxury brand with similar features. Similar switching can be expected as a result of a unilateral price increase in the case of most industries in the “Weak Pricing Power” column of Exhibit 9-4.

Contrast these industries with asset management, one of a handful of industries that is both fragmented and characterized by strong pricing power. Despite the well-documented impact of fees on future investment returns, the vast majority of asset management customers do not make decisions on the basis of price. Instead, asset management customers focus on historical returns, which allow this highly fragmented industry to maintain strong pricing power. Granted, the index fund arena is very price competitive, because any index fund is a perfect substitute for another fund tracking the same benchmark. But the active management segment of the industry has generally been able to price its products in an implicitly cooperative fashion that enables most players to generate consistently high returns on capital, presumably because price is not uppermost in the mind of a prospective mutual fund investor.

Returning to a more capital-intensive industry, consider heavy equipment manufacturers, such as Caterpillar, John Deere, and Komatsu. A large wheel loader or combine harvester requires a large capital outlay, so price certainly plays a part in the buyers’ decisions. However, other factors are important enough to customers to allow these companies a small amount of pricing power. Construction equipment is typically used as a complement to other gear on a large project, which means that downtime for repairs increases costs because, for example, hourly laborers must wait for a bulldozer to be fixed. Broken equipment is also expensive for agricultural users, who may have only a few days in which to harvest a season’s crop. Because of the importance to users of their products’ reliability and their large service networks—which are important “differentiators” or factors bestowing a competitive advantage—Caterpillar, Komatsu, and John Deere have historically been able to price their equipment at levels that have generated solid returns on invested capital.

5.1.7. Industry Comparison

To illustrate how these elements might be applied, Exhibit 9-7 uses the factors discussed in this chapter to examine three industries.

EXHIBIT 9-7 Elements of a Strategic Analysis for Three Industries

Note: “NA” in this exhibit stands for “not applicable.”

Example 9-8 reviews some of the information presented in Exhibit 9-7.

5.2. External Influences on Industry Growth, Profitability, and Risk

External factors affecting an industry’s growth include macroeconomic, technological, demographic, governmental, and social influences.

5.2.1. Macroeconomic Influences

Trends in overall economic activity generally have significant effects on the demand for an industry’s products or services. These trends can be cyclical (i.e., related to the changes in economic activity caused by the business cycle) or structural (i.e., related to enduring changes in the composition or magnitude of economic activity). Among the economic variables that usually affect an industry’s revenues and profits are the following:

• Gross domestic product or the measure of the value of goods and services produced by an economy, either in current or constant currency (inflation-adjusted) terms.
• Interest rates, which represent the cost of debt to consumers and businesses and are important ingredients in financial institutions’ revenues and costs.
• The availability of credit, which affects business and consumer spending and financial solvency.
• Inflation, which reflects the changes in prices of goods and services and influences costs, interest rates, and consumer and business confidence.

5.2.2. Technological Influences

New technologies create new or improved products that can radically change an industry and can also change how other industries that use the products conduct their operations.

The computer hardware industry provides one of the best examples of how technological change can affect industries. The 1958 invention of the microchip (also known as an “integrated circuit,” which is effectively a computer etched on a sliver of silicon) enabled the computer hardware industry to eventually create a new market of personal computing for the general public and radically extended the use of computers in business, government, and educational institutions.

Moore’s law states that the number of transistors that can be inexpensively placed on an integrated circuit doubles approximately every two years. Several other measures of digital technology have improved at exponential rates related to Moore’s law, including the size, cost, density and speed of components. As a result of these trends, the computer hardware industry encroached upon and, in time, came to dominate the fields of hardware for word processing and many forms of electronic communication and home entertainment. The computing industry’s integrated circuit innovation increased economies of scale and erected large barriers to new entrants because the capital costs of innovation and production became very high. Intel capitalized on both factors, which allowed it to garner an industry market leadership position and to become the dominant supplier of the PC industry’s highest value component (the microprocessor). Thus, Intel became dominant because of its cost advantage, brand power, and access to capital.

