In this reading, we will focus on:
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.
The three main methods for classifying companies are:
For example, firms that produce healthcare related products or provide healthcare related services will constitute the healthcare industry.
Depending on the sensitivity to the business cycle, companies can be classified as:
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:
Limitations of business-cycle sensitivities classification:
Firms that historically have had highly correlated returns are grouped together.
Limitations of statistical similarities classification:
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.
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:
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:
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)
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:
|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.|
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:
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.