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Macroeconomic and Industry Analysis

CHAPTER 11

Fundamental Analysis Approach to Fundamental Analysis

Domestic and global economic analysis Industry analysis Company analysis

Why use the top-down approach

Framework of Analysis

Global Economic Considerations

Performance in countries and regions is highly variable

Political risk Exchange rate risk

Performance in countries CountriesGrowth in GDP(%) Countries Growth in GDPP(%)

Australia 2.6 Austria 0.7Belgium 0.7 Britain 2.0Canada 1.0 Denmark -0.8France -0.2 Germany -0.2Italy 0.5 Japan 1.8Netherlands -1.1 Spain 2.4Sweden 2.0 U.S. 3.5

Considerable variation in performance across countries expanding economies: more chance to succeed contracting economies: less chance to succeed Based on these performance, form expectation for your investment

economies growing economies slowing down

Political riskConsider 2 investors: A, an American wishing to invest in Indonesian stocks and an Indonesian wishing to invest in U.S. stocksWhich one would face a more difficult task when doing macroeconomic analysis?

Exchange rate riskUS investors: 2006: invest $1000 in Japan, exchange rate 1USD = 100 Yen, $1000 is worth 100,000 YenIn 2007: 1 USD = 110 Yen, 100,000 Yen = 909 USDLose $91

Domestic Economy

Gross domestic product Market value of goods and services produced over a period of

time Unemployment rates

The ratio of number of people classified as unemployed to the total labor force

Interest rates & inflation inflation is the rate at which the general level of prices is rising. High inflation is associated with overheated economy Trade-off between inflation and unemployment

Budget Deficits Government spending > government revenue

Consumer sentiment consumers’ optimism and pessimism about the economy

Interest rate4 Factors that can influence interest rates(1) Supply of fund (savers)(2) Demand of fund (borrowers)(3) Government net supply/fund(4) Expected inflation

Demand and Supply Shocks

Demand shock - an event that affects demand for goods and services in the economy Tax rate cut Increases in government spending

Supply shock - an event that influences production capacity or production costs Commodity price changes Educational level of economic participants

Federal Government Policy

Fiscal Policy - government spending and taxing actions Increase spending: increase demand tax increase: reduce demand Net impact:

budget deficit budget surplus

Federal Government Policy (cont.)

Monetary Policy - manipulation of the money supply to influence economic activity

Tools of monetary policyOpen market operationsDiscount rateReserve requirements

If government wants to tighten money supply, what should it do?

Business Cycle

Business Cycles Business Cycle

PeakTrough

Industry relationship to business cyclesCyclical

above average sensitivity to states of economy

Defensive below sensitivity to states of economy

Business Cycles (examples)

At trough, right before recovery, one would expect cyclical industries to outperform others (economy increases (decreases) by 1%, the industry increases

(decreases) by > 1%) Example: durable goods: auto, washing machine, financial industries Cyclical firms: betas > 1 or < 1, high or low betas?

Economy enters recession: cyclical or defensive example: food, public utilities, pharmaceutical Low or high betas? performance is stable, unaffected by market conditions

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

ExamplesAvg. weekly hours of production workersStock Prices Initial claims for unemploymentManufacturer’s new orders

NBER Cyclical Indicators: Leading

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

Examples Industrial productionManufacturing and trade sales

NBER Cyclical Indicators: Coincident

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

ExamplesRatio of trade inventories to salesRatio of consumer installment credit

outstanding to personal income

NBER Cyclical Indicators: Lagging

Industry AnalysisEstimates of Earnings Growth Rates in Several Industries, 2004

Industry stock performance in 2003 Industry Stock return (%)Telecommunication 3.6Pharmaceuticals 7.2Food products 7.7Insurance 16.5Health care 17.7Software 21.1Energy 22.9Retailing 28.1Entertainment 38.2Investment services 40.1Banking 40.5Wireless 49Communications technology 79.7Semiconductors 93.9

Industry Analysis

Sensitivity to business cycles Sector Rotation Industry life cycles

Sensitivity to Business Cycle

Factors affecting sensitivity of earnings to business cyclesSensitivity of sales of the firm’s product to the

business cyclesOperating leverageFinancial leverage

Figure 11.9 Industry Cyclicality Sensitivity of sales of the firm’s product to the business cycles

Operating leverage

Operating leverage = fixed cost / variable cost If operating leverage is high

fixed cost dominates variable cost When economy changes, cost do not move enough to offset change in

sale economy goes down, sale decreases, variable cost also decreases, but is

dominated by fixed cost, total cost is quite stable, therefore, earning goes down more than the economy

Sale increases, variable cost increases, but still dominated by fixed cost, total cost is quite stable, earning goes up more than economy

Earning is very sensitive to economy

If operating leverage is low: variable cost >> fixed cost sale goes down, total cost goes down sale goes up, total cost goes up earning is stable

Financial leverage

Use of borrowing Similar to fixed cost High financial leverage, earning is more sensitive to economy Low financial leverage, earning is more stable

Sector Rotation

Sector Rotation

Selecting Industries in line with the stage of the business cycle Near peak – natural resource firms: Minerals, Gas, etc Contraction – defensive firms: food, pharmaceutical, etc. Trough – equipment, transportation and construction firms Expanding – cyclical industries: consumer durables, luxury

items

Sector Rotation Gains

Industry Life CyclesStage Sales GrowthStart-up Rapid & Increasing

Consolidation Stable

Maturity Slowing

Relative Decline Minimal or Negative

Figure 11.11 The Industry Life Cycle

Industry Life Cycle Example: VCR Start-up: new, so sale and earnings go up rapidly Consolidation stage:

product is established, more firms enter, growth rate is stable, and higher than economy

Maturity stage product reach full potential use by consumers market is very competitive pay more dividends less on reinvestment

Relative decline new better products come in, e.g., DVD Substitute for old products