Introduction to industry and company analysis (Reading 51)

Exercise Problems:

1. Industry analysis is least useful to those who are engaged in:

A. a top-down investment approach.

B. portfolio performance attribution.

C. indexing and passive investing strategies.

 Ans: C;

C is correct. Indexing and passive investing strategies would not engage in over- or under-weighting of industries, industry rotation or timing investments in industries. Therefore, industry analysis is not useful to such investors or portfolio managers.

For Choice A, industry analysis is very useful to those using a top-down investment approach.

For Choice B, the industry representation within a portfolio is often a significant component of portfolio performance attribution analysis.

2. Industry rotation is best described as the:

A. adjusting the industry weights in a portfolio based on the current stage of the business cycle.

B. recommended practice of periodically changing the industries that investment analysts are assigned to cover.

C. long-term trend of talented managers and employees exiting mature and declining industries and entering embryonic and growth industries.

 Ans: A;

Industry rotation is an active management strategy of overweighting or underweighting industries, compared to their strategic allocation weights, based on the stage of the business cycle.

3. An analyst classifies Troger, Inc. an operator of retail grocery stores in the same industry group as Dynamac Corporation, a manufacturer of industrial machinery. This analyst’s classification system is most likely based on

A. Statistical methods.

B. Products and services.

C. Sensitivity to the business cycle

 Ans: A;

A is correct. This grouping is most likely the result of a cluster analysis and may have arisen by chance.

B is incorrect. The two firms clearly offer different products and services.

C is incorrect. An industrial machinery manufacturer is likely to be a cyclical firm, while a grocery retailer is likely to be a non-cyclical firm.

4. Fusion, Inc. is a manufacturer of sports apparel. Compacti, Inc. produces cardboard boxes for packaging. In a typical industry classification system from a commercial index provider, in which sectors are these firms most likely to be classified?

  Fusion, Inc. Compacti, Inc.

A. Consumer staples  Basic materials and processing

B. Consumer discretionary  Basic materials and processing

C. Consumer staples     Industrial and producer durables

 Ans: B;

Consumer discretionary firms are cyclical and are in industries such as apparel, automotive, and hotels and restaurants.

Basic materials and processing firms produce building materials, containers and packaging, chemicals, paper and forest products, metals, minerals and mining.

Industrial and producer durables firms produce capital goods for commercial services industries including heavy machinery and equipment, aerospace, defense, transportation and commercial services and supplies.

5. Which of the following classifications of firms is least likely to comprise cyclical firms?

A. Housing.

B. Technology.

C. Telecommunications.

 Ans: C;

A cyclical firm is one whose earnings are sensitive to changes in overall growth, which means the profits are highly dependent on the stage of the business cycle. Ex: technology, housing, basic materials and processing, industrial and producer durables, consumer discretionary, energy, and financial services.

A non-cyclical firm produces goods and services for which demand is relatively stable over the business cycle. Ex: health care, utilities, telecommunications, and consumer staples.

6. Lauren Liu, CFA, classifies firms in the energy industry in peer groups that include oil refinement and natural gas exploration. Liu learns that one of the oil refinement companies, SmartOil, derives half its revenue from its Smart NGEx subsidiary. Liu adds SmartOil to her peer group for natural gas exploration companies while continuing to include SmartOil in her peer group for Oil refinement operators. Is Liu’s treatment of SmartOil appropriate?

A. Yes.

B. No, because each company should be included in only one peer group.

C. No, because the bus operations are not the    company's principal business activity.

 Ans: A;

A Peer groups should include comparable companies with similar business activities. An analyst can appropriately include a company in multiple peer groups if the company's business activities are comparable to firms in more than one peer group.

7. According to the industry life-cycle model, an industry in the shakeout stage is best characterized as experiencing:

A. slowing growth and intense competition.

B. little or no growth and industry consolidation.

C. relatively high barriers to entry and periodic price wars.

 Ans: A;

A is correct. The shakeout stage is usually characterized by slowing growth, intense competition, and declining profitability.

B is incorrect. In the mature stage there is little growth and firms begin to consolidate.

C is incorrect. In the mature stage, there are high barriers to entry (surviving firms have brand loyalty and low cost structure) and periodic price wars may occur (but firms try to avoid price wars).

8. An industry experiencing slow growth, high prices, and volumes insufficient to achieve economies of scale is most likely in the:

A. mature stage

B. shakeout stage

C. embryonic stage 

 Ans: C;

An embryonic industry is one that is just beginning to develop and is characterized by slow growth, high prices, volumes not yet sufficient to achieve meaningful economies of scale, developing distribution channels, and low brand loyalty as there is low customer awareness of the industry’s product.

9. An industry in the growth phase of the industry life cycle is most likely to experience:

A. Increasing prices.

B. Increasing profitability.

C. Intense competition among competitors.

 Ans: B;

An industry in the growth stage is usually characterized by increasing profitability (due to economies of scale), falling prices (economies of scale are reached and distribution channels increase), and limited competitive pressures (the threat of new firms peaks but the growth allows firms to grow without competing on price).

10.  Over the past few years, the companies in an industry have experienced declining profitability and slowing growth, though profitability and growth remain positive. The companies have begun to compete intensely with each other and customers switch frequently among brands. This industry's life-cycle stage is most accurately described as:

A. decline.

B. maturity.

C. shakeout.

 Ans: C;

C is correct. The shakeout industry life-cycle stage is characterized by slowing but still positive growth, intense competition, and declining profitability, as demand begins to approach market saturation.

