Analysis of Investment Risk for Industry

To achieve excess equity returns on a risk-adjusted basis, investors must be able to distinguish sources of risk in the investments they make. Although return expectations can be established by evaluating firm strategies within the industry, the analyst must always examine the risk that the strategy may be flawed or that assumptions about competition and cooperation may hold only in good economic environment.

Investment Risk and Market Competition

The question is always to look at price versus average cost. Particularly with oligopolies and monopolies, game theory helps to discern the likely success or failure of corporate strategies. Preservation of competitive position and competitive advantage often involve pricing below average cost to deter entry. Similarly, holding excess capacity can deter entry. Predatory pricing is pricing below average cost to drive others out of the industry. Any valuation of an individual company must examine the strategy contest in which companies in the industry are engaged. Risks are always present that the company's strategy will not sustain its competitive advantage.

Investment Risk and Value Chain Competition

In producing goods and services of value, companies compete not just in markets, but also along the the value chain, suppliers can choose to compete rather than simply cooperate with the intermediate company. Labor, for example, may want of the profit that a company is earning. In lean times, labor may make concessions, but in good times labor may want a larger share of the profits.

Suppliers of commodity raw materials have less ability to squeeze profits out of a downstream company than do suppliers of differentiated intermediate products. Companies may manage their value chain competition by vertically integrating (buying upstream or downstream) or , for example, by including labor in their ownership structure.

Cooperation risks are presented by the possibility that the company's supply may be its distributors may find other sources of products and services, Suppose a firm acts as a broker between producers and distributors and outsources its distribution services by selling long-term distribution contracts to producers, thus also keeping distributors happy. Because of the low fixed costs involved in brokering, the business strategy should make the firm less sensitive to recession than a distribution company with heavy fixed costs.