8 Investment Analysis and Portfolio Management First Canadian Edition Copyright © 2010 Nelson Slide 1 Investment Analysis and Portfolio Management First Canadian Edition By Reilly, Brown, Hedges, Chang 8

Chapter 8 Economic & Industry Analysis An Overview of the Valuation Process Why a Three-Step Valuation Process? Economic Analysis Industry Analysis Copyright © 2010 Nelson

An Overview of the Valuation Process Two General Approaches Top-down, three-step approach Bottom-up, stock valuation, stock picking approach The difference between the two approaches is the perceived importance of economic and industry influence on individual firms and stocks Both of these approaches can be implemented by either fundamentalists or technicians Copyright © 2010 Nelson

An Overview of the Valuation Process Three-Step Top-Down Process First examine the influence of the general economy on all firms and the security markets Then analyze the prospects for various global industries with the best outlooks in this economic environment Copyright © 2010 Nelson

An Overview of the Valuation Process Finally turn to the analysis of individual firms in the preferred industries and to the common stock of these firms. Copyright © 2010 Nelson

Why a Three-Step Valuation Approach? General Economic Influences Fiscal policy initiatives, such as tax credits or tax cuts, can encourage spending Monetary policy though controlling money supply growth or interest rate therefore affects all segments of an economy and that economy’s relationship with other economies Copyright © 2010 Nelson Continued…

Why a Three-Step Valuation Approach? General Economic Influences Inflation causes changes the spending and savings behaviour of consumers and corporations Other events such as war, political upheavals in foreign countries, or international monetary devaluations exert strong effects on the economies Copyright © 2010 Nelson

Why a Three-Step Valuation Approach? Industry Influences Identify global industries that will prosper or suffer in the long run or during the expected near-term economic environment Different industries react to economic changes at different points in the business cycle Copyright © 2010 Nelson Continued…

Why a Three-Step Valuation Approach? Industry Influences Alternative industries have different responses to the business cycle Demographic factor and international exposure will also have different impacts on different types of industries Copyright © 2010 Nelson

Why a Three-Step Valuation Approach? Company Analysis The purpose of company analysis to identify the best companies in a promising industry This involves examining a firm’s past performance, but more important, its future prospects Copyright © 2010 Nelson Continued…

Why a Three-Step Valuation Approach? Company Analysis It needs to compare the estimated intrinsic value to the prevailing market price of the firm’s stock and decide whether its stock is a good investment The final goal is to select the best stock within a desirable industry and include it in your portfolio based on its relationship (correlation) with all other assets in your portfolio Copyright © 2010 Nelson

Does the Three Step Process Work? Studies indicate that most changes in an individual firm’s earnings can be attributed to changes in aggregate corporate earnings and changes in the firm’s industry Studies have also found a relationship between aggregate stock prices and various economic series such as employment, income, or production Copyright © 2010 Nelson

Does the Three Step Process Work? An analysis of the relationship between rates of return for the aggregate stock market, alternative industries, and individual stocks showed that most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry Copyright © 2010 Nelson

Economic Analysis: Understanding Business Cycles Leading Indicators: Economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity Copyright © 2010 Nelson

Economic Analysis: Understanding Business Cycles Coincident Indicators: Economic series that have peaks and troughs that roughly coincide with the peaks and troughs in the business cycle Lagging Indicators: Economic series that experience their peaks and troughs after those of the aggregate economy Copyright © 2010 Nelson

Economic Analysis: Composite Leading Indicator Series Developed by Statistics Canada Overall gauge of the future direction of the Canadian economy Copyright © 2010 Nelson

Economic Analysis: Money Supply Friedman and Schwartz (1963) showed: Declines in the rate of growth of the money supply have preceded business contraction Increases in the rate of growth of the money supply have preceded economic expansions Copyright © 2010 Nelson

Economic Analysis: Money Supply Friedman (1969) suggested: A transmission mechanism through which changes in the growth rate of the money supply affect the aggregate economy Federal Reserve plays the central role through the open market operation Copyright © 2010 Nelson

