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IFT Notes for Level I CFA® Program

R40 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. Go through Example 1 in the curriculum.
  • 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 as analysts can then compare industry trends and relative valuation among companies. The following are the industry classification systems currently available to investors.

4.1.     Commercial Industry Classification Systems

Most index providers classify companies into industry groups using the firms’ fundamentals such as revenue. Some use three levels of classification whereas others use four levels. The three main commercial industry classification systems are:

  • Global industry classification standard.
  • Russell global sectors.
  • Industry classification benchmark.

We will look at one system, the Global industry classification standard (GICS), to understand this concept better.

Global Industry Classification Standard (GICS)

This standard classifies companies based on its principal business activity. There are four levels of classification: a company belongs to a sub-industry; the sub-industry belongs to an industry; the industry belongs to an industry group; and a group belongs to a sector. The diagram below will help you remember how companies are classified in this system:

Examples:

Exxon Mobil – integrated oil & gas (sub industry) – oil gas & consumable fuels (industry) –energy (sector)

Nike – apparel, footwear (sub-industry) – apparel & textile products (industry) – consumer discretionary (sector)

4.2.     Governmental Industry Classification Systems

Various governmental agencies organize statistical data according to the type of industrial or economic activity. The common goal is to facilitate comparison of data over time and across countries which use the same system. Continuity of data is an important criterion for measurement and evaluation of economic performance over time. Any change in continuity will impact comparability of data, making it irrelevant. Some examples of governmental industry classification systems include:

  • International Standard Industrial Classification of All Economic Activities.
  • Statistical Classification of Economic Activities in the European Community.
  • Australian and New Zealand Standard Industrial Classification.
  • North American Industry Classification System.

4.3.     Strengths and Weaknesses of Current Systems

Commercial Classification System Governmental Classification System
Generally disclose information about a specific company. Generally, do not disclose information about a specific company. Difficult for analysts to know all constituents for a particular category.
Reviewed and adjusted frequently. Reviewed and adjusted relatively infrequently – usually every five years.
Generally, distinguish between large and small businesses. Only includes for-profit publicly traded companies. No distinction between large and small businesses, for-profit and non-profit, or private and public companies.
A limitation of both the systems is that a company’s narrowest classification unit cannot be assumed to be its peer group. For instance, we cannot assume all companies in the apparel/footwear (sub-industry grouping) /consumer discretionary (sector) category to be Nike’s peer group.

4.4.     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 instance, 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.

Steps to construct a preliminary list of peer companies:

  1. Use a commercial classification system as a starting point.
  2. Study the subject company’s annual report to understand its competitive environment.
  3. Study the competitors’ annual reports.
  4. Review industry trade publications to identify comparable companies.
  5. Confirm that each 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 could be in the personal computer industry as well as the information technology services industry.


Equity Introduction to Industry and Company Analysis Part 1