Chapter 10 ECONOMIC AND INDUSTRY ANALYSIS. 1.2 Investments Chapter 10 Chapter 10 Questions What are the generic approaches to security analysis? What.

Chapter 10Chapter 10

ECONOMIC AND INDUSTRY ANALYSIS

1.2Investments Chapter 10

Chapter 10 Questions

What are the generic approaches to security analysis? What are the components of gross domestic product (GDP),

and what can they tell us about industry prospects? How do international economic factors affect the U.S.

economy? What are the major determinants of an economy’s long-term

growth?

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Chapter 10 Questions

What are the primary influences affecting the short-term growth of an economy?

What indicators can be used to forecast economic variables?

What is expectational analysis? How is the stock market related to economic

activity?

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Chapter 10 Questions

Why must an analyst review both cyclical change and structural change when analyzing an industry?

What are the five basic competitive forces that determine the intensity of competition in an industry and, thus, its rate of return on capital?

What is the industrial life cycle and its stages?

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Economic Analysis and Efficient Markets

If markets are efficient, should we bother with analysis?

Yes! In fact, in an efficient market, likely the only way to outperform market averages is to forecast the future better than the consensus.

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Generic Approaches to Security Analysis

Two basic approaches:Emphasize history, looking for trendsFocusing on the future

Still look at some historical information, but focus on looking forward to future trends

Top-down approachBottom-up approach

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Generic Approaches to Security Analysis

Top-Down Approach (Our focus)1. Review the macro-economy2. Analyze different industries and sectors3. Determine buy/sell candidates

Market analysis We can see the influence of changes in the overall

economy on various classes of investments Some investments do better than others before, during,

and after recessions, for instance

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A Quick Review of Economic Concepts

Domestic Economic Activity Forecasting trends in major economic variables such as

GDP, inflation, interest rates GDP (Gross Domestic Product) components

Consumption spendingInvestment spendingGovernment expendituresExport and import activity

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A Quick Review of Economic Concepts

Domestic Economic Activity Domestic Economic Policies

Monetary policyPolicies of the Fed to control the money supply and thereby affect

the overall economyOpen market operationsDiscount rate changesReserve requirement changes

Fiscal policyGovernment taxing and spending policies to influence the

economy and pursue other public interests

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A Quick Review of Economic Concepts

The Global Economy Domestic firms impacted by global competition and a global

business environment The health of foreign economies impacts domestic firms who

export Trade impacted by exchange rates

Exchange rates impacted by relative interest rates, inflation rates, and real economic growth within a country and across countries

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Economic and Security Market Influences

As we forecast economic growth, a number of factors will influence our expectations

Influences on Long-term ExpectationsTechnologyPopulationLabor force participationProductivityResource availabilityIncentives to expand

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Economic and Security Market Influences

Influences on Short-term ExpectationsInfluences caused by fluctuations in demandLiquidity and bank lendingMonetary policyInflationInterest ratesInternational influencesConsumer sentimentTax and other fiscal policyEconomic “shocks”

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Forecasting Tools

Searching for leading indicators that will provide signals of future economic directions

Inflation IndicatorsInflation at times is related to turning points in the business

cycleInflation destroys the purchasing power of wealthFederal Reserve actions indicate likely trends in inflation

Money supply and money growth rates relative to measures of economic growth

Commodity prices

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Forecasting Tools

Monetary IndicatorsImpact both inflation and liquidityFederal Reserve policy

Differences in Interest RatesThe Treasury yield curve can sometimes give indications

about future economic growth Cyclical Economic Indicators

Tracking “official” leading economic indicators Econometric Modeling

Models developed to forecast economic variables

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Risks in Economic Forecasting

Dominated by “group think”Always using consensus numbers ensures no better than

average forecastsForecasts must be different (often) and yet still correct

(usually) to create value Many analysts are short-sighted Lots of data can overwhelm us Try to support a position Over-reliance on expected “normal” changes without regard

to the possibility of “shocks”

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Expectational Analysis

Underlying concept: Forecasting should take into account:

The current environmentAssumptions behind estimatesA procedure for monitoring both changes in the

environment and violations of the assumptions being made

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Expectational Analysis

In the top-down approach:1. Analyze the current macro-economy and make

assumptions about future monetary and fiscal policies.Apply the analysis to sectors of the economy, identifying key assumptions made about the link between macroeconomic variables and sectors.

2. Apply to industries, linking macro and sector variables and monitoring values over time.

3. Apply to firms, noting Economy-Industry-Firm assumptions that affect recommendations.

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Industry Analysis

Many stock research firms organized analysts by industry groupingIndustry-specific expertise is valuable

Industry: a set of businesses that produce similar products used by customers for similar purposes

Sometimes useful to use various industry numerical classifications

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Links Between the Economy and Industries

Economic trends affect industry performance Economic trends:

Cyclical changes Ups and down of the business cycleDifferent industries experience unique results depending on the

point within the business cycleMay call for a “rotation” strategy

Structural changesChanges in government institutions, regulatory environment,

changes in technology, many moreNeed to anticipate structural changes and analyze the likely impact

on various industries

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The Stock Market and the Business Cycle

Financial Stocks Excel

trough

peakConsumer Durables

Excel

Capital Goods Excel

Basic Industries

Excel

Consumer Staples Excel

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Structural Influences

In addition to economic changes, various other trends also represent structural influences that will having varying effects across industriesSocial Influences

Demographics: baby boom and beyondLifestyles: changing definition of “traditional”Social values: environment, alcohol, tobacco

TechnologyPolitics and Regulation

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Competitive Structure of an Industry

Porter’s competitive forces are factors that determine a firm’s competitive environmentRivalry among existing competitors

Both price-based and non-price-based competitionThreat of new entrants

Are there barriers to entry?Threat of substitute productsBargaining power of buyers

Volume discounts, quality demandsBargaining power of suppliers

Can suppliers increase prices or reduce quality?

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Industry Life Cycle

Another tool: 5-stage industry life cycle model:1. Pioneering development

After marketing or technological breakthrough

2. Rapidly accelerating industry growthMarket develops, strong demand, new entrants

3. Mature industry growthGrowth starts to flatten

4. Stabilization and market maturityGrowth matches industry growth

5. Deceleration of growth and declineDeclining profits, some losses, exit from industry

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Sources of Industry Information

Standard & Poor’s Industry SurveyCovers over 50 major industries

Standard & Poor’s Analysts HandbookContains financial data

Value Line Industry SurveyDivides firms into industry groups

Individual InvestigationRead annual reports, industry publicationsCollect other relevant data from SEC filings, published

informationField interviews