Level 1 CFA® Exam:
Industry Analysis - Introduction

We can distinguish among three approaches to industry classifications. These are:

• products or services supplied,
• business-cycle sensitivity, and
• statistical similarities.

Products or Services Supplied

Products or services supplied are the most common criterion applied in industry classification.

A group of companies manufacturing similar products or offering similar services makes up an industry. An automotive industry may serve us as an example. The further division includes heavy truck vehicles with Volvo, Daimler AG, or Navistar and commercial vehicles with Toyota, Honda, Volkswagen, or Ford, etc.

A few industries form a group called a sector, like a health care sector. The health care sector consists of industries such as the sale of pharmaceuticals or biotechnology.

Please note that nowadays many companies expand their business activities and so it's hard to determine what their primary business activity is. Because based on the principal business activity we can place companies in particular industries and sectors, the division is quite complicated.

General Electric is a company that can't be assigned to one industry or sector as its revenues come from a few different sources. Among them, we can find the power industry, movie industry, banking, or even rail industry.

Classification systems that are based on products or services supplied are:

• Global Industry Classification Standard,
• Russell Global Sectors,
• Industry Classification Benchmark.

(We described them below).

Business-Cycle Sensitivity

Another division of industries is based on a company's sensitivity to changes in the business cycle. And so, we have cyclical companies and non-cyclical companies.

(...)

Statistical Similarities

The statistical similarities approach is based on the correlation between past returns on companies' securities.

One technique is called cluster analysis. According to it, we form a group of companies that are characterized by a high correlation. Because of considerable changes in correlations between particular companies, the compositions of such groups depend on time or a geographical region.

Industry Classification in Practice

Before we describe different industry classification systems, let's have a look at some exemplary sectors:

• basic materials are represented by companies that manufacture building materials, paper, metal, etc.,
• consumer discretionary are represented by companies that manufacture consumer-related products such as apparel or provide services like restaurants or hotels,
• consumer staples are represented by companies with lower economic sensitivity which produce food, beverages, cigarettes, and so on,
• energy is represented by companies whose business activity involves natural resources exploration and energy production,
• financial services include banking, finance, and insurance,
• health care is represented by entities manufacturing pharmaceuticals or biotech products and so on.

Commercial Industry Classification Systems

Commercial industry classification systems are usually developed by index providers such as Standard & Poor’s or MSCI Barra. The division is typically complex. The structure includes multiple levels and sub-industry groups. Here are some classification systems developed by index providers:

• Global Industry Classification Standard,
• Russell Global Sectors, and
• Industry Classification Benchmark.

(...)

Governmental Industry Classification Systems

Among industry classification systems we can also distinguish governmental ones adopted by government agencies. Their purpose is to make it easier for analysts to compare data and evaluate the performance of different entities. Here are some examples:

• International Standard Industrial Classification of All Economic Activities,
• Statistical Classification of Economic Activities in the European Community,
• the Australian and New Zealand Standard Industrial Classification,
• North American Industry Classification System.

(...)

Advantages & Disadvantages of Industry Classification Systems

Of course, all of those systems have their strengths and weaknesses. A disadvantage of governmental classification systems is that they don't make a distinction between small and large businesses, or for-profit and not-for-profit organizations, neither do they distinguish between public and private companies.

What is more, in governmental industry classification systems no information about the classified companies may be disclosed. As a result, it's difficult to obtain information concerning entities that belong to a certain category.

A big advantage of both the commercial and governmental classification systems are regular updates at given times, though the governmental ones provide them less often.

1. When analyzing a company you should start with analyzing the industry that the company operates in.
2. We can distinguish three approaches to industry classifications among which we can find: products or services supplied, business-cycle sensitivity, and statistical similarities.
3. There are many different industry classification systems, but we can roughly divide them into governmental and commercial ones.
4. Peer groups are groups of companies that share similar characteristics and are affected by similar economic factors.