A is incorrect. The decline industry stage is characterized by negative growth.

B is incorrect. The lack of brand loyalty among customers suggests the industry has not yet reached the mature stage

11.  In the industry life cycle model, the threat of new entrants into an industry is greatest during the:

A. mature stage

B. growth stage

C. embryonic stage

 Ans: B;

B is correct. New competitors are more likely to enter an industry during the growth stage.

A is incorrect. In the mature stage, the industry tends toward an oligopoly as competitors consolidate.

C is incorrect. New entrants are less of a threat during the embryonic stage, when growth is slow and customer acceptance of the new product or service is highly uncertain.

12.  Archer Products is in an industry that has experienced low levels of price competition but recently excess capacity has led to aggressive price cutting. An analyst would be least likely to describe Archer’s industry as:

A. Concentrated and with high barriers to exit

B. in the shakeout stage with low concentration

C. in the maturity stage with high barriers to   entry

 Ans: C;

The maturity phase of an industry life cycle is not typically characterized by excess capacity or price competition. Therefore, choice C is the least likely situation.

For choice A, the conditions described may be consistent with a concentrated industry that is moving into the decline phase of an industry life cycle (excess capacity leads to aggressive -price cutting, especially when barriers to exit are high).

These conditions could also be consistent with an industry that is moving into the shakeout phase (characterized by developing excess capacity and intense price competition) following the growth phase.

13.  Which of the following industries is most likely characterized by low barriers to entry, fierce competition, fragmented structure, and weak pricing power?

A. Restaurants.

B. Proprietary drugs.

C. Credit card processing.

 Ans: A;

Restaurants industry is characterized by low barriers to entry because anyone with a modest amount of capital and some culinary skill can open a restaurant. The industry, however, is fragmented which can lead to fierce competition and weak pricing power.

14.  A company is most likely to earn economic profits if it is operating in an industry characterized by:

A. high industry concentration, high barriers to entry, and low industry capacity

B. low industry concentration, low barriers to entry, and low industry capacity.

C. low industry concentration, high barriers to entry, and high industry capacity

 Ans: A;

High industry concentration refers to an industry that has a small number of firms, which often leads to less price competition, higher pricing power, and higher return on invested capital.

High barriers to entry refer to industries where it is costly for new competitors to enter the industry, which allows companies already in the industry to maintain high profitability and prices.

Low industry capacity refers to a situation where demand is greater than supply at current prices, which allows companies to maintain high prices and profits.

15.  Which of the following factors least likely contributes to a stable market share?

A. High barriers to entry.

B. Intense competition.

C. High switching cost.

Ans: B;

High barriers to entry, low introduction of new products and innovation, less intense competition and high switching cost contribute to more stable market shares.

16.  An equity analyst follows two industries with the following characteristics.

Industry 1: A few companies with proprietary technologies; products with unique features; high switching costs; and minimal regulatory influences.

Industry 2: A few companies producing relatively similar products; sales varying with disposable income and employment levels; high capital costs and investment in physical plants; rapid shifts in market shares of competing firms; and minimal regulatory influences.

Based on the above information, the analyst will most appropriately conclude that compared to the firms in Industry 2, those in Industry 1 would potentially have:

A. larger economic profits.

B. over-capacity problems

C. high bargaining power of customers.

 Ans: A;

A is correct. Industry 1 is an industry adopting the differentiation strategy. Such industry tends to have greater pricing power, higher switching cost to customers and larger economic profits.

B is incorrect. Industry 2 with undifferentiated products tends to have intense rivalry and over-capacity problems.

C is incorrect. As said above, Industry 1 tends to have greater pricing power and thus customers have low bargaining power.

17.  A firm attempts to gain market share from its competitors by improving its manufacturing efficiency so that it can increase output and reduce the price of its product. This firm's competitive strategy is most accurately described as a(n):

A. offensive differentiation strategy.

B. offensive cost leadership strategy.

C. defensive cost leadership strategy.

 Ans: B;

A competitive strategy is described as defensive if it is used to maintain a firm’s market share and offensive if it is used to gain market share.

Cost leadership is a competitive strategy in which a firm attempts to become the lowest cost producer in the industry. This will enable the firm to offer lower prices than its competitors.

A differentiation strategy involves making the product distinct from competing products so that customers will be willing to pay a premium price.

18.  Companies pursuing cost leadership will most likely:

A. invest in productivity-improving capital equipment.

B. engage in defensive pricing when the competitive environment is one of high rivalry.

C. establish strong market research teams to match customer needs with product development.

 Ans: A;

A is correct. Companies pursuing cost leadership must be able to invest in productivity-improving capital equipment in order to be low-cost producers and maintain efficient operating systems.

 B is incorrect. When the competitive environment is one of high rivalry (intense), companies pursuing cost leadership will most likely engage in aggressive or even predatory pricing.

C is incorrect. Companies pursuing differentiation will establish strong market research teams and have creative personnel.

19.  An industry experiencing intense competitive rivalry among incumbent companies is best characterized by:

A. differentiated products and low exit barriers.

B. a small number of competitors and low fixed costs.

C. customers basing purchase decisions largely on price.

 Ans: C;

C is correct. In general, industries where price is a large factor in customer purchase decisions tend to be more competitive.

A is incorrect. Competition in industries with differentiated products is not as intense as that in industries with similar products.

B is incorrect. A small number of firms (greater concentration) reduces competition.