How hard the cycle hits
Economic cycles affect every business, but not equally. The syllabus sorts industries into three classes.
| How demand behaves | Examples | |
|---|---|---|
| Defensive | Low income elasticity: a rise or fall in income barely changes demand, so the cycle has minimal effect and prospects move with secular trends | Food, agricultural inputs, healthcare |
| Semi-cyclical | Sales grow in the expansion phase and decline in the recession phase, but a base level of demand keeps sales reasonably healthy even in recessions | Consumer durables |
| Deep cyclical | Extreme swings driven by the economic cycle and/or the commodity cycle; sales drop sharply in recessions as companies put expansion plans on hold, then grow massively at the first signs of recovery as pent-up demand turns into orders | Capital goods, steel |
Deep cyclical industries can see orders nearly vanish because their customers' capex stops. Semi-cyclical industries fall but keep a floor, since people still replace a broken refrigerator. Defensive industries barely notice. A description mentioning a base level of demand that survives a recession points to semi-cyclical.
Sizing the market
Under-penetrated industries have high growth potential because there is more headroom; as industries mature, new growth avenues shrink and growth rates fall. So the analyst must estimate both the potential size of the market and its current size.
Both are hard. Current size is difficult to measure when there are many unorganised players or private companies whose information is not public. Potential size needs many assumptions that can go wrong. Studying past trends supplements the analysis, shows how the industry has been growing and what drives that growth, and reveals the underlying secular trends.
Top-down measures the market starting from macroeconomic factors and works down to the industry level. Bottom-up quantifies the market by looking at individual companies and aggregating their data. For a medical therapy, top-down is: how many patients underwent the therapy, times the average expenditure per patient. Bottom-up is: the revenue of every hospital offering the therapy, times the proportion of each one's revenue that came from it, summed.
A country's tyre industry has three organised players reporting revenues of 6,000, 8,000 and 10,000 crore, and a survey shows about 20% of total sales come from the unorganised sector. The organised players sum to 24,000 crore, which is the other 80% of the market. Total size is 24,000 / 0.80 = 30,000 crore. The tempting wrong answer, 24,000 plus 20% of 24,000, gives 28,800 and appears nowhere in the options; 36,000 and 48,000 come from applying the percentage the wrong way.
- Defensive industries have low income elasticity, feel the cycle minimally and move with secular trends: food, agricultural inputs, healthcare. Semi-cyclical industries grow in expansions and decline in recessions but keep a base level of demand: consumer durables. Deep cyclical industries swing with the economic and commodity cycles: capital goods, steel; sales collapse when capex is put on hold and surge on pent-up demand at the first sign of recovery.
- Under-penetrated industries have headroom; mature ones grow slowly, so both the current and the potential market size matter. Measuring current size is hard with unorganised or private players, and potential size rests on assumptions, so past trends supplement the estimate.
- Top-down sizing starts from macro factors and works down to the industry (patients treated times spend per patient); bottom-up aggregates individual companies' data (each hospital's revenue from the therapy).