Determining Industry Size, Growth, Characteristics, Profitability and Market Share trends

The process of industry and competitive analysis is a crucial part of understanding the business landscape. It begins with defining an industry, followed by a comprehensive survey to gather essential information for its evaluation. This survey involves several key steps, including estimating the industry size, calculating the historical growth rate, evaluating the character of the growth rate, measuring industry profitability, and identifying major industry players and market share trends.

Industry Size

The measurement of an industry’s size is typically based on the cumulative annual sales figures observed from the product’s or customer’s perspective. It is critical to mention that the total sales might not encompass every sector of a company’s sales. For example, in the case of a conglomerate like Amazon, only the revenues generated from its retail division would be accounted for when evaluating the retail industry size, excluding the contributions from other branches like Amazon Web Services.

An industry’s expansion pace can be determined by analyzing the year-to-year rates annually or by calculating the compounded annual growth rate spanning multiple years. Additionally, a detailed assessment of the industry’s growth can be conducted by segregating the contributions from volume increments and alterations in price or mix.

Approaches to Estimating Industry Size

The industry size estimation can be quite complex, especially for sectors not predominantly occupied by large public corporations, such as the automotive, smartphone, aviation, and pharmaceutical industries. In these cases, a significant portion of sales can be attributed to private firms, including smaller businesses, which might not have readily available data or be too cumbersome to accumulate.

To determine the size of industries, analysts use various methods. They can use economic indicators provided by government agencies, rely on surveys conducted by independent consulting firms, or study industry-specific data found in confidential resources disclosed during investor presentations by issuers. However, it’s the analyst’s responsibility to confirm the accuracy and credibility of these data points.

Industry Growth

The growth rate can be determined either through year-over-year rates annually or as a compounded annual growth rate spanning multiple years. Ideally, growth in the industry should be broken down by contributions from volume and price/mix factors.

Characterizing Industry Growth

The historical growth trajectory of an industry can be described by the intensity of its growth rate and its sensitivity to the business cycles.

One method of characterizing industry growth rate is a style box. This analysis involves comparing the historical growth rate of an industry against broader economic indicators during periods of economic downturns and booms. The analysis is significantly influenced by the growth rate magnitude and how the industry responds to economic cycles.

$$\begin{array}{l|l|l}
& \textbf{Mature} & \textbf{Growth} \\
\hline
\textbf{Defensive} & \begin{array}{@{}c@{}}
\text{-Utilities} \\
\text{-Beverages} \\
\text{-Pharmaceuticals}
\end{array} &
\begin{array}{@{}c@{}}
\text{-Biotechnology} \\
\text{-Software} \\
\text{-Gaming}
\end{array} \\
\hline
\textbf{Cyclical} &
\begin{array}{@{}c@{}}
\text{-Crude oil} \\
\text{-Natural gas} \\
\text{-Freight transportation}
\end{array} &
\begin{array}{@{}c@{}}
\text{-Semiconductors} \\
\text{-Fintech} \\
\text{-Digital advertising}
\end{array} \\
\end{array}$$

Growth Industries

Growth industries are sectors that have not fully tapped into their potential market. Their growth trajectories are often independent of the general economic trends and are propelled by technological advancements or novel business models. Examples include the renewable energy sector and artificial intelligence (AI) industries.

Analysts scrutinizing growth industries focus on determining the sustainability of high growth rates and predicting the maximum market penetration level. These inquiries become particularly intricate with nascent industries. For instance, determining the peak market penetration for the electric vehicle industry can be complex, given its current growth phase.

Mature Industries

Mature industries are those that have exhausted their market growth potential, exhibiting growth rates that either mirror the general economic trends or are on a decline due to shifting consumer preferences. An example is the traditional print media industry, which is declining as digital media takes precedence.

Investors keen on mature industries are vigilant about potential disruptions, alterations in market competition, and the pace at which the industry is receding. For instance, investors in the cable television industry are constantly monitoring the rise of streaming services as a disruptive force.

Business Cycle Sensitivity

The business cycle sensitivity of an industry is predominantly determined by the business models of the companies within that industry and is often linked to the industry’s maturity stage. Factors influencing this sensitivity encompass consumer dependency ( discretionary or necessary) on the products or services, pricing strategies, interest rate impacts on the business model, and the nature of the product (durable goods versus recurring purchases).

Investors generally anticipate fluctuating returns from companies operating in cyclical industries. However, diverse perspectives regarding the duration and intensity of these cycles result in fluctuating valuations of companies over time. For instance, the real estate industry often experiences variations in valuations due to differing investor perceptions about market cycles.

The distinction between growth and mature companies can sometimes be of limited value. For instance, a significant economic downturn will likely negatively affect all companies, meaning differences emerge in magnitude rather than being purely categorical. Furthermore, within a given industry, firms at various life cycle stages can exhibit notable differences in growth, defensiveness, and cyclicality.

