1. Macroeconomic and Industry Analysis
CHAPTER 11

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

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

4. Performance in countries
Countries Growth in GDP(%) Countries Growth in GDPP(%)
Australia Austria 0.7
Belgium Britain 2.0
Canada Denmark
France Germany
Italy Japan 1.8
Netherlands Spain 2.4
Sweden U.S
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

5. 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?

6. 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

7. 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

8. 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

9. 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

10. Federal Government Policy
Fiscal Policy - government spending and taxing actions
Increase spending: increase demand
tax increase: reduce demand
Net impact:
budget deficit
budget surplus

11. 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?

12. Business Cycle

13. 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

14. 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

15. 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

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

17. 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

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

19. Industry stock performance in 2003
Industry Stock return (%)
Telecommunication
Pharmaceuticals
Food products
Insurance
Health care
Software
Energy
Retailing
Entertainment
Investment services
Banking
Wireless
Communications technology
Semiconductors

20. Industry Analysis Sensitivity to business cycles Sector Rotation
Industry life cycles

21. 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

22. Figure 11.9 Industry Cyclicality Sensitivity of sales of the firm’s product to the business cycles

23. 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

24. 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

25. Sector Rotation

26. 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

27. Sector Rotation Gains

28. Industry Life Cycles Stage Sales Growth Start-up Rapid & Increasing
Consolidation Stable
Maturity Slowing
Relative Decline Minimal or Negative

29. Figure 11.11 The Industry Life Cycle

30. 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