Chapter 9 Investment Environment. 2 Dimensions of the Economy Macroeconomic Environment Macroeconomics – Study of aggregate measures of economic activity

Chapter 9

Investment Environment

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Dimensions of the EconomyMacroeconomic Environment

• Macroeconomics – Study of aggregate measures of economic activity– International– National– Regional– State

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• Gross Domestic Product (GDP) – measures the final market value of goods and services produced by all labor and property located in the U.S.– For Domestic Firms– For a given period– Does not reflect domestic production for

foreign-owned enterprises – • i.e. Toyota Camrys produced in Kentucky

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• Macroeconomic Forecasts commonly reported include:– Predictions of consumer spending– Business investment– Home building– Exports– Imports– Federal purchases– State and local government spending

• Widely followed by the press• Difficult to develop: may involve thousands of economic

variables and hundreds of functional relationships

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• Macroeconomic predictions are important because they’re :– Used by businesses and individuals to make day-to-day

and long-term investment decisions• Interest rates projected to rise:

– Homeowners rush to refinance fixed-rate mortgages– Businesses float new bond and stock offerings to refinance

existing debt

• If predictions are accurate – cost savings and revenue gains become possible

• If predictions are inaccurate – higher costs and lost marketing opportunities occur

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Dimensions of the EconomyMicroeconomic Environment

• Microeconomics – is the study of economic data at the industry, firm, plant, or product level

• Not widely followed by the press • Microeconomic trends are much easier to accurately

forecast – Narrower range of important factors to be considered– However microeconomic forecasting is not easy and not

always precise:• i.e. Actual new vehicles sold in 1994 = 15.4 million

– Ford forecasted demand – 14.5 million– GM forecasted demand – 14 million– Chrysler forecasted demand – 16 million

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Macroeconomic ForecastingBusiness Cycles

• Common Stock Investing – gives investors the opportunity to share in the benefits provided by economic growth– Profit and sales performance of all companies depends to

some extent on the vigor of the overall economy.– Business activity in the U.S. expands at roughly 7.5% per

year in terms of GDP– In inflation adjusted or real dollars = 3% expansion

• 7.5% less 4.5% inflation = 3%• During robust expansions – real GDP 4 – 5%• During severe recessions – GDP can decline

– Significant impact on highly leveraged companies

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• Business Cycle – Rhythmic pattern of contraction and expansion in the overall economy.– Troughs and Peaks

– Important consideration for investors

– Between Oct 1954 and March 1991:• 9 complete business cycles

• Cycle contraction average duration – 11 months

• Cycle expansion average duration – 50 months– Periods of economic expansion dominate

– Healthy and growing economy indicator

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• Despite intense interest and widespread news coverage– The causes of economic contractions and

expansions remain something of a mystery• The economy shifts from boom to bust

• “Why” the economy shifts from boom to bust is largely beyond our knowledge

• Changes in the pattern and pace of economic activity remain a matter of intense debate

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Macroeconomic ForecastingEconomic Indicators

• Economic Indicators – data series that describe the pattern of projected, current, or past economic activity– Leading Economic Indicators and Related

Composite Indexes (Figure 9.2, page 336)– Indicators of business-cycle peaks broadly

relied on in business-cycle forecasting:

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Macroeconomic ForecastingEconomic Indicators

– Leading Index – cyclical turning points occur “before” those in aggregate economic activity

• Building permits precede housing starts• Orders for plant and equipment lead production in durable goods

industries• Reflect plans or commitments for the activity that follows

• Common Stock prices reflect aggregate profit expectations by investors –

• a consensus view of the likely course of future business conditions

– Coincident Index – cyclical turning points tend to occur at about “the same time” as those in aggregate economic activity

– Lagging Index - cyclical turning points generally occur “after” those in the aggregate economic activity

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Macroeconomic Forecasting Economic Indicators

• Composite Index – Weighted average of leading, coincident, or lagging economic indicators– Creates a forecasting series with less random

fluctuation (noise)– Smoother than the underlying individual data series– Produces false signals of change in economic

conditions less frequently– Turns down just prior to the start of each recessionary

period– Rises just prior to the start of each subsequent

economic expansion

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Macroeconomic Forecasting Information about Economic Trends

