How to judge an Industry’s Attractiveness? – Fintelligence

thumbnail
Reading Time: 4 minutes


There are about 5000 companies listed on the Bombay Stock Exchange (BSE). As analysts if we were to analyse each one of them, it might take us a couple of lifetimes just to do that. Hence, we need to narrow down our search for great companies to a place where there are higher chances of them existing. Legendary investor Charlie Munger once said, “The first rule of fishing is to fish where the fish are”.

An economy consists of innumerable companies divided into specific industries like Telecom, Chemical, Entertainment, Automobile, Power, etc. and each these industries have their own unique characteristics. In a way, an industry is an entire eco-system in itself with companies within it operating in a similar fashion. Factors like regulations, revenue and cost drivers, rivalry, bargaining power of buyers and suppliers, etc. apply more or less similarly to all the companies in that particular industry. This eco-system has a huge impact on the constituent company’s profitability in the long run and hence the industry’s profitability as a whole. If the companies within the industry are doing well, it makes the industry attractive. Hence in order to judge any industry’s attractiveness, we need to look at how well the companies in that industry are performing.

One of the key determinants of whether an industry is attractive or not is ‘Economic Profit’ because it indicates whether the industry has created wealth or destroyed it in the past. Economic profit is the return that the industry/company earns over and above its average cost of capital. Below are few ways to calculate it.

  1. Return on Capital Employed (ROCE) – Weighted average cost of capital (WACC) where, ROCE = Earnings before Interest and Tax*(1-Effective tax rate)/Total Capital Employed and WACC = Cost of debt*(1-Effective tax rate)*Weight of debt + Cost of equity*Weight of equity
  2. Return on Invested Capital (ROIC) – WACC where, ROIC = (Earnings before Interest and Tax – Other Income)*(1-Effective tax rate)/Fixed Assets + Working Capital
  3. Cash flow return on Invested Capital (CFROIC) – WACC where, CFROIC = Cash flow from operations after Interest and tax/Fixed Assets + Working Capital.
Also Read on FinMedium:  Gujarat Alkalies Stock Analysis: A Safe Statistical Bet

CFROIC was used by Michael J. Mauboussin in his Credit Suisse report titled ‘Measuring the Moat’, to calculate the Economic profit of various industries.

The key here is to use any of the formula CONSISTENTLY.

After understanding how to calculate Economic profit of a company, lets now understand how to calculate the same for an entire industry to judge its attractiveness:

  1. List down all the companies in the industry
  2. Calculate the Economic profit of a company for the past 10 years* and then average it to get the ‘Average economic profit of the company’
  3. Do the above step for all the companies in the industry and then average it to get the ‘Average economic profit of the industry’

*The reason for considering 10 years is that it is a sufficiently long-time frame for a company to have seen both, good and bad times and hence our results will not be skewed.

To be able to call an industry attractive, its economic profit should be positive since that indicates that the industry has earned over and above its average cost of capital thereby creating wealth.

Also Read on FinMedium:  Types of mutual funds: a quick overview

However, that being said, it is not necessary that all the companies in a bad industry would have destroyed wealth. Remember, we are taking the average of all companies in the industry while calculating industry’s economic profit. There can be a few companies who earn more than their cost of capital even in a bad industry. The same goes for good industries too. There will be a handful of companies in it earning less than their cost of capital thereby destroying wealth.

Below is the extract of the Credit Suisse report I mentioned earlier:

In my study of Industry analysis, I have applied the same concept to a few Indian industries. Here are the observations:

My observations from the above exercise:

  1. Paints Industry- Four out of five listed Paints companies earned more than their cost of capital and hence created wealth over the long term. This makes it an inherently good industry. However, there is one company – Shalimar Paints which has destroyed wealth by earning approximately 7% less than its cost of capital. This was primarily due to its low/negative ROCE.
  2. Commodity Chemicals – 20 out of 30 companies have earned economic profit making the average economic profit of 4.8% for the industry. What this means is ‘Commodity chemical’ industry as a whole has earned approximately 4.8% over its cost of capital
  3. Commercial Printing & Stationary – You can see how horribly this industry has performed over the past decade where 3 out of 4 companies have destroyed wealth thereby making it a bad industry. However, Navneet Educations stood as an exception by performing exceptionally well.
  4. Two-wheeler and Three-wheelers – They have generated enormous wealth consistently with no company earning less than its cost of capital.
Also Read on FinMedium:  Five books to start your reading plans in 2020

To refer to the calculations made to reach the above conclusions kindly visit the link below:

https://drive.google.com/file/d/1IdGu6AmFHqnPbIYVhu8Ydr6Ny2MwX9e2/view?usp=sharing

The reasoning behind doing this analysis was to make you, my readers, understand that when we select a good industry, our chances of selecting great companies increase dramatically.

With limited time that we have, we should focus on the industries which have created wealth in the past. In these industries we can reasonably believe that they will continue to do well in the future too since the nature of any industry is very sticky. The dynamics don’t change soon. When the industry’s eco-system is favourable, its constituent companies tend to do well which is the best indicator to judge an industry’s attractiveness.



Source link

Every Wednesday and Saturday, we send Info-Graphic and FinMedium Weekly Digest newsletters to our 25000+ Subscribers.

Join Them Now!

Please Share :)
Amey Chheda
Amey is a Chartered Accountant, an Equity Investor, and a Blogger.
Back To Top