Chapter 3

Analyzing the General Environment

PEST or PESTLE Assessment

Introduction

A common and useful beginning to strategic analysis is to consider and assess the general or macro environment in which industries and firms operate. Here we are concerned with very large trends and movements that likely will affect the competitive position of firms and their success. In a sense, these are the ground rules of competition. Still, assessing the general environment seems like a very large and amorphous problem. How can you be sure that you are not overlooking the right information?

In chapter 2, you asked and answered questions about your industry. Here, you will address questions and find answers that define key issues for your industry. These are schema or models or ways of organizing information. The model we’ll use in this chapter has been presented under a variety of names, but they all express the same idea: Getting a solid understanding of these issues is more easily done if you have an organized and thorough set of questions to ask and answer.

You will need to ask and answer questions about either four or six dimensions of the general environment. You will want to understand what effect Political, Economic, Sociocultural, and Technological factors will have on your industry’s future. Note the topics—this arrangement is why the model is called PEST. The PESTLE approach simply separates Legal and Environmental issues from the political and sociocultural issues. The focus of this chapter is to clarify the sorts of questions you should ask and answer, as well as where you might turn for the information necessary to answer the questions.

So, why should you conduct a PEST assessment? Not everything of importance to industry firms is competition based. It could be, rather, the actions that legislatures or courts take, or the direction the economy takes, that can most broadly affect success. The recent (2008–2010) recession’s effect on industry is well known—but if you are planning, don’t you want to anticipate the timing and extent of recovery? Consumer beliefs and technological change may be harder to define or measure but can be even more disruptive. Consider how the spread of broadband Internet across the United States has threatened, if not destroyed, the old customer solutions for the music, home video, and electronic games industries. Easy downloading means that customers don’t actually need the actual shrink-wrapped CD or movie—and this means that the old value chain of brick and mortar stores and associated inventory is no longer required. At a more fundamental level, even controlling the intellectual content turns out to be more difficult than in the past (hence the vigilance of the music and film industries regarding peer-to-peer file sharing applications like Napster). Identifying and analyzing technological shifts can help prepare firms to adapt (though, to be fair, the changes may come faster than companies can adapt, even if managers see them coming).¹ The reason you should undertake a PEST assessment is because it highlights the pressures and opportunities all firms in your industry will likely face.

The PEST Model

What is going to happen in the future, and how will it affect us? While we all take a shot at predictions, it turns out that some changes are of more interest or significance than others because they reflect long-term evolutions in belief or need or expectancy. Unlike fads or fashion, these trends can have long-lasting—even revolutionary—effects.

Ronald Inglehart, for example, has long been associated with a research project called the World Values Survey and describes several key trends in countries around the globe.² For example, he finds rising social support for environmental protection (think global warming agreements or green initiatives), for the expansion of women’s rights (in particular, think of the striking images from Iran in this last election), and for increased participation in political-economic decision making in countries or societies where economies have been reasonably secure for a generation or more. He contrasts this “secular-rational” perspective with a “traditional” orientation that values respect for authority, nationalist pride, and the domination of business and politics by males and associates each with a particular stage in economic development. When economic security is tenuous and survival is the top concern, cultural values that emphasize stability and predictability (i.e., traditional values) are favored. Conversely, when survival is taken for granted (a postmaterialist perspective), people seem to value quality of life, personal happiness, and increased tolerance for other views. These are large trends, sometimes taking several generations to work their way through a society. As we’ll see later, these shifts in values can manifest in all sorts of political or economic (or S or T) ways that affect particular industries.

