Part 10. Intro to Industry & Company Analysis

Question 1

Uses of industry analysis:

Answer 1

• Provides framework for understanding the firm.
• Focus on group of specific industries to better understand business conditions firms those industries face.
• Insight into business environment provides info on firms potential growth, competition, and risks.
• Credit analysis to provide information about whether firm will be able to meet obligations in next recession.
• Active management strategy analyses industries that are undervalued or overvalued in order to weight them appropriately.
• Engage in industry rotation by underweighting or overweighting industries based on current phase of business cycle.
• Performance attribution analysis provides sources of portfolio return determined relative to benchmark, with industry representation being significant of attribution analysis.

Question 2

Group classifications

Answer 2

This can be by:

• products & services they offer (use principal business activity to classify).
• sensitivity to business cycles, e.g. cyclical or non-cyclical
• statistical methods, e.g. cluster analysis - group firms with highly correlated returns, have lower return correlations between groups.

Question 3

Limitations of statistical methods:

Answer 3

• historical correlations may not be the same as future
• groupings of firms may differ over time and across countries.
• groupings of firms is sometimes non-intuitive.
• method is susceptible to statistical error, (i.e. firms can be grouped by relationship occurs by chance, or not grouped together when should be).

Question 4

Commercial classifications

Answer 4

The providers generally use firm fundamentals such as revenue to classify firms, but nomenclature differs among providers, the broadest category generally sector level, followed by industry and sub-industry.

Classifications include:

• Global Industry Classification Standard (by S&P, MSCI Barra, Russell Global Sectors)
• Industry Classification Benchmark (by Dow Jones and FTSE)

Question 5

Government classifications

Answer 5

Main systems:

• International Standard Industrial Classification of All Economic Activities (ISIC) - produced by UN in 1948 to increase global comparability of data.
• Statistical Classification of Economic Activities in EC - similar to ISIC but designed for Europe.
• Australian & New Zealand Standard Industrial Classification - jointly developed by these countries.
• North American Industry Classification System (NAICS) - jointly developed by USA, Canada and Mexico.

Question 6

How is government classifications different to commerical?

Answer 6

• Most do not identify individual firms in a group, so analyst cannot know the groups exact composition.
• Commercial providers identify the constituent firm.
• Gov systems are updated less frequently, e.g. NAICS updated every 5 years.
• Gov does not distinguish between small and large firms, profit or non-profit organisations or private and public firms.
• Commercial providers only include for profit and public firms, and delineate by size of firm.

Question 7

Cyclical firm

Answer 7

A firm whose earnings are highly dependent on the stage of the business cycle.

These firms have:

• high earnings volatility
• high operating leverage
• products are often expensive
• non-necessities whose purchases can be delayed until economy improves.

Examples:

• basic materials and processing, consumer discretionary, energy, financial services, industrial and producer durables, technology

Question 8

Non-cyclical firm

Answer 8

This produces g/s for which demand is relatively stable over the business cycle.

e.g. health care, utilities, telecommunications, consumer staples

Question 9

Non-cyclical industries

Answer 9

These can further be separated into defensive (stable) or growth industries.

Defensive industries - those that are least affected by stage of business cycle and include utilities, consumer staples, and basic services.

Growth industries - have demand so strong they are largely unaffected by stage of business cycle.

Question 10

Growth cyclical

Answer 10

This describes firms with strong long-term growth that have revenue quite sensitive to economic cycles.

Question 11

Limitations of classifications:

Answer 11

• Cyclical industries dependant on business cycle often include growth firms less dependent on business cycle.
• Non-cyclical industries ca be affected by severe recessions; this was the case for 2008-9 downturn.
• Defensive industries may not always be safe investments, e.g. grocery stores are subject to intense prices competition that reduces earnings.
• Defensive industries may also contain some truly defensive and some growth firms, as business cycle phases differ across countries and regions, with 2 cyclical firms operating in different countries may simultaneously be experiencing different cyclical effects on earnings growth.

Question 12

Peer group

Answer 12

A set of similar companies an analyst will use for valuation comparisons, more specifically consists of companies with similar business activities, demand drivers, cost structure drivers, and availability of capital.

Question 13

How to form a peer group:

Answer 13

• Use commercial classification providers to determine which firms are in the same industry.
• Examine firms annual reports to see if they identify key competitors.
• Examine competitors annual reports to see if competitors are named.
• Use industry trade publications to identify competitors.
• Confirm comparable firms have similar sources of sales and earnings, demand and geographic markets.
• Adjust financial statements of non-financial companies for financing subsidiary data they include.