• Leading business periodicals publish forecast data and analysis– Investors rely on data to make informed judgments about

vital economic trends• Useful starting point in the development of their own future

expectations• Barron’s –

– Market Laboratory - Economic Indicators (Figure 9.3, Page 338)– Level of production – (what is made)– Distribution (what is sold)– Inventory (what is on hand)– New orders received, Unfilled orders, Purchasing power, Employment,

Construction Activity

• Forbes, Fortune, and Business Week magazines

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Macroeconomic ForecastingProblem of Changing Expectations

• The expectations of purchasing agents and other managers can become a self-fulfilling prophecy– If business purchasing agents are optimistic about future trends

in the economy:• Boost inventories in anticipation of surging customer demand

– Inventory buildup can contribute to economic growth

– If purchasing agents fear an economic recession:• Cut back on orders and inventory growth

– The cut back can contribute to any resulting economic downturn

– Business leaders can help lead to a growing economy– Government-employed and / or politically motivated

economists often actively seek to manage economic expectations of business leaders and the general public

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Population Growth and Demographics

Population Growth

• Growing Value of the stock market is tied to economic growth– Population growth is a prime contributor to economic

growth– With annual GDP growth of 7.5% consisting of:

• 4.5% inflation + 3% real business activity expansion

– Population growth - 1% of real GDP growth per year– Productivity growth – 2% of real GDP growth per year

• Ability of a fixed amount of labor, capital, and equipment to produce a growing amount of output (increased efficiency)

– As long as economic or productivity growth exceeds the population growth, economic well-being is increased

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Population Growth and DemographicsDemographics

• 1946 – 1964 the U.S. population growth rate reached 1.8% per year – Baby Boom– Just after WWII

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• By 2020, the nation’s Baby Boomers will range in age from 56 – 74 – “Benefits” of a maturing population:

• Increased savings – stock market investments

• Added productivity

– “Concerns”• Market crash as they dump stocks and bonds to finance their

retirement

• Strain on Social Security (funded by fewer current workers)’

• Strain on Medicare

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– However: • Many Baby Boomers will not retire at 65 (as their parents)• The concept of retirement as we know it today may go out of

style– Boomers are apt to stay on the payroll because:

• They like to work• The “golden years” concept is long dead• Demand a vital role in American life• Staying healthy longer• Can’t afford to retire – haven’t set aside enough for

comfortable retirement• The age at which one qualifies for full Social Security

System benefits is gradually rising

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– Even a slight delay in the average retirement age:• Large tax windfall for the Social Security and Medicare• Combined output of experienced workers could keep fueling

economic growth• Delay in selling financial assets

– IRS – offers senior citizens huge incentives to avoid realizing capital gains

• Retain financial assets to death Heirs pay taxes only on any appreciation earned after the time of inheritance

– Creates huge benefits for stock and bond markets and the overall economy

– Therefore, it’s safe to bet that negative economic and financial market effects tied to the aging of the Baby Boom generation have been greatly exaggerated

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Productivity GrowthProductivity Surveys

• The U.S. Commerce Department - conducts mandatory annual surveys regarding detailed annual statistics:– The annual study takes the form of a mail

survey

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• Annual Survey of Manufacturers basic data obtained include:

• Kind of business• Location• Ownership• Value of shipments• Payroll• Employment• Cost of materials• Inventories• New capital expenditures• Fuel and energy costs• Hours worked• Payroll supplements

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– Statistics collected for industry groups– Geographic area reports– Reports on Exports

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• The Bureau of Labor Statistics uses info to:– Calculate annual productivity series– Update producer price indexes– Calculate weights for new index components

• The Federal Reserve Board uses to:– Prepare the Index of Industrial Production

• The Bureau of Economic Analysis uses to:– Prepare annual GDP updates – Weights for GDP deflators

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• The Department of Commerce’s International Trade Administration uses export data to:– Evaluate and forecast industrial activity

• State and Local agencies use the data to:– Design trade and economic policies

• Private industry and trade associations us data to:– Plan operations, analyze markets, and make investment

and production decisions

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Productivity GrowthChanges in Productivity Growth

• Productivity Growth – – Pace of economic betterment– The rate of increase in output per unit of input

• One of the most prominent uses of economic survey information is to track the pace of economic betterment, or productivity growth, in the overall economy.

