Overview – Why Bother Understanding How Different Industries Work?
Imagine you’re a sociology researcher, and you’ve been given the task of understanding how people from a certain country react to hardships. How do you plan on successfully finishing this job?
One way would be to take a bottom-up approach: interview as many people as you can, collect data then, based on your findings, piece together a conclusion. Although this approach looks simple enough and will likely get you the answer you want, it’s a very time-consuming and repetitive process. You’re trying to gain an overall understanding by starting from scratch, which forces you to gather as much data as possible to ensure your generalization is as accurate as possible.
On the other hand, you can choose to take a top-down approach, that is, have a high-level understanding of the people of this country by looking at their culture and social norms, then based on this, get specific details to your question by interviewing people.
You know from existing literature that their culture values community, mutual support, and helping others in times of need. With this in mind, you have a rough idea of how these people generally think and behave, which also means you can make some assumptions about how they’ll respond to your question – your job now is to go out and confirm those assumptions.
There are innumerable companies around the world, but many of them operate very similarly to others. Because of this, companies with similar operations can be grouped together to make categorization a bit easier – these categories are known as industries.
This systematic grouping of different companies that offer similar services and/or products can prove to be extremely helpful for all sorts of people, including investors. Although this sounds like something that would only be of interest to economists and policymakers, there are benefits to be had for investors by taking the time to understand how different industries work.
Industries and Sectors – What’s the Difference?
Before continuing, let’s first understand the difference between an industry and a sector.
Many people use the terms interchangeably, and there’s usually no harm in doing so when used in a casual context. However, there is a difference between these two terms, and in some contexts, it’s important to understand what those differences are and to use the correct term.
Put simply, an industry can be thought of as a group of enterprises that engage in similar business activities with very similar (or even identical) operations, while a sector can be thought of as a category of an entire economy and/or as a collection of several industries. A visualization of this hierarchy is shown in the diagram below:
Let’s go over a simple example: Canada’s Big 5 banks (RBC, TD, CIBC, BMO, and Scotiabank) are all part of the banking industry. At their core, they more or less provide the same products and services such as bank accounts, mortgages, retail banking, commercial banking, and loans. Not only that, but they’re all similar in how they earn their revenue as well – a bank typically earns the bulk of its revenue by charging interest on the loans they provide, and that is certainly the case for all five of these banks.
Although the Big 5 banks are all part of the banking industry, they are also part of the broader financial services sector, which encompass a wide variety of financial activities such as retail and commercial banking (the Big 5 provide these services), investment banking (Goldman Sachs, Citigroup), and insurance (Manulife Financial, Sun Life Financial). The Big 5 is similar to these other companies in that they all provide financial-related services, but when it comes to specific operations they vary considerably.
Why Focus On Industries, but Not Sectors?
As was mentioned in the overview, it’s in an investor’s best interest to understand how different industries work. But why is that the case, that is, why focus on industries and not sectors?
Looking back at our previous discussion, sectors are extremely broad: they can either be thought of as a specific portion of an economy and/or a collection of several industries. Because of this wide net, just because companies are part of the same sector doesn’t mean they’re similar enough that they can be compared on an apples-to-apples basis.
This has some very serious implications for investors because if they erroneously compare companies from the same sector but operate in different industries they run the risk of performing a wildly inaccurate comparison, which could lead to some very incorrect conclusions.
For example, imagine an investor wants to expand their technology-related holdings, and recently their attention has been drawn to two companies: NVIDIA and Microsoft.
On the surface, these companies appear similar enough: they both operate in the realm of technology and both offer some form of software/hardware as their main products – seems close enough, right? Upon closer inspection, however, it becomes clear that these companies aren’t as similar as they initially appear.
Although they both focus on technology, NVIDIA’s focus lies primarily on producing computer hardware, namely graphics processing units (GPUs), while Microsoft’s focus is on software and information technology (IT). You can’t possibly hope to compare a hardware-focused company to a software-focused one on an equal basis. This is the risk investors run when comparing companies that hail from the same sector but operate in different industries.
It would make a lot more sense to compare NVIDIA to another company that also produces GPUs, such as AMD, and to compare Microsoft to other software/IT companies such as IBM and Oracle. Because these comparisons are now between technology companies with similar operations, the subsequent analysis is now much more accurate.
Comparing different companies is an integral component of investment analysis, but the first step is to make sure that the companies being compared operate in the same industry, otherwise, your analysis will be inherently flawed before you’ve even started.
Now that we’ve cleared some things up, what exactly does an investor stand to gain by understanding how a certain industry works?
Saving Time by Taking a Top-Down Analytical Approach
Investors only have a limited amount of time and energy to work with, so it’s only natural that they’re always looking for new ways to save time and to further streamline their workflow. When looking at prospective companies to invest in, taking the time to first understand how the industry they’re part of works may seem like a lot of work at first, but in reality, can lead to a lot of time being saved down the road.
Let’s say you want to expand your portfolio into the oil and gas industry, but you have no idea how this industry works.
