Level 1 CFA® Exam:
Industry Analysis – Miscellanea
In strategic analysis, we should pay special attention to several factors. First, we will focus on barriers to entry.
When barriers to entry are not high, we deal with a competitive market. This is due to a large number of entities that can easily enter the market and have their share in it. For this reason, pricing power is low. An industry that is characterized by low barriers to entry is the casual dining industry. This industry doesn’t require any know-how or capital and almost anyone can try to enter the market.
Considerable difficulties in entering a market are, in fact, favorable for the entities that already operate in this market. It reduces competition and, therefore, companies have more pricing power. An example of a market with high barriers to entry is the energy market. To begin to operate in the market we need huge capital, knowledge, and access to technology. As a result, there is a small number of market operators and strong pricing power.
Remember to distinguish between barriers to entry and barriers to success. Very often it is easy to enter a market but it may be difficult to have a share in it. High barriers to entry are not always associated with strong pricing power. An example is the automotive market or the aviation market. Both are characterized by high barriers to entry, but in both cases pricing power is weak.
We are dealing here with a kind of paradox, which can be explained as follows:
First, it is the price that influences someone’s decision whether to use this kind of service or not. Companies operating in the automotive and aviation markets provide expensive but easily replaceable products. Consider aircraft manufacturers: Airbus and Boeing. When buying airplanes, airlines are trying to purchase at the lowest price. Thus, aircraft manufacturers have limited ability to generate high rates of return despite high barriers to entry.
The second explanation is the fact that the aviation and automotive industries are characterized by high barriers to exit. As a result, companies operating in these markets are more likely to be affected by overcapacity. The owners of such companies receive incentives to keep the plants operating.
Another important aspect related to industry analysis is industry concentration. An analysis of industry concentration consists in measuring the market share of the biggest companies, and especially of the entity with the largest market share. The higher it is, the greater the concentration of the market. What’s important, we can distinguish between two measures of concentration: relative and absolute.
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| Concentrated with strong pricing power | Soft drinks, Orthopedic devices, Laboratory services, Pharmaceuticals |
|---|---|
| Concentrated with weak pricing power | Commercial aircraft, Automobiles, Consumer electronics, Equity exchanges |
| Fragmented with strong pricing power | Asset management, Private banking, Propane distribution, For-profit education |
| Fragmented with weak pricing power | Retail, Solar panels, Airlines, Restaurants |
Another factor we are going to analyze is industry capacity.
Industry capacity is the amount of goods that the companies are able to produce in a given time. According to the law of supply and demand, if capacity is limited, companies are not able to satisfy the demand and prices increase. However, if supply exceeds demand, prices decrease.
It is said that industry capacity is fixed in the short term but variable in the longer term. This is explained by the time that is necessary to build the infrastructure (e.g. factories or machinery) needed to increase production capacity.
Industry capacity changes at a different pace for different industries. It takes years to construct new machinery used to produce medicines but there are cases in which technology is changing rapidly, for example in the advertising industry.
Another factor that should be taken into consideration when performing analysis is market share stability. Market shares are affected by many factors. We have already discussed most of them and these are barriers to entry, new product introductions, and product differentiation. Stable market shares mean that the industry is less competitive. However, when market shares of particular players change significantly, the industry is highly competitive.
Every company in the course of its development goes through different stages of the life cycle. The situation is similar in the case of whole industries. The basic task of any investor before deciding whether to invest in a given company should be to analyze the industry’s life cycle and to determine what phase the industry is in.
An industry life cycle consists of five stages:
- an embryonic stage,
- a growth stage,
- a shakeout stage,
- a maturity stage, and
- a decline stage.
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Industry Life-Cycle Model
Using the life cycle model is about answering a question considering the stage of development a company is at. Each stage of industry development has its characteristics which allow us to see what stage of development we’re dealing with.
New industries whose markets are not fully shaped are more competitive than mature industries due to significant fluctuations in market shares. Companies operating in such an industry are focused on building customer loyalty. What matters less is the efficiency of their actions.
Mature industries are, in turn, industries, where companies focus more on keeping existing customers than acquiring new ones. They also put more emphasis on selling products and services already known to customers instead of introducing new ones. What is also important in the case of such industries is cost rationalization. Despite the lack of significant growth in mature industries, companies still have strong cash flows.
Limitations of industry life-cycle analysis:
While industry life-cycle analysis makes it possible to draw interesting conclusions about the business, remember that it has its drawbacks. First of all, it is a theoretical model and economic reality often differs from theory. Therefore, the life cycle of any of the industries will never be exactly the same as the model. In some industries, some stages may be skipped and this may result, for example, in a direct shift from growth to decline.
Regulatory changes may also distort the life cycle of industry and lead to difficulties in analysis. Regulatory authorities through administrative decisions may affect the profitability of industries and even make some companies exit the market.
What’s more, social changes also affect industry life cycles. Social changes include all factors related to demography and the processes taking place in society. An example is the casual dining industry. When a society is getting wealthier and people can afford to eat out, it contributes to a significant increase in restaurants’ revenues.
What is important is that the industry life cycle model is best suited for industries during periods of stability. On the other hand, it is not effective to use the model in times of economic uncertainty and rapid changes which are associated with it.
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- When barriers to entry are not high, we deal with a competitive market.
- An analysis of industry concentration consists in measuring the market share of the biggest companies, and especially of the entity with the largest market share.
- Industry capacity is the amount of goods that the companies are able to produce in a given time.
- An embryonic stage is a phase in which the first products or services appear and the industry begins to develop.
- Growth is a stage in which there is a very rapid increase in demand.
- In the shakeout stage, the industry growth slows down.
- In the maturity stage, as the market is saturated, the industry experiences little growth, and in some cases even declines.
- The decline stage is the last phase in the life cycle of an industry.
- The industry life cycle model is best suited for industries during periods of stability.
- An industry is more competitive if the price is what matters most for the customer.