Macroeconomic and Industry Analysis From the various sources

2 Framework of Analysis Fundamental Analysis Approach to Fundamental Analysis –Domestic and global economic analysis –Industry analysis –Company analysis Top-down approach (“Three-Step” Valuation Approach

3

4 Three-Step Valuation Approach 1. General economic influences –First examine the influence of the general economy on all firms and the security markets –Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash (Go to slide #8) Go to slide #8Go to slide #8 2. Industry influences –Determine which industries will prosper and which industries will suffer on a global basis and within countries (Go to slide # 36 and 37) Go to slide # 36 and 37Go to slide # 36 and 37 –analyze the prospects for various global industries with the best outlooks in this economic environment 3. Company analysis –turn to the analysis of individual firms in the preferred industries and to the common stock of these firms. –Determine which companies in the selected industries will prosper and which stocks are undervalued

5 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 found a relationship between aggregate stock prices and various economic series such as employment, income, or production 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

6 1 THE GLOBAL ECONOMY

7 Global Economic Considerations Performance in countries and regions is highly variable Political risk Exchange rate risk –Sales –Profits –Stock returns

8 Economic Performance 2006

9 2 THE DOMESTIC MACROECONOMY

10 Key Economic Variables Gross domestic product EmploymentInflation Interest rates Budget Deficits Consumer sentiment

11 S&P 500 vs. EPS Estimate

12 3 INTEREST RATES

13 Factors Determining the Level of Interest Rates Supply of funds from savers Demand for funds from businesses Government’s net supply and/or demand for funds Expected rate of inflation

14 Determination of the Equilibrium Real Rate of Interest

15 4 DEMAND AND SUPPLY SHOCKS

16 Demand Shocks Demand –An event that affects the demand for goods and services in the economy Reduction in tax rates Increases in the money supply Increases in government spending Increases in foreign export demand

17 Supply Shocks Supply –An event that influences production capacity and production costs Changes in the price of imported oil Commodity price changes Floods, Droughts Changes in the wage rates Educational level of economic participants

18 5 FEDERAL GOVERNMENT POLICY

19 Fiscal Policy Government spending and taxing actions –Direct policy –Slowly implemented

20 Monetary Policy Manipulation of the money supply to influence economic activity –Initial & feedback effects Tools of monetary policy –Open market operations (federal funds rate) –Discount rate –Reserve requirements

21 Supply-Side Policies Supply-siders focus on incentives and marginal tax rates Lowering tax rates will –elicit more investment –Improve incentives to work

22 6 BUSINESS CYCLES

23 The Business Cycle Recurring patterns of recession and recovery—business cycles –Peak –Trough Industry relationship to business cycles –Cyclical –Defensive

24 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 –Stock market indexes Economic Indicators

25 Economic Activity and Security Markets Stock Market as a Leading Indicator –Stock prices reflect expectations of earnings, dividends, and interest rates –Stock market reacts to various leading indicator series –Stock prices consistently turn before the economy does

26

27

28 Coincident Indicators - indicators that tend to change directly with the economy Examples –Industrial production –Manufacturing and trade sales Economic Indicators (cont)

29 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 Economic Indicators (cont)

30 Indexes of Economic Indicators

31 Cyclical Indicators

32 Indexes of Leading, Coincident, and Lagging Indicators

33 Economic Calendar

34 Useful Economic Indicators

35 Economic Calendar at Yahoo!

36 7 INDUSTRY ANALYSIS

37 Industry Analysis Performance can vary widely across industries ROE can range from 10.6% for electronic equipment to 29.2% for the cigarette industry

38 Return on Equity

39 Industry Stock Price Performance, 2006

40 Defining an Industry Where to draw the line between one industry and another –Money-center banks: Variation by SizeFocusregion

41 ROE of Major Banks, 2007

42 North American Industry Classification System or NAICS Codes Codes assigned to group firms for statistical analysis Industry classifications are never perfect

43 Examples of NAICS Industry Codes

44 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

45 Industry Cyclicality

46 A Stylized Depiction of the Business Cycle

47 Sector Rotation Selecting Industries in line with the stage of the business cycle  Peak – natural resource firms  Contraction – defensive firms  Trough – equipment, transportation and construction firms  Expanding – cyclical industries

48 Industry Life Cycles StageSales Growth Start-upRapid & Increasing ConsolidationStable MaturitySlowing Relative DeclineMinimal or Negative

49 The Industry Life Cycle

50 Industry Structure and Performance Threat of Entry Rivalry between existing competitors Pressure from substitute products Bargaining power of buyers Bargaining power of suppliers

51 An Example of Industry Analysis Go to TxState Library Web Site Go to Database Under Database, find “Standard & Poor’s Net Advantage” Click on “Industries.” Choose the industry you want to find S&P industry analysis for recent quarter or year.