What is “Industry Risk”?
‘Industry Risk’ refers to the factors that can impact (both positively and negatively) a particular industry, which can in turn affect companies within the sector. Just as the economic performance of economies can vary widely, the performance of industries across the spectrum too can differ considerably. If one analyzes the rate of return, reflected in the return on equity (%), across varied industry groups, there are patterns and performance variations that can be attributed to industry risk. As a result of this variation in profitability across major industry groups, their stock market performance tends to exhibit considerable variation too.
Industries face various types of risks – emanating from a volatile macroeconomic environment, technological shifts, politically induced tariffs, competitive threats, and other reasons. These can adversely impact the profitability, sales, cash flow, growth, and stock prices of companies within each industry group. Therefore, it is important to assess such risks before investing.
Key Learning Points
- Industry risk factors tend to impact an industry’s profitability, volatility, and growth
- Mature industries or those with predictable growth prospects are generally associated with lower industry risk than emerging industries
- There are nine key factors that can be used to assess the level of risk of an industry or industries
- Organizations such as S&P Global and IBISWorld, among others, have their respective industry risk rating methodologies and the same are used to rate or score industries vis-a-vis industry risk
- Ratings or scores are assigned to an industry range from very low to very high risk
Assessing Industry Risk – Key Factors
Industries with predictable growth prospects or mature industries generally have lower industry risk. On the other hand, emerging industries, such as renewable energy and certain technology sectors among others, face higher uncertainty and higher industry risk. This is despite usually offering more rapid growth than mature industries.
Nine key factors to assess industry risk:
- Industry growth prospects: this should include incorporating the stage of development, cyclical and seasonal trends. It should also include a forecast of the revenue growth of the industry vis-a-vis its past performance (for example, for the previous two years) and evaluating its expected growth relative to other industries.
- Sensitivity to changes in the macroeconomic variables: this includes GDP growth, interest rates, inflation, exchange rates etc. It is relevant across the industry or business cycle and can be impacted by demographic and consumer changes, global prices and competition and technological shifts. For example, rapid changes in technology in the automobile sector can render several existing auto models obsolete. Other variables include international trade barriers and the regulatory environment. Such factors impact an industry’s profitability, volatility and growth.
- Bargaining power of suppliers: if an industry is dominated by few key suppliers or when there are few substitute suppliers (resulting in high buyer price inelasticity) or if there are few substitute inputs, then companies in that industry may have relatively weak negotiating or bargaining power. They may be at the mercy of suppliers. In such a scenario, industry risk tends to be higher.
- Bargaining power of customers/consumers: it is important to assess the power that consumers possess in any industry in determining the price of its products and services. The higher the bargaining power of consumers, the greater the industry risk.
- Competitive threats: this includes factors such as geographic location, market standing and anything that determines the intensity of industry rivalry (for example, product homogeneity and brand loyalty among other factors). The competitive environment and market structure are key factors that determine the future success of companies within an industry.
- Risk of product substitution: if customers have an easy alternative product or close substitutes (for example, in the mobile phones or soft drinks industries) it will impact industry If customers can have easy access or can readily purchase a less expensive (if substitute or switching costs are low), then industry risk is higher.
- Industry complexity: high-tech manufacturing, tends to be considered higher industry risk than, for example, the well-established textile industry. Consequently, investors tend to demand a higher rate of return for investing in such industries. This is because companies generally have to comply with more stringent regulatory requirements, ongoing and increased investment in R&D, technology, and equipment.
- Barriers to entry: one must assess how easy or difficult it is for new entrants to enter an industry to enable a company to continue to grow or maintain sales, and remain profitable. Some key factors that determine barriers to entry are: customer loyalty to brands, products or services within that industry plus government regulation and excess production capacity.
- Industry life cycle: the particular stage an industry is in, such as start-up, growth, shake-out, maturity or declining stage is relevant as it influences potential sales growth, profits and overall company growth within the
Industry Risk Ratings or Scores
Organizations such as S&P Global and IBISWorld, among others, have their respective industry risk rating methodologies based on some criteria or factors. The same are used to rate or score industries vis-a-vis industry risk. Ratings or scores assigned to an industry range from very low to very high risk.
For example, S&P Global uses an industry risk criteria based on “Cyclicality” (i.e. cyclicality of industry revenue and cyclicality of industry profitability) plus “Competitive risk and growth”. These are considered major industry risk factors and used to determine global industry risk.
These two criteria, which include sub-factors, receive an assessment ranging from very low risk (1) to very high risk (6) which are based on a series of quantitative and qualitative considerations. When combined, these assessments assist in determining the overall global industry risk assessment (please refer to the workout below).
The criteria weighs competitive risk and growth more heavily when compared to cyclicality.