Macroeconomic and Industry Analysis

From the various sources

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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

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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)

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)

– 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

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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 industryStudies have found a relationship between aggregate stock prices and various economic series such as employment, income, or productionMost 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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1 THE GLOBAL ECONOMY

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Global Economic Considerations

Performance in countries and regions is highly variable

Political risk

Exchange rate risk– Sales– Profits– Stock returns

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Economic Performance 2006

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2 THE DOMESTIC MACROECONOMY

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Key Economic Variables

Gross domestic product

Employment

Inflation

Interest rates

Budget Deficits

Consumer sentiment

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S&P 500 vs. EPS Estimate

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3 INTEREST RATES

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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

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Determination of the Equilibrium Real Rate of Interest

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4 DEMAND AND SUPPLY SHOCKS

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Demand Shocks

Demand– An event that affects the demand for goods

and services in the economyReduction in tax rates

Increases in the money supply

Increases in government spending

Increases in foreign export demand

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Supply Shocks

Supply– An event that influences production capacity

and production costsChanges in the price of imported oil

Commodity price changes

Floods, Droughts

Changes in the wage rates

Educational level of economic participants

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5 FEDERAL GOVERNMENT POLICY

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Fiscal Policy

Government spending and taxing actions– Direct policy– Slowly implemented

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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

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Supply-Side Policies

Supply-siders focus on incentives and marginal tax rates

Lowering tax rates will – elicit more investment – Improve incentives to work

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6 BUSINESS CYCLES

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The Business Cycle

Recurring patterns of recession and recovery—business cycles– Peak– Trough

Industry relationship to business cycles– Cyclical – Defensive

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Leading Indicators - tend to rise and fall in advance of the economyExamples– Avg. weekly hours of production workers– Stock Prices – Initial claims for unemployment– Manufacturer’s new orders– Stock market indexes

Economic Indicators

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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

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Coincident Indicators - indicators that tend to change directly with the economy

Examples– Industrial production– Manufacturing and trade sales

Economic Indicators (cont)

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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)

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Indexes of Economic Indicators

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Cyclical Indicators

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Indexes of Leading, Coincident, and Lagging Indicators

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Economic Calendar

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Useful Economic Indicators

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Economic Calendar at Yahoo!

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7 INDUSTRY ANALYSIS

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Industry Analysis

Performance can vary widely across industries

ROE can range from 10.6% for electronic equipment to 29.2% for the cigarette industry

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Return on Equity

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Industry Stock Price Performance, 2006

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Defining an Industry

Where to draw the line between one industry and another– Money-center banks: Variation by

SizeFocusregion

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ROE of Major Banks, 2007

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North American Industry Classification System or NAICS Codes

Codes assigned to group firms for statistical analysis

Industry classifications are never perfect

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Examples of NAICS Industry Codes

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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

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Industry Cyclicality

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A Stylized Depiction of the Business Cycle

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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

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Industry Life Cycles

Stage Sales GrowthStart-up Rapid & Increasing

Consolidation Stable

Maturity Slowing

Relative Decline Minimal or Negative

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The Industry Life Cycle

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Industry Structure and Performance

Threat of Entry

Rivalry between existing competitors

Pressure from substitute products

Bargaining power of buyers

Bargaining power of suppliers

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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.