Flashcards in industry classification Deck (23):
Reasons for categorisation by industry
Equity analysts (and other interested parties such as credit ratings analysts) often specialise in an industry and confine their research and advice to the relative merits of companies within that industrial group. The main reasons why this is so fall under two headings:
2. correlation of investment performance.
It is sensible for investment analysts to specialise within particular industrial sectors because:
The factors affecting one company within an industry are likely to be relevant to other companies in the same industry.
Much of the information for companies in the same industry will come from a common source and will be presented in a similar way.
No single analyst can expect to be an expert in all areas, so specialisation is appropriate.
The grouping of equities according to some common factor gives structure to the decision-making process. It assists in portfolio classification and management.
Correlation of investment performance
Research has shown that, after overall market movements have been taken into consideration, the share price movements of companies within industrial groupings tend to correlate more closely with each other than with companies in other industries. The share price movements reflect the changes that have occurred in the operating environment. Such changes affect companies in individual industries in similar ways.
Factors affecting one company in a sector that will probably be relevant to other companies in the same sector include:
resources: companies in the same sector will use similar resources (eg labour, land and raw materials), and will therefore have similar input costs
markets: companies in the same sector supply to the same markets, and will therefore be similarly affected by changes in demand
structure: companies in the same sector often have similar financial structures and will therefore be similarly affected by changes in interest rates.
As there is a degree of correlation between the shares of companies in the same sector
, investment managers construct their equity portfolios so that there is a good spread between sectors. In doing so, they would check to ensure that they are not over concentrated in sectors that are themselves positively correlated, eg “construction and materials” and “industrial engineering”.
Problems with industry groupings?
The FTSE (together with the Dow Jones) industry classification system is one example of a
stock classification system. Other systems are in use, for example the Standard and Poor’s classification in the US and the Morgan Stanley Capital International system for global equities.
The FTSE system classifies companies into ten industry groups, which are further divided into supersectors, sectors and subsectors.
The aim of the system is to group individual companies into subsectors based primarily on the company's source of revenue or where it constitutes the majority of revenue.
The industry groups and their characteristics are described below. Each group encompasses a wide range of industries so the characteristics outlined below can only be broad generalisations.
Oil and gas
These companies are involved in the extraction and supply of oil and gas products used throughout the economy.
Key characteristics are:
large companies. Many of the companies, particularly integrated companies, will be large multinationals (eg BP Amoco) competing on the world market. Indeed, several of the UK’s largest companies come from this group. Some smaller firms are involved in specialist areas (eg geological surveying).
commodity price dependent. Share prices in this sector may be more closely related to movements in oil prices than to general stock market or economic movements. Most commodities are priced in dollars (including oil) making them similar to a dollar-denominated investment.
risky. This is particularly true of smaller exploration companies. For example, striking or failing to strike oil can have a big impact on their share price. In other cases new technology (eg the emergence of renewable energy sources) could have an adverse impact.
global. In many cases, domestic sales will be a small proportion of total sales. This makes the state of the world economy more important than the state of the domestic economy for these companies.
This group includes the chemical industry and the mining industry, as well as companies producing steel and other metals, and those engaged in forestry and paper. As such, these companies are mainly producing “intermediate” goods.
Industrial companies are involved in the various stages in the supply and production of goods. Many of the goods tend to be capital items, ie aircraft, ships, machinery, electronic and electrical equipment. This group includes companies in the building material and construction industries, as well as industrial transportation and industry support services.
The distinctive features are:
dependent on the level of investment spending – the companies are dependent on the strength of the economy and in particular the level of economic investment, ie “capital formation”.
cyclical – the performance of general industrials is very dependent on the state of the economy and the trade cycle. The impact of the trade cycle can be heightened by the accelerator principle, which you may remember from Subject A102.
company profits tend to move ahead of the trade cycle – because capital expenditure throughout the economy is usually greatest at the start of a period of rapid economic growth. Share prices also move early in anticipation of a recovery.
dependent on government spending – a fairly large proportion of capital expenditure is under the control of the government (eg building roads, schools, hospitals), which means that general industrials may be exposed to the whims of government expenditure.
volatile profits – because of the volatile demand for capital goods (due to the accelerator principle), profits can be very volatile. Also, in some cases the unit size of production is large. In these cases, winning or losing a new contract can have a big impact on profits.
high profit margins when conditions are good – but when the economy moves towards recession, general industrials need to be able to cut their costs quickly to minimise their losses.
low gearing because of volatile profits – recall that the stability of profits is an important consideration when determining whether or not to invest in a particular corporate bond.
possibly exposed to overseas markets and competition – (eg engineering), in other cases domestic demand is more important (eg building materials).
Companies in the consumer goods groups manufacture consumer durables and non-durables. Durables include cars, furniture, televisions and “white goods” such as washing machines. Non-durables include food and drink and tobacco,
Generally the impact of an economic cycle is less severe on non-durable consumer goods companies than on general manufacturers. This is especially true for companies producing basic necessities.
Other key features are:
increasingly capital-intensive – increasing mechanisation of production processes is gradually increasing the proportion of added value from capital (where previously the industry has not been seen as capital intensive), reducing the degree of labour intensiveness in these industries.
importance of brand names – in many cases a strong brand name allows higher profit margins to be generated. Consequently, many firms in this sector have large advertising budgets. Brand names can be difficult to value.
increasingly international – as advertising and consequently brand names become known around the world, this sector is becoming increasingly international.
moderate to high gearing – gearing tends to be highest where profits are most stable, as investors are less inclined to lend at a fixed rate to riskier companies. Generally the impact of an economic cycle is less severe on consumer goods companies than on general industrials. The smaller unit size (of goods sold) for most consumer goods companies (compared with general industrials) also increases stability by reducing the dependence on individual customers.
low profit margins – due to extreme competition.
