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CHAPTER 11

CHAPTER 11. Macroeconomic and Industry Analysis. Framework of Analysis. Fundamental Analysis Approach to Fundamental Analysis Domestic and global economic analysis Industry analysis Company analysis Why use the top-down approach. Global Economic Considerations.

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CHAPTER 11

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  1. CHAPTER 11 Macroeconomic and Industry Analysis

  2. Framework of Analysis • Fundamental Analysis • Approach to Fundamental Analysis • Domestic and global economic analysis • Industry analysis • Company analysis • Why use the top-down approach

  3. Global Economic Considerations • Performance in countries and regions is highly variable • Political risk • Exchange rate risk

  4. Performance in countries • Countries Growth in GDP(%) Countries Growth in GDPP(%) Australia 2.6 Austria 0.7 Belgium 0.7 Britain 2.0 Canada 1.0 Denmark -0.8 France -0.2 Germany -0.2 Italy 0.5 Japan 1.8 Netherlands -1.1 Spain 2.4 Sweden 2.0 U.S. 3.5 • Considerable variation in performance across countries • expanding economies: more chance to succeed • contracting economies: less chance to succeed • Based on these performance, form expectation for your investment • economies growing • economies slowing down

  5. Political riskConsider 2 investors: A, an American wishing to invest in Indonesian stocks and an Indonesian wishing to invest in U.S. stocksWhich one would face a more difficult task when doing macroeconomic analysis?

  6. Exchange rate riskUS investors: 2006: invest $1000 in Japan, exchange rate 1USD = 100 Yen, $1000 is worth 100,000 YenIn 2007: 1 USD = 110 Yen, 100,000 Yen = 909 USDLose $91 change in US dollars and other currencies from 1999-2003

  7. Domestic Economy • Gross domestic product • Market value of goods and services produced over a period of time • Unemployment rates • The ratio of number of people classified as unemployed to the total labor force • Interest rates & inflation • inflation is the rate at which the general level of prices is rising. • High inflation is associated with overheated economy • Trade-off between inflation and unemployment • Budget Deficits • Government spending > government revenue • Consumer sentiment • consumers’ optimism and pessimism about the economy

  8. Interest rate4 Factors that can influence interest rates(1) Supply of fund (savers)(2) Demand of fund (borrowers)(3) Government net supply/fund(4) Expected inflation

  9. Demand and Supply Shocks • Demand shock - an event that affects demand for goods and services in the economy • Tax rate cut • Increases in government spending • Supply shock - an event that influences production capacity or production costs • Commodity price changes • Educational level of economic participants

  10. Federal Government Policy • Fiscal Policy - government spending and taxing actions • Increase spending: increase demand • tax increase: reduce demand • Net impact: • budget deficit • budget surplus

  11. Federal Government Policy (cont.) • Monetary Policy - manipulation of the money supply to influence economic activity • Tools of monetary policy • Open market operations • Discount rate • Reserve requirements • If government wants to tighten money supply, what should it do?

  12. Business Cycle

  13. Business Cycles • Business Cycle • Peak • Trough • Industry relationship to business cycles • Cyclical • above average sensitivity to states of economy • Defensive • below sensitivity to states of economy

  14. Business Cycles (examples) • At trough, right before recovery, one would expect cyclical industries to outperform others • (economy increases (decreases) by 1%, the industry increases (decreases) by > 1%) • Example: durable goods: auto, washing machine, financial industries • Cyclical firms: betas > 1 or < 1, high or low betas? • Economy enters recession: • cyclical or defensive • example: food, public utilities, pharmaceutical • Low or high betas? • performance is stable, unaffected by market conditions

  15. NBER Cyclical Indicators: Leading Leading Indicators - tend to rise and fall in advance of the economy Examples • Avg. weekly hours of production workers • Stock Prices • Initial claims for unemployment • Manufacturer’s new orders

  16. NBER Cyclical Indicators: Coincident Coincident Indicators - indicators that tend to change directly with the economy Examples • Industrial production • Manufacturing and trade sales

  17. NBER Cyclical Indicators: Lagging 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

  18. Industry AnalysisEstimates of Earnings Growth Rates in Several Industries, 2004

  19. Industry stock performance in 2003 • Industry Stock return (%) Telecommunication 3.6 Pharmaceuticals 7.2 Food products 7.7 Insurance 16.5 Health care 17.7 Software 21.1 Energy 22.9 Retailing 28.1 Entertainment 38.2 Investment services 40.1 Banking 40.5 Wireless 49 Communications technology 79.7 Semiconductors 93.9

  20. Industry Analysis • Sensitivity to business cycles • Sector Rotation • Industry life cycles

  21. 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

  22. Figure 11.9 Industry Cyclicality Sensitivity of sales of the firm’s product to the business cycles

  23. Operating leverage • Operating leverage = fixed cost / variable cost • If operating leverage is high • fixed cost dominates variable cost • When economy changes, cost do not move enough to offset change in sale • economy goes down, sale decreases, variable cost also decreases, but is dominated by fixed cost, total cost is quite stable, therefore, earning goes down more than the economy • Sale increases, variable cost increases, but still dominated by fixed cost, total cost is quite stable, earning goes up more than economy • Earning is very sensitive to economy • If operating leverage is low: variable cost >> fixed cost • sale goes down, total cost goes down • sale goes up, total cost goes up • earning is stable

  24. Financial leverage • Use of borrowing • Similar to fixed cost • High financial leverage, earning is more sensitive to economy • Low financial leverage, earning is more stable

  25. Sector Rotation

  26. Sector Rotation • Selecting Industries in line with the stage of the business cycle • Near peak – natural resource firms: Minerals, Gas, etc • Contraction – defensive firms: food, pharmaceutical, etc. • Trough – equipment, transportation and construction firms • Expanding – cyclical industries: consumer durables, luxury items

  27. Sector Rotation Gains

  28. Industry Life Cycles StageSales Growth Start-up Rapid & Increasing Consolidation Stable Maturity Slowing Relative Decline Minimal or Negative

  29. Figure 11.11 The Industry Life Cycle

  30. Industry Life Cycle • Example: VCR • Start-up: new, so sale and earnings go up rapidly • Consolidation stage: • product is established, more firms enter, growth rate is stable, and higher than economy • Maturity stage • product reach full potential use by consumers • market is very competitive • pay more dividends • less on reinvestment • Relative decline • new better products come in, e.g., DVD • Substitute for old products

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