Evaluating Industries and Competition

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While many investors focus on analyzing individual companies, their financials, and management quality, they often underestimate how much industry outlook and competition determine expected returns.

This post draws from Michael Shearn's 2011 "The Investment Checklist: The Art of In-Depth Research" to explain how to evaluate industries and competitive landscapes.

By the end, you'll understand how to identify attractive industries, assess different types of competition, spot emerging threats from substitutes or foreign competitors, and construct frameworks for finding the best businesses within any sector.

The first step in evaluating any investment is determining whether the business operates in a good or bad industry.

According to Shearn, a large part of your potential returns often comes from the industry itself rather than the specific company you are invested in.

Measuring Industry Attractiveness

The simplest way to evaluate an industry is by examining the distribution of returns on invested capital (ROIC) across all participants.

In good industries, most companies perform well with a narrow range of returns. In difficult industries, you'll find wide differences in ROIC between winners and losers.

Shearn gives the example of the pharmaceutical industry versus the oil and gas industry from 2000 to 2010, where the differences are significant:

• The pharmaceutical industry maintained consistently high ROIC, with returns ranging from 13% to 21%.

• Meanwhile, major oil companies showed a much wider and lower range, with ROIC spanning from 3% to 15%.

The pharmaceutical industry's narrow range shows that even the worst performers weren't far from the best. In contrast, the oil industry's broader distribution indicates a more challenging environment where success is harder to achieve.

The Imperial Capital Method

Shearn highlights how Steve Lister, co-founder of Toronto-based private equity firm Imperial Capital, has developed one of the most complete industry evaluation systems.

Lister believes that finding the right industry matters most because, over time, individual business profitability tends to trend toward the industry average. This makes it difficult for any single company to outperform its industry over the long term.

His firm uses a 100-point scorecard to assess industry economics:

Key questions on Imperial Capital’s scorecard include:

• What drives the industry?

• How do people compete within the industry?

• What is the larger macro picture?

• What are the industry trends?

• What is the average cash conversion cycle for the industry?

• What is the industry's exposure to cyclical markets?

• Does the industry have the ability to pass on price increases?

• What is the volatility of demand from customers?

After scoring industries on their 100-point system, Imperial Capital digs deeper into the most promising ones. They analyze whether growth trends are positive or negative and whether changes are temporary or structural.

For instance, within healthcare, Lister's team examined over 100 niches, analyzing growth rates, profitability, business counts, and reimbursement risks. They ranked each niche and identified the 12 most profitable segments.

They then seek out former or current CEOs who deeply understand these industries. As Lister explains:

Lister finds these industry veterans at conferences and through his professional network.

Overall, this combination of systematic scoring and insider knowledge helps Imperial Capital avoid hidden pitfalls that data alone might miss.

Research Resources

Standard & Poor's Industry Surveys provide detailed historical analysis for many industries. These reports break down into useful sections including:

• How the industry operates

• Current trends

• Key industry ratios and statistics

• Guidance on analyzing specific sectors

The comparative company analysis in the appendix lists competitors and provides useful competitor information.

The reports also include a section on industry references, pointing you toward trade journals, industry associations, and other sources for deeper research.

These reports are accessible through many university and local library systems.

Understanding an industry requires studying its history over extended periods, ideally more than 10 years. This historical perspective uncovers forces and patterns that aren't apparent when examining just one snapshot in time or studying only one business.

The Advertising Agency Evolution

Shearn provides the advertising industry as a compelling example of how historical analysis prevents investment mistakes.

For decades, agencies charged based on "billings," earning a percentage of what clients spent on media placement. If a campaign cost $200M in media spending, the agency might earn 10% or $20M. Operating margins routinely exceeded 20%.

Two fundamental shifts disrupted this profitable model:

• Value misalignment: Companies realized that paying percentages of advertising bills didn’t match value creation. Sales results depended on ad quality, research effectiveness, and audience reach, not spending amounts.

• Market fragmentation: Internet advertising broke up mass markets. Companies could now reach national audiences through hundreds of websites instead of just major TV networks and limited print media, reducing agencies’ brokering power.

