## Why do we need sectoral research?

As individual investors, our primary focus is to,

- find disparities between a company's market price *(the price at which it trades)* and its intrinsic value *(the underlying value of the company we find fair)*.
- make an assessment on this disparity, and attempt to exploit it to make money.

### Can't catch 'em all

A prerequisite to finding such a disparity is having a set of companies to work with. Collectively, the market is made up of thousands of companies; *it is chaos, unexplored territory with limitless potential, if you will.*

It would be naive to take a shot at tracking all listed companies. So, we need a method to *carve out order from this chaos* so to speak. Intuitively, arranging companies under different buckets based on some basis seems like a good starting point. One such basis is categorizing companies on the basis of the sector/industry under which it conducts business, then further categorizing them based on sub-sectors, and so on.

For example, a company 'A' selling chocolates and a company 'B' selling pencils would both broadly be part of the *'fast moving consumer goods' (FMCG)* sector, however, company 'A' would come under *Foods* sub-sector, and company 'B' would come under *Stationary* sub-sector.

This categorization helps us keep track of a broader universe of stocks - it gives us an approach for thinking about companies based on the sector under which they operate before we even begin conducting our due-diligence on them.

### Categorization, sure -- but then what?

There are two investing strategies with which we can use this categorization,

1. **Top-down strategy:** This strategy involves studying macroeconomic factors to narrow down preferred sectors to invest in, then finding the best opportunities in such sectors. The focus on individual companies is lower here, and sector conditions are the prime focus. Sometimes, top-down strategy investors also prefer buying baskets of 2-3 stocks in a sector rather than finding the strongest company.
2. **Bottom-up strategy:** In this approach, we first find potential opportunities in companies based on some set of criteria or a checklist, and then slowly *move up* to studying the sector and other peers. The focus on sector conditions is lower here than in top-down strategy; the idea is to find companies that can remain healthy in sector downturns, and outperform its peers.

Either of them do involve at least some sectoral research, so let's get to how we can do that.

## Researching a sector

Broadly speaking, a sectoral research includes,

1. Information about the product, and its applications
2. Understanding the value chain of the sector
3. Market history, key events, and an overview on current conditions
4. Benchmarks, and metrics to keep track of

To keep up with this section, I implore you to pick a sector, and try answering the questions I frame for each of these points. I will try to provide examples from different industries for each question for your better understanding, but you can stick to the sector of your preference and pencil down answers in your context.

### The product

1. **What is the sector selling?** Quite self explanatory, and perhaps overly simplistic, but helps answering a few forthcoming questions that are often ignored. For example,
- Fast moving consumer goods sector, often abbreviated as FMCGs, sell products that are generally cheap, and sell quickly as a consequence of frequently being used, such as packaged foods, beverages, stationary products, etc.
- Financial sector, often abbreviated as BFSIs in India, deals with financial products such as loans, insurance, brokerage services for capital markets, etc.
- Pharmaceuticals sector sells medicines, drugs, vaccines and other health related products.

2. **How is the sector sub-categorized?** Most, if not all sectors can further be divided into different segments, and you'll often find the economic dynamics of such segments differ with one another, but generally not contradicting to that of the sector itself. Often, a company operating under a segment eventually forays into all sub-sectors. For example,
- Fast moving consumer goods sector can be categorized into personal care, home care, packaged foods, beverages, and stationary/office segments.
- Automobile & components sector can be categorized into pureplay automobile manufacturers, and auto-ancillaries.
- Utilities sector can be categorized into Power, Gas, Water, etc.

3. **What is the market size?** Market size refers to potential revenue/volume a company can attain if it had 100 percent market share in the sector. Determining market size helps us perceive,
- the growth potential of companies operating within a sector, and
- the growth potential of the sector itself under conductive macroeconomic factors.

For example,

- Domestic automobile sectors sold 21.5 million vehicles in financial year 2020.[^1](https://www.ibef.org/industry/india-automobiles.aspx)
- Fast moving consumer goods sector *was a 3.4 lakh crore market* in India as of financial year 2018.[^2](https://www.ibef.org/industry/fmcg.aspx)
- Pharmaceuticals sector [placeholder]

4. **Is the sector prone to disruption?** There is great value in identifying disruptions in any sector, for one you can avoid the incumbent companies that would lose from such a disruption, and secondly, you can perhaps take a position in the disruptor.

There are two kind of disruptions a sector can face,

- A change in business dynamics of the sector. The obvious example of this kind of disruption is the entry of Reliance's Jio into telecom sector forcing the incumbent players in the sector to either match its prices, or shut shop.
- A change in the fundamental product itself. For example, introduction of affordable electric vehicles incurred major valuation downrating of traditional automobile incumbents in the western markets.

### Value Chain

A value chain analysis refers to evaluating various aspects involved in running a business, such as

- Procuring required raw materials & machinery,
- Recruitment of labor / workforce,
- Conducting Research & Development (R&D),
- Building the product,
- Managing & storing inventory, and
- Marketing, distribution, delivery and installation of the product.

We evaluate value chain of a company to,

- Understand the value created by a company in a marketplace,
- Understand potential inefficiencies and bottlenecks faced by a company in building & selling its product, and
- Take account of steps taken by a company to weed out such inefficiencies and bottlenecks.

If you think about it, a company's intrinsic value is *some* function of the **additional** value it exclusively creates in the marketplace, and the **relative** efficiency with which it conducts its business. I feel this is roughly what people mean when they're referring to a company's *competitive edge*, or what Warren Buffett calls *moat*, which investopedia defines as,

> a distinct advantage a company has over its competitors which allows it to protect its market share and profitability.

This additional value in the company's products can be many things - brand power, pricing power, recall, first movers advantage, technological superiority and so on. For example, and these are arguable, Maruti's moat lies both in its brand power and its sales & services network, HDFC Bank's moat lies in its relatively superior underwriting, and so on.

You will find commonalities in value chain analysis of most companies working under the same sector. Thus, a broad understanding of value chain of a sector essentially gives you a bird's-eye view of any company operating in it. Paradoxically, the process of understanding value chain of a sector itself needs an assessment of value chain of a few companies in the sector. In due-diligence, there truly are no shortcuts.

Let us go through the mentioned aspects of a value chain with some examples—

**1. Preferred geographical locations:** Though this aspect doesn't necessarily belong to value chain analysis, the destination of production sites is often relevant in a company's business model. This can be in terms of keeping costs of building the product low, procurement of relevant raw materials, recruitment of skilled labor, or building superior products.

For example, Paper industry prefers Himachal Pradesh as a preferred manufacturing destination as the energy costs in the state are favorable, and raw materials (softwood pulp, wheat straw, etc.) are readily available. Another sectoral example is the established leather industry in Uttar Pradesh, since livestock population in the state is highest in the country. Or, large number of cement production plants in Rajasthan due to the state being rich in limestone.

**2. Procurement of raw materials:** Certainly, companies like to keep their raw material *landed* costs as low / benign as possible without compromising on intended quality of its products. This is of course because volatility in raw material prices would affect the cost of production, which in turn affects the profitability of the company.

A company has few avenues to keep raw material costs benign, such as,

- Using raw materials efficiently by optimizing usage and minimizing wastage.
- Having favorable long term contracts with suppliers to safeguard from volatility.
- Minimizing the proximity of the company's production site to the supplier, since transportation of raw materials is borne by the procurer.