Security Analysis Prof Mahesh Kumar Amity Business School

The Global Economy Global Factors a) Exchange Rate b) Country Risk c) Credit Risk d) Protectionism and trade policy e) Free Flow of Capital f) Status of Nation’s Workforce

The Domestic Macro Economy Domestic Factors a) GDP: measure of the economy’s total production of goods and services. Rapidly growing GDP indicates an expanding economy with ample opportunity for a firm to increase sales. b) Employment: The unemployment rate is the percentage of the total labor force yet to find work. The unemployment rate measures the extent to which economy is operating at full capacity.

The Domestic Macro Economy c) Inflation: is the rate at which the general level of prices is rising. High rate of inflation is often associated with ‘overheated’ economies i.e. economies where demand of goods and services is over stripping productive capacity, which leads to upward pressure on prices. d) Interest rates: High interest rates reduce the present value of future cash flows, thereby reducing the attractiveness of investment opportunities.

The Domestic Macro Economy e) Budget Deficit: The budget deficit of a government is the difference between government spending and revenues. Any budgetary shortfall must be offset by government borrowing and large borrowings will increase the interest rates and thus choking off the business opportunities. f) Sentiments: Consumers’ and producers’ optimism or pessimism is an important determinant of economic performance. If consumers have confidence in their future income levels, for example, they will be more willing to spend on big ticket items. Similarly businesses will increase production and inventory levels if they anticipate higher demand for their products. In this way, beliefs influence how much consumption and investment will be pursued and affect the aggregate demand for goods and services.

Demand and Supply Shocks A demand shock is an event that affects the demand for goods and services in the economy. Examples of positive demand shocks are reduction in tax rates, increase in money supply, increase in government spending, or increases in foreign export demand. A supply shock is an event that influences production capacity and costs. Examples of supply shocks are changes in the price of imported oil, freezes, floods, droughts that might destroy large quantities of agricultural crops; changes in the educational level of economy’s work force; or changes in the wage rates at which the labor force is willing to work.

Demand and Supply Shocks  Demand shocks are usually characterized by aggregate output (GDP) moving in the same direction as interest rates and inflation.  Supply shocks are usually characterized by aggregate output moving in the opposite direction as interest rates and inflation.

Fiscal Policy Fiscal policy refers to the government’s spending and tax actions and is part of ‘demand side management’. A large budget deficit means that the government is spending considerably more than it is taking by way of taxes. The net effect is to increase the demand for goods (via spending) by more than it reduces the demand of goods (via taxes), thereby stimulating the company.

Monetary Policy Monetary policy refers to the manipulation of money supply to affect the macro economy and is the other main leg side of demand–side policy. Monetary policy works largely through its impact of interest rates. Increase in money supply lower short term interest rates, ultimately encouraging investment and consumption demand. Over long periods, however most economist believe higher money supply leads to a higher price level and does not have a permanent effect on economic activity.

Supply Side Policies Supply side policies treat the issue of the productive capacity of the economy. The goal is to create an environment in which workers and the owners of capital have the maximum incentive and ability to produce and develop goods. Supply side economists also pay considerable attention to tax policy. Whereas demand siders look at the effect of taxes on consumption demand, supply siders focus on incentives and marginal tax rates.

Business Cycle The economy recurrently experiences periods of expansions and contractions, although the length and depth of those cycles can be irregular. This irregular pattern of recession and recovery is called the business cycle. The transition points across cycles are called peaks and troughs. A peak is the transition from the end of an expansion to the start of contraction. A trough occurs at the bottom of a recession just as the economy enters a recovery.

Business Cycle Performance of different industry groups behave differently as the economy passes through different stages of business cycle. Example, at a trough, cyclical industries, those with the above-average sensitivity to the state of economy, would tend outperform other industries. Examples of cyclical industries are producers of durable goods such as automobiles or washing machines and capital goods ( goods used by other firms to produce their own goods). Because purchases of these goods can be deferred during recession, sales are particularly sensitive to macro economic conditions.

Business Cycle In contrast to cyclical firms, defensive industries have little sensitivity to the business cycle. These are the industries that produce goods for which sales and profits are least sensitive to the state of economy. Defensive industries include food producers and processors, pharmaceutical firms and public utilities. These industries will outperform others when the economy enters a recession.

