How to analyze a sector- A short primer
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How to analyze a sector? One question that routinely comes up when I run a Q&A is how to analyze a sector!? So I decided to write a thread explaining it in detail!
We will divide this into two main parts - Where to look & What to look for
Where do look? (Resources)
As a small retail investor, your primary constraint is access to quality resources and data. Luckily for us, there are multiple publically available high quality resources you can tap into.
1. IPO Filings - Look up the IPO filings for leading businesses in the sector. These are readily available on the SEBI website or via a simple google search. The RHP has two dedicated sections about the industry and about the business that are generally rich in data & insight.
2. Initiating coverage reports - When sell-side analysts begin covering a firm for the first time, they typically come out with an extensive initiating report. This generally has good insight into the sector along with the analysts view on the sector and the firm.
3. Sector bodies - Many sectors will report their numbers on a fixed basis (monthly/quarterly) to a sector body that often shares it in the public domain. You will get extremely indepth information for AMCs (AMFI), Insurers(IRDA), aviation(DGCA), automobiles(SIAM) and many others
4. IBEF (high level, but decent) IBEF is a free resource that has short sector reports on more than 40 sectors. These reports are more top down, in that they'll be less focused on individual companies and more focused on explaining the sector in the Indian context.
Which brings us to question 2 -
What to look for (Frameworks)
There are many well known frameworks available - Porters 5 force, PESTEL, etc to get started, but broadly you are looking for the following factors.
1. Competitive environment - Is the market structure monopolistic, duopolistic, oligopolistic or bordering perfect competition. How is the environment changing - are new players coming in, how easy is it for new players to enter, how easy is it for new players to scale.
2. Moats - What do great businesses in the sector do to seperate themselves from the ordinary. How much difference does this bring in their returns. Can a player with large capital destroy this moat. Can a player with a technological superiority destroy the moat?
3. Business Economics - How much free cash is an average business generating in the sector. How much free cash is a great business able to generate. What explains the differential. Will this difference expand or contract going forward.
4. Cyclicity: How cyclical is the end customer demand in the space. What are the key drivers of that cycle. How cyclical are the key RM prices for the business. What are the key drivers of that cycle. How well are firms able to pass through price hikes.
5. Balance Sheet idiosyncrasies: Balance Sheet idiosyncrasies: Does the sector have high receivables because of B2B/B2G clients? Does the sector have high debt due to high capex intensity and low free cash generation? Does the sector have high inventory due to product enhancement, or service level maintenance?
6. Growth: How fast is the sector growing. How fast can organized players in the sector grow. How fast can market leaders within organized grow. Are there trends (premiumization, export capture, new products etc).
7. Regulatory: - How active is the regulator/government in the industry. Do they control pricing. Do they control quality. Do they want to increase government control. Do they want to increase taxation. Do they want to change duties. Do they allocate resources?
8. Risks- Are there risks of consumer preference change. Technological leapfrogging. Unlimited cheap capital destroying moats. Go crazy with your creativity.