Level I – Equity Investments

Introduction to Industry and Company Analysis

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 Contents and Introduction
1. Introduction
2. Uses of Industry Analysis
3. Approaches for Identifying Similar Companies
4. Industry Classification Systems
5. Describing and Analyzing an Industry
6. Company Analysis

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 2. Uses of Industry Analysis

• Understanding a company’s business and business environment

• Identifying active equity investment opportunities

ƒ Overweight industries expected to perform well
ƒ Sector rotation

• Portfolio performance attribution

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 3. Approaches for Identifying Similar Companies
• Companies grouped based on products and/or services

• Companies grouped based on their relative sensitivity to the business cycle

ƒ Cyclical company is one whose profits are strongly correlated with the strength of the overall
economy (e.g. auto and tech companies); non-cyclical company is one whose performance is
mostly independent of the business cycle (e.g. healthcare and utilities)
ƒ Example 1. Non-cyclical companies are at times further labeled as ‘growth’ or ‘defensive’
ƒ Cyclical/non-cyclical is a spectrum
ƒ Growth/defensive labels may be misleading
ƒ Different regions might be at different stages of the business cycle

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• Companies grouped based on statistical similarities

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ƒ Companies with high correlations are grouped together

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ƒ High correlations might be because of chance

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 4. Industry Classification Systems
• A well-designed classification system is a useful starting point
for industry analysis; analysts can compare industry trends
and relative valuation among companies

• Four sub-sections
ƒ Commercial Industry Classification Systems
ƒ Governmental Industry Classification Systems
ƒ

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Strengths and Weaknesses of Current Systems

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ƒ Constructing a Peer Group

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 Commercial Industry Classification Systems
Most index providers classify companies into industry groups
• Global Industry Classification System (GICS)
ƒ Developed by Standard and Poor’s and MSCI Barra
ƒ Sector (10) Æ Industry Group (24) Æ Industry (68) Æ Sub-Industry (154)
• Russell Global Sectors (RGS) uses a 3-tier structure
• Industry Classification Benchmark (ICB) uses a 4-tier structure
Sectors:
Basic Raw Materials and Processing, Consumer Discretionary, Consumer Staples, Energy, Financialal

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Services, Health Care, Industrial/Producer Durables, Technology, Telecommunications, Utilities
es

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Descriptions are in the curriculum;

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Example 2 makes you classify companies into sectors. You must do Example 3.

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 GICS Excerpt
Industry
Sector Group Industry Sub-Industry
Energy
10101 Equipment &
10 Energy 1010 Energy 0 Services 10101010 Oil & Gas Drilling
Drilling contractors or owners of drilling rigs that contract their services for drilling wells
10101020 Oil & Gas Equipment & Services
Manufacturers of equipment, including drilling rigs and equipment, and providers of supplies and
services to companies involved in the drilling, evaluation and completion of oil and gas wells.
Oil, Gas &
10102 Consumable
0 Fuels 10102010 Integrated Oil & Gas
Integrated oil companies engaged in the exploration & production of oil and gas, as well as at least
one other significant activity in either refining, marketing and transportation, or chemicals.
10102020 Oil & Gas Exploration & Production
Companies engaged in the exploration and production of oil and gas not classified elsewhere.
10102030 Oil & Gas Refining & Marketing
Companies engaged in the refining and marketing of oil, gas and/or refined products not classified
in the Integrated Oil & Gas or Independent Power Producers & Energy Traders Sub-Industries.

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10102040 Oil & Gas Storage & Transportation

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Companies engaged in the storage and/or transportation of oil, gas and/or refined products.
oduucts

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Includes diversified midstream natural gas companies facing competitive markets,, oil and a refined

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product pipelines, coal slurry pipelines and oil & gas shipping companies.

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 Governmental Industry Classification Systems
• Various governmental agencies organize statistical data according to type of
industrial or economic activity; common goal is to facilitate comparison of data
over time and across countries which use the same system

• Continuity of data is critical to the measurement of and evaluation of economic

performance over time

• Examples of governmental industry classification systems:

ƒ International Standard Industrial Classification of All Economic Activities (ISIC) was adopted by
the UN in 1948
ƒ Statistical Classification of Economic Activities in the European Community

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ƒ Australian and New Zealand Standard Industrial Classification

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ƒ North American Industry Classification System

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Strengths and Weaknesses of Current Systems
Commercial Classifications Governmental Classification

• Generally disclose information about a specific • Generally do NOT disclose information about a
company specific company

• Reviewed and adjusted frequently • Reviewed and adjusted relatively infrequently

• Generally distinguish between large and small • Do not distinguish between large and small
businesses companies

• Only cover for-profit, publicly traded

companies

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Companies in the narrowest sub-classification unit might not represent a peer group

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 Constructing a Peer Group
Definition: A peer group is a group of companies engaged in similar business activities
whose economics and valuation are influenced by closely related factors

