1.1 – Introduction

Welcome to another Varsity Module!

This module on Varsity explores sectors as an investment avenue. We all know that a well-diversified portfolio is the key to building a successful stock portfolio. The diversification should be across sectors and market capitalizations.

If we are looking at picking stocks from different sectors, we need to understand sectors from a stock-picking perspective. The objective of this module is just that, i.e., to help you understand what to look for in each sector as a stock picker or an equity investor.

Each chapter will focus on one sector. So after reading this chapter, you can jump across to any sector you are curious to learn about without worrying about losing the chain of thought.

By the way, my name is Vineet Rajani; I hold a CFA charter and have four years of experience in researching equities. I recently joined the Zerodha Varsity team to help Karthik develop content, and the sector analysis module is the first module I’ll be working on. I hope you all will like this module as much as you’ve liked all the previous modules 🙂

1.2 – What is a sector, and what is an industry?

A sector is a set of companies engaged in similar business activities. For example, Infosys, TCS, and HCL are similar businesses, forming the Information Technology sector. HDFC Bank, ICIC Bank, and SBI are banks, and these companies belong to the banking sector. Sun Pharmaceuticals, Apollo Hospitals, and Dr. Lal Path Labs are all companies belonging to the healthcare sector.

Sectors can have sub-sectors or industries. Sectors and industries are often used interchangeably. Each industry has a distinct business at a granular level, but at a broader level, many industries can make one sector. While banking, insurance, and mutual funds are all distinct industries, collectively, they are financial services and make up the financial services sector. Similarly, the healthcare sector comprises sub-sectors such as hospitals, diagnostics, pharmaceuticals, pharmacies, preventive healthcare, and wellness.

The following table classifies various industries in a limited set of sectors. There are about 3-4 globally accepted standards for industry classification. This table shows how Refinitiv classifies the sectors and industries.

An investor would want to analyze a particular sector when they see a factor or phenomenon influencing it. For instance, an investor investing in the fertilizer or packaged foods sector would want to take note of the monsoon season’s data as it tends to impact those sectors as a whole. Or an investor in the IT sector may want to keep an eye on the USD-INR exchange rate as the sector makes a significant part of revenues in USD.

Investors also take an interest in the sector of their occupation – a doctor might want to invest in healthcare stocks, or a software engineer might be confident about their understanding of the technology sector. Investor frenzy in a particular sector also stimulates the interest of other investors in that sector.

1.3 – What is sector analysis?

Sector analysis involves looking for factors, features, events, and metrics that impact the businesses in a given sector. A factor might positively impact one sector while a negative impact on another. The idea of sector analysis hinges on the fact that certain aspects or events are specific to sectors and do not impact the overall market.

Sector analysis is a part of fundamental analysis. While our module on fundamental analysis explains the approach to researching a particular company, sector analysis focuses on the features and operational or performance metrics unique to a sector. The exercise becomes meaningful when several companies within a sector are compared based on these metrics.

1.4 -Different Approaches for Different Sectors

No two sectors are the same; therefore, no two sectors can be analyzed the same way. Banks, for instance, are analyzed using key performance indicators such as NPAs, capital adequacy ratios, and interest margins. Insurance companies are analyzed for solvency ratio, claims settlement ratio, expense ratio, persistence ratio, etc. Airlines look at revenue per seat kilometer, cost per seat kilometer, fuel costs, and occupancy rates to understand performance. These metrics depict the operational efficiency of the players in an industry and how those players stack against each other.

For industries in the heavy manufacturing space – cement, steel, aluminum, and the like – production capacity, production volume, and sales volume are important comparables. Volume metrics are significant for automobiles and electronics too. Companies in FMCG, or Fast Moving Consumer Goods, focus significantly on distribution, brand awareness, packaging, etc.

When an investor begins studying a sector, understanding the value chain could be a good starting point (I will explain the concept of “value chain” soon). A study of the value chain provides more insights into a particular sector’s unique dynamics. The exercise could also unearth certain industry players’ competitive advantages or disadvantages.

