The Importance of Industrial Analysis in Investment Strategies
Industrial analysis examines the environment, conditions, and characteristics of the industry in which similar companies operate. The main driving factors for the industry, such as competition, supply and demand, technologies, products and services, are the focus of the analysis. A key task is to identify the opportunities and risks shaping the industry.
Industrial analysis is conducted for various purposes. It is essential for any business that wants to understand the environment in which it operates and to build its strategy in accordance with its prospects.
Many investors use a top-down analysis approach when selecting stocks to invest in. In this approach, the main economic trends and the assessment of the industry in which a company operates are of significant importance.
Industry Classification Systems
Global Industry Classification Standard (GICS®)
The GICS® is a project by MSCI and S&P Dow Jones Indices, which classifies companies from developed and emerging markets into a four-tier hierarchical structure (11 sectors, 25 industry groups, 74 industries, and 163 sub-industries). Each company falls into one of each of the four categories. For example, under GICS®, a company in the Industrials sector is also part of the Transportation industry group, the Ground Transportation industry, and the Rail Transportation sub-industry.
The main criterion for determining which sector and industry a particular company should be allocated to is the business activity that generates the most significant revenue.
Here is a list of the 11 sectors according to GICS®:
- Materials
- Consumer Discretionary
- Consumer Staples
- Energy
- Financials
- Health Care
- Industrials
- Information Technology
- Communication Services
- Utilities
- Real Estate
Industry Classification Benchmark (ICB)
The ICB is another popular classification system, using a four-tier hierarchical structure (11 industries, 20 supersectors, 45 sectors, and 173 subsectors).
As seen, different systems use different terminology regarding their structure, categorizing companies into broad and narrower groups of activities.
There are also other classification systems besides those listed, including government ones.
Types of Industry Analysis
Porter’s Five Forces
Michael Porter developed one of the most influential frameworks for industry analysis, known as “Porter’s Five Forces.” This framework helps businesses understand the competitive dynamics within their industry by examining five key forces:
- Threat of Substitute Products: The potential emergence of substitute products with higher quality or lower prices can significantly impact existing companies. For example, the rise of streaming services like Netflix posed a substantial threat to traditional cable TV providers.
- Bargaining Power of Buyers: When buyers are few and can easily switch to substitute products, they gain leverage to demand lower prices or higher quality. For instance, in the automotive industry, large fleet buyers like rental car companies can negotiate better terms due to their purchasing power.
- Bargaining Power of Suppliers: If suppliers are few and provide essential resources, they can exert significant influence over companies in the industry. For example, in the tech industry, companies that supply critical components like microchips can dictate terms to manufacturers.
- Threat of New Entrants: Industries with low barriers to entry often face intense competition as new companies can easily enter the market. For instance, the food delivery industry saw a surge of new entrants during the pandemic, increasing competition among existing players.
- Rivalry Among Existing Competitors: Established competitors in the industry continuously strive to improve their market position. This rivalry can lead to price wars, increased marketing efforts, and innovation. For example, the rivalry between Coca-Cola and Pepsi has driven both companies to constantly innovate and expand their product lines.
While Porter’s Five Forces provide a robust framework for industry analysis, it’s essential to consider other factors such as technological advancements, regulatory changes, and macroeconomic trends to gain a comprehensive understanding of the industry landscape.
Broad Factor Analysis (PEST Analysis)
Broad Factor Analysis, also known as PEST Analysis, focuses on external factors that can significantly impact an industry. PEST stands for Political, Economic, Social, and Technological factors.
- Political Factors: This involves an assessment of the political system and stability, as well as specific laws, trade regulations, tax policies, and other legislative measures. For example, recent laws related to ESG (Environmental, Social, and Governance) policies have significantly altered the framework within which coal and clean energy producers operate.
- Economic Factors: Economic factors such as growth rate, monetary policy, and inflation are crucial for different industries. Some of these factors can have long-term effects. For instance, cyclical industries like automotive and construction are more sensitive to the business cycle compared to non-cyclical industries like healthcare and utilities.
- Social Factors: Social factors like demographic trends (increasing or decreasing population) and the age and qualification of the workforce are important for the economic outlook and individual industries. For example, an aging population can increase demand for healthcare services, while a younger, tech-savvy workforce can drive innovation in the tech industry.
- Technological Factors: Access to and integration of technological innovations affect productivity and the quality of products and services. For instance, advancements in artificial intelligence and automation can significantly enhance manufacturing efficiency and product quality.
SWOT Analysis
SWOT Analysis is another popular method for examining an industry. This type of analysis looks at internal (Strengths and Weaknesses) and external (Opportunities and Threats) factors for the industry. It is also applied to individual companies, products, and other purposes.
- Strengths: Strengths can be key competitive advantages such as advanced technological solutions, access to cheap capital, highly skilled workforce, etc. For example, a company with a strong brand reputation and loyal customer base has a significant strength.
- Weaknesses: Weaknesses are those factors that prevent the industry from being competitive. These can include high borrowing costs, logistical inefficiencies, inability to optimize the technological process. For instance, a company with outdated technology or poor supply chain management may struggle to compete.
- Opportunities: Opportunities can come in various forms, often unexpectedly. These can include government support for the industry, relaxed trade regulations, or the emergence of a new business niche. For example, the rise of e-commerce has created new opportunities for retail businesses to reach a global market.
- Threats: Similar to opportunities, threats can also be difficult to predict. These include rising taxes and tariffs, shortages of production raw materials, or changes in consumer preferences. For instance, a sudden increase in raw material prices can pose a significant threat to manufacturing companies.
Company Analysis in the Context of Their Industries
Understanding the industry in which a company operates often precedes the analysis of the company itself. In general terms, the industry represents the primary framework within which a business conducts its activities. This includes legal, regulatory, and normative rules, competition, supply and demand, types of services and products, technological integration, and more.
Michael Porter categorizes competitive strategies into two main types: low-cost strategy and differentiation strategy.
- Low-Cost Strategy: In this approach, a business aims to gain market share by optimizing the production process and offering its products at lower prices compared to competitors. This strategy is often employed by companies in industries where price competition is intense, such as retail or manufacturing.
- Differentiation Strategy: This strategy focuses on offering a product that is unique in its qualities, type, or distribution method. Companies that successfully differentiate their products can often charge premium prices. Examples include luxury brands or tech companies that innovate with new features.
Investors seek to identify industries with good growth potential and, through comparative analysis of individual stocks within that industry, identify promising investment opportunities.
Since companies within a given industry are influenced by similar factors, peer groups often react similarly to the different stages of the business cycle. As a result, the returns on their stocks are often highly correlated.
The scope of analysis at the individual company level can be very broad, including:
- Financial Analysis: Assessing financial health through metrics like revenue, profit margins, and cash flow.
- Business Strategy: Understanding the company’s long-term plans and growth strategies.
- Corporate Governance: Examining the structure and effectiveness of the company’s leadership and board of directors.
- Competitive Position: Analyzing the company’s market share and competitive advantages.
- Production Capacity: Evaluating the efficiency and scalability of the company’s production processes.
- Marketing and Distribution: Assessing the effectiveness of the company’s marketing strategies and distribution channels.
- Sales of Goods/Services: Reviewing sales performance and customer satisfaction.
Conclusion
By understanding the industry context, investors and analysts can better assess a company’s potential and make more informed decisions. Various classification systems categorize businesses based on their activities. Porter’s Five Forces analyzes the key factors affecting industry competition, while PEST and SWOT analyses offer valuable insights into the external and internal factors that impact industries.
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