Macroeconomic and Industry Analysis

CHAPTER 12

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Framework of Security AnalysisSecurity Analysis (or Fundamental analysis)– The analysis to determine values of firms, by

predicting earnings and dividends with publicly economic and accounting information

Three levels of security analysis– Global and domestic economic analysis (Ch 12)– Industry analysis (Ch 12)– Company analysis (equity valuation in Ch 13 and

financial statement analysis in Ch 14)

Why use the top-down sequence– Sometimes macroeconomic and industry

circumstances might have a greater influence on profits than the firm’s relative competitiveness within its industry

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International economic analysis– Illustrate the global economic risk, regional or

country risks, and exchange rate risk

Domestic economic analysis– Introduce key domestic economic variables– Interest rates analysis– Analysis of demand and supply shocks– Fiscal and monetary policies of the government– Business cycle analysis

Industry analysis– Sensitivity of industry performance to business cycle

(sector rotation strategy)– Life cycles of an industry

The Goals of Chapter 12

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12.1 THE GLOBAL ECONOMY

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Global Economic AnalysisGlobal economic risks– Subprime and credit crises in 2008 (introduced in

Ch 2)The subprime crisis in the U.S. spreads over the world through MBS

Credit crisis: Financial institutions worldwide lose much capital in the subprime crisis and stop the lending business due to the doubt of the credit quality of other banks and business firms

– The economies of most countries are affected by the subprime and credit crises in 2008 (Table 12.1)

Stock markets in virtually all countries were deeply affected, with average returns typically worse than –40%

Different performance in countries and regions implies the existence of regional and country risks

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Table 12.1 Economic Performance, 2008

※ There is considerable variation in economic performance across countries, e.g., while China grew by 9.6% in GDP, the GDP in Japan grew by only 0.3%

※ Exchange rate risk: due to the depreciation of the Venezuela currency, there is a substantial difference between the stock market return in local currency and in U.S. dollars

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Global Economic AnalysisRegional or country risks – two crises– Asian financial crisis in 1997

The boom of Thailand economy in 1996 and 1997 attracted international capital inflow, which resulted in the highly sufficient currency supply in Thai economy

Thai banks extended credit to domestic firms beyond what Thailand could support, which resulted in serious depreciation of Thai baht and economic recession

The international speculators attacked not only Thailand but also neighboring Asian nations, some with and some without characteristics similar to Thailand, like Indonesia, Philippines, Malaysia, South Korea, Taiwan, etc

※These events in different nations highlighted the close interplay between politics and economics, and the currency value and stock market performance

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Global Economic Analysis– Russian financial crisis in 1998

From 1995 to 1998, Russian borrowers (both government and non-governmental) had gone to the international capital markets for large quantities of capital, i.e., to borrow dollar-denominated Eurobonds

Falling global commodity prices reduced the trade surplus of Russia since its exports were predominantly commodity-based, e.g., oil sales were 45% of the amount of exports in 1997

With the deterioration in general economic conditions and the deficiency of currency reserves of the Russian Central Bank in August of 1998, the Russian ruble devaluated and Russian government rescheduled the payment of sovereign (government) debt

It was the first time that the government debt defaulted

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Global Economic Analysis

Exchange rate risks– Affect the international competitiveness of a

country’s industries and thus affect sales and profits of business firms and stock returns of investors

The depreciation of the local currency will benefit exporters but hurt importers in that country

The gains for the investment in foreign stocks may be enhanced or reduced after taking the exchange rate into consideration

– The poor performance of the stock market of Venezuela in U.S. dollars demonstrates the effect of the exchange rate risk could be substantial

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12.2 THE DOMESTIC MACROECONOMY

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Key Economic VariablesIn order to earn abnormal profits with the macroeconomic analysis, you must forecast the economic condition better than others– Introduce some key economic variables to assess

the status of the macroeconomy

Gross domestic product (GDP) (國內生產毛額 )– The measure of the economy’s total production of

goods and services– Rapidly growing GDP indicates an expanding

economy

Industrial production index (工業生產指數 )– A measure of economic activity narrowly focused

on the manufacturing side of the economy (ignoring services)

