CH 17 Macroeconomic and Industry Analysis

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Framework of Analysis

Fundamental Analysis– Top-down approach (“Three-Step” Valuation

ApproachDomestic and global economic analysis

Industry analysis

Company analysis

– Bottom-up approach

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Top-Down Approach

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Three-Step Valuation Approach

1. General economic influences– First examine the influence of the general economy on all firms and the

security markets– Decide how to allocate investment funds among countries, and within

countries to bonds, stocks, and cash (Go to “Economic Performance 2010” slide)

2. Industry influences– Determine which industries will prosper and which industries will suffer

on a global basis and within countries (Go to “Return on Equity by Industry” slide)

– Analyze the prospects for various global industries with the best outlooks in this economic environment

3. Company analysis– Turn to the analysis of individual firms in the preferred industries and to

the common stock of these firms.– Determine which companies in the selected industries will prosper and

which stocks are undervalued

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Does the Three-Step Process Work?

Studies indicate that most changes in an individual firm’s earnings can be attributed to changes in aggregate corporate earnings and changes in the firm’s industry

Studies have found a relationship between aggregate stock prices and various economic series such as employment, income, or production

Most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry

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1. THE GLOBAL ECONOMY

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Global Economic Considerations

Performance in countries and regions is highly variable

Political risk– The global environment may present much

greater risks than normally found in U.S.-based investments.

Exchange rate risk– Changes the prices of imports and exports.

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Economic Performance 2009

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Change in Real Exchange Rates

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2. THE DOMESTIC MACROECONOMY

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The Domestic Macroeconomy

Stock prices rise with earnings.

P/E ratios are normally in the range of 12-25.

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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S&P 500 vs. EPS Estimate

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Key Economic Variables

Gross domestic product

Employment

Inflation

Interest rates

Budget Deficits

Consumer sentiment

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U.S. GDP

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GDP by State

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Monthly Unemployment Rate

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Inflation Rate in U.S.

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Interest rates : Market data from WSJ

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U.S. National Debt

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Country foreign exchange reserves minus external debt

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Michigan Consumer Sentiment Index

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3. INTEREST RATES

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Factors Determining the Level of Interest Rates

Supply of funds from savers

Demand for funds from businesses

Government’s net supply and/or demand for funds

Expected rate of inflation– The Fisher Effect

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Determination of the Equilibrium Real Rate of Interest

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4. DEMAND AND SUPPLY SHOCKS

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Demand Shocks

Demand– An event that affects the demand for goods

and services in the economyReduction in tax rates

Increases in the money supply

Increases in government spending

Increases in foreign export demand

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Supply Shocks

Supply– An event that influences production capacity

and production costsChanges in the price of imported oil

Commodity price changes

Floods, Droughts

Changes in the wage rates

Educational level of economic participants

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5. FEDERAL GOVERNMENT POLICY

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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

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.– Initial & feedback effects

Increasing the money supply lowers interest rates and stimulates the economy.

Less immediate effect than fiscal policy

Tools of monetary policy– Open market operations (federal funds rate)

Most important

– 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.

Lowering tax rates will – elicit more investment – Improve incentives to work

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6. BUSINESS CYCLES

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Business Cycles

Recurring patterns of recession and recovery—business cycles– Peak– Trough

Industry relationship to business cycles– Cyclical – Defensive

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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Economic Indicators

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.

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Leading Indicators - tend to rise and fall in advance of the economy

Examples– Avg. weekly hours of production workers– Stock Prices or Stock market indexes– Initial claims for unemployment– Manufacturer’s new orders

Economic Indicators

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Leading Indicator

Stock Market as a Leading Indicator– Stock prices reflect expectations of earnings,

dividends, and interest rates– Stock market reacts to various leading

indicator series– Stock prices consistently turn before the

economy does

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Stock Market as a Leading Indicator

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S&P 500 Index Since 2007

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Coincident Indicators - indicators that tend to change directly with the economy

Examples– Industrial production– Manufacturing and trade sales

Economic Indicators (cont)

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Lagging Indicators - indicators that tend to follow the lag economic performance

Examples– Ratio of trade inventories to sales– Ratio of consumer installment credit

outstanding to personal income

Economic Indicators (cont)

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Indexes of Economic Indicators

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Cyclical Indicators

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Leading, Coincident, and Cyclical Indicators

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Useful Economic Indicators

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Economic Calendar

Many sources, such as The Wall Street Journal and Yahoo! Finance, publish the public announcement dates of various economic statistics.

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Economic Calendar at Yahoo!

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7. INDUSTRY ANALYSIS

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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.

ROE can range from 10.6% for electronic equipment to 29.2% for the cigarette industry

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Return on Equity by Industry

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Industry Stock Price Performance, 2006

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Industry Stock Price Performance, 2009

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Defining an Industry

Where to draw the line between one industry and another

North American Industry Classification System, or NAICS codes

Codes assigned to group firms for statistical analysis

Firms with the same four-digit NAICS codes are commonly taken to be in the same industry.

Industry classifications are never perfect

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Examples of NAICS Industry Codes

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Sensitivity to the Business Cycle

Three factors determine how sensitive a firm’s earnings are to the business cycle.

1. Sensitivity of sales:– Necessities (food, drugs, and medical

services) vs. discretionary goods (jewelry)– Items that are not sensitive to income

levels (such as tobacco and movies) vs. items that are, (such as machine tools, steel, autos, transportation)

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Industry Cyclicality

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Sensitivity to the Business Cycle

2. Operating leverageThe split between fixed and variable costs

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.

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Operating Leverage of Firms A and B

Throughout the Business Cycle

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Sensitivity to the Business Cycle

3. Financial leverage: – the use of borrowing– Interest is a fixed cost that increases the

sensitivity of profits to the business cycle.

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Stylized Depiction of the Business Cycle

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Sector Rotation

Sector rotation: Portfolio is shifted into industries or sectors that should outperform, according to the stage of the business cycle.

Selecting Industries in line with the stage of the business cycle Peaks: The economy might be overheated with high

inflation and interest rates, and price pressures on basic commodities. Invest on natural resource extraction firms such as

minerals or petroleum

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Sector Rotation, cont’d Contraction: The economy enters a contraction

or recession.Invest on defensive industries such as pharmaceuticals and food

Trough: The economy is poised for recovery and subsequent expansion. Invest on capital goods industries such as

equipment, transportation and construction firms

Expansion: The economy is growing rapidly. Invest on cyclical industries such as consumer

durables

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Sector Rotation

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Industry Life Cycles

Stages– Start-up: Rapid and increasing sales growth– Consolidation: Stable sales growth– Maturity: Slowing sales growth– Relative Decline: Minimal or negative sales

growth

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The Industry Life Cycle

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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 in a low-growth industry, especially one that’s boring and upsets people [such as funeral homes or the oil-drum retrieval business], 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

Michael Porter has highlighted 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

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An Example of Industry Analysis

Go to TxState Library Web Site

Go to Database

Under Database, find “Standard & Poor’s Net Advantage”

Click on “Industries.”

Choose the industry you want to find S&P industry analysis for recent quarter or year.

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Basic Sectors

Information Technology– AAPL, MU, GOOG

Telecommunication Services– T, VZ

Industrials – GE, CAT

Consumer Discretionary– GPS, GM

Basic Materials– MON, DOW

Energy– XOM, VLO

Consumer Staples– KO, PG

Health Care– PFE, LLY, MRK, JNJ

Utilities– DUK, FE

Financials– WFC, JPM

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