• Example: if output grows by 5% following only a 2% increase in the quantity of inputs, then the overall rate of productivity growth would be roughly 3% (Increased efficiency)

• Robust productivity growth:– Economic welfare rises quickly– Superior efficiency is suggested– Exceptional profitability often ensues

• Sluggish productivity growth:– Economic welfare improves slowly

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Competitive EnvironmentInvestment Strategy in

Hotly Competitive Markets

• The firm’s competitive environment is described by the market structure it faces

• Market Structure – Characterized on the basis of four important industry characteristics:– 1. Number and size distribution of active buyers and sellers

and potential entrants – individuals or firms posing a sufficiently credible threat of market entry to affect the price / output decisions of incumbent firms

– 2. The degree of product differentiation– 3. The amount and cost of information about product price

and quality– 4. Conditions of market entry and exit

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• Effects of Market Structure are measured in terms of:– Firm profits– Investor rates of return– Prices paid by consumers– Availability and quality of output– Pace of product innovation

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• Disequilibrium Profits – Above-normal returns earned in the interval between – the time when a favorable influence on industry

demand or cost conditions first occurs and– when competition fully develops

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• Disequilibrium losses – are below-normal returns suffered in the time interval that can arise between:– When an unfavorable influence on industry

demand or cost conditions first transpires and– When exit or downsizing finally occurs

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• When barriers to entry and exit are significant:– Competitor reactions tend to be slow– Disequilibrium profits can persist for extended

periods

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• The greater the number of market participants:– The more vigorous the price and product quality

competition, which tend to lead to:• Meager business profits • Poor investor returns

• Exception: superior efficiency can sometimes lead to superior profits even in competitive markets– McDonald’s Corp– Wal-Mart Stores

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Imperfectly Competitive Markets

• Imperfectly Competitive Markets – some blend of competition and monopoly– Never ending search for uniquely attractive products

• Monopoly – A single seller• Oligopoly – Few Sellers• Only difficult-to-enter monopoly and oligopoly

markets hold the potential for long-lasting above-normal returns

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• Not all industries offer the same potential for sustained profitability– Number and size distribution of competitors– Degree of product differentiation– Level of information available in the marketplace– Conditions of entry when assessing the investment

merits of a given company

• All this contributes to the difficulty of correctly assessing the profit potential of current products or prospective lines of business.

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• An effective investment strategy in imperfectly competitive markets must be based on the search for firms with a clear competitive advantage.

• Competitive Advantage – is a unique or rare ability to create, distribute, or service products valued by customers.– Long-lasting above-normal rates of return require a

sustainable competitive advantage that cannot be easily duplicated

• Product differentiation

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How are Markets Measured?Economic Census

• Economic Census – Comprehensive statistical profile of the economy from the national to the state, to the local level.– Measures the percentage market share concentrated in

(or held by) an industry’s top firms• Leading-firm market share data calculated from sales

information for various clusters of top firms

– Primary source of detailed public facts about the nation’s economy

– Taken at five-year intervals during years ending with the digits 2 and 7

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• Companies use census data to:– Lay out territories– Allocate advertising– Locate new stores of offices

• Firms supplying goods and services to other businesses use census date to:– Target industries for business-to-business marketing

• Manufacturers look at stats on:– Materials consumed:

• To learn more about industries that use their products • To gain insight concerning industry growth potential

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• Investors:– Compare operating ratios to census averages to see how

they stack up against competitive norms

• Consultants, government researchers, and job seekers use census data to:– Analyze changes in industrial structure, location, and

the pace of growth in job opportunities

• Industry trade associations and news media study census data to:– Learn key business facts and to project trends

