Picking the right wave for better returns
A 7-step checklist
Are you a surfer?
I’m not.
But when investing, I prefer to pick quality companies riding a wave.
We previously wrote about how to measure the company's quality, and how SPECIAL it truly is. You can find the previous articles below:
S for Sales Strength
P for Profitability
E for Endurance
But what about the I for Industry? Before picking a company, shouldn’t we pick a great industry?
Here are the different topics that we’ll look at to get a feel for the industry:
What is the growth in the industry?
What do the competitive landscape and regulations look like?
How sensitive is the industry to the overall economy?
Let’s dive into each section ⬇️
1. What is the growth in the industry?
Plain growth
Growth comes in many forms. We can look at the size of the past and future growth.
But there’s a problem though.
When you run a search like “What is the projected market growth for medical aesthetic devices in the United States?”, you’ll get different answers.
Here’s what we get when using Google Search:
The ballpark number seems to be around the 9% CAGR range. A tip: this is the kind of research an AI Chatbot is made for.
Here’s the result when asking the same question in Perplexity Pro
Thanks to
for providing a free trial for his subscribers.Based on the various market research reports provided, here is a summary of the projected growth for the medical aesthetic devices market in the United States:
While there are some variations, most sources project strong growth in the 9-10% CAGR range for the U.S. market over the next 5-10 years. The market is expected to roughly double in size by the end of the decade, driven by factors like increasing awareness of aesthetic procedures, technological advancements, and growing demand for minimally invasive treatments.
Conclusion: The exact number is not what we’re searching for. We’re looking for 2 things:
Is the industry growing faster than GDP?
How much faster using an order of magnitude (conservatively)?
The Aesthetic devices industry in the US will likely grow twice as fast as the overall GDP growth rate.
Secular trends
Secular trends are driven by fundamental changes in the economy such as evolving consumer behavior, demographic changes, or the development of new technology.
The simplest of trends is pure population growth. I bring this up because we talked about it in the past when comparing Dino Polska to Walmart.
Although both companies have started with a rural approach to their store locations, there is one big difference when comparing the underlying trends.
The historical increase in population in the United States:
Dino will not benefit from a rise in population in Poland (nor will its competitors). This means the grocery market will expand through a change in affluence through demographics within Poland, it will not grow because of population growth.
Walmart benefited from a triple whammy:
Total market increase due to pure population growth
Total market increase due to increase in demographic affluence
Market share increase within a growing market because the offer was better
Here are examples of other, more specific secular trends. I’ve added industries that might benefit from these trends and an example of a company:
Declining fertility rates in the developed world -> Assisted Reproductive Tech -> Progyny (Ticker: PGNY)
Increased life expectancy in the developed world -> Health Care -> United Health Group (Ticker: UNH) | Brookdale Senior Living (Ticker: BKD)
Increased urbanization in countries of Eastern Europe -> REITs
2. What does the competitive landscape look like?
As Mauboussin says in “Measuring The MOAT.”
There can be winners in bad industries, and losers in great industries. Industry alone does not determine destiny.
The goal here is not to dive into individual companies just yet. We want to see if there are criteria that determine how competitive an industry is.
As Bruce Greenwald mentions in his book Competition Demystified the most important thing in any market: Barriers to Entry.
Or as he so eloquently states, product or service differentiation is not enough:
In the long run, everything is a toaster
Bruce Greenwald
Low barriers to entry
Let’s take the restaurant business as an example. Running a restaurant is hard. But almost anyone can get into the business.
The consequence?
A lot of competition
Lower profit margins
What do the profit margins for the restaurant industry look like for public companies in the US?
Gross margins: 30%
Net margins: 9%
Now these margins are not that bad. Just make sure to differentiate your local restaurant (which probably has lower margins) from a publicly traded restaurant company that runs a franchise operation and has 1000s of locations.
High barriers to entry
Let’s take an extreme example, you want to start a new railroad company. The railroads are an industry with significant barriers to entry.
What does the data tell us?
Gross margins: 52%
Net margins: 27%
The 4 public railroad companies in the United States have higher margins than the average in the semiconductor industry. This is probably one of the reasons why Buffett bought one between 2005 and 2010 (BNSF Railway Company).
In total, the data below covers 96 industries. We’ve ranked them based on net profit margin and added their relative ranking. We’ve also added the total US market as a reference point.
Why is this useful? Instead of starting with a single company idea, you choose a sector and find the best companies within the sector.
