Environment Analysis – Investment Research

Environment Analysis – Investment Research

(This is part 3b of the Stock Investment Research Process series. See previous parts here- Part1, Part2, Part3a)

In this part of the analysis, we are looking at a company from three different angles.

First of all, we look into the actual ‘Life Cycle Stage‘ of the Industry in which our company operates. We also look at the life cycle stage of each product of the company.

Then we see how exactly are the products of the company performing? In terms of both their Market Share and Growth. We will use a framework called ‘Growth-Share Matrix‘.

And thirdly, and perhaps more importantly, we analyse the ‘Competitive Environment‘ in which the company operates in, and look at the 5 major forces affecting it.

Don’t worry. None of the above is as hard as it sounds.

These are just some guidelines on how to think about the company and its products.

life-cycle Stage

life cycle

The above picture is self-explanatory. This applies to both Industry as well as Products.

Try to understand the life cycle stage of the Industry. And also of individual products of the company.

It is important to know about this.

We need to know how fast it can grow and how long into the future we can project this growth, especially when we attempt to ‘value’ the company.

Think about IT companies in the 1990-2000 era. They were just past the introduction stage. Throughout the last decade the IT services industry in India grew at very fast pace (growth phase).

E.g. Market Capitalization (total combined worth of all publicly trade-able shares) of TCS at the time of its IPO in 2004 was 43,000 crores. Just 10 years later, now the market cap is 4.8 Lakh crores. The sales and profits of TCS grew at 27% annualized rate during the last 10 years.

During the same period, another company in a matured industry, Hindustan Unilever, grew its sales and profits only at near 13% annualized.

Growth-Share Matrix (a.k.a BCG Matrix)

This is a framework developed by Bruce Henderson (founder of Boston Consulting Group).

Most companies will have many products, each at various stages of growth/market share. Let us use BCG framework to think about the products of the company we are analyzing.

BCG

 

Characteristics of  each of the four types:

Dogs (low growth, low market share)

  • Dogs are in low-growth markets and have low market share
  • It’s very difficult to turn around their fortunes
  • It is best to avoid / discontinue this type of products
  • Does our company have any such Dogs in its product portfolio?

Question Marks (high growth, low market share)

  • These are high growth, low market share products
  • These are essentially new products. wider market is yet to discover and adopt them
  • If they don’t increase market share quickly, they might become dogs
  • Company must invest in them heavily to gain market share (critical-mass) or sell them

Stars (high growth, high market share)

  • Stars are defined by having high market share in a growing market
  • They are leaders in the business but still need a lot of support (cash) for promotion
  • if market share is maintained, Stars might grow into Cash cows

Cash Cows (low growth, high market share)

  • High market share in mature market
  • If competitive advantage has been achieved, cash cows can maintain high profit margins and generate lots of cash
  • Because of low growth, promotional spending is low
  • Investments in supporting infrastructure can increase efficiency and thus increase cash flow
  • Cash cows provide money to grow and develop Question marks and Stars

Does our company have some nice cash cows? Or are there more question marks? Or are the dogs wasting all the money created by cows? Do you see its stars becoming high yielding cash cows?

Whether the ‘Question marks’ can grow into ‘Stars’  or whether ‘Stars’ can become ‘Cash cows’ depends a lot on the competitive environment the company operates in.

Michael Porters 5 forces analysis

Michael Porter

Michael E Porter, a Harvard professor and a thought leader in strategy and competitiveness, gives us a framework to analyze the level of competition within an industry.

This is famously known and Porters 5 forces.

Porters 5 forces

 

Let us look into these forces one by one.

Factors affecting Rivalry among existing competitors:

  • Number of competitors (concentration)
  • Relative size of competitors (industry balance)
  • Overall industry growth rate
  • Exit barriers – is it easy to move out?
  • Fixed costs vs variable costs within this industry
  • Product differentiation between competitors

Factors affecting Threat of new entrants

  • Barriers to entry
    • Capital requirement (e.g. cost of building power reactors for a power company)
    • Economies of scale
    • Access to distribution channels ( think what happened when Reliance entered fuel retail)
    • Government policies (e.g banking license to start a new bank)

Factors affecting Threat of substitutes

  • Relative price of substitute
  • Relative quality of substitutes
  • Switching costs to buyers
  • Ease of availability of substitutes
  • Technological innovation. (this is somewhat unpredictable. Think how Mobile phone cameras killed off Kodak)

Factors affecting Supplier power

  • Number of other suppliers
  • Differentiation of supplier product
  • Availability of substitutes
  • Importance of Supplier product to the company
  • Importance of industry to suppliers
  • Possibility of backward integration by buyer (ie, the company making the input product on its own)
  • Possibility of forward integration by supplier ( what if the supplier themselves can be come a competitor to the company)

Factors affecting Buyer power

  • Number of buyers relative to sellers
  • Buyers profit margins
  • Buyers switching costs to use another product
  • Importance of product to the buyer
  • Possibility of backward integration by buyer (ie, the buyer starts making the product on its own)
  • Possibility of forward integration by the company ( what if company starts using uses its products for its own purpose, thereby not needing the buyer)

In case you like this in a pictorial form, here it is. Click to expand. (source)

porters_five_forces_lg

The various forces described above define the competitive environment of the company.

A big change in any of these forces can have long-lasting and big impact in the profitability and survival of the company.

So before we invest, we must take time to study and understand the competitive landscape.  It becomes easier if we stick within our circle of competence.

It helps to read industry related publications and research reports to understand the overall trends. It will also help to study the developments in main competitors of the company we are interested in (or invested in).

……

End of Part 3. In the next section we will see how we can analyse the management quality.

Stay tuned 🙂

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