Course Content
MARKET ORGANIZATION AND STRUCTURE
This chapter is covered in Reading 36 of Study Session 12 of the institute. After reading this chapter, the candidate should be able to: a. explain the main functions of the financial system; b. describe classifications of assets and markets; c. describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes; d. describe types of financial intermediaries and services that they provide; e. compare positions an investor can take in an asset; f. calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call; g. compare execution, validity, and clearing instructions; h. compare market orders with limit orders; i. define primary and secondary markets and explain how secondary markets support primary markets; j. describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets; k. describe characteristics of a well-functioning financial system; l. describe objectives of market regulation.
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LOS A: Main Functions of Financial System
LOS B: Classification of Assets and Markets
LOS C: Types of Assets
LOS D: Financial Intermediaries
LOS E: Positions of Investors
LOS F: Margin
LOS G and H: Order Types
LOS I: Primary and Secondary Markets
LOS J: Trading
LOS K: Well Functioning System
LOS L: Objectives of Market Regulations
SECURITY MARKET INDEXES
This chapter is covered in Reading 37, of Study Session 12 of the material provided by the institute. After reading this chapter, a student should be able to: a. describe a security market index; b. calculate and interpret the value, price return, and total return of an index; c. describe the choices and issues in index construction and management; d. compare the different weighting methods used in index construction; e. calculate and analyze the value and return of an index given its weighting method; f. describe rebalancing and reconstitution of an index; g. describe uses of security market indices; h. describe types of equity indices; i. describe types of fixed-income indices; j. describe indices representing alternative investments; k. compare types of security market indices.
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LOS A: Security Market Index
LOS B: Index Return
LOS C: Index Construction
LOS D and E: Index Weightings
LOS F: Rebalancing and Reconstitution of Indices
LOS G: Uses of Security Market Indices
LOS H: Types of Equity Indices
LOS I: Fixed Income Indices
LOS J and K: Alternative Investment’s Indices
MARKET EFFICIENCY
This chapter is covered in Reading 38, of Study Session 12 of the material provided by the institute. After reading this chapter, a student should be able to: a. describe market efficiency and related concepts, including their importance to investment practitioners; b. distinguish between market value and intrinsic value; c. explain factors that affect a market’s efficiency; d. contrast weak-form, semi-strong-form, and strong-form market efficiency; e. explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management; f. describe market anomalies; g. describe behavioral finance and its potential relevance to understanding market anomalies.
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LOS A: Market Efficiency
LOS B: Market Value Vs. Intrinsic Value
LOS C: Factors That Affects the Market Efficiency
LOS D and E: Weak, Semi-Strong, & Strong Form of Market Efficiency
LOS F: Market Anomalies
LOS G: Behavioral Finance
OVERVIEW OF EQUITY SECURITIES
This topic is covered in the reading 39 of study session 13 of the study material provided by the institute. After reading this chapter a student should be able to: a. describe characteristics of types of equity securities; b. describe differences in voting rights and other ownership characteristics among different equity classes; c. distinguish between public and private equity securities; d. describe methods for investing in non-domestic equity securities; e. compare the risk and return characteristics of different types of equity securities; f. explain the role of equity securities in the financing of a company’s assets; g. distinguish between the market value and book value of equity securities; h. compare a company’s cost of equity, its (accounting) return on equity, and investors’ required rates of return.
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LOS A and B: Equity Securities
LOS C: Public & Private Equity Securities
LOS D: Non-Domestic Equity
LOS E: Risk and Return Characteristics of Different Types of Equity Securities
LOS F: Role of Equity Securities in Financing of Company’s Assets
LOS G: Market Value Vs. Book Value
LOS H: Cost and Return on Equity
INTRODUCTION TO INDUSTRY AND COMPANY ANALYSIS
This topic is covered in reading 40 of study session 13 of the study material provided by the institute. After reading this chapter a student should be able to: a. explain uses of industry analysis and the relation of industry analysis to company analysis; b. compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system; c. explain the factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descriptors such as “growth,” “defensive,” and “cyclical”; d. explain how a company’s industry classification can be used to identify a potential “peer group” for equity valuation; e. describe the elements that need to be covered in a thorough industry analysis; f. describe the principles of strategic analysis of an industry; g. explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition; h. describe industry life cycle models, classify an industry as to life cycle stage, and describe limitations of the life-cycle concept in forecasting industry performance; i. compare characteristics of representative industries from the various economic sectors; j. describe macroeconomic, technological, demographic, governmental, and social influences on industry growth, profitability, and risk; k. describe the elements that should be covered in thorough company analysis.
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LOS A: Industry Analysis
LOS B and C: Grouping and Classification of Company
LOS D: Peer Group
LOS E: Components of Industrial Analysis
LOS F: Principles of Strategic Analysis of Industry
LOS G: Effects of Various Factors
LOS H: Life Cycle Models
LOS I and J: Industry Comparison
LOS K: Elements of Thorough Company Analysis
EQUITY VALUATION: CONCEPTS AND BASIC TOOLS
This topic is covered in reading 41 of study session 13 of the study material provided by the institute. After reading this chapter a student should be able to: a evaluate whether security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market; b describe major categories of equity valuation models; c describe regular cash dividends, extra dividends, stock dividends, stock splits, reverse stock splits, and share repurchases; d describe dividend payment chronology; e explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-flow-to-equity models; f calculate the intrinsic value of a non-callable, non-convertible preferred stock; g calculate and interpret the intrinsic value of equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate; h identify characteristics of companies for which the constant growth or a multistage dividend discount model is appropriate; i explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables; j calculate and interpret the following multiples: price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value; k describe enterprise value multiples and their use in estimating equity value; l describe asset-based valuation models and their use in estimating equity value; m explain the advantages and disadvantages of each category of the valuation model.
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LOS A : Intrinsic Value and Market value
LOS B: Categories of Equity Valuation Model
LOS C: Dividends, Stock Splits, and Share Repurchases
LOS D: Dividends Payment Chronology
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LOS E: Present Value Models
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LOS F: Intrinsic Value of Non-Callable Non-Convertible Preferred Stock
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LOS G: Gordon Growth Model
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LOS H: Multi-Stage Dividend Discount Models
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LOS I and J: Price Multiples
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LOS K: Enterprise Value Multiples
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LOS L: Asset Based Valuation
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LOS M: Advantage and Disadvantages of Each Model
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Equity Investments
About Lesson