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Key Economic VariablesEmployment (就業 )– The unemployment rate is the percentage of the

total labor force (those who are either working or actively seeking employment) yet to find work

– The unemployment rate measures the extent to which the economy is operating at full capacity

Capacity utilization rate (focusing on the manufacturing side) (產能利用率 )– The ratio of actual output from factories to potential

output– Measure the extent to which the manufacturing of

the economy is operating at full capacity※Higher levels of these two rates imply that the

macroeconomy performs as could as it can

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Key Economic Variables

Inflation (通貨膨脹 )– The rate at which the general level of prices is

rising– High Inflation rates are often associated with

“overheated” economies, i.e., the demand for goods and services exceeds productive capacity, which leads to upward pressure on prices

– Trade-off between inflation and unemployment: stimulate the economy enough to maintain nearly full employment, but not so much as to bring inflationary pressures

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Key Economic VariablesBudget Deficits (預算赤字 )– The budget deficit of the government is the

difference between government spending and taxes– Any budgetary shortfall must be offset by

government borrowing (through issuing T-bonds)– Large amounts of government borrowing could force

up the interest rate and thus “crowd out” private borrowing and investing

Interest rates (利率 )– High interest rates reduce the PV of future CFs,

thereby reducing the attractiveness of investment opportunities

Therefore, high interest rates could restrain the overheated economy

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Key Economic VariablesSentiment indicator (消費者心理因素指標 )– Consumers’ and producers’ optimism or pessimism

concerning the economy are important determinants of economic performance

– Beliefs influence how much consumption and investment will pursued and thus affect the aggregate demand for goods and services

– For example, the consumer confidence index (CCI) is calculated and published in many countries (in Taiwan, the CCI survey is conducted by NCU)

The P/E ratio rule: – For S&P 500 index, the P/E ratio tends to be in the

range of 12 to 25 (see Fig 12.2)– The exact P/E ratios for market indexes vary with

the above mentioned economic variables

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Figure 12.2 S&P 500 versus EPS Estimate

※ EPS is defined as the earnings per share for the S&P 500 index portfolio

※ The series of S&P 500 is almost between the series of 12 × EPS and 25 × EPS, which implies that the P/E ratio is on average in the rage of 12 to 25

25

12

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12.3 INTEREST RATES

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Interest RatesThe level of IRs is one of the most important macroeconomic factor to be considered in one’s investment analysis– Forecasts of IRs affect present values and thus

expected returns for investments (especially fixed-income investments)

– For stock markets, increases in interest rates tend to be bad news

High IRs reduce the PVs of stock investment

High IRs attract investors to deposit capital in banks (or invest in fixed-income securities offering high yields) and thus affect the incentive to invest in stocks

– However, forecasting IRs is one of the most difficult parts of applied macroeconomics

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Interest RatesFour factors determining the IRs※The first three factors determine the level of real

interest rates (see Fig. 12.3) and the last factor is the expected inflation rate

1. Supply of funds from saversSupply ↑ the supply curve is shifted to the right (for the same real IR, funds supply ↑) equilibrium real IR ↓

2. Demand for funds from businessesDemand ↑ the demand curve is shifted to the right (for the same real IR, funds demand ↑) equilibrium real IR ↑ (from point E to point E’)

3. Government’s net supply or demand for fundsCurrency supply ↑ real IR ↓ (stimulate economic growth)

Government borrowing demand ↑ real IR ↑

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Figure 12.3 Determination of the Equilibrium Real Rate of Interest

※ The fund-supply curve slopes up from left to right because the higher the real interest rate, the greater the fund supply from household savings

※ The fund-demand curve slopes down from left to right because the lower the real interest rate, the more projects firms will undertake, due to the lower capital cost

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Interest Rates

4. Expected rate of inflationInterest rates contain a premium for expected inflation

The Federal Reserve (the central bank) typically raises interest rates proactively when inflation is expected to increase