As margins declined, agencies responded by leveraging their balance sheets to acquire competitors, assuming the healthy margins would continue indefinitely. Management teams claimed they were creating value through global campaign capabilities and cost synergies.

Curious about this strategy, Shearn directly asked managers about the benefits of size. When he studied past ad agency consolidations, he found that these claimed "benefits" never materialized.

The acquired agencies weren't absorbed into unified operations. Instead, they continued operating as separate businesses with their own income statements, often competing with other agencies owned by the same parent company.

Thus, acquisitions boosted revenues on paper but failed to create real efficiencies. Recognizing this pattern, Shearn passed on investing in advertising agencies, which proved wise as consolidation failed to create the promised synergies.

Analyzing competition means understanding how many competitors exist, how they compete with each other, and what factors drive competitive intensity.

Assessing Competition Levels

Limited competition generally creates better investment opportunities. More competitors typically mean more choices for customers and lower profits for businesses. Companies facing fewer competitors are also simpler to analyze since you have fewer moving parts to track.

You can quickly gauge competition levels by checking the Competition section in a company's 10-K filing.

Companies with limited competition list competitors by name, while those facing intense competition simply state they have "many competitors."

For example, Moody's (bond rating agency) 2009 10-K specifically named nine competitors, whereas Dollar Financial's (check-cashing and consumer loans) 2010 10-K described a fragmented industry with approximately 7,000 neighborhood check cashing stores and 22,000 short-term lending stores.

Competition in Fast-Changing Industries

Technology and other rapidly evolving industries require a different analytical approach. By the time you analyze individual competitors, the landscape may have shifted entirely. Instead, view competition from the customer perspective.

In 2001, companies like Expedia, Travelocity, and Priceline (online travel industry) were all in early development stages.

Rather than analyzing each competitor, Shearn attended industry conferences like PhoCusWright to understand customer and supplier preferences.

Priceline's opaque bidding model initially seemed limited, allowing customers to choose only star ratings rather than specific hotels. However, customers valued the deep discounts while hotels appreciated avoiding public price reductions that could damage their pricing power.

This differentiated service model drove Priceline's stock from $8 in 2000 to over $400 by 2010.

How Companies Compete

Beyond understanding customer value, businesses compete in different forms with distinct implications for investors:

• Capital-based competition: Businesses with more money can fund projects that smaller competitors cannot afford, such as large mining operations, extensive distribution networks, or costly research facilities. This creates lasting advantages since competitors cannot match these investments.

• Service-based competition: Companies differentiate through customer service quality. Strong service cultures maintain advantages, though new management teams can sometimes close gaps by improving their service levels.

• Price-based competition: Competitors constantly match each other's prices, making it nearly impossible to raise margins. Profit improvements must come from cost cuts, which become increasingly difficult over time.

• Competition by copying: Management teams try to replicate successful competitors' products or business lines. This rarely works because they copy surface features without understanding the underlying capabilities or risks that make the original successful.

Overall, you should understand how companies compete because it will help you identify which businesses have sustainable advantages versus those trapped in destructive competition patterns.

Competition Intensity Factors

Once you know how companies compete, examine what drives competition intensity:

• Industry structure: Industries with many similarly-sized players face constant battles for market share with no clear winner. Concentrated industries with a few dominant players allow leaders to leverage scale advantages in pricing, shelf space, advertising, and technology investments.

• Growth rates: Industry growth greatly affects competitive behavior. In expanding markets, companies can grow without stealing customers from rivals. When growth slows, businesses must take market share from competitors to keep growing, leading to more aggressive tactics and sometimes irrational behavior.

• Temporary versus permanent shifts: You must distinguish between short-term competitive moves and lasting changes. Some companies use unsustainable strategies like below-cost pricing to gain market share temporarily.

• Operating cost trends: Track operating costs per customer or transaction across industry participants. Rising ratios signal increasing competition and potential margin pressure. When companies spend more to acquire and serve each customer, it shows competitors are fighting harder for business.

These factors often work together, with slowing growth rates triggering price wars that drive up customer acquisition costs across an entire industry.

