2017 Level I Exam
Introduction to Industry and Company Analysis
USES OF INDUSTRY ANALYSIS
Understanding a company's business and environment
Industry analysis will help one understand growth opportunities and competitive issues. It
can also help understand the appropriateness of debt financing.
Identifying active equity investment opportunities
Industry analysis is useful under the top-down approach. It can be used to determine the
appropriate industry portfolio weights.
Portfolio performance attribution
Performance attribution is used to determine the sources of a portfolio's return. Part of the
attribution is for the industry or sector.
APPROACHES TO IDENTIFYING SMILIAR COMPANIES
Products and/or Services Supplied
This is the common modern classification. For example, the auto industry would include Toyota,
Ford, and Nissan. A company is classified based on its principal business activity. Some
companies will report revenue by different business segments. A sector refers to a group of
related industries.
Business-Cycle Sensitivities
Cyclical companies have profits that are strongly correlated with the overall economy strength.
Demand ebbs and flows with the economy. Cyclical industries include automobile, housing, and
technology. The impact could be from local or global economy status.
Non-cyclical companies are largely independent of the economy. Demand is stable throughout
the business cycle. Non-cyclical industries include food and health care. Some classify these
companies as defensive or growth. Even non-cyclical companies will likely suffer in a recession.
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Statistical Similarities
This method uses past security returns to group companies with high correlations. The
companies grouped together may appear to have little in common. There is no guarantee the past
correlations will persist into the future.
INDUSTRY CLASSIFICATION SYSTEMS
Commercial Industry Classification Systems
Global Industry Classification Standard (GICS)
GICS was designed for global comparisons of industries. It classifies in both developed and
developing economies. Four levels are used: sub-industries, industries, industry groups, and
sectors.
Russell Global Sectors (RGS)
RGS classifies companies globally based on products or services produced by company. Three
tiers are used: sectors, subsectors, and industries. RGS has nine sectors compared to ten used by
GICS.
Industry Classification Benchmark (ICB)
ICB classifies companies based on source of majority of revenue. Four tiers are used: industries,
supersectors, sectors, and subsectors. The terminology is quite different from GICS.
Governmental Industry Classification Systems
International Standard Industrial Classification of All Economic Activities (ISIC)
ISIC categories based on principal type of economic activity. It is organized into five levels:
categories, sections, divisions, groups, and classes. Groups such as the UN and the International
Monetary Fund use ISIC.
Statistical Classification of Economic Activities in the European Community (NACE)
NACE is referred to as the European version of ISIC. It is composed of four levels: sections,
divisions, groups, and classes.
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Australian and New Zealand Standard Industrial Classification (ANZSIC)
ANZSIC is aligned with ISIC and has five levels: divisions, subdivisions, groups, classes, and
subclasses.
North American Industry Classification System (NAICS)
NAICS replaced the Standard Industrial Classification system. It categorizes in five levels based
on primary business activity and distinguishes between establishments and enterprises. NAICS
uses six-digit code system.
Strengths and Weaknesses of Current Systems
Most government systems do not disclose information about individual companies, so
classifications like NAICS are unknown. Commercial classification systems are updated more
frequently. Government systems do not distinguish by size or public/private. The narrowest
classification unit unfortunately does not always correspond to a company's peer group.
Constructing a Peer Group
One can start with a commercial classification system to construct a peer group, but it is a
subjective process. One approach starts with companies in the same industry.
Suggested steps in identifying peer companies
Examine commercial classification systems.
Review company's annual report for discussion of competitive environment. Often
companies will cite competitors.
Review industry trade publications.
Confirm the comparable companies have similar business activity revenues and demand
environment.
Companies with many divisions may be included in more than one category. The analyst must
distinguish between industry and peer group.
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DESCRIBING AND ANALYZING AN INDUSTRY
Analysts spend much time studying the characteristics, conditions, and trends of an industry.
They develop projections based on the information gathered. The forecasts must be correct and
sufficiently different from the consensus to be valuable. Industry performance is compared to
other industries and to itself over time. Strategic groups may be treated as separate industries.
The analyst by classify industries by life-cycle stage. The experience curve shows the declining
direct cost per unit. The curve declines because fixed costs are spread over greater production,
labor efficiency increases, and production methods improve.
Principles of Strategic Analysis
Economic fundamental can vary widely among industries. Some can be earning economic profits
while others are destroying capital. Industry analysis must be forward looking.
Strategic analysis looks at the competitive environment to help determine corporate strategy.
Michael Porter developed a "five forces" framework to determine intensity of industry
competition.
1. Threat of substitute products
This can affect demand, particularly in economic downturns.
2. Bargaining power of customers
The customers can sometimes influence prices, especially when there are only a few,
large customers for a given product.
3. Bargaining power of suppliers
For example, unionized workers can limit labor availability.
4. Threat of new entrants
This depends on the barriers to entry.
5. Intensity of rivalry
More intense competition if many small competitors, high fixed costs, commodity-like
products, or have high exit barriers.