Business Cycle When perception about the health of the economy becomes more optimistic, for example, the prices of most stocks will increase as forecasts of profitability rise. Because cyclical firms are most sensitive to such developments, their stock prices will rise the most. Thus the firms in cyclical industries tend to have high beta stocks. In general, stocks of cyclical firms will show the best results when the economic news is positive but the worst results when that news is bad. Conversely, defensive firms will have low betas and performance that is relatively unaffected by overall market conditions.

Industry Analysis Just as it is difficult for an industry to perform well when the macro economy is ailing, it is unusual for a firm in troubled industry to perform well. Just as we have seen that the economic performance can vary widely across countries, performance also can vary widely across industries.

Sensitivity of Industry to the Business Cycle Three factors will determine the sensitivity of firm’s/ industry earnings to the business cycle. a) The sensitivity of sales: Necessities will show little sensitivity to business conditions. e.g. food, drugs and medical services. Other industries with low sensitivity are those for which income is not a crucial determinant of demand. e.g. tobacco products, movie industry. In contrast, firms in industries such as machine tools, steel, autos, and transportation are highly sensitive to the state of the economy.

Sensitivity of Industry to the Business Cycle b) Operating leverage: refers to the division between fixed and variable costs. Firms with greater amount of variable costs as opposed to fixed costs will be less sensitive to business conditions. This is because in economic downturns, these firms can reduce costs as output falls in response to the falling sales. Firms with high fixed costs are said to have high operating leverage, as small swings in business conditions can have large impacts on profitability.

Sensitivity of Industry to the Business Cycle c) Financial Leverage: which refers to the use of borrowing. Interest payments on debt must be paid regardless of sales. They are fixed costs that also increase the sensitivity of profits to business conditions.

Sector Rotation as Portfolio Management Strategy On the basis of relationship between industry analysis and the business cycle, analyst can draw a portfolio on the basis of sector rotation.  Near the peak of business cycle, the economy might be overheated with high inflation and interest rates and price pressures on basic commodities. This might be a good time to invest in firms engaged in natural resource extraction and processing such as minerals and petroleum.  Following peak, when the economy enters a contraction or recession, one should expect defensive industries that are less sensitive to economic conditions to be the best performers. At the height of the contraction, financial firms will be hurt by shrinking loan volume and higher default rates. Towards the end of the recession, however, contraction induces lower inflation and interest rates, which favor financial firms.

Sector Rotation as Portfolio Management Strategy  At the trough of recession, the economy is poised for recovery and subsequent expansion. Firms might thus be spending on purchases of new equipment to meet anticipated demand. This, then, would be good time to invest in capital good industries, such as equipment, transportation or construction.  Finally, in an expansion, the economy is growing rapidly. Cyclical industries such as consumer durables and luxury items will be most profitable in this stage of the cycle. Banks might also do well in expansions, since loan volume will be high and default exposure low when the economy is growing rapidly.

Industry Life Cycles A typical industry life cycle might be described by four stages: a start up stage, characterized by extremely rapid growth; a consolidation stage, characterized by growth that is less rapid but still faster than the general economy; a maturity stage, characterized by growth no faster than the general economy ; and a stage of relative decline, in which the industry grows less rapidly than the rest of the economy, or actually shrinks.

Industry Life Cycles Start up stage: The early stages of an industry are characterized by a new technology or product. At this stage, it is difficult to predict which firms will turn out to be wildly successful, and others will fail altogether. Therefore there is considerable risk in selecting one particular firm within the industry. At the industry level, however sales and earnings will grow at an extremely rapid rate, because the new product has not yet saturated its market.

Industry Life Cycles Consolidation stage: After a product becomes established, industry leaders begin to emerge. The survivors from the start up stage are more stable, and market share is easier to predict. Therefore, the performance of the surviving firms will more closely track the performance of the overall industry. The industry still grows faster than the rest of the economy as the product penetrates the marketplace and becomes more commonly used.