Along the way, the computer hardware industry was supported and greatly assisted by the complementary industries of computer software and telecommunications (particularly in regard to development of the Internet); also important were other industries—entertainment (television, movies, games), retailing, and the print media. Ever more powerful integrated circuits and advances in wireless technology, as well as the convergence of media, which the Internet and new wireless technology have facilitated, continue to reshape the uses and the roles of PC hardware in business and personal life. In the middle of the twentieth century, few people in the world would have imagined they would ever have any use for a home computer. Today, the estimate is that about 1.6 billion people, or almost a quarter of the world’s population, have access to connected computing. For the United States, the estimate is at least 76 percent of the population; it is much less in emerging and underdeveloped countries. More than 4 billion mobile cellular telephone subscriptions exist in the world today,15 and the advances of mobile telephony appear poised to increase this figure dramatically in the years ahead as mobile phone and computer hardware technologies merge to provide new hand-held computing and communication capabilities.

Another example of the effects of technology on an industry is the impact of digital imaging technology on the photographic film industry. Digital imaging uses an electronic image sensor to record an image as electronic data rather than as chemical changes on film. This difference allows a much greater degree of image processing and transmission than in film photography. Since their invention in 1981, digital cameras have become extremely popular and now widely outsell traditional film cameras (although many professional photographers continue to use film for esthetic reasons for certain applications). Digital cameras include such features as video and audio recording. The effects of this major change in photographic technology have caused film and camera manufacturers—including Kodak, Fujifilm, Nikon Corporation, and Pentax Imaging Company—to completely restructure and redesign their products to adapt to the new technology’s appeal to consumers.

5.2.3. Demographic Influences

Changes in population size, in the distributions of age and gender, and in other demographic characteristics may have significant effects on economic growth and on the amounts and types of goods and services consumed.

The effects of demographics on industries are well exemplified by the impact of the post–World War II Baby Boom in North America on demand for goods and services. Born between 1946 and 1964, this bulge of 76 million people in the North American population has influenced the composition of numerous products and services it needs in its passage from the cradle through childhood, adolescence, early adulthood, middle age, and into retirement. The teenage pop culture of the late 1950s and 1960s and all the products (records, movies, clothes, fashions) associated with it, the surge in demand for housing in the 1970s and 1980s, and the increasing demand for retirement-oriented investment products in the 1990s and early 2000s are all examples of the range of industries affected by this demographic bulge working its way through age categories of the population.

Another example of the effects of demographics on industries is the impact of an aging population in Japan, which has one of the highest percentages of elderly residents (21 percent over the age of 65) and a very low birth rate. Japan’s ministry of health estimates that by 2055, the percentage of the population over 65 will rise to 40 percent and the total population will fall by 25 percent. These demographic changes are expected by some observers to have negative effects on the overall economy because, essentially, they imply a declining workforce. However, some sectors of the economy stand to benefit from these trends—for example, the heath care industry.

5.2.4. Governmental Influences

Governmental influence on industries’ revenues and profits is pervasive and important. In setting tax rates and rules for corporations and individuals, governments affect profits and incomes, which in turn, affect corporate and personal spending. Governments are also major purchasers of goods and services from a range of industries.

Example 9-10 illustrates the sudden shifts in wealth that can occur when governments step in to support or quash a securities market innovation. In the example, an income trust refers to a type of equity ownership vehicle established as a trust issuing ownership shares known as units. Income trusts became extremely popular among income-oriented investors in Canada in the late 1990s and early 2000s because under then-current regulation, such trusts could avoid taxation on income distributed to unit-holders (investors)—that is, avoid double taxation (once at the corporate level and once at the investor level). As Example 9-10 describes, the tax advantage that regulations permitted was eventually removed.

Often, governments exert their influence indirectly by empowering other regulatory or self-regulatory organizations (e.g., stock exchanges, medical associations, utility rate setters, and other regulatory commissions) to govern the affairs of an industry. By setting the terms of entry into various sectors, such as financial services and health care, and the rules that companies and individuals must adhere to in these fields, governments control the supply, quality, and nature of many products and services and the public’s access to them. For example, in the financial industry, the acceptance of savings deposits from and the issuance of securities to the investing public are usually tightly controlled by governments and their agencies. This control is imposed through rules designed to protect investors from fraudulent operators and to ensure that investors receive adequate disclosure about the nature and risks of their investments. Another example is that medical patients in most developed countries are treated by doctors who are trained according to standards set by medical associations acting as self-regulatory organizations empowered under government laws. In addition, the medications that patients receive must be approved by government agencies. In a somewhat different vein, users of tobacco products purchase items for which the marketing and sales taxes are heavily controlled by governments in most developed countries and for which warnings to consumers about the dangers of smoking are mandated by governments. In the case of industries that supply branches of government, such as the military, public works, and law enforcement departments, government contracts directly affect the revenues and profits of the suppliers.

