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Industry and competitive analysis is a macro approach to analyzing what drives industry size, profits, and market share, as well as determining a company's position within its industry.

Different industries have different long-run levels of profitability that depend on the opportunities they have and the risks to which they are exposed. Whether a company can sustain economic profits over time depends largely on its industry. Competition tends to drive company profitability toward an industry base rate over time.

Within a given industry, differences in profitability among the participants result from differences in business model, company size, and competitive strategy. While industry factors function as a limit on companies' profitability, company-specific factors have tended to be more to blame when firms underperform their industries.

The role of industry and competitive analysis is to determine an industry's base rate of profitability and what factors affect that rate. Based on this, an analyst can project the future profitability of the industry and assess companies' positions in relation to the industry median or mean.

Industry analysis is useful for:

• Improving financial forecasts by examining industry drivers and compiling industry-wide data. It is important not to underestimate the impact of macro factors and to remember that company-specific factors alone have a limited impact on a company's success.
• Finding desirable investments that may have been overlooked without analyzing the overall industry and its participants.
• From a portfolio perspective, investors may desire more industry-specific risk and less company-specific risk. This can be achieved through smaller investments in multiple companies within a targeted industry.

Industry and competitive analysis involves five steps:

1. Define the industry. This involves some subjectivity as to what factors define an industry (such as product similarity or geographical region) and how to treat companies that operate in multiple industries. Third-party classification systems can be useful.
2. Survey the industry in terms of its size, growth rate, profitability, and trends in the market shares of its participants.
3. Analyze the industry structure using a framework such as Porter's five forces, and determine which forces are key for the industry's profitability.
4. Examine external influences on the industry, such as political, economic, social, technological, legal, and environmental impacts (PESTLE).
5. Analyze companies' competitive strategies in terms of how each company fits within the industry and what competitive advantages each company has.

Many problems exist in properly defining an industry. Initial government-created classification systems were production based (e.g., manufacturing, distribution, retail) and infrequently updated. With the rise of global markets and evolving technology, such national classification systems eventually become obsolete. Third-party firms have therefore developed more global industry classification systems that are more useful to analysts. Classifying firms by industry provides a method of examining trends and firm valuations and allows analysts to compare firms in different countries.

Commercial Classifications

One way to group companies into an industry is by the products and services they offer. For example, firms that produce automobiles constitute the auto industry. A sector is a group of similar industries; hospitals, doctors, pharmaceutical firms, and others belong to the health care sector. Systems grouped by products and services usually classify firms by their principal business activity (largest source of sales or earnings).

Commercial industry classifications include:

• Global Industry Classification Standard (GICS) — developed by S&P Dow Jones Indices and MSCI
• Industry Classification Benchmark (ICB) — developed by FTSE Russell, for public companies
• Refinitiv Business Classification (TRBC) — includes public companies, private companies, not-for-profits, and government entities

Their hierarchical structures (four or five tiers):

• GICS: sector → industry groups → industries → subindustries
• ICB: industries → supersectors → sectors → subsectors
• TRBC: economic sectors → business sectors → industry groups → industries → activities

The top level for all three systems consists of 11 common sectors or industries:

1. Energy
2. Financials
3. Basic materials
4. Information technology
5. Industrials
6. Telecommunications services
7. Consumer discretionary/cyclicals
8. Utilities
9. Consumer staples/noncyclicals
10. Real estate
11. Health care

The process these providers use to classify firms:

• A firm with one business line is classified in that business line.
• A firm with multiple business lines is classified in the one that comprises more than 60% of total revenue.
• If no business line meets the 60% test, classify the firm by a business line that accounts for more than 50% of total revenue, profits, or assets.
• If no business line meets the 50% test, use judgment to select the most appropriate business line, or classify the firm as a conglomerate.

Potential Limitations of Classification Systems

Inappropriate groupings. Some industry groupings may be either too wide or too narrow for an analyst's specific needs. An analyst might use different classification tiers or alter groupings subjectively. For example, "computer software" could range from accounting to nutrition management software; an analyst might want to focus on directly competing products. Conversely, large retailers like Costco or Walmart may be classified in different industries even though they compete.

Companies selling multiple products. A single company with multiple divisions in differing industries is assigned to only one group, which creates comparability issues. For example, Amazon is assigned to "consumer discretionary retail," even though most of its profits come from IT service management.

Geography. For services such as health care or insurance that companies largely cannot offer globally, it makes sense to analyze them locally or nationally. The reverse is true for media companies, which were local pre-internet but can now compete globally.

Grouping changes. Classification system providers update their groupings periodically to reflect natural business changes. This can disrupt the continuity of industry-level statistics, may require revising historical data, and can impair comparability. New companies established and others going out of business change the constituents of groupings. Over long periods, industry data may exhibit survivorship bias.