Industry Life Cycles Maturity Stage: At this point, the product has reached its full potential for use by consumers. Further growth might merely track growth in general economy. The product has become far more standardized, and producers are forced to compete to a greater extent on the basis of price. This leads to narrow profit margins and further pressure on profits. Firms at this stage sometimes are characterized as cash cows, having reasonably stable cash flow but offering little opportunity for profitable expansion. The cash flow is best ‘milked from’ rather than reinvested in the company.

Industry Life Cycles Relative Decline: In this stage, the industry might grow less than the rate of the overall economy, or it might even shrink. This could be due to obsolescence of the product, competition from new products, or competition from new low cost suppliers.

Peter Lynch’s classification of Industries Slow Growers: Large and aging firms that will grow only slightly faster than the broad economy. These firms have matured from their earlier fast-growth phase. They usually have steady cash flow and pay generous dividend, indicating that the firm is generating more cash than can be profitably reinvested in the firm. e.g. Hindalco, Bajaj Auto etc. Stalwarts: They grow faster than the slow growers, but are not in the very rapid growth start up stage. They also tend to be in non cyclical industries that are relatively unaffected by recession.

Peter Lynch’s classification of Industries Fast Growers: Small and aggressive new firms with annual growth rate in the neighborhood of 20% to 25%. Company growth can be due to broad industry growth or to an increase in market share in a more mature industry. Cyclical: These are firms with sales and profits that regularly expand and contract along with the business cycle. Examples are auto companies, steel companies or the construction industry.

Peter Lynch’s classification of Industries Turnarounds: These are the firms that are in bankruptcy or soon might be. If they can recover from what might appear to be imminent disaster, they can offer tremendous investment returns. Asset Plays: These are the firms that have valuable asset not currently reflected in the stock price. These assets do not immediately generate cash flow, and so may be more easily overlooked by other analysts attempting to value the firm.

Profit Potential of Industries: Porter Model According to this model there are five determinants of competition and profit potential of industry: a) Threat of Entry: Add capacity, inflate costs, push prices down and reduce profitability. High entry barriers reduce this risk. b) Rivalry between existing competitors: If the rivalry between the firms in an industry is strong, competitive moves and counter moves dampen the average profitability of the industry. c) Pressure from substitute products: d) Bargaining Power of Buyers: Buyers can bargain for price cut, ask for superior quality and better service and induce rivalry among competitors. If they are powerful they can depress the profitability of supplier industry. e) Bargaining Power of Suppliers: Suppliers like buyers can also raise prices, lower quality and curtail the range of free services they provide.

Technical Analysis Technical Analysis is essentially the search for recurrent and predictable patterns in stock prices. The key to successful technical analysis is a sluggish response of stock prices to fundamental supply-and-demand factors. Technical analysts are also called as chartists because they study records or charts of past stock prices hoping to find patterns they can exploit to make profit.

The Dow Theory for Technical Analysis The Dow Theory posits three forces simultaneously affecting stock prices: a) The primary trend is the long term movement of prices, lasting from several months to several years. b) Secondary or intermediate trends are caused by short term deviation of prices from the underlying trend line. These deviations are eliminated via corrections, when prices revert back to trend value. c) Territory or minor trends are daily fluctuations of little importance.

Technical Analysis involving moving averages In one version of this approach average prices over the past several months are taken as indicators of the ‘true value’ of the stock. If the stock price is above the value, it may be expected to fall. In another version, the moving average is taken as indicative of long term trends. If the trend has been downward and if the current stock price is below the moving average then a subsequent increase in stock price above the moving average line might signal a reversal of downward trend.

Technical Analysis involving relative strength approach The chartists compares stock performance over a recent period to performance of the market or other stocks in the same industry. A simple version of relative strength takes the ratio of the stock price to market indicator such BSE Sensex. If the ratio increases over time, the stock is said to exhibit relative strength because its price performance is better than that of the broad market.

Technical Analysis involving resistance levels and support levels Resistance levels and support levels are the price levels above which it is difficult for stock prices to rise, or below which it is unlikely for them to fall, and they are believed to be determined by market psychology.

Technical Analysis on the basis of trading volume As per this analysis, a price decline accompanied by heavy trading volume signals a more bearish market than if volume were smaller, because the price decline is taken as representing broader-based selling pressure