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• North American Industry Classification System (NAICS) – is a method for categorizing establishments by the principal economic activity in which they are engaged.– Classifies North America’s economic activities

at 2, 3, 4, 5, and 6 digit levels of detail– Table 9.4 and 9.5, Page 350

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How are Markets Measured?Concentration Ratios

• Concentration Ratios – Data that show the percentage market share held by a group of leading firms– When concentration ratios are low:

• Industries tend to include many firms and competition tends to be vigorous

– When concentration ratios are high:• Leading firms dominate

• Concentration Ratio Weakness: • Ignores domestic sales for foreign competition (imports)• Ignores exports by domestic firms• National totals – while an economic market may be national,

regional, or local in scope.

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Legal EnvironmentRegulation

of the Competitive Environment• Regulation – Government Control

– Operating regulations:• Pollution emissions• Product packaging and labeling• Worker safety and health

– Financial regulations:• Interest rates, fees, lending policies, and capital requirements

• Regulation compliance:– Drives up administrative costs and product prices, most

of which are passed on to the consumer• An important concern to investors

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Legal EnvironmentAntitrust Policy

• Antitrust Policy – Laws and rules designed to promote competition– Regulates merger activity:

• Evaluate expected cost savings / efficiencies vs.possible harm to competition

• May restrict pricing of a merged firm or force the firm to divest a product line

• Does market entry seem likely to offset the effects of increased concentration

– And will consumers incur switching costs

– The narrower the market, the more likely a merger will be investigated:

• Staples and Office Depot – the two largest firms in their market– Stifle competition and increase prices - anticompetitive

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Legal EnvironmentAntitrust Policy

– Attempts to eliminate anticompetitive practices • Cartels – Price fixing and monitoring among few

competitors– Airline and Nasdaq Market Makers – Secret Cartel

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Corporate GovernanceCorporate Governance Inside the Firm

• Corporate Governance – Control system that helps corporations effectively administer economic resources– Failure to effectively command the firms economic

resources can be blamed on a failure of Corporate Governance

– Useful means for eliminating any potential divergence of interests between managers and stockholders

• Incentive Pay – Compensation according to measurable performance

– Profit Increase– Sales Increase– Stock Price Increase

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Corporate GovernanceOwnership Structure

• Capital Structure – the breakdown of debt and equity used to finance total assets

• Ownership Structure – Divergent claims on the value of the firm:– Inside equity – Common stock held by management and

other employees (info contained in the annual Proxy Stmt)– CEO– Top managers – Members of the board of directors.– Employees – (ESOP)

• When insider holdings are “large”, substantial self-interest in the ongoing performance of the firm can be presumed

– Incentive to run the firm in a value maximizing manner

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– Widely dispersed outside equity • top management can sometimes become insulated

from the threat of stockholder sanctions following poor operating performance

– Widely dispersed outside debt– Bank debt

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– Institutional equity – Common stock held by mutual funds, pension plans, and other large investors

• Increasing Trend• Managers have strong incentives to maximize corporate

performance• Institutional investors have a high probability of managerial

inefficiency or malfeasance discovery– Fiduciary responsibilities forces institutional investors to tender

shares in the event of an above-market tender offer or takeover bid. Managers are more susceptible to unfriendly takeover bids if not acting in the best interest of the shareholders

– Many must liquidate holdings in the event of dividend omissions or bankruptcy filings

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Answers to Selected End of Chapter 9 Questions

and Suggested Study

• Study the following end-of-chapter questions:

• 2. (b)• 3. (a)• 5. (c)• 6. (c)• 7. (d)• 8. (c)• 9. (b)• 10. (a)

• 11. (b)• 12. (d)• 13. (d)• 14. (d)• 18. (d)• 19. (a)• 20. (b)• Read the Chapter • Read the Chapter

“Summary” • Review the Power Point

Presentation

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Chapter 9 Investment Environment. 2 Dimensions of the Economy Macroeconomic Environment Macroeconomics – Study of aggregate measures of economic activity