※Short-run effect of money supply from the government: to shift the supply curve to the right and lower the equilibrium real IR

※Long-run effect of money supply from the government: to increase prices of goods (thus increase the inflation rate and the nominal IR), but has no permanent impact on the real economic activities (like aggregate output, consumption level, and employment) and the real interest rates

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12.4 DEMAND AND SUPPLY SHOCKS

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Demand ShocksDemand shock– An event that affects the demand for goods and

services– Demand could increase due to, for example,

Reduction in tax rates

Increases in the money supply, governmental spending, and foreign export demand

– Positive demand shocks is usually associated with the increases of IRs and inflation rates(demand ↑ demand > supply price and thus inflation rate ↑ nominal IR ↑; or demand ↑ funds needed by businesses ↑ IR ↑)

Increases of demand generally implies the expansion and boom of the economy

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Supply ShocksSupply shock– An event that influences production capacity and

costs– Supply decreases due to, for example,

Increases of prices of raw materials

Freezes, floods, or droughts that may destroy agricultural crops

Decreases in the wage rates– Negative supply shocks are usually associated

with the increases of IRs and inflation rates (supply ↓ demand > supply price and thus inflation rate ↑ nominal IR ↑)

Negative supply shocks result in reduced output, leading to slower economic growth

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Demand and Supply ShocksHow to relate the above knowledge to investment analysis?– Choose industries that will be helped by your

expectation about the change of the demand and supply and avoid those that will be hurt

For example, positive demand shock choose the automobile or luxury producers, which benefit most from the positive demand shock

(in contrast, food producers, for example, also benefit from the positive demand shock but not much)

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12.5 FEDERAL GOVERNMENT POLICY

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Government PolicyDemand-side policy– The economy will not by itself arrive at a full

employment equilibrium, so macroeconomic policies are used to affect the demand for goods and services to stimulate the economy toward this goal

– Most fiscal and monetary policies are based on this demand-oriented argument

Supply-side policy– The goal is to create an environment in which

workers and owners of capital have the maximum incentive and ability to produce and develop goods

– For example, the proponents of this method argue that lowering tax rates will elicit more investment and improve incentives to work, thereby enhancing economic growth

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Fiscal PolicyFiscal policy– The use of government spending and taxing

actions to stabilize or spur the economyIncreases in government spending directly inflate the demand for goods and services

Increases in tax rates immediately siphon income from consumers and result in fairly rapid decreases in consumption

– With most direct impact on the economy– However, slowly implemented because of the

requirement the negotiation and compromise between executive and legislative branches

So, the fiscal policy cannot in practice be used to fine-tune the economy

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Fiscal Policy

– Government’s budget deficit or surplus: Tax income < government spending budget deficit

Tax income > government spending budget surplus

The effect of budget deficits: increase the demand for goods and services (via government spending) by more than it reduces the demand for goods and services (via taxes collection), and therefore stimulate the economy

(for most countries, they adopt the budget-deficit policy to stimulate the economy)

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Monetary PolicyMonetary Policy– Manipulation of the money supply to influence

economic activity– Different from the direct influence from fiscal policies,

monetary policies work indirectly through their impact on interest rates and thus on the incentive to purchase and invest

– Short- and long-term effects on interest ratesIncreases in the money supply lower short-term real and thus nominal IRs, encouraging investment and consumption

Over longer periods, it is believed that a higher money supply leads only to a higher price level and does not have a permanent effect on economic activity

※The stimulation/inflation trade-off is the major consideration to determine how to use monetary policy

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Monetary Policy– Three tools of monetary policy

Open market operations: Central banks trade Treasury securities for its own account (for fine-tune the monetary policy daily) (The most direct and commonly used tool)

– Buy Treasury securities increases in money supply– Sell Treasury securities decreases in money supply

Reserve requirements: The proportion of deposits that banks must hold as cash on hand or as deposits in the central bank

– Reserve requirements decreases banks can lend more loans to firms effective money supply increases and the economy is stimulated

Discount rate: The interest rate that the central bank charges banks on short-term loans

– Discount rate ↓ expansionary monetary policy– The rate is under the direct control of the central bank, and

is changed relatively infrequently

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Monetary PolicyFederal funds rate in the U.S.