Analysis of Industry Profitability Measurement

One of the best approaches to gauge the profitability of an industry is by examining a time series distribution of returns on invested capital over a period of time. This analysis is grounded on evaluating after-tax operational profits against every dollar of capital invested, disregarding the influence of the capital structure. Nevertheless, implementing this strategy is often impracticable unless most companies in the industry are publicly listed.

To circumvent this obstacle, analysts frequently resort to evaluating the profitability of publicly listed companies, projecting a similar profitability trajectory for private firms within the industry. This projection can be realized by leveraging multiple data sources to infer the profitability metrics of private entities or by consulting data disseminated by government bodies or independent consultancies.

While aiming for a profitable industry is a rational approach, scrutinizing the chronological trends of profitability within the industry is often more insightful. This involves an in-depth analysis of the fluctuations in profitability over a span of time, identifying whether it is on an upward or downward trajectory. Detecting a significant trend in this analysis can serve as a pivotal focal point for analysts, guiding further investigative efforts.

Analysis of Market Shares and Industry Concentration

Market Share

Market shares are computed annually to gauge the influence and standing of different companies in an industry. This is done by determining the proportion of the total industry revenue that each company generates. Nevertheless, because determining the exact size of the industry can be challenging, it’s advisable to view market shares as estimates within a certain range rather than pinpoint numbers.

Observing how a company’s market share evolves over time can give us insights into how customers view the company’s products in comparison to rival offerings. For example, a growing market share might indicate a positive customer response to a company’s new line of eco-friendly products.

When analyzing market dynamics, it is essential to take note of acquisitions, especially substantial ones. Even though acquiring a rival can bolster a company’s market share, it is vital to assess whether the company is expanding its market presence organically without relying on acquisitions. This paints a more accurate picture of a company’s inherent growth and market acceptance. For instance, if a tech startup expands its market share by developing innovative products, it indicates organic growth.

Industry Concentration

It is crucial to factor in the concentration level within the industry. A lower concentration, characterized by the presence of many small competitors, is typically linked to intense competition unless the industry focuses on localized services or offers highly differentiated products. In contrast, increasing concentration, where few companies dominate the market, often results in reduced competition and increased profitability. For instance, a burgeoning industry like craft breweries, characterized by numerous small players, usually experiences high competitive intensity.

Herfindahl-Hirschman Index (HHI)

A widely used tool to assess industry concentration is the Herfindahl-Hirschman Index (HHI), which is derived by summing up the squares of the market shares of all industry participants. As such, the Herfindahl-Hirschman Index (HHI) is calculated as follows:

\[ HHI = \sum_{i=1}^{n} s_i^2 \]

where: \(s_i\) stands for the market share of the ith company, represented as a whole number (for example, a market share of 40% is denoted as 40, rather than 0.40).

To illustrate, an industry dominated by four firms with market shares of 40%, 30%, 20%, and 10% would have an HHI of \(40^2 + 30^2 + 20^2 + 10^2 = 3000\). In the extreme case of a monopoly, the HHI would reach the maximum value of 10,000 (\(=100^2\)).

Antitrust agencies in various nations deem markets with an HHI between 1500 and 2500 moderately concentrated and those with an HHI above 2500 highly concentrated. As a rule of thumb, if an acquisition in a highly concentrated market increases the HHI by over 200 points, it might face regulatory hurdles, as it could potentially lessen competition further.

Question

Which of the following are most likely the key issues for investors in a mature industry?

1. Identifying major industry players and analyzing market share trends.
2. Estimating the size of the industry and calculating its historical growth rate.
3. Monitoring for disruptive threats, changes in competitive intensity, and the speed of decline.

The correct answer is C.

Investors in mature industries face several important challenges. These include keeping an eye out for disruptive threats, shifts in competitive intensity, and the pace of decline. Mature industries typically experience slow growth, have established competitors, and predictable market dynamics. Yet, they can also be vulnerable to disruptions from new technologies or business models. Changes in competitive intensity might occur due to shifts in market share or strategies among competitors. The speed at which the industry declines can also be a concern as it moves toward obsolescence. Investors must diligently monitor these factors as they can have a substantial impact on the profitability and sustainability of companies within the industry.

In mature industries, there are key challenges to consider. Disruptive threats can jeopardize established business models, shifts in competitive intensity may put pressure on profit margins, and a rapid decline can lead to stranded assets. Consequently, having a deep understanding of these dynamics is essential when making investment decisions in such industries.

A is incorrect. Identifying major industry players and analyzing market share trends are also important aspects of industry analysis. However, they are not the key issues for investors in a mature industry. In a mature industry, the major players and market share trends are usually well-established and do not change significantly over time. Therefore, while understanding these factors can provide insights into the competitive landscape, they are not the primary concerns for investors in a mature industry.

B is incorrect. While estimating the size of the industry and calculating its historical growth rate are important aspects of industry analysis, they are not the key issues for investors in a mature industry. The size and growth rate of the industry are more relevant for investors in growth industries where the potential for expansion is a key driver of investment returns. In a mature industry, the focus is more on the competitive dynamics and the risks of disruption or decline.