In this section, we will go over the concept that defines the stages that companies typically pass as they mature. We will also explain why understanding this is crucial for investors.
Industry Life Cycle
In order to understand this topic we will examine the following real-world example:
If we take a look at the software industry, we will see how most companies have very high growth rates (their revenues are expected to grow a lot), high returns on investment, and very little or no dividends. In fact, as of November 2020, the industry’s 5-year growth was 305%, its return on investment (ROI) was about 14.5% and its dividend yield was about 1%.
Now, if we shift our attention to the electric utility industry, we will likely find companies with lower rates of return, lower growth prospects, and significantly higher dividends. The electric utility industry as a whole had a 5-year return of 68%, an ROI of 3% and a dividend yield of 3.5%.
Why should this be the case?
The software industry is still fairly new. Recently available technologies, programs and ideas are still evolving and offer opportunities for the highly profitable investment of resources. Rapidly increasing demand and constant innovation and improvement are drivers of growth in many companies within the sector.
However, this unprecedented growth will eventually slow down. The high-profit prospects are extremely seductive and it will attract a lot of competition, which will likely hold down prices and reduce profit margins. Then, new technologies become proven and more predictable, risk levels fall. As companies may not get as much from reinvesting their gains as they used to, fewer profits are reinvested and cash dividends increase.
The above is an example of how an industry evolves and becomes mature over time. Industries in the early stages of their life cycle offer high-risk/high-potential-reward. But as industries mature, they offer a lower-risk and lower, more stable returns.
Ultimately, in a mature industry, we see many companies with stable dividend payouts and cash flows and lower volatility, which are known as “cash cows”.
Stages of the Industry Life Cycle
The previous analysis suggests that a typical industry life cycle is described by four main stages:
Start-Up Stage (High Growth)
The early stages of an industry are often characterized by a new technology or product, such as desktop personal computers in the 1980s, cell phones in the 1990s, or smart-phones in the last 10 years. At this stage, it is difficult to predict which companies will emerge as industry leaders and which ones will fail. Therefore, there is a high risk in selecting one particular company within the industry. For instance, in the smart-phone industry, there is an ongoing battle for market share between Google’s Android and Apple’s iPhone, and it is still difficult to determine which company will turn out as the leader.
However, at the industry level, it is clear that sales and earnings will grow at an extremely rapid rate when the new product has not yet saturated its market. For example, in 2000 very few people had smartphones. Therefore, the potential market for the product was huge. Now let’s consider the market for a more mature product such as a refrigerator. Pretty much every household has refrigerators, so the market for this product is mostly focused on the replacement of old fridges. Logically, the growth rate in this market is and will be lower than that of smart-phones.
Consolidation Stage (Stable Growth)
After a product or a service becomes established, industry leaders begin to emerge. The survivors from the start-up stage are more stable, and market share is easier to predict. Therefore, the performance of the surviving companies will more closely track the performance of the overall industry. Companies in this stage are likely to grow faster than the rest of the economy as their products or services penetrate the marketplace deeper to become more commonly used.
Maturity Stage (Slowing Growth)
At this point, the product has reached its potential for use by consumers. Further growth might slow down to be in line with the growth of the general economy. The product has become standardized, and the companies are forced to compete to lower prices in order to seem more attractive and attract market share. This leads to shrinking profit margins, which places further pressure on profits. As we mentioned earlier, at this stage the bigger companies in the industry are known as “cash cows”, with more stable cash flows but little opportunities for increased profitability. This makes it less attractive for companies to reinvest in their operations, so they turn to distribute their profits to investors via dividends.
Earlier, we pointed to desktop computers as a start-up industry in the 1980s, which became a mature industry by the 1990s, and eventually, the desktop computer industry gave way to the laptop computer industry, which was in the start-up stage in the late 1990s and early 2000s. Then, it progressively entered a mature stage in recent years.
Relative Decline Stage (Negative or Minimal Growth)
In this stage, the industry might grow at less than the rate of the general economy, or it may even shrink. There are a few reasons for this decrease, like the obsolescence of the product, increased competition from new low-cost suppliers, or competition from new products. For instance, look at the replacement of desktop computers by laptops.
Revival or “Death”
At this point, companies are faced with decreasing sales as the market for the products is diminishing due to fewer, less reliable customers. So, in order to stay alive, companies may try different routes, like acquiring other younger companies and incorporating new products in hopes to revive their sales numbers; or trying to expand into other markets from within as they normally have large amounts of cash, which they may use to make efforts into broadening their reach. Unfortunately, it may be the case that some companies can’t tackle the increasing pressures and go out of business.
Peter Lynch’s Industry Classification System
The famous portfolio manager Peter Lynch makes the following point in One Up on Wall Street:
“Many people prefer to invest in a high-growth industry, where there’s a lot of sound and fury. Not me. I prefer to invest in a low-growth industry… In a low-growth industry, especially one that’s boring and upsets people [such as funeral homes or the oil-drum retrieval business], there’s no problem with competition. You don’t have to protect your flanks from potential rivals… and this gives [the individual firm] the leeway to continue to grow.”
In fact, Lynch uses an industry classification system in a very similar way to the industry life cycle explained above, although he structures it a little differently:
These are older, large companies that are likely to grow only at a slightly faster pace than the economy. These companies would be in the mature stage, past the start-up and consolidation stages. They usually enjoy large, steady cash flows and offer high dividend payouts.
This refers to large, well-known companies such as Coca-Cola. These grow faster than the slow growers but yet aren’t growing as fast as smaller, start-up companies. Companies in this classification can be in the consolidation or early maturity stages. They also tend to be part on non-cyclical industries that are not affected by macroeconomic shocks.
Companies that are part of this class are normally small start-ups with aggressive growth rates of at least 20% to 25% a year. This high growth can be attributed to high industry-wide growth, to the increase in market share, or both combined.
These are companies with sales and profits that regularly expand and contract according to the business cycle, such as the automotive industry, the construction industry or the steel industry.
Turnarounds are companies that are far into the relative decline stage and are about to go bankrupt soon. They may try to revive somehow, and if they do, they can offer tremendous growth opportunities. A great example could be Chrystler in 1982 when it was about to go bankrupt but it was rescued and then skyrocketed over 1,500% over the following 5 years.
Firms in this class have great assets that are currently not really reflected in the stock price, therefore making them undervalued and a solid opportunity. Examples of this could be companies that own extremely valuable real estate, or an intangible asset. Sometimes, these assets don’t immediately produce cash flow so they may be overlooked, but they offer a great opportunity.
In the next section, we will wrap up this awesome discussion about the economy and industry analysis with an examination of our Capital Markets Expectations, which is the gateway for portfolio planning and building.