There are a number of think tanks and specialists who view themselves as “futurists,” or trendspotters, such as Alvin Toffler (author of Futureshock and The Third Wave), John Naisbitt (author of Megatrends), marketing guru Faith Popcorn, as well as many others. These are worth at least reading a bit about because, if nothing else, they bring topics and ideas to the table. Sometimes the ideas might seem obvious, such as the move away from a petroleum-based energy economy or the trend in health care from focusing on cure to focusing on detection and intervention). Some are more intriguing such as Thomas Frey’s observations about how nation-state-based political structures and systems are overstressed and collapsing. This will lead to problems with how governments handle health care, retirement, and social safety nets. Frey suggests that national systems will fail and be replaced by more global systems. He also has an interesting observation about the rise of business colonies, or industry-based, temporary, and mobile affiliations of talent located around the current hub of activity to set up and solve problems before moving on.³

There are many sources of information about trends that we can find, but how do we interpret this material? That is the purpose of a model like PEST: It helps us frame, ask, and answer important questions that identify and describe the trend or event, and then determine how it will affect the focal industry. This is a key point: Note the two elements of the answer. It is essential to describe what is happening, but unless you go further and figure out what it all means, then the description is not useful. Don’t just describe the effect to yourself—analyze it!

The P in PEST stands for changes coming from the political and legal arena. In a general sense, governments interact with business to deter or limit unfair competition, to protect consumers from certain business practices, or to protect society from certain business practices. The issue in this analysis is the extent to which national, state, or regional government changes, or is expected to change, its position toward the focal industry. We usually see this through new laws from legislatures or through new or changed regulations from government agencies. For example, in the near past, the United States Congress passed laws affecting the survival of firms in the financial and automotive industries, considered placing caps on executive pay, changed how real estate loans are appraised, and is in the process of setting new greenhouse gas emission policies and laws. Congress has also considered an overhaul of health care systems in the United States, which will likely have a tremendous effect on hospitals, physicians, insurance companies, pharmaceutical firms, and medical schools, among others. Regulatory and governmental agencies also play an important role; for example, the Federal Drug Administration (FDA) recalls food and drug products for safety concerns and has flagged some (such as the new warnings for Chantix and other smoking-cessation drugs) and suspended others (such as Vioxx and Celebrex). The Federal Reserve is considering increasing reserve requirements for banks, which constricts the ability to loan money.

Changes in laws and regulations usually reflect larger social trends. Certainly, laws can be reversed or revoked, but in general they only emerge when conditions are right. So, once you’ve found the relevant changes, you need to finish by analyzing what they mean. For example, Table 4.1 lists some recent developments for the automotive industry. President Obama has pressed for an increase in Corporate Average Fleet Economy (CAFE) standards (or an overall fleet MPG average) of 35 to 39 MPG. That is the description—but what does it mean? One thing, certainly, is a change in fleet makeup, such as a shift away from trucks and SUVs toward smaller vehicles. That is not a decision made lightly, as it will call for the expansion of some plants and the closure of others as well as significant new investment in tooling and capital equipment. Automakers will have to introduce smaller models incorporating new materials and technologies. This involves two threats; first, there is only about two years of development time available to have the three years investment and production time needed for new vehicles. This is a very short window. Second, these changes will likely prove expensive. Cars can improve MPG by using lighter materials like carbon fiber or magnesium or ultrahigh-strength steel, but they cost more. This will affect buyer willingness to pay and may dampen demand. In short, automakers have little time to make some very costly and risky decisions.⁴ Here is a simple exercise to reinforce this approach: What will the end of rebates for hybrid cars or new emission requirements mean to the industry?

Some analysts include legal developments as a natural part of the P assessment while others consider it separately. In either event, the issue is that the legal system is part of the overall political governance system. Courts interpret law and, in the U.S. context, confirm or overturn legislation and thereby establish precedent. Therefore, legal decisions have the same ultimate effect as changes in law or regulation. To illustrate, California and a number of other states are seeking to impose emission standards that are more restrictive than federal standards. The process could go forward only if California is granted a waiver from Environmental Protection Agency (EPA) standards, so the state sued the EPA to force the waiver. Auto industry firms joined forces to file federal lawsuits seeking to block the grant of waiver in California, but in late June 2009, the EPA did issue a waiver to California, thereby permitting the imposition of higher standards.⁵ What effect will increased standards have on firms in the industry? Is this an important decision?