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There are several key items an analyst should evaluate that relate to the threat of new entrants
and level of industry competition. These items include barriers to entry, industry concentration,
industry capacity, market share stability, industry life cycle, and price competition.
Barriers to Entry
High barriers to entry make it easier for a company to sustain economic profits. Industries with
low barriers (such as restaurants) have little pricing power and intense competition. Even with
high entry barriers existing competitors could choose to have price wars. Historical data on new
entrants can help an analyst determine the entry barriers. Success can still be a challenge even if
the entry barrier is low, such as in the mutual fund industry. High exit barriers could induce
companies to keep operating even when losing money. Entry barriers can change over time.
Industry Concentration
Industries with fewer players generally have weaker price competition, but there are exceptions.
Relative market shares of competitors is key when determining industry competition.
Fragmented industries usually have much price competition because there are so many
competitors each company only worries about itself. Companies in concentrated industries have
more to lose with price competition.
As mentioned, some industries (e.g. commercial aircrafts with Boeing and Airbus, automobiles,
oil refiners, computer memory) with high concentration have weak pricing power. Often they are
capital-intensive and sell a commodity product.
Industry Capacity
Limited capacity gives participants more pricing power. If an industry cannot meet excess
demand, prices will rise. Usually capacity is fixed in the short term and variable in the long term.
Capacity constraints can even occur in financial industries (e.g. reinsurance market). Generally
human and financial capital can be redeployed faster than physical capacity.
Market Share Stability
This is influenced by barriers to entry and new product introductions. Industries with specialized
products and slow innovation tend to have more market share stability.
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Industry Life Cycle
Description of an Industry Life-Cycle Model
Industries evolve over time. Five sequential stages can be identified.
1. Embryonic
The industry is just beginning to develop in this stage. Characteristics include slow
growth and high prices. There is high failure risk and significant investment required.
2. Growth
Characterized by rapidly increasing demand, improving profitability, falling prices,
and low competition. The demand comes from new customers.
3. Shakeout
Characterized by slowing growth, intense competition, and declining profitability.
Growth is now dependent on market share, so companies cut prices. Companies focus
on reducing cost structure and building brand loyalty.
4. Mature
Mature industries have little or no growth, industry consolidation, and high entry
barriers. Market is completely saturated, so growth is from replacement demand.
Surviving companies are efficient and have brand loyalty.
5. Decline
Characterized by negative growth, excess capacity, and high competition. Demand
could drop due to technological substitution or global competition.
Using an Industry Life-Cycle Model
New industries are usually more competitive than mature ones. Companies need to "act their
stage". For example, companies in growth stage should focus on building customer loyalty.
Companies in mature industries should focus on extending successful product lines. Usually
these companies have more cash flows than necessary to grow the business, so they should
return money to their shareholders.
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Limitations of Industry Life-Cycle Analysis
The industry evolution will not necessarily follow a predictable pattern. External factors can
have a large impact. Technological changes can abruptly shift an industry into the decline
stage (e.g. when word processors replaced typewriters). Government policy can also
influence the pattern. Social changes and demographics have an impact.
Price Competition
Competition generally centers around what is most important to the customer. Pricing is often a
key factor. For some industries customers pay more attention to other factors (e.g. historical
returns in asset management). It is not simply a commodity industry versus a non-commodity
industry.
External Influences on Industry Growth, Profitability, and Risk
Macroeconomic
Overall economic activity impacts demand for products and services. Important economic
variables include gross domestic product, interest rates, availability of credit, and inflation.
Technological
Technology can help create new products or change the way customers use existing products.
For example, the microchip revolutionized the computer industry. Later, software development
and the internet fundamentally changed the industry again. Also, digital cameras completely
altered the photographic film industry.
Demographic
Changes in population size or composition (e.g. gender, age) can affect demand for goods and
services. Baby boomers get a lot of attention in the United States. Some countries like Japan
have a pronounced aging population.
Governmental
The government influences and industry through taxes, rules and spending. Sometimes the
government will empower other organizations to govern an industry (e.g. doctor qualifications,
stock exchanges).
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Social
Changes in society occur regarding how people work and spend their leisure time. For example,
the population's view on smoking has changed over the last few decades.
COMPANY ANALYSIS
Company analysis includes studying financial position, products, and competitive strategy of
company. The analyst does this after looking at the company's external environment. Two main
competitive strategies are a low-cost strategy and product/service differentiation strategy. Pricing
with a low-cost strategy could be defensive (under weak competition), aggressive, or even
predatory (gain market share even if accruing short-term losses). Companies following low-cost
strategies must be efficient. Differentiation strategies seek to gain attention from unique or high
quality products. HR must hire creative people to better match customer needs with products.
A company analysis should include the following:
1. Corporate profile (overview of company)
2. Industry characteristics
3. Analysis of demand for products/services
4. Analysis of supply of products and services
5. Company's pricing environment
6. Financial ratios and measures (activity, liquidity, solvency, profitability, and financial)
It is common to use spreadsheets to forecast financial statements. Models can easily become
overly complex and error prone. One should always scrutinize the results for reasonableness.
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