Investment Analysis
Lecture 7
Industry Analysis
Investment Analysis
Financial Statement Information & IAS
Global Industry Analysis
Country Analysis
Forecasting Economic Growth
Short-run:
Business Cycle
Long-run:
Sustainable
Economic
Growth
Industry Analysis
Return Elements
•Demand Analysis
•Industry Life Cycle
Analysis
•Competition
Structure
•Competitive
Advantage
•Competitive
Strategies
•Coopetition
•Sector Rotation
Equity Analysis
Risk Elements
•Market Competition
•Value Chain
Competition
•Rivalry Intensity
•Substitutes
•Buyer Power
•Supplier Power
•New Entrants
•Government
Participation
•Risks
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.
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.
1.
“N” firm concentration ratio, which the combined market share of the
largest N firms in the industry.
2.
Herfindahl Index, which is the sum of the squared market shares of the
firms in the industry.
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.
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
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.
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.
Solution:
• 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.
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 higherthan-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.
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:
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Buyer power
Supplier power
Rivalry intensity
New entrants
Substitutes
Market competition
Government participation
Value chain competition
Risk & covariance
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.
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.