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Industry Analysis
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Our last step Is to investigate the industry In which the firm operates. Let's face it: It's just plain easier to make money in some industries than it is in others. (Ask the CEO of any airline company.) Although the attractiveness of an industry doesn't tell the whole story—after all, Southwest Airlines has made plenty of money for shareholders—it's important to have a feel for the competitive landscape.

First, get a rough sense of the industry so you can classify it. Are sales for firms in the industry generally increasing or shrinking? Are firms consistently profitable or does the industry go through periodic cycles when most firms lose money? Is the industry dominated by a few large players, or is it full of firms that are roughly the same size? How profitable is the average firm—are operating margins fairly high (more than 20 percent) or fairly low (less than 15 percent)? (An operating margin is income from operations as a percentage of sales. I discuss such financial ratios in more detail in Chapter 6.)

You can answer some of these questions by looking at aggregate statistics— average growth rates, average margins, and so on. However, averages can't tell you everything, so be sure that you examine a number of individual com­ panies. An easy way to do this is to look at a list of companies in the industry you're researching sorted by sales or market cap, and examine a dozen or so to get a feel for the industry.

You don't need to do detailed analysis at this point—just glance over sales and earnings growth rates and margins. The most important thing is to look at a variety of firms over a reasonably long time frame—at least 5 years and, preferably, 10.

Investor's Checklist: Economic Moats

• Because success attracts competition as surely as night follows day, the
most highly profitable companies tend to become less profitable over time.
That's why economic moats are so important: They help great companies
stay that way.

• For concrete evidence of an economic moat, look for firms that consis-
tently earn high profits. Focus on free cash flow, net margins, return on equity,
and return on assets.

•  After you've looked at these specific measures, try to identify the source of
the company's economic moat. Companies generally build sustainable
competitive advantages through product differentiation (real or perceived),
driving costs down, locking in customers with high switching costs, or
locking out competitors through high barriers to entry.

•  Think about economic moats in two dimensions: depth (how much
money the company can make) and width (how long it can sustain
above-average profits). In general, any economic moat based on techno­
logical innovation is likely to be short-lived.

• Although the attractiveness of an industry doesn't tell the "whole story, it's important to get a feel for the competitive landscape. Some industries are just easier to make money in than others.

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