Economic Analysis: Money Supply History shows that each recession since 1915 was preceded by a decline in the growth of money supply Copyright © 2010 Nelson

Economic Analysis: Inflation, Interest Rates, & Stock Prices Inflation and Interest Rates Generally move together Investors are not good at predicting inflation Inflation Rates and Bond Prices Negative relationship More effect on longer term bonds Inflation, Interest Rates and Stock Prices Not direct and not consistent Effect varies over time Copyright © 2010 Nelson

Economic Analysis: Inflation, Interest Rates & Stock Prices Copyright © 2010 Nelson

Analysis of World Security Markets Leading economic series are available for virtually all the developed countries, and the empirical relationships to the economy are quite similar to those of the United States Real GDP growth is typically consistent with what is implied by the leading series Other factors include The monetary environment The inflation outlook Copyright © 2010 Nelson

Industry Analysis What is an Industry? Identifying an industry can be difficult Clearly airlines, railroads and utilities are easy to categorize How do we deal with manufacturing firms that have three different divisions none of which are dominant? Copyright © 2010 Nelson

Characteristics of an Industry Price History P/E ratios Common Stock Yields Price/Book Ratios Price/Cash Flow Ratios Price/sales Ratios Copyright © 2010 Nelson

Characteristics of an Industry Operating Data & Results Comparative Results Return on Investment Return on Equity (ROE) Sales Growth Trend in Operating Profit Industrial life cycle Effects of bus cycles Secular trends Industry growth Regulatory change Copyright © 2010 Nelson

The Business Cycle & Industry Sectors Cyclical or Structural Changes Cyclical changes in the economy arise from the ups and downs of the business cycle Structure changes occur when the economy undergoes a major change in organization or how it functions Rotation strategy is when one switches from one industry group to another over the course of a business cycle Copyright © 2010 Nelson

The Business Cycle & Industry Sectors: Economic Variables Inflation Higher inflation is generally negative for stocks Interest Rates For example, financial and housing industries will be adversely affected by high interest rates Copyright © 2010 Nelson

The Business Cycle & Industry Sectors: Economic Variables International Economics Economic growth in world regions or specific countries benefits industries with a large presence in the areas Consumer Sentiment The performance of consumer cyclical industries will be affected by changes in consumer sentiment Copyright © 2010 Nelson

Structural Economic Changes: Alternative Industries Social Influences Demographics Lifestyles Technology Politics and Regulations Economic reasoning Fairness Regulatory changes affect numerous industries Regulations affect international commerce Copyright © 2010 Nelson

Structural Economic Changes: Alternative Industries Social Influences Demographics Lifestyles Technology Politics and Regulations Economic reasoning Fairness Regulatory changes affect numerous industries Regulations affect international commerce Copyright © 2010 Nelson

The Industry Life Cycle The Five-Stage Model Pioneering development Rapidly accelerating industry growth Mature industry growth Stabilization and market maturity Deceleration of growth and decline Copyright © 2010 Nelson

Analysis of Industry Competition Competition and Expected Industry Returns Porter’s concept of competitive strategy is described as the search by a firm for a favourable competitive position in an industry To create a profitable competitive strategy, firm must first examine basic competitive structure of its industry Potential profitability of firm is heavily influenced by profitability of its industry Copyright © 2010 Nelson

Analysis of Industry Competition Porter’s Competitive Forces (Exhibit 8.13) Rivalry among existing competitors More rivalry means intense competition Threat of new entrants Are there barriers to entry? Threat of substitute products Substitute products limit the profit potential of an industry Copyright © 2010 Nelson Continued…

Analysis of Industry Competition Porter’s Competitive Forces (Exhibit 8.13) Bargaining power of buyers Volume discounts, quality demands Bargaining power of suppliers Can suppliers increase prices or reduce quality? Copyright © 2010 Nelson

Analysis of Industry Competition Copyright © 2010 Nelson