– The federal funds rate is the interest rate at which banks make short-term loans to meet the reserve requirement from other banks who have excess funds

– It is determined by the monetary supply and demand among banks and changes frequently, so it is a better indicator to gauge the monetary policy adopted by the central bank

If this rate rises, it indicates that the central bank contracts the money supply

If this rate declines, in can be inferred that the central bank expands the money supply

– Monetary policy is determined by the central bank, and in the U.S., Board of Governors of the Federal Reserve System (Fed) plays the same role as the central banks in other nations

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12.6 BUSINESS CYCLES (景氣循環 )

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The Business CycleRecurring patterns of recession and recovery are called business cycles (see Fig. 12.11)– Peak: The transition from the end of an expansion to

the start of a contraction– Trough: Occurring at the bottom of a recession just

before the economy entering a recovery (expansion)

Industry relationship to business cycles (cyclical vs. defensive industries)– Cyclical industries

Industries with above average sensitivity to the state of the economyFor example, the producers of durable goods (e.g., cars) or capital goods (that are used by other firms to produce their own products)Firms in cyclical industries tend to have high betas

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Figure 12.11 Four Phases of the Business Cycle

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The Business Cycle– Defensive industries

Industries with below-average sensitivity to the state of the economy

For example, food producers, pharmaceutical firms, and public utilities

– The demand of food, drugs, electricity, and gas is consistent regardless of the business cycle

Firms in defensive industries tend to have low betas

– The trading strategy based on the business cycleOptimistic about the economy, hold cyclical stocks

Pessimistic about the economy, hold defensive (or counter-cyclical) stocks

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Leading Indicators (領先指標 ) – economic series tend to rise and fall in advance of the economy, for example,– Stock prices (S&P 500 stock index)

Stock prices are forward-looking estimates for future profitability and thus able to be a leading indicator

Since the stock prices themselves are leading indicators, the information of other leading indicators contributes less for stock investment – by the time they predict an upturn, the stock market has already made its move

Stock prices can be a leading indicator for the business cycle, but there is no leading indictor for stock prices

– Money supply growth rateDue to the indirect and lag influence of the monetary policy on the economy

Economic Indicators

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Coincident Indicators (同期指標 ) – indicators that tend to change at the same time with the economy, e.g.,– Industrial production– Manufacturing and trade sales

Lagging Indicators (落後指標 ) – indicators that tend to follow the lag economic performance, e.g.,– Ratio of inventories to sales (high inventories

suggest the economy is in recession)– Ratio of consumer installment credit outstanding to

personal income

Cyclical indicators are summarized in Table 12.2

Economic Indicators

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Economic Indicators

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Economic Indicators ※ Ten series of leading indicators are

grouped to generate a composite index of leading economic index

※ The composite coincident and lagging indexes are constructed similarly

※ The gray bars represent 7 most famous contraction periods in US history, and the numbers near the turning points indicate the length of the lead time or lag time (in months) from the peak and the trough of the corresponding business cycle

※ The leading index consistently turns before the rest of the economy, and the coincident and lagging indexes in general behave as expected

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Economic Indicators

※ A wide range of economic indicators are released to the public on a regular “economic calendar”

※ The above table lists the release dates and sources for about 20 statistics

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12.7 INDUSTRY ANALYSIS

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Industry AnalysisThe industry analysis is as important as the macroeconomic analysis because it is unusual for a firm in a troubled industry to perform well

Performance can vary widely across industries in 2008– Returns of equity can range from 10.2% for the

electric utilities industry to 36.8% for the cigarette industry (see Fig. 12.7)

Performance of firms in the same industry varies substantially (ROEs of several firms in application software are shown in Fig. 12.9)

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Figures 12.7 and 12.9 Returns on Equity, 2008

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Defining an IndustryWhere to draw the line between one industry and another– North American Industry Classification System (北美產業分類系統 ) or NAICS Codes

