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How to choose a sector for investment ahead of the curve?

09 August 20226 mins read by Angel One
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When someone plans to start investing the first question they ask is, when is the right time to invest?  And the answer to this question is very simple – when you have money. It has been time and again proved that timing the market is almost impossible. Now the question that arises here is if it is difficult or impossible to time the markets – how to maximise our profit and returns to be generated from investment.  Here the answer is – It is not about timing the market but more about time in the market. It means one must have patience to invest for the long term and generate wealth. And that happens in a proper way if our selection of investment instruments is right. Depending on respective financial goals and risk profile one needs to select the right instrument. If your risk profile and financial goal allows you to opt for equity investment, the next question that arises is, where to invest? Many would say the answer to this question is a bit tricky. As the selection process may seem to be complicated. But as we say, markets are simple and we complicate things unnecessarily. If some is ready to give some time and apply common sense – the selection process not only gets simpler but also happens ahead of the curve. Here we are presenting a few simple steps to identify the right sector for investment.

Right Approach and Common Sense

It is stated that the most important factor in the business of investment is common sense. Add to that the right approach and it would be simple to identify the right sector for investment. The usual top down approach suggests one must opt for EIC analysis. In simple words it means Economic, Industry and Company analysis.

To explain it further, we must first have a look at the economic aspects like the general state of the economy like domestic production, consumption patterns, general price levels, growth and quality of life etc. This factor also helps in understanding income drivers, demographics, Savings and investment patterns and also employment rates in the economy. Apart from this, economic aspects throw light on political scenarios, economic policies, export- imports and global Standing of the country. If the parameters above provide a positive outcome we must move to the next level of selecting the right sector or industry for investment.

Analysing any industry or a sector requires looking at it from various angles and finally reaching a conclusion about its attractiveness as an investment proposition. Market participants use different methods to make this analysis. A few of the parameters are listed below.

Size of the Opportunity Matters

When we analyse any industry the first and the foremost factor we must look at is the market size of the sector and the expected growth rate. While one may find it difficult to get expected growth rates of the industry, the best source of that information is the annual report of the leader from that particular sector.

Always remember in Investing it is not about the size of the fish it is the size of the pond that matters. If the size of the pond is larger, eventually the fish would also acquire the larger size. Hence the first and the foremost factor is market size of the sector and the expected growth rate going ahead.

It may happen that the size of a particular sector is smaller when we are analysing it. However there are all compelling factors driving the growth forward, there is no harm in looking at the opportunity.  Just to give an example, once the Sector like Pipe manufacturers and even the Wire & Cable segment were considered as small sectors. However we have seen that eventually the sector’s size has witnessed growth and many multi baggers were found from those sectors only. The story has been no different for the Indian specialty Chemical sector. We have seen how the segment has created wealth over past one decade.

Few Broader Forces

One we are done with the market size and the growth rate – there are broader forces to look at. The first factor is threat from the substitutes. Here we can take an example of how analog speedo meters were eventually replaced by the digital speedo meters. We have seen the innovations leading to substitutes. Like Kodak which was once seen as a great investment opportunity, eventually became obsolete as the digital cameras and prints arrived.

Second factor is the Threat of New Entrants. We have seen that our analysis on the growth Factor of the industry may be right. However there comes new players and that player just disrupts the market. We have seen how the entry of Reliance Jio has affected the other players from the telecom sector. Once seen as a sunrise sector, now is becoming a duopoly sort of scenario. We have seen how the discount broking business has emerged over the years making it difficult for traditional players in the broking industry.

Third factor is the threat of an Established player. While it is possible that the new entrant is disrupting the markets, even an established player with deep pockets would kill a new entrant. Either they would acquire the new player or may finish the player with raging price wars. Larger players like Facebook and Amazon have acquired many such small emerging players.

