Researching a Sector

How do we research a sector — in the Indian context

Disclaimer & Disclosures

  • The author of this section DOES NOT have any long or short position for companies used in this section for illustration purposes as of the date of being published. This may or may not change in the future.

  • The companies used as examples are mentioned solely for educational purposes, mention of any company is random and is certainly NOT an investment recommendation.

Introduction

As individual investors, our primary focus is to,

  • find disparities between a company's market price (the price at which it trades) and its intrinsic value (the underlying value of the company we find fair).

  • make an assessment on this disparity, and attempt to exploit it to make money.

Can't catch 'em all

A prerequisite to finding such a disparity is having a set of companies to work with. Collectively, the market is made up of thousands of companies^1; it is chaos, an unexplored territory with limitless potential, if you will.

It would be naive to take a shot at tracking all the listed companies. So, we need a method to carve out order from this chaos so to speak. Intuitively, arranging companies under different buckets based on some basis seems like a good starting point. One such basis is categorizing companies on the basis of the sector/industry under which it conducts business, then further categorizing them based on sub-sectors, and so on.

For example, a company 'A' selling chocolates and a company 'B' selling pencils would both broadly be part of the 'fast moving consumer goods' (FMCG) sector, however, company 'A' would come under Foods sub-sector, and company 'B' would come under Stationary sub-sector.

This categorization helps us keep track of a broader universe of stocks - it gives us an approach for thinking about companies based on the sector under which they operate before we even begin conducting our due-diligence on them. Once categorised, we can work with the sectors that we understand.

Categorization, sure — but then what?

There are two investing strategies with which we can use this categorization,

  1. Top-down strategy: This strategy involves studying macroeconomic factors to narrow down preferred sectors to invest in, then finding the best opportunities in such sectors. The focus on individual companies is lower here, and sector conditions are the prime focus. Sometimes, top-down strategy investors also prefer buying baskets of 2-3 stocks in a sector rather than finding the strongest player in the sector.

  2. Bottom-up strategy: In this approach, we first find potential opportunities in companies based on some set of criteria or a checklist, and then slowly move up to studying the sector and its players. The focus on sector conditions is lower here than in top-down strategy; the idea is to find companies that can remain healthy even in sector downturns, and so can outperform its peers over the long term.

Either of them does involve at least some sectoral research, so let's get to how we can do that.

A framework for Sectoral Analysis

Broadly speaking, a sectoral research should include,

  1. Information about the product, and its applications,

  2. Understanding the value chain of the sector,

  3. Market history, key events, and an overview on current conditions, and,

  4. Benchmarks, and metrics to keep track of the sector.

To keep up with this section, I implore you to pick a sector, and try answering the questions I frame for each of these points. I will try to provide examples from different industries for each section for your understanding, but you can stick to the sector of your preference and pencil down the answers for the sector you picked.

Information about the product, and its applications

What is the sector selling?

Quite self-explanatory and perhaps overly simplistic, but noting down does help to answer a few forthcoming questions that are often ignored. For example,

  • Fast moving consumer goods sector, often abbreviated as FMCGs, sell products that are generally cheap, and sell quickly as a consequence of frequently being used, such as packaged foods, beverages, stationery products, etc.

  • Financial sector, often abbreviated as BFSIs in India, deals with financial products such as loans, insurance, brokerage services for capital markets, etc.

  • Pharmaceuticals sector sells medicines, drugs, vaccines and other health related products.

How is the sector sub-categorized?

Most, if not all sectors can further be divided into different segments, and you'll often find the economic dynamics of such segments differ from one another, but generally not contradicting that of the sector itself. Often, a company operating under a segment eventually forays into all sub-sectors. For example,

  • Fast moving consumer goods sector can be categorized into personal care, home care, packaged foods, beverages, and stationary/office segments.

  • Automobile & components sector can be categorized into pureplay automobile manufacturers, and auto-ancillaries.

  • Utilities sector can be categorized into Power, Gas, Water, etc.

What is the market size?

Market sizing refers to the estimation of a variable with little or no data available. In general, market size refers the potential revenue / volume a company can attain if it had 100 percent of estimated market share in the sector. Determining market size helps us perceive,

  • the growth potential of companies operating within a sector, and

  • the growth potential of the sector itself under conducive macroeconomic factors.

