Economy and Industry analysis
Unit IV
Top-down approach for security
analysis
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• 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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• 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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• 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
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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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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• Gross domestic product
• Unemployment rates
• Inflation
• Interest rates
• Budget deficit
• Consumer sentiment
The Domestic Macroeconomy:
Key Variables
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).
Gross Domestic Product: II
Where:
C is consumption, I is investment,
G is government spending, (X – M) is net trade.
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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
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Demand-side Policy
• Fiscal policy – the government’s spending and taxing actions
• Monetary policy – manipulation of the money supply
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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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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)
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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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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.
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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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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
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• 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
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
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
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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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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Figure 17.10 A Stylized Depiction of the Business Cycle
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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.
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
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
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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
Sector Rotation
• Trough – capital goods industries
• Expansion – cyclical industries such as consumer durables
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.
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.
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.
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.
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Industry Life Cycles
Stage
• Start-up
• Consolidation
• Maturity
• Relative Decline
Sales Growth
• Rapid and increasing
• Stable
• Slowing
• Minimal or negative
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Figure 17.12 The Industry Life Cycle
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
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
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
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
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.
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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. . . .
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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
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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