5.2.5. Social Influences

Societal changes involving how people work, spend their money, enjoy their leisure time, and conduct other aspects of their lives can have significant effects on the sales of various industries.

Tobacco consumption in the United Kingdom provides a good example of the effects of social influences on an industry. Although the role of government in curbing tobacco advertising, legislating health warnings on the purchases of tobacco products, and banning smoking in public places (such as restaurants, bars, public houses, and transportation vehicles) probably has been the most powerful apparent instrument of changes in tobacco consumption, the forces underlying that change have really been social in nature—namely, increasing consciousness on the part of the population of the damage to the health of tobacco users and those in their vicinity from smoking, the increasing cost to individuals and governments of the chronic illnesses caused by tobacco consumption, and the accompanying shift in public perception of smokers from socially correct to socially incorrect—even inconsiderate or reckless. As a result of these changes in society’s views of smoking, cigarette consumption in the United Kingdom declined from 102.5 billion cigarettes in 1990 to less than 65.0 billion in 2009, placing downward pressure on tobacco companies’ unit sales.

6. COMPANY ANALYSIS

Company analysis includes an analysis of the company’s financial position, products and/or services, and competitive strategy (its plans for responding to the threats and opportunities presented by the external environment). Company analysis takes place after the analyst has gained an understanding of a company’s external environment—the macroeconomic, demographic, governmental, technological, and social forces influencing the industry’s competitive structure. The analyst should seek to determine whether the strategy is primarily defensive or offensive in its nature and how the company intends to implement the strategy.

Porter identifies two chief competitive strategies: a low-cost strategy (cost leadership) and a product/service differentiation strategy.

In a low-cost strategy, companies strive to become the low-cost producers and to gain market share by offering their products and services at lower prices than their competition while still making a profit margin sufficient to generate a superior rate of return based on the higher revenues achieved. Low-cost strategies may be pursued defensively to protect market positions and returns or offensively to gain market share and increase returns. Pricing also can be defensive (when the competitive environment is one of low rivalry) or aggressive (when rivalry is intense). In the case of intense rivalry, pricing may even become predatory—that is, aimed at rapidly driving competitors out of business at the expense of near-term profitability. The hope in such a strategy is that having achieved a larger market share, the company can later increase prices to generate higher returns than before. For example, the predatory strategy has been alleged by some analysts to have been followed by major airlines trying to protect lucrative routes from discount airlines. Although laws concerning anticompetitive practices often prohibit predatory pricing to gain market share, in most cases, it is difficult to accurately ascribe the costs of products or services with sufficient precision to demonstrate that predatory pricing (as opposed to intense but fair price competition) is occurring. Companies seeking to follow low-cost strategies must have tight cost controls, efficient operating and reporting systems, and appropriate managerial incentives. In addition, they must commit themselves to painstaking scrutiny of production systems and their labor forces and to low-cost designs and product distribution. They must be able to invest in productivity-improving capital equipment and to finance that investment at a low cost of capital.

In differentiation strategies, companies attempt to establish themselves as the suppliers or producers of products and services that are unique either in quality, type, or means of distribution. To be successful, their price premiums must be above their costs of differentiation and the differentiation must be appealing to customers and sustainable over time. Corporate managers who successfully pursue differentiation strategies tend to have strong market research teams to identify and match customer needs with product development and marketing. Such a strategy puts a premium on employing creative and inventive people.

