‘Bill Gates wouldn’t be a billionaire if he were in forest products’
- Anonymous.

The performance of the sector can have a bigger impact on your returns than the choice of company to invest in.

The prospects of a company are influenced by the industry in which it is in and the competitive position that the firm has within the industry. We covered the competitive position in last month’s schools series. This month we will look at the industry.

Many of us spend hours looking at the performance of the companies we own or plan to buy, but much less time studying the industry. Professional players do the reverse; they spend a lot of time looking at the industry they want to invest in and then look at the companies within that industry.

The reason is that a high proportion of a company’s performance is determined by the industry it is in. For instance, an investor in banking stocks would have done very well over the past couple of years regardless of which bank stock he or she chose to buy.

When analysing an industry we at Smart Investor look at three things, the industry growth, the level of competition and how the industry is structured.
Industry growth
A rising tide lifts all boats. In an industry that is growing rapidly, even poorly managed and badly positioned firms will see revenue and profit growth. However, if an industry is declining in size, then, regardless of how smart the managers in individual firms are, over time the revenues and profits will also decline. A fast growing industry is always a desirable attribute for investors.

There are three things to consider when looking at growth; the growth rate, whether an industry is cyclical or not and the stage in which the industry is in.

The rate of industry growth can fall into one of four positions; it can be growing faster than the economy, growing in line with the economy, growing slower than the economy or declining in absolute terms.

When assessing where it falls, it is also important to understand if the industry is a cyclical industry. Cyclical industries grow faster than the economy when the economy is expanding and decline faster than the economy when the economy is contracting. An example is the construction industry.

During times of strong economic growth firms and individuals increase their capital investment budgets and get to work on new buildings, but when the economy is slowing they stop new construction projects. Identifying where the industry is in its cycle can help you to project how long the growth will last, it can also help prevent a common mistake amongst even experienced analysts and investors, of projecting the high growth of a cyclical industry well beyond the business cycle.

Understanding the stages of industry growth will also help to assess how fast the industry will grow in future. An industry passes through four stages over time: introduction, growth, maturity and decline. Where it sits within these stages plays a big role in terms of how the industry will grow in the future. The introductory stage is one of relatively low unit volumes, where firms spend a high percentage of revenue on marketing and product awareness. For an industry in this stage, the best is yet to come and there will be spectacular growth in the future.

The growth stage is one of very rapid growth, when many first time customers are coming into the market. The telecommunications industry in Nigeria has been in rapid growth for the past few years. Some analysts are saying that its growth stage is coming to an end, whilst other analysts believe that there are more years of growth to come. Who is right will weigh heavily on the investment returns from people who have recently invested in MTN’s or Starcomms’ private placement. During the growth stage, analysts should spend a lot of time trying to forecast when the industry will become mature.

The maturity stage is when most people have the product and the market is mainly replacement. At this stage, growth is much slower and may be in line with the growth in the economy. The brewing industry, dominated by Nigerian Breweries and Guinness, is an example of a mature industry.

The maturity stage can last for many years or even decades, in the case of many products. During the decline stage customers are leaving the industry altogether and getting their needs filled with products from other industries. A declining industry can sometimes be revitalised when a new use is found for its products. Kerosene usage was declining following the introduction of electricity in many western countries until it began to be used as jet fuel for modern aircraft engines.

Level of competitiveness
We all know that the more people who show up for the party, the less food will be available for each guest. The same goes for the number of players in the industry. More players and, more importantly, the level of (price) rivalry amongst the players can make the industry attractive or unattractive.

Warren Buffet once remarked that if he could get a water utility in a medium sized town with a laid back regulator, he would be more than happy. His meaning being that with no competition (water utilities are normally monopolies) he would make lots of money, if the regulator didn’t force him to give it back to customers.

When looking at the competitiveness of an industry you are really trying to get a feel for the amount of price competition amongst the players. Price competition, because it lowers margins, can be devastating to the profitability within an industry. And you would not want to invest in companies in an industry where price competition will make it difficult for firms to give you a decent return.

The amount of rivalry is influenced by the industry growth (if the industry is growing there is less reason to try to offer lower prices to get customers from your competitors), the barriers to entry (if it is too easy to set up in the industry then many new players will come in), barriers to exit and the level of consolidation (if there are a few big players, they will often have the clout to bring the industry into line. Smaller players will be too scared to challenge the leaders).

In many industries the government, through a regulator, manages prices, e.g. the petroleum marketing industry.
Industry structure
The structure of an industry also plays a big role in its attractiveness. Within any industry there is a finite amount of revenue that all the players (firms, suppliers and customers) compete for. The group with the highest amount of bargaining power will often take any surplus profits.

For instance, in the glass bottle manufacturing industry there are just a few large bottle customers (the breweries and soft drink companies) so they have an inordinate negotiating advantage and can dictate the prices that the packaging companies can charge. Not a conducive environment to make money.

Or conversely in the computer industry there are few suppliers of microprocessor chips (Intel being the major one) so they tend to dictate the price and end up taking a large amount of the profit.

Industry analysis is an important part of evaluating an investment decision. The most successful investors spend some time looking at the growth prospects for the industry, the level of competitiveness and the power structures between the firm and its customers, suppliers, and government.