1. ECONOMIC AND INDUSTRY ANALYSIS
Chapter 13
ECONOMIC AND INDUSTRY ANALYSIS

2. Chapter 13 Questions
What are the generic approaches to security analysis?
What are the components of gross domestic product (GDP), and what can they tell us about industry prospects?
How do international economic factors affect the U.S. economy?
What are the major determinants of an economy’s long-term growth?

3. Chapter 13 Questions
What are the primary influences affecting the short-term growth of an economy?
What indicators can be used to forecast economic variables?
What is expectational analysis?
How is the stock market related to economic activity?

4. Chapter 13 Questions
Why must an analyst review both cyclical change and structural change when analyzing an industry?
What are the five basic competitive forces that determine the intensity of competition in an industry and, thus, its rate of return on capital?
What is the industrial life cycle and its stages?

5. 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.

6. Generic 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

7. Generic Approaches to Security Analysis
Top-Down Approach (Our focus)
Review the macro-economy
Analyze different industries and sectors
Determine buy/sell candidates
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

8. 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

9. 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

10. 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

11. 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

12. 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”

13. 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

14. 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

15. 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”

16. 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

17. 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.

18. 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

19. 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

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

21. 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

22. 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?

23. 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

24. Sources of Industry Information
Standard & Poor’s Industry Survey
Covers over 50 major industries
Standard & Poor’s Analysts Handbook
Contains financial data
Value Line Industry Survey
Divides firms into industry groups
Individual Investigation
Read annual reports, industry publications
Collect other relevant data from SEC filings, published information
Field interviews