In addition to this the other factors like bargaining power of suppliers and bargaining power of buyers is also needed to be studied with detail. We have recently seen how the shortage of Chips is affecting the supply side for many automobile companies. There is demand but supply constraints are affecting the overall growth prospects. Similarly if the bargaining power of the buyer is better the overall industry margins suffer significantly.

Entry Barriers – Most Important Factor

When we speak about a sector analysis it is important to understand the entry barriers in the sector. It may be a technical knowhow, may be its capital intensive nature or may be the skilled working staff. However if entry barriers are there the selection process usually becomes easier. As we come to know about the entry barriers, the next step is to understand the structure analysis of the sector.

The structure analysis includes the factors like

  •   How many players exist in the industry?
  •   Is there domination of a few players in the industry?
  •   How is business scattered between organized and unorganized players?
  •   Are there any threats from substitute products?
  •   How are equations between suppliers and buyers?
  •   Is there backward/forward integration already in existence or a possibility in future?

As we are done with the structure analysis the next step is to study the conduct analysis. And That includes the following questions.

  •   Is business cyclical in nature?
  •   If business is cyclical, what are the factors affecting the business – commodity prices, interest rates, currency prices or some other global factors?
  •   Is it a highly specialized business which requires skilled labour or it is a low skill based industry?
  •   How will technological changes affect this business?
  •   Is business heavily dependent on government policies?

As the structure and conduct analysis is done with, the performance analysis based on the financial (backed by different numerical ratios) parameters is conducted.

Critical Success Factor

Every industry has got one critical success factor and if the same parameter is showing growth the industry is usually considered to be in better health. While each industry has got its own critical success factor or a key industry driver – one must consistently track the same. Let’s have a look at a few of the CSF of a few of the industries.

For a Telecom sector the CSF is Average Revenue Per User (ARPU). As the ARPU increases the margins and profitability eventually increases. In case of IT and IT related services CSF is USD/INR rate, Deal Size and client and geographical diversification are tracked extensively. In the Retail sector the Same Store Sales Growth (SSSG) matters and hence is tracked extensively.

While we have listed a few of the CSF of sectors, we have to analyse the parameters on a regular basis to catch the prospects ahead of the curve. Like we are providing a few of the examples where we had selected themes or sectors.

Like for Metals following parameters were indicating towards the expected growth.

– Increased Public Spending & Government Protection – (Anti-Dumping)

–  Prices started slowly firming up (even in global markets)

–  Increased Capacity Utilisation – Operating Leverage

–  Small companies taken over by the larger companies also started providing better numbers.

In case of Real Estate following were the factors indicating towards the expected growth in the sector.

–  Increased Regulation – RERA, Debt Restructuring, Watch dog coming into play

–  Focus on Mass – Affordable Housing, End Users (Not Investors)

–  Inventory Peaking Out – (No new schemes launched – and slowly reducing inventory)

In the Sugar Sector we had following positives

–  Sugarcane requires lot of water – Lower Rain

had already Impacted Sugarcane output

–  Prices started firming up in Global as well as Domestic Market

–  Government was supporting in two ways –

  1. Restructuring of Debt
  2. Ethanol Pricing / Mixing

For the Hotels and Hospitality sector a Few of the positive parameters were as follows

– Increasing Occupancy Rates (During Covid-19 as well)

– Improving Tariff Rates (Revenue Per Available Room)

– RevPAR = Average Daily Room Rate (ADR) * Occupancy rate.

– Increased Tourism (Business /Leisure) leading to favourable Demand Supply Scenario

The above parameters are just a few of the examples of our observations. Everyone needs to track the different parameters and CSF constantly and grasp it ahead of others. However remember there may be some early signs of improvement and growth. But the growth may fade away also as the scenario changes. Important factor here is as we take the exposure ahead of the curve, it may take some time for the overall sector to start moving and the participation eventually increasing. One must have patience and great conviction in the research to hold such investment decisions for better wealth creation. Remember the exposure taken may not yield results if the things eventually fade away, the better idea would be book loss if your risk capacity does not allow to carry such investment ahead.

 

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