ECONOMIC AND INDUSTRY ANALYSIS
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.
General Approaches to Security Analysis
Two basic approaches:Emphasize history, looking for trendsFocusing on the future
Still look at some historical information, but focus on looking forward to future trends
Top-down approachBottom-up approach
General Approaches to Security Analysis
Top-Down Approach (Our focus)1. Review the macro-economy2. Analyze different industries and sectors3. Determine buy/sell candidates
Bottom-up Approach Focus primarily on the firm-specific
factors that will lead to success, regardless of industry or macroeconomic factors
A Three-Step Process
Within the three-step process of the top-down approach, all steps are crucialGeneral economic influences Government policies strongly influence the
economic environment, leading to profound effects on industries
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
A Three-Step Process
Industry Influences We seek to determine which industries will likely
do better than others in the expected economic environment
Also, changing demographic factors have different effects across industries
Company Analysis Individual investments will either make or break
portfolio performance Once well-positioned industries are determined,
find well-positioned firms within those industries
A Three-Step Process
There is academic support for this top-down approach Most changes in individual earnings related to
changes in aggregate earnings and changes in a firm’s industry
There is a relationship between stock and bond prices and macroeconomic variables
Rates of return for individual stocks can be explained by the aggregate stock market and the firm’s industry
A Three-Step Process
Bottoms up to the top down approach! It works!
A Quick Review of Economic Concepts
Domestic Economic ActivityForecasting trends in major economic variables such as GDP, inflation, interest ratesGDP (Gross Domestic Product) components Consumption spending Investment spending Government expenditures Export and import activity
A Quick Review of Economic Concepts
Domestic Economic ActivityDomestic 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
A Quick Review of Economic Concepts
The Global EconomyDomestic firms impacted by global competition and a global business environmentThe health of foreign economies impacts domestic firms who exportTrade impacted by exchange rates Exchange rates impacted by relative interest rates,
inflation rates, and real economic growth within a country and across countries
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
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”
Forecasting Tools
Searching for leading indicators that will provide signals of future economic directionsInflation 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
Forecasting Tools
Monetary Indicators 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
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-sightedLots of data can overwhelm usTry to support a positionOver-reliance on expected “normal” changes without regard to the possibility of “shocks”
Expectational Analysis
Underlying concept:
Forecasting should take into account:The current environmentAssumptions behind estimatesA procedure for monitoring both changes in
the environment and violations of the assumptions being made
Expectational Analysis
In the top-down approach:1. 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.
2. Apply to industries, linking macro and sector variables and monitoring values over time.
3. Apply to firms, noting Economy-Industry-Firm assumptions that affect recommendations.
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 purposesSometimes useful to use various industry numerical classifications
Links Between the Economy and IndustriesEconomic trends affect industry performanceEconomic 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
The Stock Market and the Business Cycle
Financial Stocks Excel
trough
peakConsumer Durables
Excel
Capital Goods Excel
Basic Industries
Excel
Consumer Stapes Excel
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 Theme Investing
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?
Industry Life Cycle
Another tool: 5-stage industry life cycle model:1. Pioneering development
After marketing or technological breakthrough
2. Rapidly accelerating industry growthMarket develops, strong demand, new entrants
3. Mature industry growthGrowth starts to flatten
4. Stabilization and market maturityGrowth matches industry growth
5. Deceleration of growth and declineDeclining profits, some losses, exit from industry
Conducting an Industry Analysis
Common problem: paralysis of analysis Lots of data with no defined way of looking at it
Solution: get organized Define the industry Determine who is in the industry Identify and investigate the leading competitors
Read annual reports, industry publications Collect other relevant data from SEC filings, published
information Field interviews with management, customers, etc.
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