LM05 Introduction to Industry and Company Analysis

Part 1

1.  Introduction

In this reading, we will focus on:

• which factors to consider when analyzing an industry.
• what advantages are enjoyed by companies in strategically well-positioned industries.
• how to analyze the competitiveness of an industry.
• an introduction to company analysis.

2.  Uses of Industry Analysis

Industry analysis is primarily used in fundamental analysis. Its uses include:

Understanding a company’s business and business environment:

Industry analysis is used in stock selection and valuation as it helps an analyst understand the health of the industry, the issuer’s growth opportunities, and business risks. For a credit analyst, industry analysis provides insights into how much debt companies use, whether the industry is well-positioned for the companies to service this debt, and if a company is over-leveraged relative to its peers.

Identifying active equity investment opportunities:

Investors use a top-down approach to analyze the macroeconomic factors (which country offers better growth prospects); then classify industries based on positive, neutral, and negative outlook; and, finally, shortlist stocks within those industries. Investors then overweight, market weight or underweight industries. Or they also attempt to outperform the benchmark by industry or sector rotation. A sector rotation strategy involves timing investments in industries by analyzing fundamentals to take advantage of the business-cycle conditions. For example, when interest rates go down stocks in the financial and housing sectors tend to do well.

Portfolio performance attribution:

This is used to determine how a fund manager’s performance relative to a benchmark can be attributed to different sources such as asset class selection (stock/bond mix), industry/sector allocation, and stock selection.

3.  Approaches to Identifying Similar Companies

The three main methods for classifying companies are:

3.1. Products and/or services offered:

For example, firms that produce healthcare related products or provide healthcare related services will constitute the healthcare industry.

3.2. Business-cycle sensitivities:

Depending on the sensitivity to the business cycle, companies can be classified as:

• Cyclical: Earnings are highly dependent on the stage of the business cycle.
• Non-cyclical: Earnings are relatively stable over the business cycle.

Companies that grows rapidly on a long-term basis but face above-average fluctuation in their revenues and profits over the course of a business cycle are known as “growth cyclical”.

Non-cyclical industries can be further divided into:

• Defensive: Industries that are least affected by the stage of the business cycle, for example, utilities and consumer staples.
• Growth: Industries that have a very strong demand due to which they are largely unaffected by the stage of the business cycle.

Limitations of business-cycle sensitivities classification:

• Cyclical/non-cyclical is a continuous spectrum. Recession usually affects all parts of the economy; a non-cyclical sector should be seen as a relative term. For instance, to say that a household spends the same amount on groceries during a recession may not be accurate. Households often tend to curtail expenses when jobs are at risk and incomes are relatively low.
• Growth/defensive labels may be misleading. Even defensive industries may grow when the economy is doing well, and might perform poorly when the economy is sluggish.
• Different regions of the world might be at different stages of the business cycle. This is a challenge when evaluating multinational companies.

3.3. Statistical similarities:

Firms that historically have had highly correlated returns are grouped together.

Limitations of statistical similarities classification:

• The classification is not intuitive and may change over time.
• May falsely indicate a relationship where none exists. For example, grouping together tobacco and aerospace.
• May falsely exclude a significant relationship.

4.  Industry Classification Systems

A well-designed classification system is a useful starting point for industry analysis. Such systems allow analysts to compare industry trends and relative valuation among similar companies.

Classification systems are provided by both commercial entities and government agencies. However, commercial classification systems are commonly used in the investment industry because they are more frequently updated as compared to government classification systems. In this reading we will focus on commercial classification systems.

4.1.     Commercial Industry Classification Systems

Major index providers classify companies in their equity indexes into industry groupings. These classification systems contain multiple levels: starting at the broadest level – a general sector grouping, that is then subdivided into more narrowly defined sub-industry groups.

The two main commercial industry classification systems are:

• Global industry classification standard.

• Industry classification benchmark.

Global Industry Classification Standard (GICS)

• GICS was jointly developed by Standard & Poor’s and MSCI.
• It uses a four-tier structure to classify companies based on the company’s primary business activity as measured by revenue.
• As of June 2020, this system consisted of 11 sectors, 24 industry groups, 69 industries, and 158 sub-industries.

Industry Classification Benchmark (ICB)

• ICB was jointly developed by Dow Jones and FTSE.
• It uses a four-tier structure to classify companies based on the source from which a company derives the majority of its revenue.
• As of June 2020, this system consisted of 11 industries, 20 supersectors, 45 sectors, and 173 subsectors.

The ICB and GICS are similar in the number of tiers and the method by which companies are assigned to particular groups. But the two systems use significantly different nomenclature. For example, GICS uses the term ‘sector’ to describe its broadest category, while ICB uses the term ‘industry’. Also, the two systems can classify the same company very differently. The following table provides an example.

4.2 Constructing a Peer Group

A peer group is a group of companies engaged in similar business activities whose economics and valuation are influenced by closely related factors. For example, if you are valuating Toyota, it is appropriate to compare Toyota with other auto companies rather than Samsung. Some examples of Toyota’s peers include Daimler, Honda, Volkswagen, and General Motors.

Constructing a peer

• group is a subjective process. Commercial classification systems can be used as a starting point
• to quickly discover public companies operating in the
• chosen industry. The analyst can then further investigate these companies using a variety of sources, such as the companies’ annual reports
•  industry trade publications The analyst has to confirm that each comparable

company derives a significant percentage of revenue from a business activity similar to the primary business of the subject company.

A company could belong to more than one peer group. For example, Hewlett-Packard (before it separated its business in two parts) could be included in the personal computer industry as well as the information technology services industry.

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