CH 17 Macroeconomic and Industry Analysis

Framework of Analysis Fundamental Analysis Top-down approach (“Three-Step” Valuation Approach Domestic and global economic analysis Industry analysis Company analysis Bottom-up approach

Top-Down Approach

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 “Economic Performance 2010” slide) 2. Industry influences Determine which industries will prosper and which industries will suffer on a global basis and within countries (Go to “Return on Equity by Industry” slide) 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

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 found a relationship between aggregate stock prices and various economic series such as employment, income, or production 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

1. THE GLOBAL ECONOMY

Global Economic Considerations Performance in countries and regions is highly variable Political risk The global environment may present much greater risks than normally found in U.S.-based investments. Exchange rate risk Changes the prices of imports and exports.

Economic Performance 2009

Change in Real Exchange Rates

2. THE DOMESTIC MACROECONOMY

The Domestic Macroeconomy Stock prices rise with earnings. P/E ratios are normally in the range of 12-25. The first step in forecasting the performance of the broad market is to assess the status of the economy as a whole.

S&P 500 vs. EPS Estimate

Key Economic Variables Gross domestic product Employment Inflation Interest rates Budget Deficits Consumer sentiment

U.S. GDP

GDP by State

Monthly Unemployment Rate

Inflation Rate in U.S.

Interest rates : Market data from WSJ Friday, December 29, 2006 The key U.S. and foreign annual interest rates below are a guide to general levels but don't always represent actual transactions. Commercial Paper: Yields paid by corporations for short-term financing, typically for daily operation Prime Rate: 8.25% (effective 06/29/06). The base rate on corporate loans posted by at least 75% of the nation's 30 largest banks. Discount Rate (Primary): 6.25% (effective 06/29/06). Federal Funds: 5.375% high, 4.500% low, 5.125% near closing bid, 5.250% offered. Effective rate: 5.20%. Source: Tullett Prebon Information, Ltd. Federal-funds target rate: 5.250% (effective 06/29/06). Call Money: 7.00% (effective 06/29/06). Commercial Paper: Placed directly by General Electric Capital Corp.: 5.23% 30 to 60 days; 5.22% 61 to 90 days; 5.20% 91 to 122 days; 5.19% 123 to 151 days; 5.17% 152 to 180 days; 5.14% 181 to 210 days; 5.11% 211 to 241 days; 5.09% 242 to 270 days. Euro Commercial Paper: Placed directly by General Electric Capital Corp.: 3.58% 30 days; 3.62% two months; 3.68% three months; 3.72% four months; 3.76% five months; 3.81% six months. Dealer Commercial Paper: High-grade unsecured notes sold through dealers by major corporations: 5.27% 30 days; 5.28% 60 days; 5.30% 90 days. Certificates of Deposit: 5.30% one month; 5.33% three months; 5.33% six months.

U.S. National Debt

Country foreign exchange reserves minus external debt

Michigan Consumer Sentiment Index

3. INTEREST RATES

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 The Fisher Effect

Determination of the Equilibrium Real Rate of Interest

4. DEMAND AND SUPPLY SHOCKS

Demand Shocks Demand An event that affects the demand for goods and services in the economy Reduction in tax rates Increases in the money supply Increases in government spending Increases in foreign export demand

Supply Shocks Supply An event that influences production capacity and production costs Changes in the price of imported oil Commodity price changes Floods, Droughts Changes in the wage rates Educational level of economic participants

5. FEDERAL GOVERNMENT POLICY

Demand-side Policy Fiscal policy – the government’s spending and taxing actions Monetary policy – manipulation of the money supply

Fiscal Policy Most direct way to stimulate or slow the economy Formulation of fiscal policy is often a slow, cumbersome political process To summarize the net effect of fiscal policy, look at the budget surplus or deficit. Deficit stimulates the economy because: it increases the demand for goods (via spending) by more than it reduces the demand for goods (via taxes)

Monetary Policy Manipulation of the money supply to influence economic activity. Initial & feedback effects Increasing the money supply lowers interest rates and stimulates the economy. Less immediate effect than fiscal policy Tools of monetary policy Open market operations (federal funds rate) Most important Discount rate Reserve requirements

Supply-Side Policies Goal: To create an environment in which workers and owners of capital have the maximum incentive and ability to produce and develop goods. Supply-siders focus on how tax policy can be used to improve incentives to work and invest. Lowering tax rates will elicit more investment Improve incentives to work

6. BUSINESS CYCLES

Business Cycles Recurring patterns of recession and recovery—business cycles Peak Trough Industry relationship to business cycles Cyclical Defensive The transition points across cycles are called peaks and troughs. A peak is the transition from the end of an expansion to the start of a contraction. A trough occurs at the bottom of a recession just as the economy enters a recovery.

