ECONOMIC AND INDUSTRY ANALYSIS

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Chapter 13

• ECONOMIC AND INDUSTRY ANALYSIS

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Chapter 13 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 economys
  long-term growth?

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Chapter 13 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 13 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 trends
• Focusing on the future
• Still look at some historical information, but
  focus on looking forward to future trends
• Top-down approach
• Bottom-up approach

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Generic Approaches to Security Analysis

• Top-Down Approach (Our focus)
• Review the macro-economy
• Analyze different industries and sectors
• 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 spending
• Investment spending
• Government expenditures
• Export and import activity

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A Quick Review of Economic Concepts

• Domestic Economic Activity
• Domestic Economic Policies
• Monetary policy
• Policies of the Fed to control the money supply
  and thereby affect the overall economy
• Open market operations
• Discount rate changes
• Reserve requirement changes
• Fiscal policy
• Government 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 Expectations
• Technology
• Population
• Labor force participation
• Productivity
• Resource availability
• Incentives to expand

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Economic and Security Market Influences

• Influences on Short-term Expectations
• Influences caused by fluctuations in demand
• Liquidity and bank lending
• Monetary policy
• Inflation
• Interest rates
• International influences
• Consumer sentiment
• Tax and other fiscal policy
• Economic shocks

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Forecasting Tools

• Searching for leading indicators that will
  provide signals of future economic directions
• Inflation Indicators
• Inflation at times is related to turning points
  in the business cycle
• Inflation destroys the purchasing power of wealth
• Federal 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 Indicators
• Impact both inflation and liquidity
• Federal Reserve policy
• Differences in Interest Rates
• The 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 forecasts
• Forecasts 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 environment
• Assumptions behind estimates
• A 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
• 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.
• Apply to industries, linking macro and sector
  variables and monitoring values over time.
• 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 grouping
• Industry-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 cycle
• Different industries experience unique results
  depending on the point within the business cycle
• May call for a rotation strategy
• Structural changes
• Changes in government institutions, regulatory
  environment, changes in technology, many more
• Need to anticipate structural changes and analyze
  the likely impact on various industries

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The Stock Market and the Business Cycle
Basic Industries Excel
Consumer Staples Excel
peak
Consumer Durables Excel
ECONOMIC
CYCLE
Capital Goods Excel
trough
Financial Stocks 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 industries
• Social Influences
• Demographics baby boom and beyond
• Lifestyles changing definition of traditional
• Social values environment, alcohol, tobacco
• Technology
• Politics and Regulation

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Competitive Structure of an Industry

• Porters competitive forces are factors that
  determine a firms competitive environment
• Rivalry among existing competitors
• Both price-based and non-price-based competition
• Threat of new entrants
• Are there barriers to entry?
• Threat of substitute products
• Bargaining power of buyers
• Volume discounts, quality demands
• Bargaining 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
• Pioneering development
• After marketing or technological breakthrough
• Rapidly accelerating industry growth
• Market develops, strong demand, new entrants
• Mature industry growth
• Growth starts to flatten
• Stabilization and market maturity
• Growth matches industry growth
• Deceleration of growth and decline
• Declining profits, some losses, exit from industry

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Sources of Industry Information

• Standard Poors Industry Survey
• Covers over 50 major industries
• Standard Poors Analysts Handbook
• Contains financial data
• Value Line Industry Survey
• Divides firms into industry groups
• Individual Investigation
• Read annual reports, industry publications
• Collect other relevant data from SEC filings,
  published information
• Field interviews