ECONOMIC AND INDUSTRY ANALYSIS

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.

General 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

General Approaches to Security Analysis Top-Down Approach (Our focus) Review the macro-economy Analyze different industries and sectors Determine buy/sell candidates Bottom-up Approach Focus primarily on the firm-specific factors that will lead to success, regardless of industry or macroeconomic factors

A Three-Step Process Within the three-step process of the top-down approach, all steps are crucial General economic influences Government policies strongly influence the economic environment, leading to profound effects on industries 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

A Three-Step Process Industry Influences Company Analysis We seek to determine which industries will likely do better than others in the expected economic environment Also, changing demographic factors have different effects across industries Company Analysis Individual investments will either make or break portfolio performance Once well-positioned industries are determined, find well-positioned firms within those industries

A Three-Step Process There is academic support for this top-down approach Most changes in individual earnings related to changes in aggregate earnings and changes in a firm’s industry There is a relationship between stock and bond prices and macroeconomic variables Rates of return for individual stocks can be explained by the aggregate stock market and the firm’s industry

A Three-Step Process Bottoms up to the top down approach! It works!

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

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

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

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

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”

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

Forecasting Tools Monetary Indicators Differences in Interest Rates 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

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”

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

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.

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

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

The Stock Market and the Business Cycle Basic Industries Excel Consumer Stapes Excel Consumer Durables Excel peak ECONOMIC CYCLE Capital Goods Excel trough Financial Stocks Excel

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 Theme Investing

Competitive Structure of an Industry Porter’s competitive forces are factors that determine a firm’s 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?

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

Conducting an Industry Analysis Common problem: paralysis of analysis Lots of data with no defined way of looking at it Solution: get organized Define the industry Determine who is in the industry Identify and investigate the leading competitors Read annual reports, industry publications Collect other relevant data from SEC filings, published information Field interviews with management, customers, etc.