On the 9th of March, this headline popped up in the Financial Times:
The perfect hunting ground to go and look for stocks that are thrown out irrespective of the quality of their balance sheet.
I sadly didn’t hunt within the rubble as banks are outside my circle of competence, but you get the idea.
So when looking at net profit margins and industry concentration (lots of public companies within an industry signal a lot of competition), we can use the data to see which industries could be interesting.
The filters used here:
# of public companies below 10
Net profit margin > the total market
Within my circle of competence
I might take a look into these industries, but I imagine the companies won’t come cheap:
We can also conclude, that biotech is a very difficult industry to invest in. There are lots of companies and only a few winners. On average, margins are slim, but the distribution is not normal, there is a fat tail.
Airlines have historically been a bad investment. All the value created was transferred to the customer instead of to the shareholder.
Fast or slow
Is the industry fast or slow changing?
As we’ve learned from Buffett and his checklist, he looks for inevitable, slow-changing industries.
A slow-changing industry increased predictability. The probability of a company being disrupted within this type of industry is lower.
Will Nvidia keep dominating the semiconductor industry in the future?
It does have a big head start, but in a fast-changing industry like that, there is a probability that eventually, others will catch up.
Fast or slow changes do not only apply to innovation, they also apply to regulatory changes.
Have regulations changed a lot in the past or not? Are they set to change in the future?
But remember, change does not define destiny. Here are 2 examples:
One industry that has seen lots of regulatory changes in the past is the financial industry.
Their profit margins? 20% 🙂
On the other side, an industry that has seen slow changes in regulations is the food industry.
Their profit margins?
Sensitivity to the economy
We can rephrase this topic as:
Is the industry cyclical or not?
Is the industry defensive or not?
I’ve been burnt in the past on companies I figured were not cyclical, only to uncover that I wasn’t zooming out enough or there just wasn’t enough historical information available.
I’ve since changed the question. I always presume all industries are cyclical and in some form sensitive to the economy.
The question now is: How cyclical is the industry? How sensitive is it to the economy?
This line of questioning is more conservative. The goal here is to look at historical data, as far as possible in the past, and try to spot the cyclicality.
Typical examples of very cyclical industries
Automotive industry
Hotels and leisure industry
Construction and real estate
They provide products or services that people can buy when they have excess cash (or the ability to loan)
These are less cyclical:
Healthcare
Utilities
Consumer staples
They produce or provide a basic human need.
Resources to find industry information
As you’ve seen throughout this article, there are several sources you can use to research industry data. Here’s a short list.
AI Chatbots
ChatGPT, perplexity, these all provide satisfying results. Beware for hallucinations, but since citations are mentioned, you can always check for yourself.
Damodaran’s industry database
Several data I’ve used in this article came from Professor Damodaran.
His historical data goes back to 1999. Here are some examples:
Historical Return on Equity by Industry
Historical PE and PEG Ratios by Industry
Do you know of other useful resources to fetch industry data? Or maybe you’re using a software tool that immediately lets you compare a company’s metrics to the industry median or average. Let me know in the comments
ETF databases
If you want to get a sense of pure performance, one way to do this is to look at the past performance of thematic ETFs.
2 websites can give you data on this:
justetf.com for Europe
etfdb.com for the US
This gives you the following data points:
The investment return over the last years
How much money has flowed into these industries
Capital flows throughout history is something we’ll write about in a future article.
Summary
As explained in our dual strategy approach, I look at the industry in more detail when hunting for small-quality companies.
When looking at underfollowed microcaps, I’m much more industry agnostic, as you’re looking for clear undervaluation in a short time frame, regardless of what the overall industry will do in the future.
Here’s the full 7 questions checklist to quickly evaluate an industry:
Is the industry growing faster than GDP?
How much faster is it growing than GDP?
Are there significant barriers to entry?
How many public companies are there in the industry?
Is the rate of change in the industry fast or slow?
Do regulations change fast or slow?
How sensitive is it to the overall economy?
We could go into a lot more detail, but sometimes less is more.
May the markets be with you, always!
Kevin
Thanks for a very interesting article, Kevin. A perfect match with the most recent podcasts of JongBeleggen ;) Just wondering, do you have the ranked list of all the 96 industries as well?
The length of this article is more favorable and I have read it to the end :-)
I disagree that restaurants and hotels are more cyclical than utilities, but I believe this is just a subjective interpretation about cyclicality. I would go for Booking rather than Rio Tinto. Whereby the latter currently has upside, of course. In the long term....