Great Company Or Growing Industry?

By Jason Van Bergen AAA

It is no accident that companies within a particular industry move in lock-step with one another. Companies in a single industry are forever bound by the type of product or service that they provide, and they are constantly competing with one another for market share, consumer acceptance and technological leadership in their particular sub-sectors. These competitive and consumer forces shape an industry's corporations and determine the status of the industry as a whole. These forces have followed roughly the same patterns over time. Here we take a look at these stages and how they affect the companies that follow them.

Initial Growth/Emerging Industries
All companies have to start somewhere, and it takes only a single company or small group of companies to jumpstart an entire industry. Looking back in time, we see that it was not even a company but an individual by the name of Alexander Graham Bell who, with the invention of the telephone, started the entire industry of telecommunications. More recently, companies like Texas Instruments and Fairchild Semiconductor Corporation pioneered the semiconductor industry with the invention of the microchip, the central component of all computers and most high-tech electronics gear.

Companies involved in establishing emerging industries are generally participating in perilous business, as their primary concerns are raising sufficient funds to engage in early-stage research and development. In their developmental stages, which may last months or even years, these companies are likely operating on a shoestring budget, while at the same time presenting to the world a product or service that has yet to be accepted. These pioneering companies might face bankruptcy, development failure and poor consumer acceptance.

Companies in emerging industries are typically recommended to investors with a very high risk tolerance. An adage often used in relation to an initial growth investment is "If you cannot afford to lose your investment in this company, do not make the investment in the first place!"

Individual investors are likely to have access to initial growth companies through private investments, sometimes called "friends-and-family capital". At such an early stage, investors often know the company founders personally. And they can only hope to make a profit on their investment in the distant future, when the company offers its shares on a secondary trading market, or when the investor can find somebody else to purchase his or her ownership at a premium (which would take place, for example, if another company were to purchase all of the outstanding shares of the company).

Companies in emerging industries are occasionally quoted on major stock exchanges or traded over the counter, and should always be considered in terms of the significant risk they pose. These companies will often be unprofitable, and the large initial start-up costs may result in ongoing negative cash flows. As such, traditional fundamental analysis is often not applicable in emerging industries, and investors must be sophisticated enough to learn or even develop entirely different means of analyzing these stocks. Investing in emerging industries is not for the faint of heart.

Rapid Growth Industries
Companies in industries that are benefiting from rapid growth have sales and earnings that are expanding at a faster rate than firms in other industries. As such, these companies should display an above average rate of earnings on invested capital for an extended period of time, probably years. Prospects for rapid growth companies should also appear bright for continued sales and earnings growth in ensuing years.

During this period of rapid growth, companies will eventually begin to lower prices in response to competitive pressures and the decline of costs of production, which is often referred to as economies of scale. But costs decrease at a higher rate than prices, so companies entrenched in growth industries often experience growth in profits as their product or service becomes fully accepted in the marketplace. The consumer electronics industry, for example, is characterized by much research and development, followed by significant economies of scale in production. Prices in home electronics inevitably fall, but the costs of production fall faster, thereby ensuring increasing profitability.

Publicly traded companies involved in rapid growth industries, often referred to as growth stocks, are some of the most lucrative investments due to their ability to sustain growth in revenues and profits over long periods of time. Microsoft is an excellent example of a company that became very large in a growth industry (software) over a period of years, increasing its earnings all the while and, most importantly, maintaining its expectations for continued future growth.

Mature Industries
Once an industry has exhausted its period of rapid growth in revenues and earnings, it moves into maturity. Growth in companies in mature industries closely resembles the overall rate of growth of the economy (the GDP). Earnings and cash flow are still likely positive for these companies, but their products and services have become less distinguishable from those of their competitors. Price competition becomes more vicious, taking profit margins along with it, and companies begin to explore other areas for products or services with potentially higher margins. Many of our economy's most closely watched industries, such as airlines, insurance and utilities, can be categorized as mature industries.

Despite their rather staid position in mature industries, investments in these companies' stocks can remain very attractive for many years. Share prices within mature industries tend to grow at a relatively stable rate that can often be predicted with some degree of accuracy based on sustainable growth prospects from historical trends. Perhaps even more importantly, companies in mature industries are able to withstand economic downturns and recessions better than growth companies, thanks to their strong financial resources. In troubled times, mature companies can draw from retained earnings for sustenance, and even concentrate on product development in order to capitalize on the economy's eventual return to growth. Investors in mature industries are those who want to enjoy the potential for growth but also avoid extreme highs and lows.

Declining Industries
Industries that are unable to match even the basic barometer of economic growth are in a stage of decline. Some factors that could contribute to a declining industry are consumers decreasing their demand for the industry's product or service, technology that supplants legacy products with new and better ones, or companies in the industry failing to be competitive in pricing.

An industry that exemplifies all the tendencies of a declining market is the railroad industry, which has experienced decreased demand - largely due to newer and faster means of transporting goods (primarily air transport) - and has failed to remain competitive in pricing, at least in relation to the benefits of faster and more efficient transportation provided by airlines and trucking services.

We should note that declining industries may experience periods of stable or even increasing growth from time to time, even if their overall prospects are on the way down. For example, railroad transport is still very much an active industry sector, as the non-competitive firms have been weeded out.

Declining industries tend to be poor places to seek investment opportunities, although individual companies within these industries may still have investment merit. Even in the industries where prospects look bleakest, there are always companies that are able to buck the trend and generate growing revenues and profits while those around them falter. But investors who are not inclined to search for such companies are better advised to look for investments in industries that are in the younger stages.

The Bottom Line
Conservative-minded investors who are looking for a bit of stability in the equity portion of their portfolios will first want to check out mature industries, where there is the best selection of blue-chip stocks that are widely traded, having extreme trading liquidity. Investors with a taste for risk may want to take advantage of the higher potential for return that growth industries can provide. And investors who like to live their lives on the razor edge between success and failure may consider investments in emerging industries, even though such investments tend to be geared toward private companies. The only constant when it comes to considering investments in various industries is that it may be best to avoid industries in decline.

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