1.5What is a value chain? 

Simply put, a value chain begins with the sourcing of raw materials and goes up to the point of end consumption. For example, the textile industry’s value chain would include fiber production, spinning yarn, fabric production, dying and printing, garment manufacturing, packaging, distribution, and retail. Cement’s value chain starts with limestone mining, followed by clinkerization, blending, grinding, packaging, and distribution. This value chain might be extended if the cement manufacturer processes it further into ready-mix concrete (RMC) before selling it in the market.

Dissecting the value chain in this manner enables an investor to identify which steps drive costs or improve or hamper productivity. A value chain typically has many steps. Here, the investor must put on a business owner’s hat to understand what steps along the value chain add value to the business and what do not. Cement companies generally own the limestone mines and all the processes up to distribution. The cement industry is predominantly vertically integrated. Let me introduce three new concepts: Vertical Integration, Backward Integration, and Forward Integration.

    • Vertical Integration: A company is considered vertically integrated if it owns several operations across the value chain. As mentioned above, cement companies carry out all the processes, from limestone mining to cement production and distributing it to customers. Cement makers might go further and even convert it to concrete before delivering it to the customers.
    • Backward Vertical Integration: Acquiring supply-side processes in the value chain is called backward integration. Steel companies such as Tata Steel and JSW Steel can be called backward integrated as they own iron ore mines. This helps them control inventory supply and costs.
    • Forward Vertical Integration: Acquiring distribution side processes is called forward integration. A cosmetics company selling products through owned stores is forward-integrated. Indian Oil and Bharat Petroleum could also be considered forward integrated because they operate some fuel stations apart from franchising out most.
    • Lean Organizations: A fourth concept, lean organizations specialize in only one or very few steps in the value chain. Many FMCG companies neither manufacture their product nor sell it to end consumers. They focus mainly only on distribution and marketing. They are very low on vertical integration.

Although a rare phenomenon, a fully vertically integrated company owns all the processes from raw material production to end consumer retail sales. Samsung, a global leader in consumer electronics, is essentially a vertically integrated business. It produces semiconductors, memory chips, and screens that go into making mobile phones, then assembles mobile phones at its plants and even sells them through its own retail stores. While Samsung also sells through other retailers and e-commerce channels, its retail stores symbolize some level of vertical integration.

Most companies within an industry exhibit similar business structures across the value chain. FMCG companies in India can hardly be backward integrated. Palm oil, a key ingredient in many food products, personal care, and cosmetic goods, is primarily sourced from Malaysia and Indonesia. Packaging for these products uses petroleum derivatives which have their source in oil-producing countries. It does not make business sense for an FMCG company to own supply-side processes.

The case of the FMCG sector suggests that the geography of the value chain also influences a business’ vertical integration, costs, and material availability. Automobile companies are mostly assembly companies. The thousands of parts that go into making a car are all sourced from vendors that may be geographically located far apart.

The significance of packaging in a value chain depends on the nature of a product, its application, size, shape, and perishability. It also depends on where the end consumer is located and what modes of transport will be used to deliver the product. Regulatory requirements must also be met concerning packaging material, dimensions, eco-friendliness, etc.

1.6 – Framework

These concepts above can be put into a framework for an investor researching a particular sector. This framework can act as a checklist for the investor to ensure that adequate efforts have been dedicated to comprehensively understanding a sector.

Political Factors: The political will of the ruling government can influence the overall business sentiment in an economy as a whole. Businesses engaged in sin goods such as liquor and tobacco and necessities such as grains and oil often carry large political overhangs.

Economic Factors: The strength of an economy and the stage of economic development can present different opportunities for different sectors. High-interest rates could limit corporate growth, while low-interest rates could enable easy borrowing and faster growth. However, low-interest rates could encourage excessive retail borrowing and spur inflation. The ability of the economic authorities to balance growth and control inflation is of the essence here. Economic factors such as inflation, exchange rates, FDI, and money supply play along with interest rates to influence the business environment.