6.1. Elements That Should Be Covered in a Company Analysis

A thorough company analysis, particularly as presented in a research report, should

• Provide an overview of the company (corporate profile), including a basic understanding of its businesses, investment activities, corporate governance, and perceived strengths and weaknesses.
• Explain relevant industry characteristics.
• Analyze the demand for the company’s products and services.
• Analyze the supply of products and services, which includes an analysis of costs.
• Explain the company’s pricing environment.
• Present and interpret relevant financial ratios, including comparisons over time and comparisons with competitors.

Company analysis often includes forecasting the company’s financial statements, particularly when the purpose of the analysis is to use a discounted cash flow method to value the company’s common equity.

Exhibit 9-8 provides a checklist of points to cover in a company analysis. The list may need to be adapted to serve the needs of a particular company analysis and is not exhaustive.

To evaluate a company’s performance, the key measures presented in Exhibit 9-8 should be compared over time and between companies (particularly peer companies). The following formula can be used to analyze how and why a company’s ROE differs from that of other companies or its own ROE in other periods by tracing the differences to changes in its profit margin, the productivity of its assets, or its financial leverage:

ROE = (Net profit margin: Net earnings/Net sales) × (Asset turnover: Net sales/Average total assets) × (Financial leverage: Average total assets/Average common equity)

The financial statements of a company over time provide numerous insights into the effects of industry conditions on its performance and the success or failure of its strategies. They also provide a framework for forecasting the company’s operating performance when given the analyst’s assumptions for numerous variables in the future. The financial ratios listed in Exhibit 9-8 are applicable to a wide range of companies and industries, but other statistics and ratios are often also used.

6.2. Spreadsheet Modeling

Spreadsheet modeling of financial statements to analyze and forecast revenues, operating and net income, and cash flows has become one of the most widely used tools in company analysis. Although spreadsheet models are a valuable tool for understanding past financial performance and forecasting future performance, the complexity of such models can at times be a problem. Because modeling requires the analyst to predict and input numerous items in financial statements, there is a risk of errors—either in assumptions made or in formulas in the model—which can compound, leading to erroneous forecasts. Yet, those forecasts may seem precise because of the sheer complexity of the model. The result is often a false sense of understanding and security on the part of those who rely on the models. To guard against this, before or after a model is completed, a “reality check” of the model is useful.

Such testing for reasonableness can be done by first, asking what the few most important changes in income statement items are likely to be from last year to this year and the next year and, second, attempting to quantify the effects of these significant changes or “swing factors” on the bottom line. If an analyst cannot summarize in a few points what factors are realistically expected to change income from year to year and is not convinced that these assumptions are correct, then he or she does not really understand the output of the computer modeling efforts. In general, financial models should be in a format that matches the company’s reporting of its financial results or supplementary disclosures or that can be accurately derived from these reports. Otherwise, there will be no natural reality check when the company issues its financial results and the analyst will not be able to compare his or her estimates with actual reported results.

7. SUMMARY

In this chapter, we have provided an overview of industry analysis and illustrated approaches that are widely used by analysts to examine an industry.