There are codes assigned to group firms for statistical analysis (see Table 12.5)Firms with the same 4-digit NAICS codes are commonly taken to be in the same industry

– S&P classifies firms into about 100 industry groups, and Value Line Investment Survey groups firms into about 90 industries

– Industry classifications are never perfectFor example, both J.C. Penney (high-volume “value” store) and Neiman Marcus (high-margin elite store) might be classified as department stores

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Table 12.5 Examples of NAICS Industry Codes

※The first two digits define the major industry group: NAICS code 23 = construction

※ The last two or three digits define the industry more narrowly

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Sensitivity to Business CycleIt is interesting to see how business cycles affect the performance of specific industriesThree factors affecting sensitivity of earnings to business cycles– Sensitivity of sales

Sales of necessities will show little sensitivity to business conditions, e.g., food, drugs, medical servicesSales of luxuries or discretionary goods are more sensitive to business conditions, e.g., jewelry, autos, recreational servicesSale growths of jewelry stores vs. grocery stores in Fig. 12.10

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Figure 12.10 Industry Cyclicality

※ Sales of jewelry, which is a luxury good, fluctuate more widely than those of grocery stores

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Sensitivity to Business Cycle– Financial leverage

Since interest expenses on debt must be paid regardless of sales, they will increase the sensitivity of profits to salesProfits for high-financial-leverage industries swing more widely with sales (business cycles)

– Operating leverageThe degree to which the operating costs are fixedFixed operating costs are those the firm incurs regardless of it production level; Variable operating costs are those that rise or fall as the firm produces more or less productsFixed costs ↑ the costs is without flexibility with sales profits for high-fixed-costs industries swing more widely with sales (business cycles) using high fixed costs is equivalent to increase operating leverage (similar to the effect of using financial leverage)

※ The above inference is based on the assumption that sales are positively correlated with business conditions

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Sector Rotation (產業循環 )To select industries in different phases of the business cycle– Peak – natural resource firms

The economy might be overheated with high inflationInvest in natural resource firms to against the inflation

– Contraction – defensive firms, e.g., food, drugs, or other necessities

These firms are less affected by the contractionLower inflation and IR rates favor financial firms

– Trough – equipment, transportation and construction firms

Firms might purchase new equipment to meet anticipated increases in demand in the following expansion

– Expansion – cyclical industries, e.g., consumer durables and luxury items

These firms are the most profitable in this phase

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Sector Rotation

※ The typical sector rotation across different states of the business cycle is shown in the above figure

※ Each sector historically had their “day in the sun” during a typical economic cycle

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Life Cycles of an IndustryStage Sales GrowthStart-up Rapid & IncreasingConsolidation StableMaturity SlowingRelative Decline Minimal or Negative(Next I will discuss each stage in details)

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Start-up stage– The early stages of an industry are often

characterized by a new technology or product, e.g., PC in the 1980s, cell phone in 1990s

– At this stage, sales and earnings grow at an rapid rate since the new product has not yet saturated in market

Consolidation stage– The industry survivors and leaders begin to

emerge– The performance of the surviving firms will closely

tract the performance of the overall industry– The industry will grow faster than the rest of the

economy

Life Cycles of an Industry

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Maturity stage– The product is used extensively in the market– The product has become far more standardized– There is price competition among firms in the industry– Firms at this stage are called as “cash cows,” which

are with stable CF but offering little opportunity for profitable expansion

Relative decline– The industry might grow as less than the rate of the

overall economy, or it might even shrink– This could be due to the product being out of date or

the competition from new products

Life Cycles of an Industry

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The logic behind the progression from one stage of the industry life cycle to another– High growth and fat profits bring new competitors

and thus generate new sources of supply to reduce prices, profits, and growth finally

Are high-growth industries good investment targets?– The historical records tells us they are, as long as

they offer high enough expected return to compensate the risks you bear

– But if the security prices already reflect the likelihood for high growth, then it is too late to make money from this strategy

Life Cycles of an Industry