Socio-cultural Factors: Festivals can stimulate seasonal buying for specific sectors. Socio-cultural shifts can create long-term trend growth for certain products while a decline in others. The gradual move from coal-fired stoves to gas stoves results from economic development and social acceptance of a new cooking method.

Demographic features and changes are a major influence on demand creation. The vast size of India’s youth population, in both absolute and percentage terms, has led to the creation of various products and brands meant to attract the young crowd. A decline in the average fertility rate suggests a decline in population growth. The aging of today’s young population could boost the demand for old-age products after three-four decades.

Technological Factors: The stories of Nokia and Blackberry losing market share to Apple and Samsung have been discussed every time the impact of technological change has to be depicted. Innovations in technology can create new sectors and even wipe out some. All industries related to e-commerce were built upon the Internet. The Internet was a technological breakthrough. On the other hand, typewriters and Telegram are technologies that died as better ones replaced them.

Legal Factors: The duties, tariffs, quotas, and other restrictions have an impact on the import-export trade of a country. Legal factors often create entry barriers for new players to enter a particular industry. For example, the heavy licensing requirements and different state-wise laws make liquor manufacturing a capital-intensive and difficult industry to get into. Pollution control, labor laws, and regulators like SEBI, RBI, and IRDAI constitute an economy’s legal machinery.

Environmental Factors: The natural environment of a country can present opportunities for some sectors while discouraging others. Mining businesses are possible only if a country has minerals under its earth.

Pollution and environmental deterioration result in imposing restrictions and requirements on industries. Water and effluent treatment plants have become a regulatory mandate for various chemical and industrial goods companies. Natural calamities could purge industries while displacing civilizations. Insurance companies carry a huge risk on account of natural disasters.

These factors also influence each other. Economic development could lead to social development and shifts in culture. Issues related to society and the environment could be behind the development of certain legal barriers. Some legal factors can also be politically influenced.

These factors make the PESTLE Analysis (Political-Economic-Social-Technological- Legal-Environmental), a framework commonly taught in colleges and business schools.

1.7 – How companies within a sector can differ? 

Beyond the PESTLE framework, as an investor, you must also study how a particular company competes with its peers. By the way, competition is much more than just outselling each other. A company also competes during the sourcing of raw materials. Two dairy companies, for example, will compete with each other to source milk from farmers.

Companies also compete with new players in the industry. New players can disrupt the industry. A large influx of new players can change the industry’s competitive landscape. Industries also have to worry about being replaced by substitutes.

A company’s ability to outrun its competition and negotiate with external factors depends on what differentiates it from its peers. Let us look at a few differentiating factors.

Size: Size is essentially about the capital of the company. Being big or small comes with its advantages and disadvantages.

Larger companies managed to stay afloat through the Covid-related lockdowns while many smaller companies shut down. Why did this happen? Business activity was mostly dull through the lockdowns. So regular operations were not yielding profit. Larger companies survived by using capital reserves. Remember how large retailers survived while many smaller retailers closed shops?

Huge capital reserves also open opportunities that are otherwise out of reach. For example, the huge capital and licensing requirements to set up a telecom business are a barrier. Smaller businesses or individuals with small capital do not even consider starting a telecom business. But the deep pockets of Reliance Industries enabled it to pump in loads of capital to set up Jio. Its war chest was huge enough to wipe out some existing players (remember Aircel, Uninor) while others were forced to merge (Vodafone and Idea).

Larger companies also enjoy economies of scale. Ever wonder why a readymade shirt generally costs lower than a tailor-made one? Makers of readymade shirts source everything in bulk to get deep discounts. These discounts can be passed down to customers in the form of lower prices. Conversely, a tailor cannot compete with the quick turnaround of automated sewing machines. A tailor charges a higher price to make up for the hours dedicated to a single shirt.