The companies can be classified using more than one criterion, i.e. through product or services, geographical location, sector, industry, etc. These classifications are discussed in detail as follows:

1.         By Product/ Services.

The companies are placed in industries based on their principal business activities that form the source of the majority of their revenues or earnings. The industry represents a group of companies offering similar goods and services. A sector, on the other hand, is a group of related industries.

2.         By Business Cycle Sensitivity.

a.  The industries may be classified as cyclical or non-cyclical based on their sensitivity to the business cycles.

b.  The performance of a cyclical industry is correlated with the performance of the economy as a whole. They usually witness a relatively high demand during expansion and lower ones during contractions. These industries generally have a very high operating leverage, characterized by a high fixed cost and low variable cost. These usually consist of durable and discretionary goods, such as home electronics.

c.  Whereas, the performances of the companies belonging to non-cyclical industries are relatively independent of business cycles. These industries generally have a very stable demand over the business cycle. They mainly consist of consumable and non-discretionary items industry, such as healthcare and utilities.

d.  The non-cyclical industry may be classified into two groups, i.e. the defensive industry and the growing industry.

e.  A defensive industry is the one, where the revenues/profits are least affected by the fluctuations in economic activities. Examples of defensive industries are stapled consumer goods industries, the basic services industry, and the ones determined by regulations.

f.  In growth industries, on the other hand, there are specific demand dynamics that override the broad economic factors. This sector generates growth regardless of the phase of the business cycle.

g.  The economic downturns do affect all the companies in an economy. Thus, the cyclicality of an industry is not an absolute factor; some industries are considered just relatively more cyclical than others.

h.  Countries across the world witness different stages of a business cycle at different times. Therefore, it is inappropriate to establish common industry benchmark values for all industries across different countries.

