Pick the right sector

After assessing that an economy is worth investing in, one needs to decide the industry where one can park one’s money. For, while the economy may be doing outstandingly well, not every industry in the economy would be a good bargain buy. Here is a list of 15 factors that you might like to consider in your search for the right industry

Sales: It is sales that bring in profit to an industry. What is important is not the absolute level of sales but its growth trend. While there is nothing like an “ideal growth” because growth is also a function of the base level of sales (given the mathematics of a low base, the growth levels tend to be high, when sales levels are low) and while it can differ from industry to industry, sales should grow at least at two times the inflation levels. Sales (market share) is the key metric for FMCG industries.

Return on Capital Employed: Look at the ROCE in the industry. ROCE measures how productively money is used. Capital employed is the sum of equity funds and loan funds. Return refers to EBIT. Hence ROCE here is pretax ROCE. Again, while this can vary from industry to industry, it makes little meaning in investing in an industry whose ROCE is less than 15 per cent.

Competition: While competition pushes an organisation to stretch and is, hence, welcome, an overhang of it would lead to unhealthy practices such as price cuts and unrealistic cost reductions. Price cuts merely transfer the profit margin from the industry competitors to the customer. Competition eats into profits and can, over time, erode profitability and convert the industry into a commodity. Price-driven competition can often threaten the very survival of an industry. The airlines industry comes as an example.

Critical cost component: Getting to know the critical cost component is important. You must also know whether the industry has control over that component. For instance, for the tobacco industry, indirect tax is a critical cost component. The industry has no control over it. For some industry, imported raw material may be the key cost component.

Technology: Technology is the new mantra. Technology has done wonders to the way we live and transact business. Mobiles, Internet and e-commerce have all revolutionised our lives. Any industry that does not embrace technology is doomed. If an industry is still old-fashioned and keeps away from technology, you must keep away from that industry.

Governmental promotion: Governmental support can go a long distance in propelling the growth of an industry. The Information Technology industry is the best example of this, with IT having flourished thanks to a series of governmental concessions such as tax sops, cheap land allocation and, most importantly, non-interference in its functioning (!). You would love an industry that has such pampering and backing.

Skilled manpower: Does the industry enjoy technically skilled manpower? It’s important to figure out what is driving success. Skilled manpower helps to maintain product quality and offer customised products, thereby resulting in better customer satisfaction. The mammoth growth of the IT, ITES industry in India is not merely on account of cost arbitrage but efficiency arbitrage as well, with a slew of well trained, English speaking, high-on-IQ manpower being available.

Constant Innovation: Does the industry constantly reinvent itself? This is more critical in the case of industries that experience rapid changing technology/customer expectations and have to spend huge sums of money in constantly upgrading to newer product versions. Industries such as Pharmaceutical and Consumer electronics spend huge sums of money towards R&D to ensure that their products stay “latest”.

Supply-side constraints: Some industries perennially face lack of supplies at reasonable prices, which hamper their ability to exploit favourable market conditions. Take the fact that the demand for crude has opened up a huge market for oil exploration companies. But worldwide shortages of drilling equipment, such as rigs and offshore diving vessels, have slowed down the exploration activity.

Commoditised products: Where the products sold by players in an industry are not unique, then customers make their choices purely based on pricing. For example, agro-based industries such as sugar, cotton, are price takers, since customers try to pull down the prices close to the cost of production.

Regulatory constraints: A highly regulated industry generally has very little scope to enjoy pricing independence and margin improvement. For example, despite strong customer base and established products, the cigarette industry struggles to protect its margins as the government constantly toys with excise duty on cigarettes.

Cyclical demand: If the demand is highly cyclical, the margins come under pressure since the industry has to constantly spend cash to “be on alert” should an opportunity come. For instance, the demand for drilling equipment is cyclical. However, manufacturers of these equipment would have to continue incurring maintenance capex to keep their production facilities in shape, till the next wave of demand comes through.

Growing domestic demand: An industry that enjoys a growing domestic demand is insulated from happenings in the global market place including exchange rates. Currently, FMCG, Retail and real-estate enjoy this advantage.

Expanding export market: This is not to belittle an export-driven industry. Such industries generally enjoy higher margins due to their relatively lower cost base. In addition, export markets of developed countries are huge in size, offering potential for the exporter to grow his sales rapidly. Companies such as TCS and Infosys have been able to maintain high sales growth and decent margins for the last several years because of the export factor.

Macro trends: Rising interest rates, unfavourable currency movements, change in fiscal policies, etc, can impact industries. Rising interest rates have slowed down growth of banking industries as credit intakes slow down. Similarly, recent depreciation of the rupee has had negative impact on industries such as paint that rely on imported raw materials.

Surely, you will, by now, have got a good understanding of what to look for in an industry