The Business Cycle Cyclical Industries Defensive Industries Above-average sensitivity to the state of the economy. Examples include producers of consumer durables (e.g. autos) and capital goods (i.e. goods used by other firms to produce their own products.) High betas Little sensitivity to the business cycle Examples include food producers and processors, pharmaceutical firms, and public utilities Low betas

Economic Indicators Leading indicators tend to rise and fall in advance of the economy. Coincident indicators move with the market. Lagging indicators change subsequent to market movements.

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

Leading Indicator 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

Stock Market as a Leading Indicator

S&P 500 Index Since 2007

Economic Indicators (cont) Coincident Indicators - indicators that tend to change directly with the economy Examples Industrial production Manufacturing and trade sales

Economic Indicators (cont) 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

Indexes of Economic Indicators

Cyclical Indicators

Leading, Coincident, and Cyclical Indicators

Useful Economic Indicators

Economic Calendar Many sources, such as The Wall Street Journal and Yahoo! Finance, publish the public announcement dates of various economic statistics.

Economic Calendar at Yahoo!

7. INDUSTRY ANALYSIS

Industry Analysis It is unusual for a firm in a troubled industry to perform well. Economic performance can vary widely across industries. ROE can range from 10.6% for electronic equipment to 29.2% for the cigarette industry

Return on Equity by Industry

Industry Stock Price Performance, 2006

Industry Stock Price Performance, 2009

Defining an Industry Where to draw the line between one industry and another North American Industry Classification System, or NAICS codes Codes assigned to group firms for statistical analysis Firms with the same four-digit NAICS codes are commonly taken to be in the same industry. Industry classifications are never perfect

Examples of NAICS Industry Codes

Sensitivity to the Business Cycle Three factors determine how sensitive a firm’s earnings are to the business cycle. 1. Sensitivity of sales: Necessities (food, drugs, and medical services) vs. discretionary goods (jewelry) Items that are not sensitive to income levels (such as tobacco and movies) vs. items that are, (such as machine tools, steel, autos, transportation)

Industry Cyclicality

Sensitivity to the Business Cycle Operating leverage The split between fixed and variable costs Firms with low operating leverage (less fixed assets) are less sensitive to business conditions. Firms with high operating leverage (more fixed assets) are more sensitive to the business cycle.

Operating Leverage of Firms A and B Throughout the Business Cycle

Sensitivity to the Business Cycle Financial leverage: the use of borrowing Interest is a fixed cost that increases the sensitivity of profits to the business cycle.

Stylized Depiction of the Business Cycle

Sector Rotation Sector rotation: Portfolio is shifted into industries or sectors that should outperform, according to the stage of the business cycle. Selecting Industries in line with the stage of the business cycle Peaks: The economy might be overheated with high inflation and interest rates, and price pressures on basic commodities. Invest on natural resource extraction firms such as minerals or petroleum

Sector Rotation, cont’d Contraction: The economy enters a contraction or recession. Invest on defensive industries such as pharmaceuticals and food Trough: The economy is poised for recovery and subsequent expansion. Invest on capital goods industries such as equipment, transportation and construction firms Expansion: The economy is growing rapidly. Invest on cyclical industries such as consumer durables

Sector Rotation

Industry Life Cycles Stages Start-up: Rapid and increasing sales growth Consolidation: Stable sales growth Maturity: Slowing sales growth Relative Decline: Minimal or negative sales growth

The Industry Life Cycle

Which Life Cycle Stage is Most Attractive? Quote from Peter Lynch in One Up on Wall Street: " Many people prefer to invest in a high-growth industry, where there’s a lot of sound and fury. Not me. I prefer to invest in a low-growth industry in a low-growth industry, especially one that’s boring and upsets people [such as funeral homes or the oil-drum retrieval business], there’s no problem with competition. You don’t have to protect your flanks from potential rivals . . . and this gives you the leeway to continue to grow.” Peter Lynch in One Up on Wall Street

Industry Structure and Performance: Five Determinants of Competition Michael Porter has highlighted five determinants of competition: Threat of entry Rivalry between existing competitors Pressure from substitute products Bargaining power of buyers Bargaining power of suppliers

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.

Basic Sectors Information Technology Telecommunication Services AAPL, MU, GOOG Telecommunication Services T, VZ Industrials GE, CAT Consumer Discretionary GPS, GM Basic Materials MON, DOW Energy XOM, VLO Consumer Staples KO, PG Health Care PFE, LLY, MRK, JNJ Utilities DUK, FE Financials WFC, JPM