Investments and Portfolio Management WEEK 7 1

Market and Industrial Analysis Objectives : Understand the importance of macro-economic analysis in the portfolio management process Carry out market analysis Carry out industry analysis 2

Bottom Up analysis Based on analysis of company data e.g. P/E ratio or on technical analysis of price patterns for a selected asset. E.g. merger and acquisition decisions based on forecasting future cash flows of the company (Advanced Corporate Finance) would be considered to be using a Bottom Up approach. BUT: All companies are affected by general economic conditions to some extent. Similarly, anything affecting the industry, such as the emergence of a substitute industry, will affect all companies within that industry. Therefore, these should be considered. 3

Fundamental analysis This is covered in week 8, but involves the evaluation of internal, company factors to determine whether to invest. Sometimes fundamental analysts use a bottom up approach e.g. just pick a company and evaluate it. However, many fundamental analysts recognize that the environment plays an important part and will look at this first to determine which companies to examine fundamentally. 4

Top-down approach Analyse aggregate economy and Macroeconomic analysis E.g. GDP, interest rates Can use PESTEL analysis or concentrate on specific elements, such as a focused analysis on the financial markets themselves. Analyse industry factors To determine which sectors will do well considering economic outlook Can use Porter’s 5 Forces Analyse companies within the industry 5

Aggregate Economy and Macro-economic analysis ECST <GO> leads to analysis of all country economic statistics. Clicking on one of these statistics (e.g. GDP) will show the result by industry sector 6

Aggregate Economy and Macro-economic analysis 7

Rates of Return Annual Equity Returns US$ Country 2010 2009 2008 2007 Iceland 57.2% 10.3% -96.2% 13.1% Thailand 56.7% 71.7% -49.9% 39.0% Philippines 55.9% 70.4% -55.5% 36.7% Chile 49.6% 88.8% -43.6% 23.0% United States 15.3% 25.7% -38.6% 3.8% United Kingdom 7.0% 39.5% -51.2% 8 (Source: The Wall Street Journal cited by Reilly and Brown, 2012)

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PESTEL Analysis Step 2 – External analysis Political Taxation Foreign Trade regulations Government Stability Consumer protection Social/Demographic Income distribution Social mobility Education levels Population size Age distribution Lifestyle changes Consumerism Fashions/tastes Social issues Economic Globalisation Business cycles Interest rates Inflation Employment levels Exchange rates Legal Monopoly legislation Environmental legislation Employment law Consumer protection Health & Safety Technological Internet / Access to information Government spending on RnD New products New processes/production methods Rate of Change Communications Transport Ecological Environmental Protection Depletion of natural resources Pollution Health/Animal Welfare Disposal of Waste Products 10

Economic conditions Gross Domestic Product (GDP) - the expenditure on final goods and services minus imports High GDP => new capital investment => higher levels of production => higher GDP….. i.e. economic growth takes place Economic decline can occur when level of investment is insufficient to replace depreciated capital. From an investment perspective, when economies grow so to earnings and the value of financial assets. Demand for funds also increases, causing interest rate rises. 11

Fiscal (Govt.) Policy Fiscal Policy = government spending and taxation policies Expansionary – increase spending, or decrease taxes Contractionary – decrease spending or increase taxes Expansionary => increases demand and therefore increase prices and output (depending on other factors such as employment capacity) But if debt/GDP increases as a result then growth may be affected. 12

Monetary (central bank) Policy Monetary Policy = central bank policy affecting the supply or cost (interest) of money in the economy Expansionary – buy govt. bonds, increasing money supply. Interest rate decreases. Capital expenditure increases. Contractionary – sell govt. bonds, decreasing money supply. Interest rate increases. Capital expenditure decreases. Foreign sector Exchange rates Emerging economies 13

Industry analysis Methods: Porter’s Five forces Threat of New Entrants Competitive Rivalry Power of Buyers Power of Suppliers Threat of Substitutes Stages of industrial development (see slide 15) Supply chains (see slide 16) Industry valuations (see slide 17) 14

Stages of Industrial Development Pioneering Stage High development costs Low sales Small/negative profits Rapid accelerating growth stage Sales grow at increasing rate Firm expansion High profit margins Mature growth stage Sales grow, usually above economic growth but slower than previously. Increased competition Lower profit margins Stabilisation stage equilibrium Deceleration and declining growth stage 15

Supply Chains Leontief (c. 1930) developed a general theory of production based on economic interdependence. Such a relationship can be captured by supply chain models: Note: this function SPLC <GO> has a non-printable screen. See core text pg. 510 for a better image. 16

Industry Valuation Industry valuation can be carried out in similar ways to company valuation: E.g. Industry forecast EPS * industry P/E ratio The industry Sales per share (S) can be used to estimate the profit margin (m) as follows: m = EPS/SPS effectively, this is earnings as a percentage of turnover. If the ‘per share’ values cannot be predicted then total industry earnings and sales can be used. 17

Summary A top-down approach analyses markets and industries before selecting assets within them. There are a variety of models which can be used to help analyse the external environments, in addition to numerous economic ratios. 18

Reading Suggested additional reading: The slides for this week’s lecture have been based on: Stafford Johnson, R. (2014), Equity Markets and Portfolio Analysis, John Wiley & Sons – Chapter 13 Suggested additional reading: Read how a student managed equity fund is using a top-down approach for its management: Stafford Johnson, R. (2014), Equity Markets and Portfolio Analysis, John Wiley & Sons, pp 528-529 19

Useful Bloomberg Functions ECONOMIC <GO> produces a menu for a variety of economic analysis functions, including: ECFC <GO> economic forecasts ECST <GO> world economic statistics WIRP <GO> interest rate probabilities TOP ECO <GO> top economic news PMI <GO> 4 <GO> shows data tables for a selected country, including GDP data and analysis of different industries 20

Useful Bloomberg Functions COUN <GO> and ‘economics’ tab, provide an overview of the economy of a country of choice Real GDP chart Economic forecasts Economic calendar Economic News Central Bank 21

Useful Bloomberg Functions GDP <GO> shows world GDP statistics WEI <GO> looks at world economic indices. If you have determined the country and industry of choice, you can click on the name of an appropriate country index, which then provides a list of securities by sector, thus allowing you to select an appropriate security. RV <GO> shows relative analysis of firms within an industry Select a ticker, using SECF <GO>if necessary, and then type BI INDUSTRY <GO>. This provides industry news and intelligence for the industry within which that asset operates. Can also type BI <GO>, select ‘sector’, select ‘industry’, select ‘comp sheets’ 22