• 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-line 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.
• The three main approaches to classifying companies are
  • Products and/or services supplied.
  • Business-cycle sensitivities.
  • Statistical similarities.
• Commercial industry classification systems include
  • Global Industry Classification Standard.
  • Russell Global Sectors.
  • Industry Classification Benchmark.
• Governmental industry classification systems include
  • International Standard Industrial Classification of All Economic Activities.
  • Statistical Classification of Economic Activities in the European Community.
  • Australian and New Zealand Standard Industrial Classification.
  • North American Industry Classification System.
• A limitation of current classification systems is that the narrowest classification unit assigned to a company generally cannot be assumed to constitute its peer group for the purposes of detailed fundamental comparisons or valuation.
• A peer group is a group of companies engaged in similar business activities whose economics and valuation are influenced by closely related factors.
• Steps in constructing a preliminary list of peer companies:
  • Examine commercial classification systems if available. These systems often provide a useful starting point for identifying companies operating in the same industry.
  • Review the subject company’s annual report for a discussion of the competitive environment. Companies frequently cite specific competitors.
  • Review competitors’ annual reports to identify other potential comparables.
  • Review industry trade publications to identify additional peer companies.
  • Confirm that each comparable or peer company derives a significant portion of its revenue and operating profit from a similar business activity as the subject company.
• Not all industries are created equal. Some are highly competitive, with many companies struggling to earn returns in excess of their cost of capital, and other industries have attractive characteristics that enable a majority of industry participants to generate healthy profits.
• Differing competitive environments are determined by the structural attributes of the industry. For this important reason, industry analysis is a vital complement to company analysis. The analyst needs to understand the context in which a company operates to fully understand the opportunities and threats that a company faces.
• The framework for strategic analysis known as “Porter’s five forces” can provide a useful starting point. Porter maintains that the profitability of companies in an industry is determined by five forces: (1) The influence or threat of new entrants, which in turn is determined by economies of scale, brand loyalty, absolute cost advantages, customer switching costs, and government regulation; (2) the influence or threat of substitute products; (3) the bargaining power of customers, which is a function of switching costs among customers and the ability of customers to produce their own product; (4) the bargaining power of suppliers, which is a function of the feasibility of product substitution, the concentration of the buyer and supplier groups, and switching costs and entry costs in each case; and (5) the intensity of rivalry among established companies, which in turn is a function of industry competitive structure, demand conditions, cost conditions, and the height of exit barriers.
• The concept of barriers to entry refers to the ease with which new competitors can challenge incumbents and can be an important factor in determining the competitive environment of an industry. If new competitors can easily enter the industry, the industry is likely to be highly competitive because incumbents that attempt to raise prices will be undercut by newcomers. As a result, industries with low barriers to entry tend to have low pricing power. Conversely, if incumbents are protected by barriers to entry, they may enjoy a more benign competitive environment that gives them greater pricing power over their customers because they do not have to worry about being undercut by upstarts.
• 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.
• The effect of industry capacity on pricing is clear: Tight capacity gives participants more pricing power because demand for products or services exceeds supply; overcapacity leads to price-cutting and a highly competitive environment as excess supply chases demand. The analyst should think about not only current capacity conditions but also future changes in capacity levels—how long it takes for supply and demand to come into balance and what effect that process has on industry pricing power and returns.
• Examining the market share stability of an industry over time is similar to thinking about barriers to entry and the frequency with which new players enter an industry. Stable market shares typically indicate less competitive industries, whereas unstable market shares often indicate highly competitive industries with limited pricing power.
• An industry’s position in its life cycle often has a large impact on its competitive dynamics, so it is important to keep this positioning in mind when performing strategic analysis of an industry. Industries, like individual companies, tend to evolve over time and usually experience significant changes in the rate of growth and levels of profitability along the way. Just as an investment in an individual company requires careful monitoring, industry analysis is a continuous process that must be repeated over time to identify changes that may be occurring.
• A useful framework for analyzing the evolution of an industry is an industry life-cycle model, which identifies the sequential stages that an industry typically goes through. The five stages of an industry life cycle according to the Hill and Jones model are
  • Embryonic.
  • Growth.
  • Shakeout.
  • Mature.
  • Decline.
• 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 include
  • Technology.
  • Demographics.
  • Government.
  • Social factors.
• Company analysis takes place after the analyst has gained an understanding of the company’s external environment and includes answering questions about how the company will respond to the threats and opportunities presented by the external environment. This intended response is the individual company’s competitive strategy. The analyst should seek to determine whether the strategy is primarily defensive or offensive in its nature and how the company intends to implement it.
• Porter identifies two chief competitive strategies:
  • A low-cost strategy (cost leadership) is one in which companies strive to become the low-cost producers and to gain market share by offering their products and services at lower prices than their competition while still making a profit margin sufficient to generate a superior rate of return based on the higher revenues achieved.
  • A product/service differentiation strategy is one in which companies attempt to establish themselves as the suppliers or producers of products and services that are unique either in quality, type, or means of distribution. To be successful, the companies’ price premiums must be above their costs of differentiation and the differentiation must be appealing to customers and sustainable over time.
• A checklist for company analysis includes a thorough investigation of
  • Corporate profile.
  • Industry characteristics.
  • Demand for products/services.
  • Supply of products/services.
  • Pricing.
  • Financial ratios.
• Spreadsheet modeling of financial statements to analyze and forecast revenues, operating and net income, and cash flows has become one of the most widely used tools in company analysis. Spreadsheet modeling can be used to quantify the effects of the changes in certain swing factors on the various financial statements. The analyst should be aware that the output of the model will depend significantly on the assumptions that are made.

