Investment Analysis Lecture 7 Industry Analysis

Financial Statement Information & IAS Investment Analysis Financial Statement Information & IAS Global Industry Analysis Country Analysis Industry Analysis Return Elements Demand Analysis Industry Life Cycle Analysis Competition Structure Competitive Advantage Competitive Strategies Coopetition Sector Rotation Risk Elements Market Competition Value Chain Competition Rivalry Intensity Substitutes Buyer Power Supplier Power New Entrants Government Participation Risks Forecasting Economic Growth Short-run: Business Cycle Long-run: Sustainable Economic Growth Equity Analysis

Industry Analysis Return Elements Demand Analysis Investment Analysis Industry Analysis Return Elements Demand Analysis Industry Life Cycle Analysis Competition Structure Competitive Advantage Competitive Strategies Coo petition Sector Rotation Risk Elements Market Competition Value Chain Competition Rivalry Intensity Substitutes Buyer Power Supplier Power New Entrants Government Participation Risks

Investment Analysis Return Analysis The investor’s ultimate goal should be to earn excess returns on a risk adjusted basis. Therefore, it is important to consider both return potential and risk characteristics when conducting the industry analysis. In general terms, to assess return potential we need to look at the firm’s sources of growth and how it maintains a competitive advantage. The following points should be considered: Demand Analysis: Analysts should perform a local/global demand analysis by predicting how changes in GDP will affect sales using a regression framework. Industry Life Cycle Analysis: Analysts should determine where the industry falls within the stages of the standard life cycle: pioneer, growth, mature or decline. The actual stage the industry is in will affect the potential investment returns, so it is important that the analyst makes an assessment that is as accurate as possible based on the available information.

Return Analysis (cont’d …) Investment Analysis Return Analysis (cont’d …) Competition Structure Analysis: Analysts should assess the degree of industry concentration. There are two methods to achieve this assessment. “N” firm concentration ratio, which the combined market share of the largest N firms in the industry. Herfindahl Index, which is the sum of the squared market shares of the firms in the industry.

Return Analysis (cont’d …) Investment Analysis Return Analysis (cont’d …) Both the N firm and Herfindahl measures are used to estimate the amount of cooperation versus competition within the industry. If the values for both measures are low, then it is more likely that there is a high level of competition and less cooperation within the industry. All other things being equal, this results in modest or no economic profits for each firm within the industry. In applying the N firm concentration ratio, assume we have a situation where the 20 largest firms have a combined share of 40%. This suggests a competitive industry environment in which excess returns are not likely. In contrast, suppose we have another industry in which two firms have a combined share of 100%. This suggests an oligopoly in which excess returns are likely. At best, this ratio gives a big picture but not precise sense of the level of competition within the industry, partly because not all firms are considered.

Return Analysis (cont’d …) Investment Analysis Return Analysis (cont’d …) The Herfindahl Index (H) is similar but more precise. It reflects all of the firms in the industry, and greater emphasis is given to firms that hold relatively large market shares . n Herfindahl Index = ∑ MSi2 i=1 Where: MSi = Market Share of Firm i n = Number of Firms in the Industry

Return Analysis (cont’d …) Investment Analysis Return Analysis (cont’d …) A value below 0.1 suggests low concentration, a value of 0.1 to 0.18 suggests moderate concentration and a value of 0.18 suggests high concentration. As long as there are at least two firms in the industry, Herfindahl Index should be less than one.

Return Analysis (cont’d …) Investment Analysis Return Analysis (cont’d …) Example 1 Assume there are 20 firms in the industry, each with a 5% market share. Calculate and interpret the Herfindahl Index. Solution: H = (0.05)^2 x 20 = 0.05 (0.05 < 0.1, therefore, low concentration) A low H (below 0.1) suggests that the industry is competitive, that there are no dominant firms and that the cooperation between firms is not likely. Example 2 Now assume that there are 5 firms in the industry, each with a 20% market share. Calculate and interpret the Herfindahl Index. Contrast the results with those of the previous example. H= (0.20)^2 x 5 = 0.2 (0.2 > 0.18, therefore, high concentration) A high H (above 0.18) suggests that the industry is dominated by a few firms that have an incentive to cooperate to maximize their returns.

Return Analysis (cont’d …) Investment Analysis Return Analysis (cont’d …) Value Chain: Analysts should also examine the value chain. The value chain involves a set of ongoing changes in moving from raw materials to the final product. Return opportunities may be examined by analyzing the entire industry’s value chain and how each company plans to create profits throughout the chain. Firm managers often try to predict the sources of profits within the industry’s value chain. The analyst must do the same in an attempt to predict the timing and amount of dividends as well as dividend growth rates. Degree of Industry Cooperation: Analysts should examine the level of coordination (known as coopetition) among the participants who produce value along the value chain. Analysts should try to quantify the level of increased returns achieved through cooperation. However, such returns may be unstable, especially if a firm derives higher-than-normal profits due to cooperation. In good economic times, this is usually not a problem. In bad economic times, the profits may completely disappear due to sudden competition. Analysts must always be aware of the potential for wide fluctuations in returns when firms engage in cooperation.

Return Analysis (cont’d …) Investment Analysis Return Analysis (cont’d …) Competitive Advantage: Certain locations in the world/country may have a competitive advantage in producing or providing specific goods and services. High workforce education levels, efficient production methodologies and low competition are examples of way in which a country/region could gain a competitive advantage. The analyst should identify those countries/regions that have a competitive advantage in an attempt to maximize return opportunities. Generic Competitive Strategies: The analyst should identify generic competitive strategies (e.g., cost leadership, differentiation, cost focus) that firms in the industry are pursuing. In determining whether excess returns are possible, the analyst will need to consider how likely it is that the firm’s strategy will succeed. This could be achieved by examining the firm’s commitment to the strategy and anticipated reactions from its competitors.

Investment Analysis Risk Analysis Although it is important to consider the return aspects, it is just as important to consider the risk aspects of investments also. The concepts of risk and return are interrelated. Only when industry risk is examined an analyst might obtain a full picture of the merits of investing in a particular industry by analyzing the following main factors: Buyer power Supplier power Rivalry intensity New entrants Substitutes Market competition Government participation Value chain competition Risk & covariance

Risk Analysis (cont’d …) Investment Analysis Risk Analysis (cont’d …) Competition within the industry: Analysts should examine competition within the industry. Firms compete using various price strategies in order to maintain a competitive advantage. For example, pricing below average cost and holding excess capacity would deter entry of new firms. Pricing below average cost might also drive existing competitors out of business. Government intervention: Government intervention comes in the form of financial assistance to domestic firms and regulations to control competition. As a result, foreign firms bear the risk of increased competition in domestic markets. Also, there is always the risk that the chosen regulations will not be in a firm’s or industry’s favor.

Risk Analysis (cont’d …) Investment Analysis Risk Analysis (cont’d …) Value chain competition: Analysts should also examine competition along the value chain. Participants have a choice either to compete or to cooperate. The analyst must consider the risk that firm’s along the value chain may not always cooperate with one another. However, vertical integration may mitigate some of that risk. Overall risk: Analysts should examine a firm’s or industry’s overall risk by estimating standard deviation of returns. Analysts could also look at a firm’s or industry’s covariance of returns with the overall economy through an analysis of historical regressions of company returns against market returns.