1. Industry analysis: How it is useful in identifying right investments

Industry analysis: How it is useful in identifying right investments

Industry analysis is key to understanding true performance of a company and making the right investments

By: | Updated: August 21, 2015 12:22 PM
Industry analysis and investments

Industry analysis is a tool that facilitates a company’s understanding of its position relative to other companies that produce similar products or services. (PTI)

Industry analysis is a tool that facilitates a company’s understanding of its position relative to other companies that produce similar products or services. Understanding the forces at work in the overall industry is an important component of effective strategic planning.

Let’s discuss industry analysis in depth and see how it is useful in identifying investment opportunities.

What is an industry?

Industry is defined as a group of companies offering similar products and/or services. For instance, major companies in the global heavy truck industry include Volvo, Tata Motors, Ashok Leyland, 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, Maruti Suzuki, Ford, Honda, Nissan and Hyundai, all of which produce light vehicles that are close substitutes for one another.

What is a sector?

The term sector is often used to refer to a group of related industries. The healthcare sector, for example, consists of a number of related  industries, including 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 major 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 Cipla, Pfizer, Dr Reddy’s Lab, Lupin, Aurobindo Pharma, Glaxo SmithKline, etc., 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 of the different business segments in their financial statements.

Industry analysis

Investors needs to study statistical relationships between industry trends and a range of economic and business variables and they need to develop practical, reliable industry forecasts by using various approaches to forecasting. One needs to check the chosen industry’s past trends, demand-supply mechanics and future outlook. Investors also need to examine industry performance (a) in relation to other industries to identify industries with superior/inferior returns and b) over time to determine the degree of consistency, stability, and risk in the returns in the industry.
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.

Identifying correct sector

An industry has sub-parts. For instance, if you look at the chemical industry, you will find many sectors such as fertilisers, pharmaceuticals, petrochemicals, dyes, polymer, paint and varnishes, etc. Therefore, it is necessary to focus on the relevant sector. Without this, it will be impossible to make an accurate industry analysis. So, take up an industry and find out the sectors. Select the particular sector that is doing well and its prospects are good. Moreover, it is worthwhile to look at the different market segments in a particular sector.

Review existing literature

One should start with reading all the available but relevant industry reports and statistics to check whether it is worth reading further on the specific industry. Some of the existing reports might have an in-depth information and detailed analysis so that the need for new industry analysis is eliminated. However, it is not always advisable to depend on the existing industry analysis reports as the market is always volatile and industry factors keep on changing constantly. Therefore, it is essential to check for the most recent report and, on that basis, envisage its relevance in the current market.

Demand & supply analysis

As we all know, demand and supply are the primary factors governing any market. So, it becomes relevant to look into the demand-supply scenario for a particular product or industry by studying its past trends and also reasonably forecasting future outlook. One can do comparative analysis with other companies competing in the same manner to find out the economic health of the company under consideration. Future demand and supply forecasting helps investors to understand the viability of future investments in companies those sector.

Five forces analysis

Michael Porter propounded the concept of five forces analysis, which is an integral part of any industry analysis.

Under this model, one needs to study the competitive scenario of a company using five parameters to see the competitive landscape. The five forces are (i) barriers to entry (ii) supplier power (iii) threat of substitutes (iv) buyer power and (v) degree of rivalry. All these forces are extensively used while analysing any industry.

An industry analysis is not only just about studying the particular industry on a micro level; it is important to incorporate factors that are influencing the industry at the macro level. The macro-level factors include recent industrial developments, innovation in the industry, legal and regulatory frame work, etc.

To conclude, though there are many approaches to industry analysis, the above steps are essential and industry analysis is useful for understanding a company’s business and business environment and identifying active equity investment opportunities.

Step-by-step approach
* Study statistical relationships between industry trends and a range of economic and business variables
* Develop practical, reliable industry forecasts by using various approaches to forecasting
* Check the chosen industry’s past trends, demand-supply mechanics and future outlook
* Examine industry performance (a) in relation to other industries to identify industries with superior/inferior returns and b) over time to determine the degree of consistency, stability, and risk in the returns in the industry
* 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
* Take up an industry and find out the sectors. Select the particular sector that is doing well and its prospects are good. Moreover, it is worthwhile to look at the different market segments in a particular sector

The writer is associate professor of finance & accounting, IIM Shillong

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