Macroeconomic and Industry Analysis CHAPTER 11

Framework of Analysis Fundamental Analysis Approach to Fundamental Analysis Domestic and global economic analysis Industry analysis Company analysis Why use the top-down approach

Global Economic Considerations Performance in countries and regions is highly variable Political risk Exchange rate risk

Performance in countries Countries Growth in GDP(%) Countries Growth in GDPP(%) Australia 2.6 Austria 0.7 Belgium 0.7 Britain 2.0 Canada 1.0 Denmark -0.8 France -0.2 Germany -0.2 Italy 0.5 Japan 1.8 Netherlands -1.1 Spain 2.4 Sweden 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 risk Consider 2 investors: A, an American wishing to invest in Indonesian stocks and an Indonesian wishing to invest in U.S. stocks Which one would face a more difficult task when doing macroeconomic analysis?

Exchange rate risk US investors: Exchange rate risk US investors: 2006: invest $1000 in Japan, exchange rate 1USD = 100 Yen, $1000 is worth 100,000 Yen In 2007: 1 USD = 110 Yen, 100,000 Yen = 909 USD Lose $91

Domestic Economy Gross domestic product Unemployment rates 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 rate 4 Factors that can influence interest rates (1) Interest rate 4 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 policy Open market operations Discount rate Reserve requirements If government wants to tighten money supply, what should it do?

Business Cycle

Business Cycles Business Cycle Peak Trough Industry relationship to business cycles Cyclical 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

NBER Cyclical Indicators: Leading Leading Indicators - tend to rise and fall in advance of the economy Examples Avg. weekly hours of production workers Stock Prices Initial claims for unemployment Manufacturer’s new orders

NBER Cyclical Indicators: Coincident Coincident Indicators - indicators that tend to change directly with the economy Examples Industrial production Manufacturing and trade sales

NBER Cyclical Indicators: Lagging Lagging Indicators - indicators that tend to follow the lag economic performance Examples Ratio of trade inventories to sales Ratio of consumer installment credit outstanding to personal income

Industry Analysis Estimates of Earnings Growth Rates in Several Industries, 2004

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

Industry Analysis Sensitivity to business cycles Sector Rotation Industry life cycles

Sensitivity to Business Cycle Factors affecting sensitivity of earnings to business cycles Sensitivity of sales of the firm’s product to the business cycles Operating leverage Financial 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 Cycles Stage Sales Growth Start-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