Other Ways to Group Companies

Companies can also be grouped in ways other than by product or service. These methods are useful for constructing indexes and performing investment attribution analysis:

• Geography. Companies grouped by countries (developed, emerging, frontier). The country is most often where a company is headquartered or listed, even if it does most of its business elsewhere (e.g., Toyota is "Japanese" but generates most revenue in North America).
• Business cycle sensitivity. Sensitivity ranges from defensive (stable demand over the cycle — health care, utilities, telecommunications, consumer staples) to cyclical (earnings highly dependent on the business cycle, with high earnings volatility and high operating leverage — basic materials, consumer discretionary, energy, financials, industrials, technology).
• Financial measures. Groupings based on size (market cap), valuation/profitability ratios, or growth rates. These show more turnover than country/product groupings. Alternatively, cluster analysis can group firms with historically high return correlations.
• ESG factors such as personnel diversity or use of "green" production methods can be quantified as standardized ESG scores.

Industry Size

Industry size is total annual sales of the product, which is not always the same as total annual sales of all the companies in the industry. Because some companies operate in multiple product lines, only a fraction of a company's total annual sales might be relevant for a given industry.

In some industries, the overall size may include a significant percentage of sales from private companies and unincorporated businesses, which creates problems in gathering relevant data. In these cases, industry size is usually approximated using alternative data, such as government economic indicators or independent third-party data.

Industry Growth Characteristics

An industry's growth rate can be calculated as an annual rate each year or as a compound annual growth rate over several years. Analysts classify industry groups broadly as growth industries or mature industries.

• Growth industries have product markets with considerable growth potential, often related to new technology. Drivers of success tend to be independent of the general economy. Analysts must judge the persistence of high growth rates and estimate when they will decline — more problematic when growth is based on emerging technology.
• Mature industries have little or no growth potential remaining; growth rates are likely in line with the general economy or may be declining if the industry faces threats from substitute products. Analysts should focus on changes in the intensity of competition and any signs of overall industry decline.

Business cycle sensitivity also needs to be considered. Cyclical industries experience more volatility in returns, but varying perceptions of the duration and severity of business cycles can result in a wide range of valuations.

A style box can classify industries by business cycle sensitivity (cyclical vs. defensive) and growth rate (mature vs. growth). Examples:

• Utilities → defensive & mature
• Crude oil production → cyclical & mature
• Biotechnology → defensive & growth
• Digital advertising → cyclical & growth

Drawbacks: a broad recession will probably hurt all companies, so cyclical/defensive is a matter of degree. Growth firms can also exist within cyclical industries and may be relatively unaffected by recession as their product gains acceptance.

Industry Profitability

Ideally, industry profitability should be based on return on invested capital (ROIC) — an after-tax metric independent of capital structure. Companies can be segmented in deciles or percentiles to observe relative profitability over time.

It is often impractical to estimate ROIC for private companies without public statements. Instead, analysts may use the returns of publicly traded companies as proxies, or use publicly available market prices for end products and production costs, or government/third-party research data.

The goal is to determine if there are clear trends — increasing, decreasing, or stable industry profits over time.

Market Share

Market share is a company's annual revenues divided by the industry size. Because measuring industry size is problematic, market shares are estimates rather than exact data. The trend in a company's market share over time is crucial for determining whether its products are viewed favorably by customers.

Acquiring a competitor automatically increases market share — closer investigation is needed to determine if a company is increasing market share net of acquisitions.

Industry concentration is often expressed via the Herfindahl-Hirschman Index (HHI) — the sum of the squares of the market shares of all participants:

HHI thresholds:

• HHI < 1,500 → low concentration
• 1,500 ≤ HHI ≤ 2,500 → moderate concentration
• HHI > 2,500 → high concentration

In general (with notable exceptions for local industries and highly differentiated products):

• Low/decreasing concentration → higher competitive intensity, less pricing power, lower profitability
• High/increasing concentration → lower competitive intensity, more pricing power, greater profitability

Porter's Five Forces

Industry structure analysis examines how an industry's competitive environment influences a firm's strategy. Michael Porter's framework delineates five forces that determine industry competition — and ultimately, the industry's long-run profitability. If some or all of them are strong, firms will likely earn zero or close to zero economic profits (return on invested capital minus cost):