Being small also has its advantages and disadvantages. A newly set-up business generally has limited funds, workers, and resources. But the ability to disrupt is high mostly because larger companies do not consider smaller companies a threat, and smaller companies do not have legacy issues.

Let me break this down. For example, the Brushless DC (BLDC) technology has been used for 50 years in electricals to save electricity. However, it was first used in ceiling fans in the US only in 2009. And a few years later, smaller players like Versa Drives and Atomberg adopted the technology and made it big. The incumbent players had been improving upon the existing technology but did not consider an alternative technology as an energy-saving solution. Once the smaller players disrupted the space, all larger players introduced the BLDC range of fans under their brand names.

Why didn’t the larger players act first? Introducing a new technology could mean re-training the production staff and introducing new machinery. Existing skills and systems make the management averse to changes. These are known as legacy issues. Decision-making often slows down in larger organizations. So even if they were aware of better technology, its adoption took time. Small companies are not considered a threat because even if they have a superior product, their ability to sell it and scale it up is limited. A few that do manage to scale up become the disruptors.

Age: With age comes experience. It is a commonly known concept. It is applicable to businesses too. Sometimes experience helps businesses avoid the same mistakes. Sometimes, experience makes them averse to trying new methods, techniques and technologies.

Just by the virtue of being around for years, businesses have a network of suppliers, distributors, and allies that a new business will take some time to build. However, new businesses with huge capital can overcome this obstacle. Ola and Uber disrupted other cab services mainly due to the large venture capital that they spent on technology, networking, and marketing.

Long-standing relationships with vendors are useful when the supply of inputs is limited. They could also allow easier payment terms. A long-standing distribution network can be used to launch new products. For example, Polycab used its wide network of wire distributors and retailers to launch its electrical goods. Tata Consumer Products has been launching several new products that it can distribute using the existing Tata Tea and Tata Salt network.

These long-standing relationships can also become a hurdle in making objective business decisions. For example, HUL and Colgate-Palmolive had to face disputes with their long term distributors for offering differential pricing to B2B e-commerce platforms. HUL also faced boycott threats in Madhya Pradesh when it was looking for distributors in addition to the existing ones.

Newer consumer brands established their online channels before exploring physical retailing. They do not have long-standing relationships with any distributor. Therefore, they are unlikely to face protests like HUL and Colgate-Palmolive did.

Focus: Focus can be related to products, target market, costs, or pricing.

The product focus sounds very basic. Every business is focused on its product. However, some businesses have multiple products. Some organizations have multiple businesses. Reliance Industries has three large businesses – oil, retail, and telecom. Its next bet is going to be on financial services. Similarly, ITC is a large FMCG company with a presence in hospitality, technology, packaging, and agri-exports.

So when you study conglomerates like these as part of a sector, you must consider what drives the business and profitability. You might even want to consider each business as a separate organization to draw proper comparisons with relevant peers.

A company operating in a single sector might be better equipped to innovate and scale up than a peer conglomerate with other business interests. The difference is mainly about focus. A conglomerate has diluted focus across divisions. This is also why some analysts assign a conglomerate discount when valuing a conglomerate business.

The target market is the target customers. Both Maruti Suzuki and Mercedes are automobile companies but are incomparable because they focus on different markets. Maruti will not be able to charge as high for its cars as Mercedes does. Similarly, Mercedes will not be able to sell as many cars as Maruti does. Their different market focus is also visible in their marketing tools. Maruti uses TV commercials to spread the word about its car. It wants the maximum population to buy its cars. Mercedes understands that millions may watch TV commercials, but only some can afford their cars. Therefore, it does not spend on TV commercials.

Some businesses focus on attaining cost leadership. Indigo Airlines has managed to stay afloat while so many airlines are struggling or have perished. Indigo’s flight tickets may be priced similarly to its competitors, but its focus on cost controls has led to profitability.