Finally, do keep in mind that the scope of your inquiry need not stop at the national level. Particularly as international institutions, such as the World Trade Organization, and regional trading groups and governments, such as the European Union, grow in influence, industry firms will have to be thoughtful about what is happening elsewhere. Among other effects, the international scope of many firms means that what might seem to be purely domestic issues, such as merger or acquisition between two industry firms in one country, have to pass regulatory muster wherever the two firms compete.

E stands for changes and trends in the general economic environment. The key issues are how changes in income or employment or commodity prices affect consumer willingness to buy and how input prices for the industry product or service will be affected. Note that even business-to-business firms need to be conscious of consumer decisions because demand changes will ripple back upstream.

The data you are seeking are basically macroeconomic indicators dealing with employment, inflation, money supply, production, and so on. Fortunately, these indicators are generally easily available. For example, The Conference Board’s Economic Indexes include leading, coincident, and lagging series of indicators that give a general sense of which way the economy is headed. Leading indicators include average weekly hours worked by manufacturing employees, new orders for consumer goods, new orders for capital goods, new building permits, the Standard and Poor stock index, money supply, and consumer expectations.⁶ What we are looking for here are any changes in direction and the magnitude of the change. If the indicators are trending up, then the economy is likely to strengthen. Most industries might benefit from that—but not all!

You should also be aware of other economic indicators that may be more industry related. For example, you might track exchange rates with major trading partner nations or the price of petroleum or other energy inputs. Also, there are occasionally sudden, near catastrophic shifts in economies. The 2008–2009 financial crisis is an excellent example. Many observers were caught by surprise—remember how fast and how far the stock markets dropped—and the effect has been a sharp limitation in credit availability and subsequent consumption.

Again, it is not enough to simply define what the changes or indications are; you need to determine the implications for the focal industry. So, for the auto industry, we might be interested in interest rates. If they are rising, what will this mean for industry firms? Higher interest rates mean higher payments for consumers, so this is likely to reduce demand. On the other hand, firms can keep sales stable by reducing the price of cars (or by offering special interest rates and absorbing the financing costs themselves), but this would mean reduced profits. Higher interest rates might also mean more costly or deferred investment for auto firms and higher carrying costs for inventory. In short, higher interest rates are likely to have adverse or negative effects on the firms. What would be the effect of a change in oil prices or in the exchange rate with, for example, Japan?

S stands for changes from the sociocultural arena and addresses both how the demographic structure of a society is changing and how values and beliefs are shifting.

Demographics are statistics about how a population is structured. We would be interested in changes such as population growth (or decline), the size of age cohorts or groups, education, ethnic background, income distribution, and geographic distribution. This is important data because it should indicate likely changes in consumption patterns and opportunities or threats (though some changes will be longer term than others). For example, Figure 3.1 illustrates the change in population by age group in 2010 versus 2000.⁷ Note the bump for baby boomers (especially in the 45- to 75-year-old range) and the drop in Generation X populations. What are the implications for health care firms? One possibility is vastly increased revenues given the huge jump from the prior decade. This could also have a ripple effect on health care facility construction (or, conversely, on how health care is delivered), hiring, and education. According to the U.S. Bureau of Labor Statistics, two of the top three fastest growing occupations for 2008–2009 are home and personal health care aides.⁸ For real estate firms, the news may not be good as baby boomers decide to sell out, which may lead to an oversupply of housing and subsequent erosion of real estate values. Note that this is just one way of describing population groups; there are other useful approaches.

Other demographic indicators have similar implications for predicting changes in revenue or cost flows. Consider how the way a population relocates (e.g., from the Northern United States to Southern states, such as Florida, North Carolina, Texas, etc.) affects industries competing in both areas. Demand for everything falls in one and booms in the other. For example, construction would naturally increase in the destination states (new homes, institutions, businesses, and infrastructure) and so would sales of construction equipment, materiel (direct effects) as well as the need for labor. Or, for the auto industry, consider how changes in ethnic mix might affect advertising or product mix.