You go through the annual reports of a few companies to try and figure out what’s going on, but in the end, you end up with more questions than you started with. Performing further analysis proves to be difficult because you don’t know how to proceed: what should you focus on when going over reports, what sorts of risks affect these companies, and what constitutes “acceptable” or “unacceptable” performance?
Because of your lack of understanding of the industry, the only thing you ended up doing was wasting your time going over the annual reports of companies you fundamentally didn’t understand.
What if, instead of taking this approach, you first took the time to understand how the industry worked, and then looked at individual companies?
Had you done this, then you’d know that the oil and gas industry’s value chain is largely split into three major segments: upstream, midstream, and downstream operations. Some oil and gas companies choose to focus on only one of these segments, while some of the larger companies are involved in all three of these segments, and as a result, are known as “integrated” oil and gas companies.
Each segment operates differently from the others, ranging from using different equipment, needing different types of personnel, and dealing with different kinds of capital expenditures. Oil and gas companies can earn revenue in each of these segments, but will require three different approaches to do so. A company focused solely on upstream operations will make money very differently from one focused primarily on the midstream.
With this knowledge in mind, you have a much better understanding of how companies in the industry typically operate, and as a result, your work can go a lot smoother because you know what to pay attention to and what to ignore.
Instead of trying to figure out what’s important when going through an annual report, you can jump to the pertinent sections right away, extract the relevant information you need while ignoring anything superfluous, and use the appropriate investment ratios/metrics when going through the financial statements.
Rather than wasting time trying to figure out what’s going on, you can instead hit the ground running because you know what sort of information you want and how to get it.
Since you know how companies in the industry are typically supposed to operate, then this makes your comparisons a bit easier because you have a clear mental model of what “normal” looks like, and can discern if something is amiss a lot faster.
Taking the time to understand how different industries work will certainly involve a fair amount of time, energy, and discipline. Not only that, but the benefits of doing so may not be apparent right away. However, the time you save will gradually add up, and over the long term, you may find that this accumulated saved time will dwarf the time you spent understanding how certain industries worked – talk about a major return on investment.
A Benchmark to Reference
It’s often said that you shouldn’t compare yourself to others and that your only competition should be yourself. While this may be true on a personal level, in many other endeavours this isn’t the case at all. The argument can even be made that comparisons are an integral part of how the world operates.
When an athlete wants to improve, one of the first things they’ll likely do is understand what their past performance is like, and compare all future performance data relative to that historical baseline. Whenever a new phone or computer is released, one of the first things that are brought up is its improvements compared to the previous model. Time and time again comparisons are used to assess performance and to detect if there is any improvement.
Naturally, making comparisons is something investors do all the time when performing investment analysis. This is because a prospective investment is only as good as what it’s compared to. A company that earned $1 billion in net profit over the past fiscal year sounds impressive, that is, until you learn that all its competitors earned at least $10 billion.
An understanding of different industries can help investors accelerate their analytical work, but this understanding also serves another role: it gives investors a point of reference when looking at the data of individual companies within an industry, making it easier to detect if a specific company is within acceptable performance boundaries or not.
Take for example the banking industry between Canada and the US. Canadian banks have, on average, higher asset/equity ratios than their American counterparts, or put another way, Canadian banks are more leveraged. In 2017, the average assets/equity ratio for Canada’s Big 5 was 18.3, whereas the average for America’s largest 5 banks was 9.3. This will make it much easier to determine whether a given Canadian or American bank is overleveraged or not.
Many industries have averages for specific ratios and metrics, such as the P/E, P/B, ROE, or industry-specific ones such as the banking industry’s assets/equity ratio.
Now, just because a certain company falls within the average doesn’t mean it’s time to celebrate, nor does falling outside of it mean that there’s cause for panic. It’s possible for a company to fall outside the average because of unfavourable business circumstances that are beyond its control, and it’s also possible for a company to fall within or even exceed the average but for this strong performance to be shortlived.
Investment analysis is a holistic process comprised of many steps: comparing data is an important step, but is ultimately just one of many that need to be taken before reaching a final decision.
Wrapping Up
For many investors, taking the time to study how a certain industry works seems like an endeavour that will only be of interest to academics and policymakers, not those looking at where to park their money next. However, there are benefits to be had for investors who take the time to develop this understanding.
Investors only have a limited amount of time and energy at their disposal, so trying to go through the annual report of a company without a fundamental understanding of how the underlying business works will only end up being a waste of time.
However, by having an understanding of how the industry works and how the companies within it typically operate, then an investor has a much better idea of what to look out for and what to ignore, saving them precious time and energy in the process. Better yet, these small savings will add quickly add up: a few minutes saved today can lead to hours saved down the road.
Looking at a single company’s financial and other numerical data sounds easy enough, but data is only as good as what it’s being compared to. Similarly, a company’s performance is only as good as the performance of its competitors/peers. Therefore, understanding what constitutes “typical” numerical performance for a given industry will quickly help investors discern whether a specific company is punching above its weight or is a sinking ship.
Investors don’t have to understand how different industries work if they don’t want to – some are able to get by just fine without doing so. That being said, if you value your time and energy, plan to constantly expand your investment horizons, and want to keep investing for the long haul, then acquiring this understanding may prove to be worthwhile.
