Why analyze an industry, and the steps to do it

Why look at the industry before the company?

Companies in the same industry sell similar products to similar customers, buy from similar suppliers, hire similar workers and face the same shocks. Think of a cement producer and its rivals: they all depend on construction activity, energy prices and the same few quarries. Because they share the same demand and supply conditions, the structure of the industry explains much of the long-run difference in profitability between one industry and another.

Industry analysis is the study of what drives an industry’s size, growth, profitability and market shares, and of where a company stands within it. It is step 2 of the framework you met in the previous module: company analysis (past and present), then industry and competitive analysis, then forecasting.

Does a strong industry guarantee a strong company?

No. To see why, use the measures analysts use for profit. Return on invested capital (ROIC) is after-tax operating profit per unit of capital invested in the business, and it is neutral about how the business is financed. Economic profit exists when ROIC is above the weighted average cost of capital (WACC). The gap is the spread.

$$S = \text{ROIC} - \text{WACC}$$

Research on this question found two things. Industry was the most important factor in how long economic profits last. And company-specific effects were much larger for weak performers than for strong ones. Put together, industry forces act as a ceiling, not a floor: they limit how much even the best company can keep earning, while a badly run company can earn far less than its peers.

A useful picture is a base rate : the level of growth and profitability that is typical for the industry. Competition pulls each company’s results toward it. Some companies stay above it for many years, so the pull is a tendency, not a law.

What are the two uses of industry analysis?

Use it

Improve forecasts. Competitive forces from rivals, substitutes, suppliers and customers discipline prices, costs and market share. An industry view gives the analyst a base rate for growth and margins, a record of how rivals have acted in the past, and a sense of what matters most. Without it, an analyst can overrate how much a company controls its own destiny.

Identify opportunities. Studying the industry can surface a company that looks stronger than its peers, or an entire industry the analyst wants exposure to. An investor who wants the industry and not one company can hold a basket of companies to diversify away company-specific risk.

Exam tip A question that says “anchor the forecast on the industry median” is about improving forecasts. A question that says “find companies the market misjudges” is about identifying opportunities.

What are the steps?

The process runs from the outside in, then back to the company. Each step feeds the next.

Industry and competitive analysisstep 2 of the company-analysis framework, between past and present (1) and forecasting (3)

• 1. Define the industry Memorize who sells similar products to the same customers?
  • Use a classification scheme as a start then adjust
  • Judgment calls substitutes, multi-product companies, geography
• 2. Survey the industry Memorize the facts and trends
  • Size and growth and the character of growth
  • Profitability ROIC distribution over time
  • Market share trends and concentration
• 3. Analyze structure and outside influences Memorize the why behind the survey
  • Porter’s Five Forces structure, so profitability
  • PESTLE external influences, so growth and share
• 4. Evaluate competitive position Memorize strategy against the industry
  • Strategy defends against the forces, fits the trends, can be executed
  • Competitive advantage? a record of economic profit

1. Define the industry and its main players. Third-party schemes such as the Global Industry Classification Standard (GICS), the Industry Classification Benchmark (ICB) and the Refinitiv Business Classification (TRBC) help, but the analyst decides who really competes.
2. Survey the industry: size, growth and its character, profitability, market share trends.
3. Analyze structure and external influences: Porter’s Five Forces for structure, PESTLE (political, economic, social, technological, legal, and environmental) for outside influences.
4. Evaluate the company’s competitive strategy and position, and decide whether it has a competitive advantage : a lasting ability to earn more than its rivals, shown by a record of economic profit.

The next four lessons follow steps 1 to 4 in this order.

Go deeper Industry factors versus company factors

Some things belong to the whole industry: how sensitive sales are to the business cycle, the intensity of the five forces, the pace of industry growth. Others belong to the company: its strategy, size, business model variation and how well it executes. The industry sets the base rate, and company-specific factors create the spread of results around it. That split is why an exam question may ask you to say which side a given fact falls on.

Go deeper Why specialist analysts do well

An analyst who covers one industry builds a database of competitive moves and how they worked out. That knowledge transfers across companies in the same industry, which is why research teams are organized by industry. The same logic helps explain why analysts who follow a company’s suppliers as well as the company tend to forecast earnings more accurately: they see the force from the supplier side.