For example,

  • Domestic automobile sectors sold 21.5 million vehicles in financial year 2020.^2

  • Fast moving consumer goods sector was a 3.4 lakh crore market in India as of financial year 2018.^3

Is the sector prone to disruption?

There is great value in identifying potential disruptions in a sector. There are two kinds of disruptions a sector can face,

  • A change in business dynamics of the sector. The obvious example of this kind of disruption is the entry of Reliance's Jio into the telecom sector forcing the incumbent players to either match its prices, or shut shop.^4

  • A fundamental change in the product itself. An example of this is the introduction of affordable electric vehicles in the automobile sector.

Understanding the value chain of a sector

A value chain analysis refers to evaluating various aspects involved in running a business, such as,

  • Procuring required raw materials & machinery,

  • Recruitment of labor / workforce,

  • Conducting Research & Development (R&D),

  • Building, testing, and releasing the product,

  • Managing & storing inventory, and

  • Marketing, distribution, delivery, installation & post-installation services of the product.

We evaluate value chain of a company to,

  • Understand the value created by a company in a marketplace,

  • Understand potential inefficiencies and bottlenecks faced by a company in building & selling its product,

  • Take account of steps taken by a company to weed out such inefficiencies and bottlenecks.

  • Analyse the value chain to see where costs can be reduced, and thus profits can be maximised, and

  • Understand the differentiation of various players which offers them competitive advantage.

If you think about it, a company's intrinsic value is some function of the additional value it exclusively creates in the marketplace, and the relative efficiency with which it conducts its business. I feel this is roughly what people mean when they're referring to a company's competitive edge, or what Warren Buffett calls moat, which Investopedia^5 defines as,

a distinct advantage a company has over its competitors which allows it to protect its market share and profitability.

This additional value in the company's products can be many things - brand power, brand recall, pricing power, first movers advantage, technological superiority and so on.

You will find commonalities in value chain analysis of most companies working under the same sector. Thus, a broad understanding of value chain of a sector essentially gives you a bird's-eye view of any company operating in it. Paradoxically, the process of understanding value chain of a sector itself needs an assessment of value chain of a few companies in the sector. In due-diligence, there truly are no shortcuts.

Let us go through the mentioned aspects of a value chain with some examples—

Preferred geographical locations

Though this aspect doesn't necessarily belong to value chain analysis, the destination of production sites is often relevant in a company's business model. This can be in terms of keeping costs of building the product low, procurement of relevant raw materials, or recruitment of skilled labor.

For example, Ruchira Papers, a paper manufacturing company, prefers Himachal Pradesh as a preferred manufacturing destination as the energy costs in the state are favorable, and raw materials (softwood pulp, wheat straw) are readily available from Punjab and Haryana.^6

A sectoral example of this is a large number of cement production plants in Rajasthan^8 due to the state being rich in limestone.

Procurement of raw materials

Companies like to keep their raw material landed costs as low / benign as possible without compromising on intended quality of their products. This is, of course, because volatility in raw material prices would affect the cost of production, which in turn affects the profitability of the company.

A company has few avenues to keep raw material costs benign, such as,

  • Using raw materials efficiently by optimizing usage and minimizing wastage.

  • Having favorable long term contracts with suppliers to safeguard against volatility and achieve security of supply at favorable prices.

  • Minimizing the proximity of the company's production site to the supplier, since transportation of raw materials is generally borne by the procurer, directly or indirectly.

  • Vertically integrating supply of raw materials.

For example, Tata Metalliks, a company that was initially engaged in producing and selling pig iron, has opportunistically pivoted to primarily selling ductile iron pipes in recent years. Note that one of the key raw materials needed for producing ductile iron pipes is pig iron, which the company has been producing for years.^9

Recently as you may have heard, pharmaceutical manufacturers have started relying on backward integration for the supply of active pharmaceutical ingredients (APIs), which is the raw material needed for production of drugs.^10

Procurement of machinery and equipment

Some sectors require frequent capital expenditures on machinery and equipment. This may be for,

  • Capacity expansions,

  • Maintenance, or

  • Replacement of older equipment / machinery

In such cases, it may be worthwhile to understand the costs and specifics associated with such capital expenditures.

Nascent sectors are a good example of this. As you may know, the Electric Vehicles (EV) sector needs constant investments for building charging stations — the adoption of the technology heavily depends on it. The CEEW Centre for Energy Finance estimates in its report that an investment of $2.9B is needed to develop 2.9 million public charging points in the country by FY30.^11

However, this is not to imply the capital expenditure needed for machinery and equipment is frequently done only in nascent companies. Some traditional sectors require constant upgrades too, and thus are capital intensive in nature.