3.         By Statistical Similarities

a.  Here the industries are classified together based on the correlations of past returns. The main logic behind such grouping is that such correlated companies have the same drivers that result in growth, fall, business cycles, etc. of those companies.

b.  This type of classification is done using Cluster Analysis or Clustering. It is a statistical technique of grouping together the data or companies in a cluster, having similar statistical characters.

4.         Commercial Industry Classification System

4.1.     GICS – Global Industry Classification Standard

a.  GICS classification is based on the principal business activity followed by the companies.

b.  It is basically a four-tier classification system. Under this classification, the economy is classified into 10 sectors. These 10 sectors are then classified into 24 industry groups, which are then classified into 68 industries. Finally, there are 154 sub-industries.

GICS – Global Industry Classification Standard Equity Investment CFA Level 1 Study Notes

4.2.     Russell Global Sectors

a.  This classification system classifies the industries based on the goods and services produced by it.

b.  Under this classification, the economy is divided into 9 sectors, having 32 sub-sectors. These sub-sectors are divided into 141 industries.

Russell Global Sector Equity Investment CFA Level 1 Study Notes

4.3.     ICB – Industry Classification Benchmark

a.  This classification system classifies the industries based on their primary source of revenue.

b.  There is a four-tier classification under this system. 10 sectors are classified into 19 super-sectors, which are then classified into 41 sectors. Finally, there are 114 sub-sectors.

Equity Investment CFA Level 1 Study Notes

5.         Broad Groupings of Major Sectors

a.  Consumer Discretionary. This is a very diverse sector, having categories ranging from durable goods to non-durable goods and luxury sector, etc. Some of the examples of this sector are the automobile industry, hospitality industry, apparels, FMGC, etc.

b.  Consumer Staples (Non-Discretionary). This sector includes consumer goods with less long-term durability. Some of the examples of this sector are food, beverage, personal care products, etc.

c.  Energy Sector. This sector relates to companies that produce or supply energy. This sector includes the companies involved in exploration, production, refining, etc of resources or providing services to such companies.

d.  Financial Services. This sector involves companies providing financial services to commercial or retail customers. Some of the examples of this sector are banking, insurance, asset management companies, etc.

e.  Healthcare Sector. This sector includes the companies that are involved in the production of goods and services related to healthcare. Some of the examples of this sector are the companies engaged in the production of biotech, pharmaceuticals, medical devices, etc.

f.  Basic Material and Processing. This sector includes the companies engaged in the production of building materials, chemicals, forest products, etc.

g.  Industrial/ Producer Durable Sector. This sector includes the companies involved in the production of goods with longer shelf life and that are used in the production of other goods and services. Heavy machinery, aerospace, defense equipment, transportation goods, etc. are produced by this sector.

h.  Technology Sector. This sector includes the companies involved in research and development and production of technology-based goods and services. Some of the examples of this sector are computer, software, internet service provider companies, etc.

i.  Telecommunication Sector. This sector includes the companies involved in the provision of fixed-line and wireless services.

j.  Utilities. This sector involves the companies providing utilities such as gas and power.

6.         Government-Industry Classification System

There is a government-industry classification system for industries in almost each of the countries. And, there is international classification as well. Some of the most common classification systems are:

a.  ISIC – International Standard Industrial Classification. This is a classification system for all economic activities notified by the United Nations, based on primary business activities.

b.  NACE – nomenclature statistique des activités économiques dansla Communauté européenne. It is an industrial classification system used by the European Union for the classification of all economic activities in the European Community.

c.  ANZSIC – Australian & New Zealand Standard Industrial Classification. It is an industrial classification system used in Australia and New Zealand.

d.  NAICS – North American Industrial Classification System. It is an industrial classification system used in North America.

7.         Advantages of Using Commercial Classification System Over Government Classification System

The main advantages of using the commercial classification system over the government system are:

a.  Government systems do not disclose information about specific businesses;

b.  The commercial systems get reviewed and updated more frequently;

c.  The government systems do not distinguish between small and large businesses, between profit and not-for-profit organizations, between public and private companies; whereas the commercial classifications only include for-profit and publicly traded companies.

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