PROBLEMS

1. Which of the following is least likely to involve industry analysis?

A. Sector rotation strategy.

B. Top-down fundamental investing.

C. Tactical asset allocation strategy.

2. A sector rotation strategy involves investing in a sector by:

A. Making regular investments in it.

B. Investing in a preselected group of sectors on a rotating basis.

C. Timing investment to take advantage of business-cycle conditions.

3. Which of the following information about a company would most likely depend on an industry analysis? The company’s:

A. Dividend policy.

B. Competitive environment.

C. Trends in corporate expenses.

4. Which industry classification system uses a three-tier classification system?

A. Russell Global Sectors.

B. Industry Classification Benchmark.

C. Global Industry Classification Standard.

5. In which sector would a manufacturer of personal care products be classified?

A. Health care.

B. Consumer staples.

C. Consumer discretionary.

6. Which of the following statements about commercial and government industry classification systems is most accurate?

A. Many commercial classification systems include private for-profit companies.

B. Both commercial and government classification systems exclude not-for-profit companies.

C. Commercial classification systems are generally updated more frequently than government classification systems.

7. Which of the following is not a limitation of the cyclical/noncyclical descriptive approach to classifying companies?

A. A cyclical company may have a growth component in it.

B. Business-cycle sensitivity is a discrete phenomenon rather than a continuous spectrum.

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

8. A company that is sensitive to the business cycle would most likely:

A. Not have growth opportunities.

B. Experience below-average fluctuation in demand.

C. Sell products that the customer can purchase at a later date if necessary.

9. Which of the following factors would most likely be a limitation of applying business-cycle analysis to global industry analysis?

A. Some industries are relatively insensitive to the business cycle.

B. Correlations of security returns between different world markets are relatively low.

C. One region or country of the world may experience recession while another region experiences expansion.

10. Which of the following statements about peer groups is most accurate?

A. Constructing a peer group for a company follows a standardized process.

B. Commercial industry classification systems often provide a starting point for constructing a peer group.

C. A peer group is generally composed of all the companies in the most narrowly defined category used by the commercial industry classification system.

11. With regard to forming a company’s peer group, which of the following statements is not correct?

A. Comments from the management of the company about competitors are generally not used when selecting the peer group.

B. The higher the proportion of revenue and operating profit of the peer company derived from business activities similar to the subject company, the more meaningful the comparison.

C. Comparing the company’s performance measures with those for a potential peer-group company is of limited value when the companies are exposed to different stages of the business cycle.

12. When selecting companies for inclusion in a peer group, a company operating in three different business segments would:

A. Be in only one peer group.

B. Possibly be in more than one peer group.

C. Not be included in any peer group.

13. An industry that most likely has both high barriers to entry and high barriers to exit is the:

A. Restaurant industry.

B. Advertising industry.

C. Automobile industry.

14. Which factor is most likely associated with stable market share?

A. Low switching costs.

B. Low barriers to entry.

C. Slow pace of product innovation.

15. Which of the following companies most likely has the greatest ability to quickly increase its capacity?

A. Restaurant.

B. Steel producer.

C. Legal services provider.

16. A population that is rapidly aging would most likely cause the growth rate of the industry producing eyeglasses and contact lenses to:

A. Decrease.

B. Increase.

C. Not change.

17. If over a long period of time a country’s average level of educational accomplishment increases, this development would most likely lead to the country’s amount of income spent on consumer discretionary goods to:

A. Decrease.

B. Increase.

C. Not change.

18. If the technology for an industry involves high fixed capital investment, then one way to seek higher profit growth is by pursuing:

