An investor must examine the industry in which a company operates because this can have a tremendous effect on its results, and even its existence. A company’s management may be superior, its balance sheet strong and its reputation enviable. However, the company may not have diversified and the industry within which it operates may be in a depression. This can result in a tremendous decline in revenues and even threaten the viability of the company.
The first step in industry analysis is to determine the cycle it is in, or the stage of maturity of the industry. All industries evolve through the following stages:
- The Entrepreneurial or Nascent Stage: At the first stage, the industry is new and it can take some time for it to properly establish itself. In the early days, it may actually make losses. At this time there may also not be many companies in the industry. It must be noted that the first 5 to 10 years are the most critical period. At this time, companies have the greatest chance of failing. It takes time to establish companies and new products. There may be losses and the need for large injections of capital. If a company or an industry is not nurtured or husbanded at this stage, it can collapse.
- The Expansion or Growth Stage: Once the industry has established itself it enters a growth stage. As the industry grows, many new companies enter the industry. At this stage, investors can get high reward at low risk since demand outstrips supply. The growth stage also witnesses product improvements by companies that have survived the first stage. In fact, such companies are often able to even lower their prices. Investors are more keen to invest at this time as companies would have demonstrated their ability to survive.
- The Stabilization or Maturity Stage: After the halcyon days of growth, an industry matures and stabilizes. Rewards are low and so too is the risk. Growth is moderate. Though sales may increase, they do so at a slower rate than before. Products are more standardized and less innovative and there are several competitors. Investors can invest in these industries for comfort and average returns. They must be aware though that should there be a downturn in the economy and a fall in consumer demand, growth and returns can be negative.
- The Decline or Sunset Stage: Finally, the industry declines. This occurs when its products are no longer popular. This may be on account of several factors such as change in social habits the film and video industries for example have suffered on account of cable and satellite television, changes in laws, and increase in prices. The risk at this time is high but the returns are low, even negative.
The various stages can be likened to the four stages in the life cycle of a human being – childhood, adulthood, middle age and old age. Investors should begin to purchase shares when an industry is at the end of the entrepreneurial or nascent stage and during its growth stage, and should begin to disinvest when at its mature stage.
The Industry vis-à-vis the Economy
Investors must ascertain how an industry reacts to changes in the economy. Some industries do not perform well during a recession; others exhibit less buoyancy during a boom. On the other hand, certain industries are unaffected in a depression or a boom. Some classifications are:
- Industries that are generally unaffected during economic changes are the evergreen industries. These are industries that produce goods individuals need, like the food or agro-based industries.
- Then there are the volatile cyclical industries which do extremely well when the economy is doing well and do badly when depression sets in. The prime examples are durable goods, consumer goods such as textiles and shipping. During hard times individuals postpone the purchase of consumer goods until better days.
- Interest sensitive industries are those that are affected by interest rates. When interest rates are high, industries such as real estate and banking fare poorly.
- Growth industries are those whose growth is higher than other industries and growth occurs even though the economy may be suffering setback.
Another factor that one must consider is the level of competition among various companies in an industry. Competition within an industry initially leads to efficiency, product improvements and innovation. As competition increases even more, cut throat price wars set in resulting in lower margins, smaller profits and, finally some companies begin to make losses. The more inefficient companies even closedown. To properly understand this phenomenon, it is to be appreciated that if the return is high, newcomers will invest in the industry and there will be an inflow of funds. Existing companies may also increase their capacity. However, if the returns are low, or lower than that which can be obtained elsewhere, the reverse will occur. Funds will not be disinvested and there will be an outflow. In short high returns attract competition and vice versa. However, competition in the form of new companies does not bacterially multiply just because the returns are high.
What should Investors do?
Investors should determine how an industry is affected by changes in the economy and movements in interest rates. If the economy is moving towards a recession, investors should disinvest their holdings in cyclical industries and switch to growth or evergreen industries. If interest rates are likely to fall, investors should consider investment in real estate or construction companies. If, on the other hand, the economy is on the upturn, investment in consumer and durable goods industries are likely to be profitable.
When choosing an industry, it would be prudent for the investor to bear in mind or determine the following details:
- Invest in an industry at the growth stage.
- It is safer to invest in industries that are not subject to governmental controls and are globally competitive.
- Cyclical industries should be avoided if possible unless one is investing in them at the time the industry is prospering.
It is important to check whether an industry is right for investment at a particular time. There are sunrise and sunset industries. There arecapital intensive and labour intensiveindustries. Each industry goes through a life cycle. Investments should be at the growth stage of an industry and disinvestments at the maturity or stagnation stage before decline sets in.