Question 14

Elements of thorough industry analysis

Answer 14

• Evaluate relationships between macroeconomic variables and industry trends using info from industry groups, firms in industry, competitors, suppliers and customers.
• Estimate industry variables using different approaches and scenarios.
• Compare with other analysts forecasts of industry variable to confirm validity of analysis, and potentially find industries that are mis valued as result on consensus forecasts.
• Determine relative valuation of different industries.
• Compare valuations of industries across time to determine volatility of performance over long run, during phases of business cycle. This is useful for LT investing, as well as ST industry rotation based on current economic environment.
• Analyse industry prospects based on strategic groups, groups of firms distinct from rest of industry due to delivery or complexity of products or barriers to entry, e.g. full service hotels are distinct market segment within hotel industry.
• Classify industries by life-cycle stage, whether embryonic, growth, shakeout, mature or declining.
• Position industry on experience curve, which shows cost per unit relative to output, where curve declines because of increase in productivity, and EOS, especially in industries with high FC.
• Consider forces affect industries, include demographic, macroeconomic, governmental, social and technological influences.
• Examine forces that determine competition within an industry.

Question 15

Economic profits

Answer 15

The return on invested capital minus its cost are greater than 20% in some industries and negative in others.

The degree of economic profits depend in part on pricing power (elasticity of demand for firms products).

The industry analysis should be forward looking, as analyst should understand that industry conditions and profits can change dramatically overtime.

Question 16

Strategic analysis

Answer 16

This examines how an industry’s competitive environment influences a firm’s strategy, the analysis framework developed by Michael Porter delineates 5 forces that determine industry competition.

Question 17

Principles of strategic analysis of an industry:

Answer 17

1. Rivalry amongst existing competitors - slow growth leads to competition as firms fight for market share, and high fixed costs lead to price decreases as firms try to operate at full capacity.
2. Threat of entry - Significant barriers to entry (e.g. large capital outlays for facilities) means easier to maintain premium pricing, such as it is costly to enter steel or oil production industries. EOS can discourage new entrants.
3. Threat of substitutes - Limit profit potential of industry, as they limit prices firms can charge by increasing elasticity of demand. Commodity like products have high levels of competition, and low profit margins, so more differentiated products in an industry is loess price competition, e.g. patented drugs.
4. Power of buyers - buyers ability to bargain lower prices or higher quality influences industry profitability, where bargaining by gov. and ever-larger health care providers put downward pressure on even patented drugs.
5. Power of suppliers - Suppliers have the ability to increase prices or limit supply influences industry profitability, and are more powerful if a few of them and their products are scarce. E.g. Microsoft is one of the few suppliers of operating system software, thus have pricing power.

Question 18

How threat of entry and rivalry among competitors influence environment in an industry:

Answer 18

• Higher barriers to entry reduce competition.
• Greater concentration of firms in a market reduces competition, whereas market fragmentation (large number of firms with small market share) increases competition.
• Unused capacity in industry especially if prolonged results in intense price competition, e.g. underutilised capacity in auto industry results in very competitive pricing.
• Stability in market share reduces competition, e.g. loyalty of firms customers tends to stabilise market share and profits.
• More price sensitivity in customer buying decisions result in greater competition.
• Greater maturity of an industry results in slowing growth.

Question 19

How threat of entry and rivalry among competitors influence environment in an industry:

Answer 19

• Higher barriers to entry reduce competition.
• Greater concentration of firms in a market reduces competition, whereas market fragmentation (large number of firms with small market share) increases competition.
• Unused capacity in industry especially if prolonged results in intense price competition, e.g. underutilised capacity in auto industry results in very competitive pricing.
• Stability in market share reduces competition, e.g. loyalty of firms customers tends to stabilise market share and profits.
• More price sensitivity in customer buying decisions result in greater competition.
• Greater maturity of an industry results in slowing growth.

Question 20

Effects of barriers to entry

Answer 20

• Assess ease of entry by determining how easily new entrants to the industry could obtain capital, intellectual property, and customer base needed to be successful.
• One method is to examine the composition of the industry over time.
• High barriers to entry do not necessarily mean firm pricing power is high, it may also have strong price competition among existing firms, likely with products that are undifferentiated, or when high barriers to exit result in overcapacity.
• e.g. an automobile factory may have low value in alternative use, making firm owners less likely to exit industry, continuing to operate even when at a loss results in industry overcapacity and intense price competition.
• Low barriers to entry do not ensure the success of new entrants, as the competitive environment and barriers to entry change over time.

Question 21

Industry concentration

Answer 21

• Absolute market share may not matter as a firm’s market share to its competitors; such as firms A and firm B each have a 50% market share.
• Firm with a 10% market share with no competitor with more than 2% may have a good degree of pricing power and a high return on capital.
• Industry products are undifferentiated, then consumers switch to the lowest priced producer, with more importance on price increasing competition, leading to lower return on capital.
• Greater product differentiation to features, reliability, and service after the sale will have greater pricing power, with return on capital higher for firms can better differentiate products.
• Industry being capital intensive, so costly to enter or exit, overcapacity leads to intense competition.

Question 22

Industry capacity

Answer 22

• under capacity = demand exceeds supply at current prices, resulting in pricing power and higher return on capital.
• overcapacity = supply greater than demand at current prices, results in downward pressure on price and lower return on capital.
• fixed in the short-run and variable in long run, e.g producers may begin to order new equipment during economic expansion to increase capacity, but by the time they bring additional production on market, the economy may be in recession with reduced demand.
• Specialized physical capacity may have low liquidation value and be costly to reallocate to different products.
• Non-physical capacity (e.g. financing capital) can be reallocated more quickly to new industries.