This group covers healthcare providers, medical equipment and supplies, as well as pharmaceuticals.
The companies in this group include food, drug and general retailers, media companies and companies in the travel and leisure industries, such as passenger airlines, casinos, hotels, bars and restaurants. Once again, the impact of the economic cycle will be greater on the cyclical industries.
Other key features are:
labour-intensive – most services depend upon labour more than capital.
Exceptions include hotels and retailers where property costs are high.
the more defensive companies in the group may have high gearing. Those with stable demand (eg food retailers) or with a strong asset base (eg hotels), are likely to have higher borrowings. More cyclical companies will probably have lower gearing.
the domestic market is the most important – most companies will depend heavily on the domestic market although some (eg hotels) may operate in several countries.
Utilities are involved in the supply of continuously demanded services to households and business premises. Examples include electricity, water and gas distribution. Most UK utilities were formerly owned by the government, having been privatised during the 1980s. They are vulnerable to some political risk and to changes in the regulations under which they operate.
Demand is very stable because the services that they provide are essential, or nearly essential, and because their market share will be stable (often at 100%). Thus, they are less affected by economic cycles than other groups.
Other points are:
They usually require an extensive physical infrastructure. This tends to make them capital intensive.
Most utility companies are natural monopolies due to the high fixed costs of setting up the infrastructure.
They are usually subject to tight government regulation of prices and vulnerable to other forms of political risk. The regulation is intended to prevent abuse of their monopoly position. Often, this involves a government watchdog imposing some restriction on their pricing policies, eg limiting price increases to inflation less k%.
They generally have low growth prospects; this leads to a high gross dividend yield and a lower price earnings ratio, than for any other sector. Low growth prospects are a result of:
– lack of potential sales volume growth due to monopoly position
– lack of profit margin growth due to regulatory control.
Despite their stable demand and large capital requirements, gearing is low (ie financial gearing – operational gearing may be high). This is because most of their debt was written off by the government prior to privatisation.
They are largely dependent on the domestic market, although some companies are diversifying internationally. In many cases close to 100% of sales will come from the domestic market. In the case of water and electricity distribution, 100% of sales may be from a single region within the domestic economy.
As a form of utility, these points also apply to some degree to telecommunications companies. However, deregulation of telecommunications markets has made the sector more volatile.
This group covers the providers of fixed line and mobile telephone services.
The financial group companies are the various industries making up the financial services industry, eg banks, general insurance companies, life assurance companies, investment trusts and real estate (property) companies.
The key distinctive feature of financial group companies is that they tend to be capital intensive.
banks are highly-geared and have volatile profits. Small changes in the difference between saving and lending rates can have a big impact on shareholders’ profits. Also, provisions for bad debts during a recession can wipe out profits entirely. Note that higher interest rates have two effects on banks:
1. their profits will tend to be reduced because they will have to increase their provision for bad debts.
2. profits will tend to increase due to the “endowment” effect, ie they benefit from higher interest on lending whilst the interest on some of their borrowing (eg your current account balance) remains at zero or at very low levels.
general insurers also have volatile profits and virtually no borrowings. This is because of the volatile nature of general insurance claims.
life insurers have stable profits and low gearing (profits are realised gradually over the life of their contracts which are long-term)
labour costs are important for many companies in the group. For the insurance contingent (life, composite and brokers) staff costs form a large proportion of the total costs. Staff costs are also significant for banks if compared with the difference between interest earned and interest paid. However, for property companies the cost of labour should be minor.
the domestic market is most important but there is increasing internationalisation as capital markets are deregulated. Companies involved in reinsurance often have a high proportion of overseas contracts.
These are the companies involved in the “new” industries of information technology hardware, software and the provision of computer services. While investor demand for such shares has caused share prices to increase dramatically in the past, many of the companies have yet to make profits or pay dividends. Dividend yields on these companies are therefore low, and their assets can be largely intangible.
The mnemonic FT MUG IS HOT
Financials, Technology, Basic Materials, Utilities, Consumer Goods, Industrials, Consumer Services, Health Care, Oil & Gas and Telecommunications.
“The profits of a major telephone company are unlikely to fall during a recession.” True or False?
In which of the groupings are profits most sensitive to:
the value of the dollar
the state of the domestic economy
fashion and social trends
Use each grouping only once.
Which grouping can be most closely compared to an investment in index-linked government bonds?
Two particular difficulties relate to:
1. companies that operate throughout several sectors, ie conglomerate companies. This is becoming more of an issue as companies increasingly diversify into new sectors by means of mergers and takeovers and leads to particular difficulties where the sectors involved are very different. A similar issue relates to multinational companies that may operate in several very different marketplaces.
2. the heterogeneity of companies within particular sectors. Companies may differ greatly even within the same sector – eg due to size, or because they operate within different niches of the market.
Profits in telecommunications companies (and other utilities companies)
are less sensitive to the economic cycle than profits in other industries. However, turnover will fall as businesses and to an extent domestic customers, make fewer calls. Costs will not fall to the same extent because of the high fixed costs of maintaining the infrastructure, ie marginal costs are very low.