Industry Analysis Fundamentals

Before investing in a company, you must understand its industry. Even great companies struggle in bad industries, while average companies can thrive in favorable ones. [DEFINITION] Industry Analysis: The evaluation of economic, competitive, and structural factors affecting all companies within a specific business sector. ### Why Industry Matters [KEY] Peter Lynch said: "You should never invest in a company before you understand its industry." Industry dynamics determine: - Profit potential - Competitive intensity - Growth runway - Risk factors [EXAMPLE] Two equally talented management teams: - One runs an airline (historically unprofitable industry) - One runs a software company (highly profitable industry) The software company will likely generate far better returns simply due to industry characteristics. ### Porter's Five Forces Framework Michael Porter's framework analyzes industry attractiveness: **1. Threat of New Entrants** How easily can new competitors enter? | Factor | Impact on Profits | |--------|------------------| | High barriers | Better profits | | Low barriers | Profit pressure | Barriers include: capital requirements, regulations, brand loyalty, patents, network effects **2. Bargaining Power of Suppliers** Can suppliers demand higher prices? Few powerful suppliers = profit squeeze Many competing suppliers = better margins **3. Bargaining Power of Buyers** Can customers demand lower prices? Few large buyers = tough negotiations Many dispersed buyers = pricing power **4. Threat of Substitutes** Can customers switch to alternatives? No substitutes = pricing power Many alternatives = price competition **5. Industry Rivalry** How intense is competition? Fierce price wars = low profits Rational competitors = better margins [EXAMPLE] Airline Industry Analysis: - New entrants: Moderate (capital-intensive but possible) - Supplier power: HIGH (Boeing/Airbus duopoly, oil) - Buyer power: HIGH (price-sensitive travelers) - Substitutes: Moderate (cars, trains, video calls) - Rivalry: INTENSE (price wars, overcapacity) Conclusion: Structurally unattractive industry—explains decades of poor returns. ### Industry Life Cycle Industries evolve through stages: **1. Introduction** - New product/service - Few competitors - High growth, losses common - Example: Electric vehicles (2010s) **2. Growth** - Rapid adoption - More competitors enter - High growth, improving profits - Example: Cloud computing (now) **3. Maturity** - Slower growth - Market saturated - Focus on market share - Example: Smartphones (now) **4. Decline** - Shrinking demand - Consolidation - Falling prices and profits - Example: Print newspapers [TIP] Ideally, invest in growth-stage industries with long runways. Avoid declining industries unless there's a clear transformation story. ### Industry Profitability Comparison Average profit margins by industry: | Industry | Typical Net Margin | |----------|-------------------| | Software | 20-30% | | Pharmaceuticals | 15-25% | | Financial Services | 15-25% | | Consumer Staples | 5-10% | | Retail | 2-5% | | Airlines | 0-3% | | Groceries | 1-3% | [WARNING] Low-margin industries can still create value, but execution must be exceptional. Walmart thrives with 2-3% margins through massive scale. ### Cyclical vs. Defensive Industries **Cyclical Industries:** Rise and fall with economic cycles Examples: Auto, housing, luxury goods, travel - Do well in expansions - Struggle in recessions - Harder to value (use cycle-adjusted metrics) **Defensive Industries:** Stable through economic cycles Examples: Utilities, healthcare, consumer staples - Consistent demand regardless of economy - Lower growth but more predictable - Often valued for dividends ### Regulatory Considerations Some industries face heavy regulation: **Highly Regulated:** - Banks and insurance - Utilities - Healthcare - Telecom Benefits: Barriers to entry Risks: Regulatory changes, limited flexibility [EXERCISE] Analyze the search engine industry using Porter's Five Forces: 1) Threat of new entrants, 2) Supplier power, 3) Buyer power (advertisers), 4) Substitutes, 5) Rivalry. |ANSWER| 1) Very low—Google's scale, data, and habits create massive barriers. 2) Low—Google doesn't depend on any powerful supplier. 3) Moderate—advertisers have some alternatives but Google reaches everyone. 4) Low—no substitute for searching the internet. 5) Limited—Google has 90%+ share. Conclusion: Extremely attractive industry structure, explaining Google's high margins. [SCENARIO] You're deciding between investing in: - Company A: Great management, 25% margins, in the grocery industry (1-3% industry average) - Company B: Good management, 22% margins, in software (20-30% industry average) Company A's margins are unsustainably high for grocery—they'll likely compress toward industry norms. Company B's margins are average for software and sustainable. Industry context suggests Company B is the safer long-term bet.