Many investors focus only on direct competitors but miss substitute products/services, foreign competition, and industry patterns that can significantly affect returns.

Substitute Threats

Substitute products/services can disrupt entire industries by serving the same customer need through completely different approaches.

For example, ride-sharing apps replacing taxi services or video conferencing replacing business travel.

Other recent examples of substitute disruption include:

• Traditional banks losing market share to digital payment apps like Venmo and Cash App.

• Movie theaters facing competition from streaming platforms with same-day releases.

• Gas stations seeing reduced traffic as electric vehicle charging networks expand.

Shearn notes that asset-intensive businesses like Boeing (airplanes), Dow Chemical (chemicals), and CEMEX (cement) face fewer substitute threats due to high capital requirements and technical complexity.

Foreign Competition Risks

Globalization expands competitive threats beyond domestic players

Products that are fragile, bulky, or have high shipping costs relative to their value maintain natural protection from foreign competition.

Rock quarries face minimal foreign competition, for instance, because shipping rocks across oceans usually costs more than the rocks themselves.

Manufacturing with high labor content faces the greatest foreign competition risk

Competitive threats often develop slowly, giving investors years to recognize danger and exit positions.

To provide an example, in 1995, Pillowtex (a textile manufacturer) generated $500M in sales but ignored the 1994 elimination of import restrictions that had previously limited foreign textiles.

While competitors moved production to developing countries with lower labor costs, Pillowtex spent $240M upgrading U.S. plants.

Investors had eight years to recognize this flawed strategy before the company went bankrupt in 2003, as foreign competitors could sell products for less than Pillowtex's manufacturing costs.

Identifying Industry Leaders

To identify industry leaders, Shearn recommends creating spreadsheets that compare financial and operating metrics across public competitors. Focus on companies with the highest operating margins, returns on capital, and shortest cash conversion cycles.

Shearn provides the example of two freight forwarding companies, Expeditors International and UTi Worldwide.

From 2005 to 2010, Expeditors consistently earned 4-5% net margins while UTi averaged only 2%. This significant difference came from their growth strategies. Expeditors grew organically by expanding its existing operations, while UTi grew through acquisitions, constantly buying other companies.

The superior performance suggests that in freight forwarding, building your business from within creates more value than buying competitors.

Constructing the Ideal Business

After analyzing competitors, construct a theoretical ideal business combining each competitor's strengths. This benchmark helps evaluate any specific investment opportunity.

Shearn gives the example of oil refineries, which process crude oil into gasoline and other products. According to Shearn, three factors create the ideal refinery operation:

• Protected markets: Demand exceeds supply in regions with regulatory barriers. For instance, California's environmental regulations make new refinery construction nearly impossible, allowing existing refineries to charge higher prices than east coast competitors who face more competition.

• Crude flexibility: Refineries that process multiple crude types can switch to whatever source is cheapest. Since crude oil prices vary by source (Canadian oil sands, Texas shale, Saudi fields), this flexibility improves profit margins compared to refineries limited to one crude type.

• Plant scale: Labor costs stay relatively fixed regardless of refinery size. A refinery processing 500,000 barrels daily doesn't need 10 times more workers than one processing 50,000 barrels, making larger refineries more profitable per barrel.

This ideal business framework helps you quickly identify which refineries have the best competitive positions and highest profit potential.

Learning From Industry Failures

Investors should search for articles about why competitors have failed in an industry. These case studies provide insights into specific patterns that signal potential trouble ahead.

For example, oil and gas investors should know about British Petroleum's ($BP ( ▼ 2.17% ) ) repeated safety failures:

• A 2005 Texas City refinery explosion killed 15 workers and injured 170 others due to cost-cutting and poor safety culture.

• The 2010 Gulf of Mexico disaster became the largest marine oil spill in history, showing these weren't isolated incidents.

These failures show that lax safety standards can lead to massive financial losses and government fines. Not to mention, major disasters like these often lead to stricter regulations that increase compliance costs across the entire industry.

As an investor, you should evaluate whether companies you're considering might face similar safety problems in the future.

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