2 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.
3 General Approaches to Security Analysis Two basic approaches:Emphasize history, looking for trendsFocusing on the futureStill look at some historical information, but focus on looking forward to future trendsTop-down approachBottom-up approach
4 General Approaches to Security Analysis Top-Down Approach (Our focus)Review the macro-economyAnalyze different industries and sectorsDetermine buy/sell candidatesBottom-up ApproachFocus primarily on the firm-specific factors that will lead to success, regardless of industry or macroeconomic factors
5 A Three-Step ProcessWithin the three-step process of the top-down approach, all steps are crucialGeneral economic influencesGovernment policies strongly influence the economic environment, leading to profound effects on industriesMarket analysisWe can see the influence of changes in the overall economy on various classes of investmentsSome investments do better than others before, during, and after recessions, for instance
6 A Three-Step Process Industry Influences Company Analysis We seek to determine which industries will likely do better than others in the expected economic environmentAlso, changing demographic factors have different effects across industriesCompany AnalysisIndividual investments will either make or break portfolio performanceOnce well-positioned industries are determined, find well-positioned firms within those industries
7 A Three-Step ProcessThere is academic support for this top-down approachMost changes in individual earnings related to changes in aggregate earnings and changes in a firm’s industryThere is a relationship between stock and bond prices and macroeconomic variablesRates of return for individual stocks can be explained by the aggregate stock market and the firm’s industry
8 A Three-Step ProcessBottoms up to the top down approach! It works!
9 A Quick Review of Economic Concepts Domestic Economic ActivityForecasting trends in major economic variables such as GDP, inflation, interest ratesGDP (Gross Domestic Product) componentsConsumption spendingInvestment spendingGovernment expendituresExport and import activity
10 A Quick Review of Economic Concepts Domestic Economic ActivityDomestic Economic PoliciesMonetary policyPolicies of the Fed to control the money supply and thereby affect the overall economyOpen market operationsDiscount rate changesReserve requirement changesFiscal policyGovernment taxing and spending policies to influence the economy and pursue other public interests
11 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 ratesExchange rates impacted by relative interest rates, inflation rates, and real economic growth within a country and across countries
12 Economic and Security Market Influences As we forecast economic growth, a number of factors will influence our expectationsInfluences on Long-term ExpectationsTechnologyPopulationLabor force participationProductivityResource availabilityIncentives to expand
13 Economic and Security Market Influences Influences on Short-term ExpectationsInfluences caused by fluctuations in demandLiquidity and bank lendingMonetary policyInflationInterest ratesInternational influencesConsumer sentimentTax and other fiscal policyEconomic “shocks”
14 Forecasting ToolsSearching for leading indicators that will provide signals of future economic directionsInflation IndicatorsInflation at times is related to turning points in the business cycleInflation destroys the purchasing power of wealthFederal Reserve actions indicate likely trends in inflationMoney supply and money growth rates relative to measures of economic growthCommodity prices
15 Forecasting Tools Monetary Indicators Differences in Interest Rates Impact both inflation and liquidityFederal Reserve policyDifferences in Interest RatesThe Treasury yield curve can sometimes give indications about future economic growthCyclical Economic IndicatorsTracking “official” leading economic indicatorsEconometric ModelingModels developed to forecast economic variables
16 Risks in Economic Forecasting Dominated by “group think”Always using consensus numbers ensures no better than average forecastsForecasts must be different (often) and yet still correct (usually) to create valueMany 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”
17 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
18 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.
19 Industry AnalysisMany stock research firms organized analysts by industry groupingIndustry-specific expertise is valuableIndustry: a set of businesses that produce similar products used by customers for similar purposesSometimes useful to use various industry numerical classifications
20 Links Between the Economy and Industries Economic trends affect industry performanceEconomic trends:Cyclical changesUps and down of the business cycleDifferent industries experience unique results depending on the point within the business cycleMay call for a “rotation” strategyStructural changesChanges in government institutions, regulatory environment, changes in technology, many moreNeed to anticipate structural changes and analyze the likely impact on various industries
21 The Stock Market and the Business Cycle Basic Industries ExcelConsumer Stapes ExcelConsumer Durables ExcelpeakECONOMICCYCLECapital Goods ExceltroughFinancial Stocks Excel
22 Structural Influences In addition to economic changes, various other trends also represent structural influences that will having varying effects across industriesSocial InfluencesDemographics: baby boom and beyondLifestyles: changing definition of “traditional”Social values: environment, alcohol, tobaccoTechnologyPolitics and RegulationTheme Investing
23 Competitive Structure of an Industry Porter’s competitive forces are factors that determine a firm’s competitive environmentRivalry among existing competitorsBoth price-based and non-price-based competitionThreat of new entrantsAre there barriers to entry?Threat of substitute productsBargaining power of buyersVolume discounts, quality demandsBargaining power of suppliersCan suppliers increase prices or reduce quality?
24 Industry Life Cycle Another tool: 5-stage industry life cycle model: Pioneering developmentAfter marketing or technological breakthroughRapidly accelerating industry growthMarket develops, strong demand, new entrantsMature industry growthGrowth starts to flattenStabilization and market maturityGrowth matches industry growthDeceleration of growth and declineDeclining profits, some losses, exit from industry
25 Conducting an Industry Analysis Common problem: paralysis of analysisLots of data with no defined way of looking at itSolution: get organizedDefine the industryDetermine who is in the industryIdentify and investigate the leading competitorsRead annual reports, industry publicationsCollect other relevant data from SEC filings, published informationField interviews with management, customers, etc.