The role of Industry Analysis in Corporate Finance

November 21, 2015
Michael Porter's Three Generic Strategies.svg

What surprises our IFAP and students the most during the program is not how difficult and subjective Valuation and interpreting Financial Statements can be but how quant work is not the be all and end all of Financial Analysis. In fact, once they learn the logic behind the CAPM and it’s elements, the calculation of the WACC and the formula for the free cashflow, all of which are easy once you understand the steps and the theory, what flummoxes is forecasting basic numbers like sales, working capital and capital expenditure. They realize it’s not just a case of dragging cells and using historical growth rates but understanding the company’s future in context of the industry it operates in. The best analysts are industry experts, which is why Investment Banks work in Industry teams because, like man, no company is an island.

This blog post is a part of a longer series where we try and understand the importance of Industry Analysis, its role in financial services and of course, try and develop quick frameworks that help you ask the right questions. Let’s start with its role, which goes right back to strategy and the principals of why companies exist.

There are two principles to running any firm:

  • Increase Top line or Sales or Revenue year after year and in a sustainable manner.
  • Increase the bottom-line, margin, profit, income year after in a sustainable manner

Financial AnalysisThe word ‘sustainable’ is critical because a company is an entity that lives to perpetuity. So to create wealth and fundamental value, growth and profitability have to be recurring forever. That’s what creates great companies like Saint Gobain (founded in 1665) Citigroup (1812), Harpers Collins (1817) Bowne  (RR Donelly 1775) and Kikkoman (the Japanese food company that can trace its heritage back to 1630). No PE firm wants to invest in a one hit wonder because selling it again would require them to prove sustainable returns over a lifetime.

For firms to achieve their two principles they begin with a vision and a mission statement followed by an execution plan which we broadly call Corporate Strategy, quite simply, a plan of attack. Why attack? Well because most of what we know about strategy comes from war strategy and the wisdom of the Romans, the Greeks and the Mauryas and the political treatise like Arthashastra by Chanakya, The Prince by Machiavelli and The Art of War (the one most adapted to business and investing) written by Sun Tzu.

FACT: Japan is home to the world’s oldest lots of things. Sudo Honke, the world’s oldest sake brewer, has been around since 1141. Before being absorbed into a subsidiary in 2006, the oldest continuously operating family business in the world was Kongo Gumi, which built temples, and had been doing so for 14 centuries.

The origin of Strategy

Military War strategy focused on two things, how to acquire power, stay in power once you get it and how to expand your reach, creating more wealth for your treasury and, unfortunately, yourself. They rarely did it for their people. Nothing much has changed. Strategy wouldn’t have been needed of course if there were only ONE people and ONE king who ruled the earth completely, leaving no land to conqueror or no usurper to vie for the throne. We would call this a Monopoly. A state of play where there is no competition for customers or demand making me the sole provider, which enables me to charge anything, I want. Anyone or anything come to mind? OPEC has been doing it for years. Controlling supply and price because our demand for oil can never be satiated, that was until Russia and the US entered the picture and we suddenly went from a Monopoly to an Oligopoly where there were other players.

What about De Beers, the South African diamond miner? For years they controlled who they made sightseers, a selected group of people who would be given a velvet bag in exchange for money, a bag they could not open. The aspects (four C’s) of the stones unknown to the buyer, and they had to live with it for over a 100 years until Alrosa broke open the market in 1992 and became the largest miner in the world.

When you stop being the only one, you have only two ways to grow. You either conquer unchartered territory or you take someone else’s. Unchartered territory is ofcourse the easiest and most cost effective. You lose fewer people, spend less on feeding and housing armies and don’t lose sleep over being knifed by the resistance. But alas, much like the world has run out of unchartered territory, product demand is not infinite. This means I am going to have to step on your toes, and perhaps take what is yours. To do that successfully I need to master three things.

  • Have a single simple long term goal
  • Have a comprehensive understanding of my environment
  • Have a critical and honest appreciation of the strength of my resources.

m-ifap

In the next series, we will look at the above in more detail. This is a small taste of what you will learn in IFAP, the industry’s leading Financial Analyst program. Learn more about the program here.