Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024: Equity (CFA Level I)/Industry and Competitive Analysis

Industry and Competitive Analysis

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Uses of Industry Analysis and Classification Systems5 min

Industry analysis is fundamental for investors to understand a firm's business environment. It provides a framework for understanding potential growth, competition, and risks, including appropriate debt levels and credit risk. A key application is industry rotation, which involves overweighting or underweighting industries based on the current phase of the business cycle. Performance attribution analysis helps identify the sources of portfolio return relative to a benchmark.

Industry classification systems group companies to facilitate comparison. Commercial classifications like GICS (S&P/MSCI), ICB (FTSE Russell), and TRBC (Refinitiv) use hierarchical structures (Sectors, Industry Groups, Industries). For example, GICS has 11 sectors and 25 industry groups. Government classifications like ISIC and NAICS are used for statistical purposes but have limitations for investors, such as not identifying constituent firms and less frequent updates.

Key Points

Industry rotation involves adjusting portfolio weights based on business cycles.
Commercial classifications (GICS, ICB) identify constituent firms and are updated frequently.
Government classifications (NAICS, ISIC) do not distinguish between public/private or profit/non-profit firms.
GICS has 11 Sectors; ICB has 11 Industries.
Classification limitations include multi-product firms and changes in business models over time.

Cyclicality and Strategic Groups4 min

Firms are often categorized by their sensitivity to the business cycle. Cyclical firms, such as those in Energy, Financials, and Technology, have earnings that fluctuate significantly with the broader economy. Non-cyclical firms are less dependent on the business cycle and are split into Defensive and Growth categories. Defensive industries (e.g., FMCG, Healthcare, Utilities) are stable, while Growth industries experience strong demand largely independent of the economic cycle.

Another method of grouping is by 'cluster analysis' or statistical methods. However, limitations exist, such as narrow geographic focuses or evolving business models that span multiple categories.

Key Points

Cyclical firms: Earnings highly dependent on business cycle (e.g., Auto, Tech).
Non-cyclical firms: Stable demand.
Defensive industries: Least affected by economic downturns (e.g., Staples, Utilities).
Growth industries: Demand is strong and independent of the cycle.
Statistical clustering can be used to group similar industries.

Industry Survey and Concentration5 min

Conducting an industry survey involves estimating the industry's size and growth. Analysts calculate growth rates (YoY or CAGR) and decompose growth into volume and price/mix drivers. For sectors with many private companies, analysts rely on economic indicators and surveys.

Industry concentration is a critical measure of competition. The Herfindahl-Hirschman Index (HHI) is calculated by summing the squares of the market shares of the firms in the industry. A higher HHI signifies higher concentration and typically less competition, which may attract regulatory scrutiny.

Key Points

Industry survey steps: Estimate size, calculate growth, analyze volume vs. price.
HHI measures industry concentration.
HHI calculation: Sum of squared market shares of top firms.
High HHI implies less competition and potential antitrust issues.
Private company analysis requires reliance on aggregate economic data.

Competitive Forces and External Influences6 min

Porter's Five Forces is the standard framework for analyzing industry competition: 1) Rivalry among existing competitors, 2) Threat of entry, 3) Threat of substitutes, 4) Power of buyers, and 5) Power of suppliers.

External macro factors are analyzed using the PESTLE framework: Political (fiscal policies), Economic (GDP, inflation), Social (demographics), Technological (disruptive innovations), Legal (regulations), and Environmental (carbon economy transition).

Finally, competitive positioning assesses how a firm creates value. Strategies include Cost Leadership (low cost), Differentiation (unique products), and Focus (niche markets). A firm failing to adopt a clear strategy is described as being 'Stuck in the Middle'.

Key Points

Porter's Five Forces determines industry attractiveness and profitability.
PESTLE analyzes external macro-environmental factors.
Competitive strategies: Cost Leadership, Differentiation, Focus.
'Stuck in the Middle' is an undesirable state lacking a clear strategy.
Intentional strategy is planned; unintentional strategy is driven by inertia.

Questions

Question 1

Which of the following is a primary use of industry analysis?

Industry and Competitive Analysis

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