1. Rivalry among existing competitors. Increases when many firms of relatively equal size compete. Slow growth leads to competition for market share; high fixed costs lead to price decreases as firms try to operate at full capacity (e.g., the auto industry's high fixed costs from capital investments and labor contracts force firms to produce many vehicles at low margins). Industries with undifferentiated products or barriers (costs) to exit tend to have high competition.
2. Threat of entry. Industries with significant barriers to entry (e.g., large capital outlays for facilities) can maintain premium pricing. Steel and oil production are costly to enter and thus less competitive from newcomers. Analysts identify factors that discourage new entrants, such as economies of scale.
3. Threat of substitutes. Substitutes limit profit potential by increasing the elasticity of demand. Commodity-like products have high competition and low margins; the more differentiated the products, the less price competition. For example, in pharmaceuticals, patents protect producers from competition.
4. Power of buyers. Buyers' ability to bargain for lower prices or higher quality influences profitability. Bargaining by governments and large health care providers has put downward pressure even on patented drugs.
5. Power of suppliers. Suppliers' ability to raise prices or limit supply influences industry profitability. Suppliers are more powerful if there are few of them and their products are scarce (e.g., Microsoft as a major operating-system supplier has pricing power).

The first two forces deserve further attention because almost all firms must be concerned about new entrants and competition that erodes profits. How these factors influence the competitive environment:

• Higher barriers to entry reduce competition.
• Greater concentration (a small number of firms control a large part of the market) reduces competition; fragmentation (many small-share firms) increases competition.
• Unused capacity, especially if prolonged, results in intense price competition (e.g., underutilized capacity in autos has driven competitive pricing).
• Stability in market share reduces competition (customer loyalty stabilizes share and profits).
• More price sensitivity in customer buying decisions results in greater competition.
• Greater industry maturity results in slowing growth.

PESTLE Analysis

While Porter's five forces are crucial for internal industry analysis, an analyst must also consider external factors. A PESTLE analysis considers political, economic, social, technological, legal, and environmental factors. Because external factors evolve gradually, PESTLE analysis does not need to be performed as frequently as competitive-forces analysis. Focus on the key influences only.

• Political influences — taxes and regulation. Three sectors most exposed: energy, health care, defense.
  • Energy: (1) governments desire low/stable energy prices for popularity; (2) climate agreements/regulations conflict with low fossil-fuel prices — focus on emissions reduction implies higher prices; (3) OPEC has significant influence and likely desires low prices to delay the move to renewables.
  • Health care: governments are the largest purchasers; may increase public provision or impose price controls / ration services.
  • Defense: governments are usually the only buyers; spending depends on geopolitical threats and military commitments and is constrained by competing fiscal priorities (e.g., health care).
• Economic influences — cyclical trends (GDP) or structural trends (productivity, labor force size). Interest rates, credit availability, and inflation affect costs, prices, and confidence. Key for cyclical sectors.
• Social influences — trends in how people work, play, and spend. Important for industries that sell directly to individuals. Examples: social media and "influencers" boosting demand for high-quality beauty products; pressure for sustainable inputs and ethical/human-rights-respecting production.
• Technological influences — new or improved products may make existing ones redundant. Two categories:
  • Sustaining innovation: improvements in a product over time that do not fundamentally change its nature.
  • Disruptive innovation: creates a new market or enters an existing market and creates value in a new way (e.g., film → digital photography). Typically comes from new entrants. Existing firms must eventually become part of the disruption — even though it cannibalizes existing business.
• Legal influences — changes in laws/regulations. Example: the tobacco industry has faced declining revenues from smoking bans and disclosure requirements; the new cannabis industry has developed where legalized.
• Environmental influences — climate change and concerns about environmental sustainability continue to gain importance for industry growth and profitability.

Every company has a competitive strategy, whether intentionally or not.

• Intentional strategies are carefully planned with repeated cycles of execution and evaluation.
• Unintentional strategies are haphazard, with little coordination — usually suboptimal, though there have been exceptions (e.g., pharmaceutical firms, where smaller companies developed many new drugs through informal approaches).

Effective competitive strategies are known with hindsight by producing consistent, positive economic profits over the long run. Forward-looking evaluation considers whether the strategy:

• can respond appropriately to the relevant competitive forces,
• is neutral to or benefits from relevant external influences,
• can be properly executed by the firm.

Porter identifies three generic competitive strategies — and a firm must choose one to compete effectively:

• Cost leadership (low-cost) strategy. The firm seeks to have the lowest costs of production in its industry, offer the lowest prices, and generate enough volume for a superior return. Used defensively to protect market share or offensively to gain market share. Managerial incentives should target operating efficiency.
• Differentiation strategy. Products and services should be distinctive in type, quality, or delivery. Cost of differentiation must be less than the price premium customers will pay, and the premium must be sustainable. Successful differentiators have outstanding marketing research (premium pricing), strong production personnel (superior quality), and creative advertising (promote unique features).
• Focus strategy. Targeting a niche market. May incorporate aspects of both cost leadership and differentiation.