Qualitative Factors: Industry
Evaluating the firm’s industry can offer further insight into the company’s future performance. Sometimes a company can be an excellent performer in a dying industry. This could leave you with an investment that looks good from the company standpoint, but eventually fails when the entire industry is replaced by better technology.
1. Market Concentration
Market concentration is simply a question of which companies are the “market leaders” in the industry. This is generally measured by market share. However, accurately gauging market share depends on how broadly you define the company’s market.
For example, Microsoft is in the market for Operating Systems, but this is too broadly defined because there are 4 separate Operating Systems markets: Desktop, Server, Mobile, and Tablet.
Microsoft is considered an undisputed leader in the Desktop Operating System market, where it has 92% of market share. It has a 50.2% market share in the server operating systems market and only a 2.6% market share in mobile operating systems. Its market share in tablets is too small to be significant. This is an important comparison because if you predict that Mobile systems will someday take over Desktop systems, then Microsoft’s market position is not as strong.
It is also worth looking at the market concentration for each of these markets. The more even distribution of market share, the more competitive the market will be. From the example, you can see that the desktop operating systems market is the least competitive, followed by server operating systems, and then mobile. A good investment could be found at any level of market concentration, but it should help you understand the competitive position of the company and its industry.
2.Type of Market
Looking at the type of market is another way of evaluating a the competitive position. In this case, the type of market is based on the number of competitors, and it is often related to the market concentration. There are two basic types of markets: Price Taker Markets and Price-Searcher Markets.
A price taker market is essentially a commodity market; every product in the market is exactly the same quality, price, and cost. It is characterized by low barriers to entry (easy for new competitors to show up) and has no single buyer or seller that is large enough to influence the price. It is usually best to avoid investments in firms that operate in a price taker market, but you can sometimes find companies that have built a cost or efficiency advantage.
A price-searcher market is one where there is a differentiation of goods. The difference could be in the form of quality, location, design, or many other factors. Having some difference in products allows some companies to charge more for their products even if it easy for new competitors to enter the market.
Where there is a small number of large firms (oligopoly), or only one main firm (monopoly), the largest players are more likely to have some power to set their own prices. From the example above, Microsoft is considered a monopoly in the market for desktop operating systems, while the market for server desktop operating systems is considered an oligopoly.
You are more likely to find companies with a competitive advantage in a price-searcher type of market.
3. Industry Growth
A company’s potential is often tied to the industry’s growth. A company can have positive growth in an industry with negative growth. For example, a hypothetical firm manufacturing VHS tapes and VCRs could have continued to do well while DVDs began to overtake VHS tapes, but it would eventually go out of business. A hypothetical company producing DVDs today might be put out of business as DVDs are replaced with Blu-Ray discs.
4. Regulatory Environment
Some industries are more heavily regulated than others. In a regulated industry with a high level of market concentration, the prices are sometimes fixed by the government. The company could have a very high potential for profit, but it may never realize that potential.
Other industries have regulation for how to do business, but not direct price regulation. For example, the drug industry has regulations for the safety standards of their products, but they are free to charge any price they wish. The net effect is that the drug company has a lower profit than it otherwise would, but it comes from an added cost instead of a fixed price.
In general, it is best to consider the potential impact of ongoing or upcoming regulation, but very few industries are destroyed by regulation.
The bottom line about industry growth is that if the industry is not growing, then the company will have to “steal” customers from their competitors instead of finding new customers. This creates a situation where someone has to lose, and it is often more difficult to convince customers to switch than it is to get new customers.