For example, consider the telecommunications sector with evolving technology standards for their network infrastructure. It is estimated that Reliance's Jio, Airtel, and VI (formerly known as Vodafone Idea) will need to spend a combine of roughly $28B in capital expenditures^12 in the next few years to build infrastructure of 5G.

Recruitment of labor / workforce

Different sectors require varied kinds of the workforce needed to conduct its business. The cost of recruiting a company's workforce would depend on,

  • The skills required of the labor to conduct business, as different qualifications would dictate different wages.

  • The availability of such labor, as the fundamental supply and demand principles apply.

For example, the IT sector would consider software developers and project managers as its workforce, which for reasons not in the scope of this section, requires skills that command higher wages. Employee costs are generally 50-60 percent of operating costs in these Tier-1 players of this sector^13. Thus, while tracking the IT sector, employee costs would be one of the key metrics to keep in mind.

Conducting Research & Development (R&D)

Research and Development (R&D) costs refer to expenses incurred in innovation & enhancements of products, services, and various activities of a company. Such investments are essential for a company to stay competitive in the market. Generally, sectors with higher rate of change in underlying technology have higher R&D costs, such as health care, telecommunications, and automobiles.

Building, testing, and releasing the product

While the various input costs we've discussed so far affect the margins (a measure of profitability) of a company, the real value addition of a company in the marketplace comes from its manufacturing or production activities. In other words, a company purchases inputs (such as raw materials, power, etc) from its suppliers, and transforms these inputs into finished and marketable goods.

Consider a company that purchases such inputs, and for some reason can't convert it into a finished good. What will the company do with these inputs? If it is sellable in the market, such as raw material, it would do that. But since there's no value added by the company, it would at best fetch the same prices for such inputs that it bought it for (considering there's no price arbitrage). The company wouldn't get any profits.

So, studying the production (or value addition) process of a company is essential to understand how a company generates its profits. Let us take an example here, that of manufacturing of solar modules.^14 If you are not aware, solar module are components that convert solar radiations into electricity. A solar module manufacturing process is as follows,

  1. The company would purchase inputs in the form of semiconductors (typically Silicon), tempered glass (specialized for solar modules), silver paste, and electrodes.

  2. Silicon in crystalline form is melted and cast into blocks. These blocks are cut into thin wafers.

  3. The wafers are then used as diodes, so that charges flow in only one direction. Thus, current is generated.

  4. Many such wafers are combined to form a single solar cell producing about a watt of power. And, many solar cells are combined in a single solar module.

  5. The diodes are connected with metals, so that current can be directed out of the cells.

  6. To prevent the solar light from being reflected (the light reflected of course cannot be used to generate current), an antireflective coating of Titanium Dioxide (TiO2) or Silicon Nitride (SiN) is applied on the surface of cells.

  7. An encapsulant material (typically Ethyl Vinyl Acetate) holds together solar cells between the top surface and rear surface. The top surface is tempered glass specifically made to protect solar modules and let solar radiation pass through. The rear surface is a thin polymer back sheet (typically made of Tedlar) that prevents ingress of water and gases.

  8. The panel itself is typically put in a protective frame made of Aluminum.

  9. A junction box is used to direct electrical connections outside the Aluminum frame.

Suppose you had bought a company that sells solar modules. If you had not studied the manufacturing/assembling pipeline, you would probably not be aware of the existence (let alone importance) of solar glass in the modules. In an event where there is shortage of solar glass in the market, the company would have to either pay extraordinary prices, or in the rare occasion, shut production. You, as an investor in the company, would be caught off guard with the margins of the company being affected. Thus, it is important to understand the importance of studying every aspect of the value chain of a company.

Managing & storing inventory

Once inputs are transformed into finished products, a company has to store the products and the raw material that remained unused. The finished product will be packaged and delivered to customers, and the raw material will be used as input at a later production cycle. This is referred to as inventory management.

An example of this is the rice sector. As you may know, some kinds of rice are aged before being sold. The company would need to ensure that the rice is kept safely with proper hygienic measures for long durations to safeguard against the rice being ruined.