A. Economies of scale.

B. Diseconomies of scale.

C. Removal of features that differentiate the product or service provided.

19. Which of the following life-cycle phases is typically characterized by high prices?

A. Mature.

B. Growth.

C. Embryonic.

20. In which of the following life-cycle phases are price wars most likely to be absent?

A. Mature.

B. Decline.

C. Growth.

21. When graphically depicting the life-cycle model for an industry as a curve, the variables on the axes are:

A. Price and time.

B. Demand and time.

C. Demand and stage of the life cycle.

22. Which of the following is most likely a characteristic of a concentrated industry?

A. Infrequent, tacit coordination.

B. Difficulty in monitoring other industry members.

C. Industry members attempting to avoid competition on price.

23. Which of the following industry characteristics is generally least likely to produce high returns on capital?

A. High barriers to entry.

B. High degree of concentration.

C. Short lead time to build new plants.

24. An industry with high barriers to entry and weak pricing power most likely has:

A. High barriers to exit.

B. Stable market shares.

C. Significant numbers of issued patents.

25. Economic value is created for an industry’s shareholders when the industry earns a return:

A. Below the cost of capital.

B. Equal to the cost of capital.

C. Above the cost of capital.

26. Which of the following is not one of Porter’s five forces?

A. Intensity of rivalry.

B. Bargaining power of suppliers.

C. Threat of government intervention.

27. Which of the following industries is most likely to be characterized as concentrated with strong pricing power?

A. Asset management.

B. Alcoholic beverages.

C. Household and personal products.

28. Which of the following industries is most likely to be considered to have the lowest barriers to entry?

A. Oil services.

B. Confections and candy.

C. Branded pharmaceuticals.

29. With respect to competitive strategy, a company with a successful cost leadership strategy is most likely characterized by:

A. A low cost of capital.

B. Reduced market share.

C. The ability to offer products at higher prices than competitors.

30. When conducting a company analysis, the analysis of demand for a company’s product is least likely to consider the:

A. Company’s cost structure.

B. Motivations of the customer base.

C. Product’s differentiating characteristics.

31. Which of the following statements about company analysis is most accurate?

A. The complexity of spreadsheet modeling ensures precise forecasts of financial statements.

B. The interpretation of financial ratios should focus on comparing the company’s results over time but not with competitors.

C. The corporate profile would include a description of the company’s business, investment activities, governance, and strengths and weaknesses.

1For more information, see International Financial Reporting Standard (IFRS) 8: Operating Segments. In IFRS 8, business segments are called operating segments.

2Sometimes the “growth” label is attached to countries or regions in which economic growth is so strong that the fluctuations in local economic activity do not produce an actual decline in economic output, merely variation from high to low rates of real growth (e.g., China, India).

3The label growth cyclical is sometimes used to describe companies that are growing rapidly on a long-term basis but that still experience above-average fluctuation in their revenues and profits over the course of a business cycle.

4For more information, see www.census.gov/eos/www/naics/faqs/faqs.html#q2.

5For more information, see www.census.gov/eos/www/naics/concordances/concordances.html.

6Return on invested capital can be defined as net operating profit after tax divided by the sum of common and preferred equity, long-term debt, and minority interests.

7See Porter (2008) for a recent presentation.

8What aspects of a company are important may be different for internal and external analysts. Whether information about competitive positions is accurately reflected in market prices, for example, would be relatively more important to external analysts.

9Neither company’s commercial aircraft segment has reliably generated returns on capital comfortably in excess of the company’s cost of capital for many years. Boeing’s returns on capital have been respectable overall, but the company’s military segment is much more profitable than its commercial aircraft segment.

10There are a small number of concentrated and rational commodity industries, such as potash (a type of fertilizer) and seaborne iron ore. What sets these industries apart is that they are hyper-concentrated: The top two players control 60 percent of the global potash market, and the top three players control two-thirds of the global market for seaborne iron ore.

11From “RS Platou Monthly” (November 2008): www.platou.com/loadfileservlet/loadfiledb?id=1228989312093PUBLISHER&key=1228989321421.

12Much of the discussion that follows regarding life-cycle stages owes a debt to the discussion in Hill and Jones (2008).

13Semiconductor Industry Association Factsheet: www.sia-online.org/cs/industry_resources/industry_fact_sheet.

14A small amount of “path dependence” characterizes the airline industry, in that an airline with a large fleet of a particular Airbus model will be marginally more likely to stick with that model for a new purchase than it will be to buy a Boeing, but the aircraft manufacturers’ ability to exploit this likelihood is minimal.

15See www.itu.int/newsroom/press_releases/2009/39.html.