Value shifts are more difficult to identify and track, though we can find some useful sources. One of the keys here is to understand that collective social values change slowly and a timeframe of generations is not out of the ordinary. For example, the Civil Rights Act of 1964 prohibited discrimination based on race, but it took 45 years for an African-American to be elected President. In other words, it has taken a generation for general social attitudes to change sufficiently for this to happen. If Inglehart is right, values change as a function of the duration and depth of political and economic changes, but other factors appear to complement those larger change drivers. For example, the Pew Research Center’s survey of Generation Next (young adults 18–25) argues that both technology and dramatic events affect values for this group.⁹

What do shifting values mean to industries? If consumers actually enact values through purchases, then demand conditions will change. The change in environmental values over the past two generations has made green, or clean, solutions for firms in energy, transportation, and like industries increasingly attractive. In another example, Americans seem to have changed perspectives on the acceptability of alcohol consumption (based on health and social welfare concerns). One effect has been a flattened sales curve in the beer industry for well over a decade, but perhaps in the interest of drinking less—but better—beer, it has also meant an increase in the sales of craft beers. On the other hand, not all changes are really fundamental value shifts. A clear illustration comes from the first gas crisis of the 1970s when skyrocketing fuel prices turned consumers away from large and relatively inefficient American cars toward Japanese imports. Until the 1980s (after another, smaller crisis), it appeared that car purchases reflected a values change with regard to dependence on foreign oil or to environmental sensitivity. Cars were smaller and people drove less¹⁰ (and Japanese-based car manufacturers grew significantly). Still, the return of cheap gas changed that. Once fuel prices fell in the 1990s, American buyers returned to large, relatively fuel inefficient vehicles, like SUVs.¹¹ Thus, what some analysts interpreted as changes in values turned out to be more influenced by economics.

On the other hand, short term social changes can be very interesting (and threatening), particularly if your industry is engaged in short life cycle products. Fashion changes and the choices of role models can be remarkably influential. Every era has its dominant styles and consumption decisions, and the drivers are sometimes quite clear. For example, in the 1980s, the television show Miami Vice created new trends in how men dressed (you might remember the Armani jacket over a T-shirt) as did the Woody Allen movie Annie Hall for women’s fashions in the 1970s. Fads, like the hot toy for Christmas or athletic shoes with roller skate wheels built in, are also relevant though difficult to anticipate.

Finally, T captures how changes in technologies inside and outside the focal industry can affect choices. The key here is to go back to the idea that industry firms solve problems in a particular way. Technological changes in the core of the industry’s knowledge can affect how a problem is solved. Technological changes outside the industry can affect how the economic problem is even perceived—that is, this is not a problem anymore! Here is an example: Within the automotive industry, firms are working on alternative fuel and drive mechanisms. Hybrid (gas/electric) vehicles have been introduced but these are produced by the major industry players. New technological solutions, such as plug-in electric drives and new battery technology are permitting new players, such as Tesla, Bright Automotive, Fisker, and BYD Auto Co. (among others), to compete. New drive technology means massive investment for large players and a certain abandonment of current skills and competences, which turns out to be very hard to do! In other words how a problem is solved can change the set of firms that can compete.

Changes outside of the industry could also be very disruptive if they change how consumers perceive the problem. For instance, the Internet has changed the rules of who controls product information, pricing, and reputation for many industries. In the past, buyers were more constrained in the data they could gather because search costs were high. The web (and the proliferation of industry or product specific sites) has vastly increased the amount of information available and disintermediated industry firms. For example, car dealers were able to control pricing on new cars fairly easily because there were few ways for buyers to get really effective alternative pricing information. However, the Web and sites like Consumer Reports, Edmunds.com, and Car and Diver have vastly improved buyers knowledge of car prices and financing deals, which has undermined the clout dealers had. Also, as previously observed, the technological changes represented by the spread of broadband technologies has disrupted, or is in the process of disrupting, industries that specialize in selling physical versions of electronic media, such as video and music or games and software.