Marketing, distribution, & delivery of the product

Marketing, distribution, delivery, installation (if applicable), & post-installation services (if applicable) of the product are all customer-facing activities, associated with the part of value chain that is carried out after the company produces its finished goods. Essentially, marketing refers to a company's ability in effectively promoting the value of its products & creating an image of the brand, distribution refers to the various paths a product takes in reaching the end-user, and delivery refers to how the company hands over the product to the end-user.

You'll often find companies with moats create value in this part of the value chain.

  • A great example of a marketing campaign is the Ambuja Cement ad^16 we've all seen at some point, in which after terribly failing to destroy a war between their houses, Boman Irani asks Boman Irani 'Bhaiya yeh deewar toot ti kyu nahi!?' and Boman Irani replies 'Kyuki yeh deewar Ambuja Cement se bani hai'. Fun times.

  • For fast-moving consumer goods, distribution channels are key to ensuring their brands have a consistent mind share with customers. We all know the brand value that Nestle's Maggi enjoys, but another competitive edge of the company lies in its extensive distribution channels. It doesn't matter where you are in the country, you are very likely to find stores that sell Maggi & Nescafe coffee.

Hopefully, the significance of understanding value chains has struck you by now.

Market history & key events

Any sector with a couple of years of existence has some past/forthcoming events that have a material financial impact on its players. This can be a major disruption, a government policy, a new player bent on capturing the position of incumbents, a black swan event and so on.

Take the airlines industry in the recent past as an example of a black swan event & intervention by the government. In April/May 2020, airlines had to ground their flights due to rampant spread of coronavirus. While domestic flights have resumed, operations are still at ~50% of pre-COVID levels. The Ministry of Civil Aviation (MoCA) has mandated fare bands, limiting the revenues earned by airlines.^17

For the telecom sector, a major event in its history dictates the fate of its player for the next few years; the Supreme Court of India asked 15 telecom players to pay a combine of roughly 90,000 crores to the government.^18 For the coming years, two of the total four players have to take strategic decisions with this liability in mind.

Studying such events gives you a lot of context on how a sector operates.

Overview on current market conditions

Having a finger on the pulse is vital to concluding your research on a sector. This includes catching onto a sector's growth headwinds, market maturity (where the sector is in its cycle), consumption split between organized versus unorganized market, consumption split between domestic and international players, split between the consumption in domestic and international markets, the players responsible for setting the trend in the sector (in terms of pricing power, product innovation, etc), the emerging players that could disrupt the set trends, the barrier to entry faced by new players, and so on. Look, it's impossible to list such things down here, specially since different sectors can have different things to look at, but the gist is to have an eye on what the participants of a sector as a collective are doing.

Benchmarks & metrics to keep track of

Tracking every number associated with the sectors you're tracking becomes impossible very quickly. And so, the flip side of performing due diligence is the ability to keep track of companies / sectors within your circle of competence as simply as possible. In fact, performing thorough due diligence yourself essentially allows you to abstract what's relevant in a sector, and track that. For example, with the telecom sector, much of what you need to know apart from your research is encapsulated in one number - average revenue per user (ARPU). With fast-moving consumer goods, a lot of information that you would need to keep an eye on cuts down to value/volume growth.

Sahil Bloom, VP of Altamont Capital Partners describes this beautifully in his appearance^19 on the We Study Billionaires podcast,

Occam’s razor is all about simplicity. The simplest explanation is often the best one. [...] And it really just enables you to the razor cut through the noise on an issue and just boil it down to the critical path towards an outcome. The best investors are able to boil down investment decisions to the fewest possible variables. [...] They have this unbelievable ability to aggregate all of this information about a company and just say the one or two things that actually matter. [...] They’re able to boil something complicated down to the simplest possible variable for them to look at. Gavin Baker [...] talks about this a lot in a number of interviews that I’ve heard with him, he talked about it as it related to electric vehicles, as an example. All that matters is the battery efficiency. And so, you just focus on that. You don’t need to get caught up in all the other metrics because battery efficiency is what matters for driving these businesses forward and for their success as a business model. And so you focus on that. That’s really what this is all about. Don’t add unnecessary assumptions, variables, and noise, when really only one thing matters. So identify that one thing, and then ruthlessly focus on it as a means to just bring simplicity into extremely complex companies.

Conclusion

To sum up what we've covered in this chapter, we essentially perform due-diligence over sectors to get a birds-eye view of its participants. A sectoral research includes the understanding of its products, an analysis of its value chain, looking at key events in its history, getting an overview on its current conditions, and an effective way to keep adding to it.