Other businesses focus on pricing. FMCG companies often price their products competitively, meaning they keep the prices low to maintain and increase the customer base. Ever wondered why many biscuits and chocolates still sell in ₹5-packs despite all the inflation after so many decades? It is because a consumer with limited means finds the ₹5 price point psychologically comforting. Round figures such as ₹5 or ₹10 sell more than odd figures such ₹6 or ₹7. Also, they might not be willing to spend ₹10 or higher when their budget is ₹5.

Price leadership is not always about the lowest prices. Apple has become the world’s most valuable smartphone brand by always pricing its phones at a premium. Such pricing power is achieved with a heavy focus on the product and branding.

Regulations also impact a company or sector’s pricing power. One can argue that the healthcare sector has strong pricing power. But because of its essential nature, the government regulates medicine prices.

Substitutes: Substitutes come in various forms. Tea and coffee are each other’s substitutes. Mobile phones have substituted personal cameras, computers, diaries, and watches. In the case of luxury goods, a vacation, watch, car, handbag, and chandelier are all substitutes for each other. So when I pointed out earlier that Mercedes and Maruti may not be comparable, Mercedes could compare with other luxury goods.

Substitutes are a challenge because they can come from a different sector or even create a new one altogether. There can also be regulatory support for substitutes in certain industries – solar and wind energy getting favorable policies over coal. Electric vehicles are also getting incentives over combustion engine (conventional) vehicles.

Certain businesses, mostly large ones, can identify substitutes and even own them. For example, petrol and diesel pumps are now setting up EV charging and gas stations. Since substitutes can render an industry obsolete, an analyst must try to ascertain the magnitude of the threat from substitutes.

Competition from substitutes pushes businesses to expand into the substitute business as well. New entrants in a sector often increase the competitive intensity in the market. This causes businesses to sell at lower prices. The advent of e-commerce has forced physical stores to give comparable discounts. Competition from Jio forced telecom operators to offer 1 GB of data per day for a price point they would otherwise charge for a monthly limit of 1 GB.

1.8 – Conclusion

Sector analysis could help you as an investor understand whether a sector appears attractive or not. Accordingly, you may bet on the whole sector or a few selected stocks. Either way, valuations must be justified. A good business at a high price is likely a bad investment. Therefore, you must combine sector analysis with a proper valuation analysis to improve the likelihood of investment returns. A comprehensive study would also include fundamental analysis.

I shall delve into understanding each sector in depth in the subsequent chapters of this module.

The first sector I will cover is Cement. Stay tuned!

Key Takeaways:

    • A sector is made up of similar businesses. Sectors may be further divided into sub-sectors or industries.
    • To understand specific sectors, one needs to understand their value chain
    • Several regulated sectors like stock broking, banking, and insurance are understood with the help of key performance indicators
    • You could also study sectors with the help of frameworks such as PESTLE. You could also build your own framework.
    • Companies within a sector could differ in size, age, focus, and substitutes. Each of these features comes with its advantages and disadvantages.
    • Valuations are critical. An attractive industry or business must also have favorable valuations to be investible.



56 comments

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  1. Sundeep says:

    Hello VIneet,

    Welcome to varsity. I have been a long-time reader of Varsity and I think Karthik would remember me. I was disheartened when there were no new write-ups in varsity for a long time. All that is over now and thank you for that.

    My question is, you have written about valuations, and I am searching for a good book on the topic. Could you suggest some apart from Damodaran?

    Thank you,

  2. Vineet Rajani says:

    Hi Sundeep,

    Thanks for the warm welcome!

    About your question on Valuations, I have learned only from Damodaran’s books. Wouldn’t be too sure of others.

    Regards,

  3. bhanja s k says:

    sectoral analysis of steel & metal are highly solicited.also explain the forthcoming changes in relation to C emmission we may seee in next decade.
    regards.

  4. Akshat Chokhani says:

    Great read. Especially the value chain part is extremely important for an investor to understand.
    Thanks team.
    Akshat.

  5. Vineet Rajani says:

    Thank you 🙂

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