What it means
When a new industry looks profitable, many companies rush in. Supply grows faster than demand, prices fall, and margins shrink until the weakest firms cannot cover their costs.
They close, sell up or merge, and the market is left with fewer players. Shakeouts are common in new technologies and fast-growing sectors, from early car makers to online retailers.
They usually come when growth slows or when funding dries up, because loss-making firms depend on constant cash. The survivors tend to be those with lower costs, better products or more reliable funding, and a few of them go on to dominate the market for decades.
In investing, a shakeout can also mean a quick price drop that forces out holders who bought with borrowed money or who panic. After the weak holders have sold, the price may stabilise or recover.
Traders sometimes treat a shakeout as a healthy clearing of the market, though it feels painful at the time. For finance professionals, a shakeout changes the picture for suppliers, lenders and customers.
A supplier may lose a large customer, a lender may face defaults, and a buyer may be offered acquisition targets at low prices. Credit teams watch for early signs, such as falling prices, rising inventory and growing delays in payment.
The effect on those who survive is usually positive. Fewer competitors can mean steadier prices and better margins, and market share becomes easier to win.
But survivors also carry risk, since they may have taken on debt or cut investment to stay alive. Not every industry follows a clean pattern, and the length of a shakeout varies.
Some end within a year, while others stretch over several. It is useful to ask who is funding the losses and how long they can continue.
In practice
Real-world examples.
Example
A group of start-ups sells meal kits, and aggressive discounting drives down prices for all of them. Within two years, half have closed or been bought. The remaining firms raise their prices and reach profit, and the customers who stayed find the service steadier than before.
Example
A supplier of packaging notices that three of its customers have stopped ordering. The credit manager tightens payment terms and reduces the credit limit on the others. The supplier avoids a large bad debt when one of them fails.
Example
A trader sees a share fall 8% in an hour as stop-loss orders trigger. Many holders sell in fear, and the price steadies by the afternoon. The analyst notes that the move looked like a shakeout rather than a change in the company's prospects, and she waits for the volume to settle before drawing any conclusion.
Formula
Calculation
Industry shrinkage = (firms before - firms after) / firms before x 100
Suppose a market for electric scooter rental has 40 operators at its peak. After prices fall and funding dries up, only 25 remain. Industry shrinkage = (40 - 25) / 40 = 15 / 40 = 0.375, or 37.5%. If the industry's total revenue of $200,000,000 is now shared among 25 firms, the average revenue per firm is 200,000,000 / 25 = $8,000,000, compared with 200,000,000 / 40 = $5,000,000 before.Case study
Seen in the real world.
Brightpath E-Bikes is an illustrative, fictional manufacturer that entered a crowded market of electric bicycle makers. Dozens of rivals had cut prices to win share, and many were losing money on every sale.
The finance director kept a close watch on cash and cut spending on new models. When funding dried up, eleven competitors closed within eighteen months, and Brightpath bought two of them cheaply for their stock and dealer networks.
With fewer rivals, prices recovered and the company moved into profit. The illustrative lesson is that a strong cash position during a shakeout lets a business buy opportunities that others have to give up. The finance director had kept a cash reserve equal to six months of costs, and that decision made the purchases possible.
Watch out
Common mistakes.
- Assuming that every business failing in a shakeout was poorly run, when some were simply short of funding at the wrong moment.
- Extending large amounts of credit to customers in a crowded, price-cutting market, where any of them could fail with little warning.
- Expecting survivors to be safe, when they may have weakened their balance sheets to stay alive.
Questions
People also ask.
How is a shakeout different from a recession?
A shakeout is specific to an industry or market, while a recession affects the whole economy.
Can a shakeout be good for investors?
It can be, because fewer competitors often lead to better profits for survivors, though the risk before the shakeout ends is high and picking the winners is difficult.
How can a company prepare for one?
By keeping costs flexible, holding enough cash and avoiding reliance on a single source of funding, so that a drop in prices or a funding delay does not become a crisis.
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