Question 23

Market share stability

Answer 23

• High variability likely indicates a highly competitive industry in which firms have little pricing power.
• More stable market shares likely indicate less intense competition in the industry.
• Factors affect: barriers to entry, the intro of new products and innovations, switching costs customers face changing from one firm’s products to another.
• switching costs = time, the expense of learning to use competitors’ products, tend to be higher for specialized or differentiated products.

Question 24

Industry life cycle

Answer 24

The analysis should be a component of analysts’ strategic analysis, where an industry stage in cycle has an impact on industry competition, growth and profits.

The stage will change over time, so analysts must monitor it on an ongoing basis, and determine whether firm is acting at its age.

i.e. growth firms are not yet worried about their cost efficiency, they should not pay out cash flows to investors but save them for internal growth. But, mature firms find few opportunities for new products, and typically pay out cash to investors as dividends or stock repurchases as cash flow are strong but internal growth is limited.

This analysis is likely most useful during stable periods, not during periods of upheaval when conditions are changing rapidly.

Question 25

Characteristics of representative industries:

Answer 25

• Major firms: Cadbury, Hershey, Mars, Nestle
• Barriers to entry and success: very high, low capital and tech barrier, but consumers with strong brand loyalty.
• Industry concentration: very concentrated, largest 4 firms dominate global market share.
• Influence of industry capacity on pricing: none, pricing determined by strength of brand, not production capacity.
• Industry stability: very stable, market share changes slowly.
• Life cycle: very mature, growth is driven by population changes.
• Competition: low, and lack of unbranded candy makers in market reduces competition, as consumer decision is based on brand awareness not price.
• Demographic influences: N/A
• Gov. influence: low, industry is largely unregulated, but regulation arising from concerns about obesity is possible.
• Social influence: N/A
• Tech influence: very low, but limited impact from technology.
• Business cycle sensitivity: non-cyclical, and defensive, and demand for candy is stable.

Question 26

Macroeconomic factors

Answer 26

• interest rates affect financing costs for firms, as well as financial institution profitability.
• credit availability affects consumer and business expenditure and funding.
• inflation affects costs, prices, interest rates, and business and consumer confidence.#
• structural economic factor is education level of work force, more education increases worker productivity and real wages, in turn increase demand for consumer goods.

Question 27

Technology

Answer 27

• Computer hardware - undergone drastic transformation.
• Radical improvements in circuitry assisted by transformations in other industries, including computer software and telecoms industries.
• Photography transformation from film to digital media.

Question 28

Demographic factors

Answer 28

• a large segment of population reach their 20s, residential construction, furniture, and related industries reached increased demand.
• Aging population sees significant growth in health care industry, and developers of retirement communities.

Question 29

Governments

Answer 29

• Level of tax rates affect industries, e.g. tobacco.
• Specific regulations, e.g. entry into health care industry controlled by gov that license doctors and other providers.
• Empower self-regulatory organisations, such as stock exchanges regulate their members.
• Defense industry is heavily dependent on government.

Question 30

Social influences

Answer 30

• This relates to how people, work, play or spend time.
• e.g. women entering workforce in US, means the restaurant industry benefits as there’s less cooking at home, as well as child care, women’s clothing.

Question 31

Company analysis

Answer 31

This involves analysing the firms financial condition, products and services and competitive strategy.

Competitive strategy = how a firm responds to opportunities and threats of the external environment, the strategy may be defensive or offensive.

Question 32

Two competitive strategies:

Answer 32

1. Cost leadership (low cost) strategy - firm seeks lowest COP in industry, offer lower prices, and generate enough volume to make superior return.
   - the strategy can be used defensively to protect market or offensively gain market share.
   - predatory pricing = firm hopes to drive out competitors and later increases prices, but there are often laws prohibiting this so difficult to prove if firms costs not easily traced to a particular product.
   - Should have managerial incentives to improved operational efficiency.
2. Product or service differentiation strategy - the firms g/s should be distinctive in type, quality, and delivery.

• For success, the firms cost of differentiation must be less than price premium buyers place on product differentiation.
• Price premium should also be sustainable over time.
• Successful differentiators have outstanding marketing research teams and creative personnel.

Question 33

Elements of company analysis

Answer 33

• firm overview, including info on operations, governance, strengths and weakness.
• industry characteristics
• product demand
• product costs
• pricing environment
• financial ratios, with comparisons to other firms and overtime.
• projected financial statements and firm valuation
• financial analysis - ROE, a function of profitability, total asset turnover and financial leverage (debt).

Question 34

Spreadsheet modelling

Answer 34

• Used to analyse and forecast company fundamentals.
• Problem: the models complexity can make conclusions seem precise, but estimation is performed with error can compound overtime.
• An analyst should consider factors likely to be different going forward and how this will affect the firms, with assumptions explained.