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(1)

Economy and Industry analysis

Unit IV

(2)

Top-down approach for security

analysis

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17-3

A firm’s value comes from its earnings prospects, which are determined by:

The global economic environment Economic factors affecting the firm’s

industry

The position of the firm within its industry

Fundamental Analysis

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17-4

Stock markets around the world responded in unison to the financial crisis of 2008.

Performance in countries and regions can be highly variable.

It is harder for businesses to succeed in a contracting economy than in an expanding one.

The Global Economy

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17-5

• Political risk:

– The global environment may present much greater risks than normally

found in domestic environment.

• Exchange rate risk:

– Changes the prices of imports and exports.

The Global Economy

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International Parity Relationships:

• Purchasing Power Parity

The relationship between two countries’

inflation rates and their foreign exchange rates.

• International Fisher Relationship

The relationship between nominal interest

rates and inflation rates in different countries.

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17-7

The Domestic Macroeconomy

• Stock prices rise with earnings.

• P/E ratios are an indicator.

• The first step in forecasting the performance of the broad market is to assess the status of the economy as a whole.

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17-8

Gross domestic product

Unemployment rates

Inflation

Interest rates

Budget deficit

Consumer sentiment

The Domestic Macroeconomy:

Key Variables

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Gross Domestic Product:

The value of all goods and services produced in an economy in a particular period of time.

The GDP has four components:

1. Consumption.

2. Investment.

3. Government spending.

4. Net trade (exports less imports).

(10)

Gross Domestic Product: II

Where:

C is consumption, I is investment,

G is government spending, (X – M) is net trade.

(11)

17-11

Demand and Supply Shocks

Demand shock - an event that affects

demand for goods and services in the

economy

Supply shock - an event that influences

production capacity or production costs

(12)

17-12

Demand-side Policy

• Fiscal policy – the government’s spending and taxing actions

• Monetary policy – manipulation of the money supply

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17-13

Fiscal Policy

• Most direct way to stimulate or slow the economy

• Formulation of fiscal policy is often a slow, cumbersome political process

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17-14

Fiscal Policy

• To summarize the net effect of fiscal policy, look at the budget surplus or deficit.

• Deficit stimulates the economy because:

– it increases the demand for goods (via spending) by more than it reduces the demand for goods (via taxes)

(15)

17-15

Monetary Policy

• Manipulation of the money supply to influence economic activity.

• Increasing the money supply lowers

interest rates and stimulates the economy.

• Less immediate effect than fiscal policy

• Tools of monetary policy include open

market operations, discount rate, reserve requirements.

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17-16

Supply-Side Policies

• Goal: To create an environment in which workers and owners of capital have the maximum incentive and ability to

produce and develop goods.

• Supply-siders focus on how tax policy can be used to improve incentives to work

and invest.

(17)

17-17

Business Cycles

The transition points across cycles are called peaks and troughs.

A peak is the transition from the end of an expansion to the start of a contraction.

A trough occurs at the bottom of a

recession just as the economy enters a recovery.

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17-18

The Business Cycle

Cyclical Industries

Above-average sensitivity to the state of the economy.

Examples include producers of consumer durables (e.g.

autos) and capital goods (i.e. goods used by other firms to produce their own products.)

High betas

Defensive Industries

Little sensitivity to the business cycle

Examples include food

producers and processors, pharmaceutical firms, and public utilities

Low betas

(19)

17-19

Leading indicators tend to rise and fall in advance of the economy.

Coincident indicators move with the market.

Lagging indicators change subsequent to market movements.

Economic Indicators

(20)

A. Leading indicators

1. Average weekly hours of production workers (manufacturing) 2. Initial claims for unemployment insurance

3. Manufacturers’ new orders (consumer goods and materials industries)

4. Fraction of companies reporting slower deliveries 5. New orders for nondefense capital goods

6. New private housing units authorized by local building permits 7. Yield curve slope: 10-year Treasury minus federal funds rate 8. Stock prices, 500 common stocks

9. Money supply (M2) growth rate 10. Index of consumer expectations

(21)

B. Coincident indicators

1. Employees on nonagricultural payrolls 2. Personal income less transfer payments 3. Industrial production

4. Manufacturing and trade sales C. Lagging indicators

1. Average duration of unemployment 2. Ratio of trade inventories to sales

3. Change in index of labor cost per unit of output 4. Average prime rate charged by banks

5. Commercial and industrial loans outstanding

6. Ratio of consumer installment credit outstanding to personal income

7. Change in consumer price index for services

(22)

The Economy and Financial Markets

• The semi-strong form of the EMT predicts that macroeconomic data cannot be used to earn abnormal returns.

• Indeed, stock market indices are among the best-performing leading indicators for the business-cycle.

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17-23

Industry Analysis

• It is unusual for a firm in a troubled industry to perform well.

• Economic performance can vary widely across industries.

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17-24

Figure 17.10 A Stylized Depiction of the Business Cycle

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17-25

Sensitivity to the Business Cycle

1. Sensitivity of sales:

Necessities vs.

discretionary goods

Items that are not sensitive to income levels (such as tobacco and movies) vs.

items that are, (such as

machine tools, steel, autos)

• Three factors determine

how sensitive a firm’s

earnings are to the business cycle.

