Finding a stock is good, but finding a whole industry is golden

Since I rarely have time to find good companies, I keep an eye out for good industries instead. You can do that too.

• A company can have the best management team, with the best financial policies and strategies, but if it’s stuck in a bad industry, its long-term potential is going to go nowhere.

• Great industries have these six traits: growth with strong cash generation, economies of scale, asset-light business models, high-value products with low relative costs, high barriers to entry, and a consolidated structure.

• These traits change over time, so it's crucial you understand the drivers of an industry’s success.

Spotting good companies is great, but spotting good industries is even better. After all, if an industry is growing, most companies operating there stand to benefit. As they say, a rising tide lifts all boats – yes, even the bad ones. Since I rarely have time to find good companies, I keep an eye out for good industries instead. You can do that too.

Here are six things to look out for.

A company can have the best management team, with the best financial policies and strategies, but if it’s stuck in a bad industry, its long-term potential is going to go nowhere. Fast-growing industries are easy to spot because they often make headlines, while sub-industries and niche ones are generally harder to find. I’ve pulled together a list of six attractive traits great industries have – the ones I’ve found to be most important in my experience as an analyst.

1. Growth with strong cash generation

It’s great when an industry has a fast-growing “end market” – that is essentially where the customer is. But more important than that is the type of growth the industry has. New markets grow fast, but you need to know whether there’s a path to profitability and whether you can expect strong cash generation. When a company can generate strong cash flows, it can fund its own future growth needs – an increasingly important consideration when interest rates are high.

That said, fast growth is a luxury. And more likely than not, when you do find an industry that’s growing quickly, the valuations of companies operating in that industry would already reflect that. So instead, you can look for industries with resilient growth or recurring revenues. Sure, 5% annual growth might not seem as sexy as 15%, but an industry that can sustainably grow at 5% (over the long term, even through a recession) should grab your attention.

Think of it this way: elevator companies like Kone and Schindler Holding AG (SIX:SCHN) make their initial sales selling elevators in new properties. But, the mix of their revenue changes over time, with the more elevators they sell. The greater their installed customer base, the bigger the proportion of recurring sales, stemming from biannual servicing fees and product parts replacement. Customers tend to be locked in and brand loyal, which gives the company some level of income security – even during a downturn.

Next up, look for companies exposed to long-term growth trends – for example, an aging population, or maybe digitization. These are broad themes, and lots of companies will claim to be exposed to them, so it’s worth being more critical about which part of the value chain you want to invest in.

2. Economies of scale

The bigger you grow, the cheaper your growth is. In short, that’s what economies of scale means. After spending some initial money on growth, a company can leverage that outlay to drive the next leg of growth – for cheap. This also means profitability and cash generation can grow faster than sales. And that’s a winning formula for investors.

These companies tend to have higher fixed costs, but lower variable costs. For example, a financial education company like Finimize might have to spend a certain dollar amount to employ engineers, analysts, and other staff to serve one customer on its app – but it can also serve more customers with that same, initial investment. The more customers it has, the lower the average cost per customer.

In industries with high economies of scale, when growth picks up, profitability picks up faster because fixed costs are high. Of course, the reverse scenario plays out when growth slows, so that’s something to be wary of.

3. Asset-light business models

Industries that have low fixed costs and require minimal capital to grow are considered asset-light. And asset-light companies tend to have high returns. In a higher interest rate environment, these kinds of companies are becoming popular again. That’s because as the cost of borrowing increases, it’s especially important to drive growth with less.

The share economy is an industry with some big asset-light names – Uber Technologies Inc (NYSE:UBER) and Airbnb Inc Ordinary Shares - Class A (NASDAQ:ABNB), to name just two. The pharmaceutical industry is increasingly asset-light, as companies opt to contract out their drug production through networks of contract development and manufacturing organizations (CDMOs) that help reduce their capital expenditure. In general, these asset-light industries tend to command higher valuations than asset-heavy industries, like mining or oil and gas.

4. High-value products with low relative costs

Great industries turn out products that have a high value but a relatively minimal manufacturing cost. Take, for example, your favorite perfume. You love the scent, and its unique feature may be the distinct woody undertone you can’t get elsewhere. Did you know though, that the fragrance molecules were likely only 5% of the total product cost (or less)? And, yet, that probably had a 50% influence on your purchasing decision. Products like these have a low product cost and high-value ratio, and companies in such industries tend to command high pricing power, and the ability to pass on costs easily.

Examples of such industries include companies that produce ingredients and additives for cosmetics, perfumes, and foods. A few examples are: Croda International (LSE:CRDA), Givaudan SA (SIX:GIVN), International Flavors & Fragrances Inc (NYSE:IFF), Symrise AG (SIX:SY1), Novozymes, and Chr Hansen.

5. High barriers to entry

Industries that have strong barriers to entry – competitive moats, as they’re sometimes called – essentially prevent new rivals from grabbing market share and taking away sales, thereby maintaining their profitability. These barriers come in many forms: patents, for example, brand loyalty, startup costs, regulations, or economies of scale.

Not all industries with high barriers to entry are worth investing in, but those that also have high growth or profitability are worth paying attention to. The oil and gas industry may have high regulatory and capital costs, which are effective in discouraging new competition. But because growth is slow and returns have been historically low, the high barriers to entry serve a limited purpose for investors. By contrast, the luxury industry is growing quickly, and brand loyalty for incumbents like LVMH Moet Hennessy Louis Vuitton SE (EURONEXT:MC), Hermes International SA (EURONEXT:RMS), and Compagnie Financiere Richemont SA (SIX:CFR) is high, serving as a deterrent to new competition, and allowing incumbents to continue growing strongly and with high margins.

6. Consolidated industry

The number of competitors in an industry helps determine the long-run profit potential of companies operating in it. Generally, the more consolidated an industry, the better it is for companies. When competition is rife, companies tend to have less pricing power, and there’s the risk that competitors will make predatory pricing decisions in order to steal market share.

Ideally, you’ll want to be invested in oligopolistic industries, where the majority of the market is shared by just a handful of players. Companies operating in such industries tend to enjoy relative stability and strong pricing discipline, and can retain supernormal long-term profits. Examples of such industries include industrial gases, aircraft manufacturers, automobiles, and telecoms.

And here are a few last things to bear in mind.

The traits I’ve listed for great industries haven’t been consistent over time. The truth is, markets change and some of these traits can vary in importance.

Take, for example, the past decade when interest rates were close to zero. Borrowing money was almost free, and companies could spend to chase growth, even at low returns. Startup capital, which used to be a barrier to entry for capital-intensive industries, suddenly wasn’t much of a blocker. That’s changed now. And what that tells you is: when you come across an industry that looks attractive, make sure you understand the drivers of its success.

Theodora Lee Joseph is an analyst at finimize.

ii and finimize are both part of abrdn.
finimize is a newsletter, app and community providing investing insights for individual investors.
abrdn is a global investment company that helps customers plan, save and invest for their future.