1. 8 Investment Analysis and Portfolio Management First Canadian Edition
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Slide 1
Investment Analysis and Portfolio Management
First Canadian Edition
By Reilly, Brown, Hedges, Chang 8

2. Chapter 8 Economic & Industry Analysis
An Overview of the Valuation Process
Why a Three-Step Valuation Process?
Economic Analysis
Industry Analysis
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3. 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
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4. 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
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5. 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.
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6. 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
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Continued…

7. 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
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8. 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
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Continued…

9. 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
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10. 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
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Continued…

11. 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
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12. 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
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13. 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
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14. Economic Analysis: Understanding Business Cycles
Leading Indicators: Economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity
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15. 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
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16. Economic Analysis: Composite Leading Indicator Series
Developed by Statistics Canada
Overall gauge of the future direction of the Canadian economy
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17. 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
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18. 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
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19. Economic Analysis: Money Supply
History shows that each recession since 1915 was preceded by a decline in the growth of money supply
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20. 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
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21. Economic Analysis: Inflation, Interest Rates & Stock Prices
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22. 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
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23. 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?
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24. Characteristics of an Industry Price History
P/E ratios
Common Stock Yields
Price/Book Ratios
Price/Cash Flow Ratios
Price/sales Ratios
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25. 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
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26. 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
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27. 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
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28. 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
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29. 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
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30. 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
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31. 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
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32. 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
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33. 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
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Continued…

34. 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?
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35. Analysis of Industry Competition
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