(26)

Sensitivity to the Business Cycle

Firms with low operating

leverage (less fixed assets) are less sensitive to business

conditions.

Firms with high operating leverage (more fixed assets) are more sensitive to the

business cycle.

2. Operating

leverage : the split between fixed and

variable costs

(27)

Sensitivity to the Business Cycle

• Interest is a fixed cost that increases the sensitivity of profits to the business

cycle.

3. Financial

leverage: the use of

borrowing

(28)

17-28

Sector Rotation

• Portfolio is shifted into industries or

sectors that should outperform, according to the stage of the business cycle.

• Peaks – natural resource extraction firms

• Contraction – defensive industries such as pharmaceuticals and food

(29)

Sector Rotation

• Trough – capital goods industries

• Expansion – cyclical industries such as consumer durables

(30)

Sector rotation

• Near the peak of the business cycle, the economy might be overheated with high inflation and interest rates, and price

pressures on basic commodities. This might be a good time to invest in firms engaged in

natural resource extraction and processing such as minerals or petroleum.

(31)

Sector rotation

Following a peak, when the economy enters a contraction or recession, one would expect defensive industries that are less sensitive to economic conditions, for example,

pharmaceuticals, food, and other necessities, to be the best performers. At the height of the

contraction, financial firms will be hurt by

shrinking loan volume and higher default rates.

Toward the end of the recession, however,

contractions induce lower inflation and interest rates, which favor financial firms.

(32)

Sector rotation

• At the trough of a recession, the economy is poised for recovery and subsequent

expansion. Firms might thus be spending on purchases of new equipment to meet

anticipated increases in demand. This, then, would be a good time to invest in capital

goods industries, such as equipment, transportation, or construction.

(33)

Sector rotation

• Finally, in an expansion, the economy is growing rapidly. Cyclical industries such

as consumer durables and luxury items will be most profitable in this stage of the cycle.

Banks might also do well in expansions, since loan volume will be high and default exposure low when the economy is growing rapidly.

(34)

17-34

Industry Life Cycles

Stage

• Start-up

• Consolidation

• Maturity

• Relative Decline

Sales Growth

• Rapid and increasing

• Stable

• Slowing

• Minimal or negative

(35)

17-35

Figure 17.12 The Industry Life Cycle

(36)

The early stages of an industry are often characterized by a new technology or product such as VCRs or personal computers in the1980s, cell phones in the 1990s, or the new generation of smart phones introduced more recently. At this stage, it is difficult to predict which firms will emerge as industry leaders.

Some firms will turn out to be wildly successful, and others will fail altogether.

Therefore, there is considerable risk in selecting one particular firm within the industry.

For example, in the smart phone industry, there is still a battle among competing technologies, such as BlackBerry, Google’s Android phones, and Apple’s iPhone. Predicting which firms or technologie.sAt the industry level, however, sales and earnings will grow at an extremely rapid rate,

because the new product has not yet saturated its market Start-up

(37)

Consolidation Stage

After a product becomes established, industry leaders begin to emerge. The survivors from the start-up stage are more stable, and market share is easier to predict. Therefore, the performance of the surviving firms will more closely track the

performance of the overall industry. The industry still grows faster than the rest of the economy as the product penetrates the marketplace and

becomes more commonly used

(38)

Maturity Stage

At this point, the product has reached its full potential for use by consumers. Further growth might merely track growth in the general economy. The product has become far more standardized, and producers are

forced to compete to a greater extent on the basis of price. This leads to narrower profit margins and further pressure on profits. Firms at this stage sometimes are characterized as cash cows, having reasonably stable cash flow but offering little opportunity for profitable expansion. The cash flow is best “milked from” rather than reinvested in the company

(39)

Relative Decline

• In this stage, the industry might grow at less than the rate of the overall economy, or it might even shrink. This could be due to

obsolescence of the product competition from new low-cost suppliers, or competition from new products, as illustrated by the steady

displacement of VCRs by DVD players

(40)

Investment in various stages of life cycle

At which stage in the life cycle are investments in an industry most attractive? Conventional wisdom is that investors should seek firms in high-growth industries.

This recipe for success is simplistic, however. If the security prices already reflect the likelihood for high growth, then it is too late to make money from that knowledge. Moreover, high growth and fat profits encourage competition from other producers. The exploitation of profit opportunities brings about new sources of supply that eventually reduce prices, profits, investment returns, and finally growth. This is the

dynamic behind the progression from one stage of the industry life cycle to another.

(41)

17-41

Which Life Cycle Stage is Most Attractive?

• Quote from Peter Lynch in One Up on Wall Street:

" Many people prefer to invest in a high-growth industry, where there’s a lot of sound and fury.

Not me. I prefer to invest in a low-growth industry. . . .

(42)

17-42

Which Life Cycle Stage is Most Attractive?

…In a low-growth industry, especially one that’s boring and upsets people [such as funeral

homes], there’s no problem with competition. You don’t have to protect your flanks from potential rivals . . . and this gives you the leeway to

continue to grow.”

Peter Lynch in One Up on Wall Street

(43)

17-43

Industry Structure and Performance:

Five Determinants of Competition

1. Threat of entry

2. Rivalry between existing competitors 3. Pressure from substitute products

4. Bargaining power of buyers 5. Bargaining power of suppliers

References

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