Macroeconomic and Industry Analysis

Industry Life Cycle Analysis

Many industrial economists believe that the development of almost every industry may
be analysed in terms of a life cycle with four well-defined stages:
Pioneering stage
Rapid growth stage
Maturity and stabilisation stage
Decline stage
Pioneering Stage During this stage, the technology and/or the product is relatively
new. Lured by promising prospects, many entrepreneurs enter the field. As a result,
there is keen, and often chaotic, competition. Only a few entrants may survive this
stage.
Rapid Growth Stage Once the period of chaotic developments is over, the rapid growth
stage arrives. Thanks to a relatively orderly growth during this period, firms which
survive the intense competition of the pioneering stage, witness significant expansion
in their sales and profits.
Maturity and Stabilisation Stage After enjoying an above-average rate of growth during
the rapid growth, the industry enters the maturity and stabilisation stage. During this
stage, when the industry is more or less fully developed, its growth rate is comparable
to that of the economy as a whole.
Decline Stage With the satiation of demand, encroachment of new products, and
changes in consumer preferences, the industry eventually enters the decline stage,
relative to the economy as a whole. In this stage, which may continue indefinitely, the
industry may grow slightly during prosperous periods, stagnate during normal periods,
and decline during recessionary periods.
Evaluation and Investment Implications The experience of most industries suggest that
they go through the four phases of the industry life cycle, though there are considerable
variations in terms of the relative duration of various stages and the rates of growth
during these stages. Because of these variations, it may not be easy to define what the
current stage is, how long it will last, and what would be its precise growth rate.
The broad validity of this theory and its general message that there is a definite trend
towards retardation of growth rates has several implications for you as an investor.
 Investment Analysis and Portfolio Management

Give industry analysis prior attention in your investment selection process.

Display caution during the pioneering stage—this stage has an appeal primarily
for speculators.
Respond quickly and expand your commitments during the rapid growth stage.
Moderate your investment during the maturity stage.
Sensibly disinvest when signals of decline are evident.

Study of the Structure and Characteristics of an Industry

Since each industry is unique, a systematic study of its specific features and character-
istics must be an integral part of the investment decision process. Industry analysis
should focus on the following:
I. Structure of the Industry and Nature of Competition
The number of firms in the industry and the market share of the top few (four to
five) firms in the industry
Licensing policy of the government
Entry barriers, if any
Pricing policies of the firm
Degree of homogeneity or differentiation among products
Competition from foreign firms
Comparison of the products of the industry with substitutes in terms of quality,
price, appeal, and functional performance
II. Nature and Prospects of Demand
Major customers and their requirements
Key determinants of demand
Degree of cyclicality in demand
Expected rate of growth in the foreseeable future
III. Cost, Efficiency, and Profitability
Proportions of the key cost elements, namely, raw materials, labour, energy, and
overheads
Productivity of labour
Turnover of inventory, receivables, and fixed assets
Control over prices of outputs and inputs
Behaviour of prices of inputs and outputs in response to inflationary pressures
Gross profit, operating profit, and net profit margins
Return on assets, earning power, and return on equity
IV. Technology and Research
Degree of technological stability
Important technological changes on the horizon and their implications
Research and development outlays as a percentage of industry sales
Proportion of sales growth attributable to new products
 Macroeconomic and Industry Analysis

Profit Potential of Industries: Porter Model

Michael Porter1 has argued that the profit potential of an industry depends on the
combined strength of the following five basic competitive forces:
Threat of new entrants
Rivalry among the existing firms
Pressure from substitute products
Bargaining power of buyers
Bargaining power of sellers
Threat of New Entrants New entrants add capacity, inflate costs, push prices down,
and reduce profitability. Hence, if an industry faces the threat of new entrants, its profit
potential would be limited. The threat from new entrants is low if the entry barriers
confer an advantage on existing firms and deter new entrants. Entry barriers are high
when:
The new entrants have to invest substantial resources to enter the industry.
Economies of scale are enjoyed by the industry.
Existing firms control the distribution channels, benefit from product
differentiation in the form of brand image and customer loyalty, and enjoy some
kind of proprietary experience curve.
Switching costs—these are essentially one-time costs of switching from the
products of one supplier to another—are high.
The government policy limits or even prevents new entrants.
Rivalry among Existing Firms Firms in an industry compete on the basis of price, quality,
promotion, service, warranties, and so on. Generally, a firm’s attempts to improve its
competitive position provoke retaliatory action from others. If the rivalry between
the firms in an industry is strong, competitive moves and countermoves dampen the
average profitability of the industry. The intensity of rivalry in an industry tends to be
high when:
The number of competitors in the industry is large.
At least a few firms are relatively balanced and capable of engaging in a sustained
competitive battle.
The industry growth is sluggish, prodding firms to strive for a higher market
share.
The level of fixed costs is high, generating strong pressure for all firms to achieve
a higher capacity utilisation level.
There is chronic over capacity in the industry.
The industry’s product is regarded as a commodity or near-commodity, stimulating
strong price and service competition.
The industry confronts high exit barriers.
Pressure from Substitute Products In a way, all firms in an industry face competition
from industries producing substitute products. Performing the same function as the
product of the industry, substitute products may limit the profit potential of the industry
1
Micheal E. Porter, Competitive Strategy : Techniques for Analysing Industries and Competition, The
Free Press, 1980.
 Investment Analysis and Portfolio Management

by imposing a ceiling on the prices that can be charged by the firms in the industry. The
threat from substitute products is high when:
The price-performance tradeoff offered by the substitute products is attractive.
The switching costs for prospective buyers are minimal.
The substitute products are being produced by industries earning superior
profits.
Bargaining Power of Buyers Buyers are a competitive force. They can bargain for price
cut, ask for superior quality and better service, and induce rivalry among competitors.
If they are powerful, they can depress the profitability of the supplier industry. The
bargaining power of a buyer group is high when:
Its purchases are large relative to the sales of the seller.
Its switching costs are low.
It poses a strong threat of backward integration.
Bargaining Power of Suppliers Suppliers, like buyers, can exert a competitive force in an
industry as they can raise prices, lower quality, and curtail the range of free services they
provide. Powerful suppliers can hurt the profitability of the buyer industry. Suppliers
have strong bargaining power when:
A few suppliers dominate and the supplier group is more concentrated than the
buyer group.
There are hardly any viable substitutes for the products supplied.
The switching costs for the buyers are high.
Suppliers do present a real threat of forward integration.