Technological change can also lead to blurred industry boundaries; a process called convergence. Fifteen years ago, computer networking firms, like Cisco or Bay Networks, and telecoms, such as Nortel or AT&T/Lucent, served different customers or markets, but technological changes in hardware and communications standards (particularly the digitization of telephony) means they now compete in same industry seeking to provide end-to-end data solutions. Convergence is also occurring in the biotech/pharmaceutical industries, for cable television/telephony/data providers, and even in the early stages between computing and biology. When this happens, industries from both sides can be disrupted. An even more current example concerns how smart phones are beginning to rival desk top computers as the analytic and research tool of choice for many.¹²

As a caution, discerning the importance of technological changes is notoriously difficult, especially if you are assessing them at an early stage. A recent issue of New Accountant magazine listed some famous (though possibly apocryphal) comments by people we might consider experts. For example, a number of complete misses come from the computing/IT industry where IBM’s Tom Watson, Jr. forecast a world market for five computers, and later, an engineer at IBM’s Advance Computing Systems division wondered what benefit the microchip would bring. ¹³ Technological advances completely reconfigured not just the design of computers but also what was considered a computable problem, which gave rise to the popularity of, first, minicomputers and then personal computers. Still, given what the speakers knew at the time, the comments were not unreasonable. The point is be ready to be wrong (but be alert to factors that could change your judgment).

Summary

The premise of a PEST analysis is that disciplined questions, answers, and interpretation can uncover the significant trends in the general environment that will affect a focal industry and firm. PEST requires you to consider what is happening in the political, economic, sociocultural, and technological environments. Moreover, to be effective, it requires that you not just identify and describe these trends but that you also assess why or how they matter.

Some sources for PEST data are listed in Appendix 3.1.

Appendix 3.1

Sources for Industry and PEST Information

In the short term, these are useful sites for locating industry and PEST data:

• First, try a university library tutorial on locating industry information. Don’t forget that most libraries also carry Standard and Poor, Dun and Bradstreet, and Moody’s information in hard copy format. Finally, always be sure to identify and research industry associations (usually just an online search away) for current news on members, issues, and objectives.
• Also look for professional or technical associations within an industry—these are the practitioners of the art and science that drives the industry. Like industry associations, they often have newsletters or websites that highlight key issues of importance to the members.
• For a fast and broad approach to data, the LexisNexis Academic, Congressional, and Statistical databases are great. These get you fairly recent and high-quality information.
• Additional economic information sources include the following:
  • U.S. Department of Commerce Economic Reports
  • Commerce Bureau of Economic Analysis at http://www.bea.gov/
  • Department of Labor Bureau of Labor Statistics at http://www.bls.gov/bls/proghome.htm
  • Federal Reserve at http://www.federalreserve.gov/econresdata/default.htm
  • The Conference Board at http://www.conference-board.org/ for information on economic indicators and consumer confidence
• Additional sociocultural (demographics and values) information sources include the following:
  • U.S. Census Bureau http://www.census.gov/ipc/www/idb/index.php, http://www.census.gov/ipc/www/idb/index.php
  • Population Reference Bureau http://www.prb.org/Datafinder/Geography/Summary.aspx?region=72&region_type=3
  • Pew Research Center: Social Trends http://pewsocialtrends.org/
  • The World Values Survey http://www.worldvaluessurvey.org/

In the longer term, I recommend the following:

• First, make sure you understand the overall value chain in your industry—what affects suppliers and buyers, can affect you. In other words, you have to not only think about your immediate industry but the ones that surround you as well.
• Then, but most importantly, be an educated consumer of news about and around your industry. This means general business press consumption (and I like the Economist as an internationally flavored adjunct to Business Week, Forbes, or the Wall Street Journal) as well as reading in industry journals. In any event, read!
• Remember that you still have to judge relevance, importance, accuracy, and so on. Learn to be a balanced consumer of information. That is, not all commentary or material is equally valuable. Be discerning.