Use a commercial classification system as a starting point

Study subject company’s annual report to understand competitive environment

Study competitors’ annual reports

Here is one
possible strategy Review industry trade publications to identify comparable companies
for constructing a Confirm that each company derives a significant percentage of revenue from a

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business activity similar to the primary business of the subject company

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A company could belong to more than one peer group. Example: HP could be in the PC industry
dust and the
information technology services industry
Read Example 4 and Example 5
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 5. Describing and Analyzing an Industry
• Analyze industry performance in relation to other industries and over time

• Identify industries that offer the highest potential risk-adjusted returns

ƒ Economic fundamentals and hence economic profits can vary substantially across industries
ƒ ROIC and pricing power; Exhibit 3

• Investment time horizon can be long or short

• Strategic groups are groups of companies sharing distinct business models or

catering to a specific market segment

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• Industries can be classified according to lifecycle stage

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ƒ Position on the experience curve

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Industry Analysis Framework (Porter’s Five Forces)
New Entrants
Threats

Barriers to Entry

Internal Competitive Forces

Supplier Industry Concentration Customer
Bargaining Industry Capacity, Market Share Bargaining
Forces Stability, Price Competition Forces
Industry Lifecycle

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Product/Service

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Substitution Threats

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External influences: macroeconomic, social, governmental, demographic, technological

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 Barriers to Entry
Simple high level High barriers Discourage High pricing
view: to entry new entrants power

Do not confuse barriers to entry with barriers to success

High barriers to entry do not automatically lead to high pricing power. This
might happen if:

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1) Price is a large percentage of the customer’s purchase decision

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2) Industry has high barriers to exit

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 Industry Concentration
• In concentrated industries each player generally has high pricing power
ƒ Fortunes tied with the industry and more to gain by keeping prices high even though cutting
prices might increase market share
• In segmented industries each player generally has low pricing power
ƒ More to gain by undercutting competition in an effort to gain market share
• Do not automatically assume that high concentration leads to high pricing power

Strong Pricing Power Weak Pricing Power

Concentrated Æ Soft drinks (Coke, Pepsi) Generally capital intensive and sell
commodity like products

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Commercial aircraft (Boeing, Airbus)

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Fragmented Æ

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Asset management companies (Fidelity) Consumer packaged goods

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Home improvement (Home Depot) Airlines

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Retail

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Capacity, Market Share and Price Competition
• Industry Capacity
ƒ Tight or limited capacity Æ High pricing power
ƒ Consider current capacity and future capacity levels
ƒ Physical capital takes a relatively long time to establish
ƒ Quicker to shift financial and human capital to new uses
• Market Share Stability
ƒ Impacted by barriers to entry, switching costs, new product introductions
ƒ Stable market shares indicate less competitive industries

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• Price Competition

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ƒ If price is a major factor in customer buying decisions, price completion

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 Industry Life Cycle Model
Embryonic Growth Shakeout Mature Decline

Slow Rapidly Slowing Negative Growth

Growth Increasing Growth
Demand Little or No Growth
Demand

High
Prices Falling Industry Consolidation
Prices Intense
Significant Competition High Barriers to Entry Excess Capacity
Investment
Declining High Competition
High Risk Profitability
Low
Competition Example
p 6

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Time Example
EEx
xam 7

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New industries tend to more

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Is a company

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acting its age?
What are the limitations of industry analysis?

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 Industry Comparison (Internal Factors)
Branded Pharma Oil Services Confections/Candy

Barriers to
Success/Entry

Level of Concentration

Impact of Industry
Capacity
Industry Stability

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Life Cycle

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Price Competition

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 External Influences on Industry Growth, Profitability and Risk
• Macroeconomic factors

• Technology

• Demographic factors

• Governments

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• Social influences

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 Industry Comparison (External Influences)
Branded Pharma Oil Services Confections/Candy

Demographic Influences

Government and
Regulatory Influences
Social Influences

Technological Influences

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Growth vs. Defensive vs.

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Cyclical

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Example 8 Examples 9 - 13

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 6. Company Analysis
• Analyze company’s financial position, products and/or services and
competitive strategy

• Two major strategies: 1) price leadership and 2) differentiation

• Elements that should be covered in a company analysis

• Spreadsheet modeling

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Elements That Should be Covered in a Company Analysis
• Company Profile

• Industry Characteristics

• Analysis of Demand for Products/Services

• Analysis of Supply of Products/Services

• Analysis of Pricing

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• Financial Ratios and Measures

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 Spreadsheet Modeling
• Spreadsheet modeling of financial statements helps to analyze and
forecast revenues, operating and net income, and cash flows.

• A widely used tool in company analysis, that can quantify effects of

changes in variables in various financial statements.

• An array of assumptions are used in this tool.

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 Summary
• Uses of industry analysis
• Methods by which companies can be grouped
• Constructing a peer group
• Classification systems
• Industry analysis: Porter’s five forces
• Barriers to entry, industry concentration, pricing power
• External influences
• Elements of a thorough company analysis

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 Conclusion
• Read the summary

• Review learning objectives

• Examples

• Practice problems

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• Practice questions from other sources

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