Economic and Industry Analysis

1. Economic and Industry Analysis Combined from various files 9-2010

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

3. Performance in countries and regions is highly variable. Political risk Exchange rate risk Sales Profits Stock returns Global Economic Considerations

4. Table 17.1 Economic Performance in Selected Emerging Markets

5. Gross domestic product Unemployment rates Interest rates & inflation Budget deficit Consumer sentiment Key Economic Variables

6. Fiscal Policy - government spending and taxing actions. Direct policy Slowly implemented Federal Government Policy

7. Monetary Policy - manipulation of the money supply to influence economic activity. Initial & feedback effects Tools of monetary policy Open market operations Discount rate Reserve requirements Supply Side Policies Federal Government Policy (cont�d)

8. Figure 17.10 A stylized Depiction of the Business Cycle

9. Cyclical Economic Factors Inflation Interest rates International economics Consumer sentiment

10. Cyclical Indicator Approach to Forecasting the Economy National Bureau of Economic Research (NBER) Cyclical indicator categories leading indicators coincident indicators lagging indicators Composite series and ratio of series

11. Figure 17.3 Cyclical Indicators

12. Table 17.2 Indexes of Economic Indicators

13. Figure 17.4 Indexes of Leading, Coincident, and Lagging Indicators

14. Table 17.3 Economic Calendar

15. Figure 17.5 Economic Calendar at Yahoo!

16. Table 17.4 Useful Economic Indicators

17. Economies and Markets Security markets reflect what is going on in an economy because the value of an investment is determined by its expected cash flows required rate of return Macroeconomic approach Microanalysis approach Technical analysis approach

18. Monetary Variables, the Economy, and Stock Prices Money supply and the economy Money supply and stock prices Excess liquidity and stock prices year to year percentage change in M2 money supply adjusted for small time deposits less the year-to-year percentage change in nominal GDP

19. Monetary Variables, the Economy, and Stock Prices Other economic variables and stock prices growth in industrial production changes in the risk premium twists in the yield curve measures of unanticipated inflation changes in expected inflation during periods of volatile inflation

20. Inflation, Interest Rates, and Security Prices Inflation and interest rates generally move together investors are not good at predicting inflation Inflation rates and bond prices negative relationship more effect on longer term bonds Interest rates and stock prices not direct and not consistent effect varies over time

21. Structural Economic Changes and Alternative Industries Social Influences Demographics Lifestyles Technology Politics and regulations Economic reasoning, Fairness, Regulatory changes affect industries, Taxation Globalization�and its effects on international politics and commerce

22. Theme Investing Based on identifying emerging trends, such as: Technology Aging population Freer trade and developing-country growth Identification of themes provides insight into industry analysis

23. Analysis of World Security Markets Goldman, Sachs & Co. World Investing Strategy Highlights Inflation and exchange rates Correlations among returns Individual country stock price changes Individual country analysis World asset allocation

24. The Stock Market and the Business Cycle

25. The Stock Market and the Business Cycle

26. The Stock Market and the Business Cycle

27. Links Between the Economyand Industry Sectors Identify and monitor key assumptions and variables Economic trends are either Cyclical - up and down with business cycle Structural - major change Combined changes have implications for the industry being analyzed Switching from one industry group to another over the course of a business cycle is known as a rotation strategy

28. Sector Rotation Portfolio is adjusted by selecting companies that should perform well for the stage of the business cycle Peaks � natural resource extraction firms Contraction � defensive industries such as pharmaceuticals and food Trough � capital goods industries Expansion � cyclical industries such as consumer durables

29. Industry Analysis The second step in the three-step fundamental analysis procedure In the first step (chapter 14) we discussed the macroanalysis of the stock market The last step will analyze individual companies and stocks

30. Sensitivity to business cycles Factors affecting sensitivity of earnings to business cycles: Sensitivity of sales of the firm�s product to the business cycles Operating leverage Financial leverage Industry life cycles Industry Analysis

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

32. Figure 17.11 The Industry Life Cycle

33. Life Cycle-Sales and Profits

34. Market Share and cost

35. Analysis of Industry Competition Competition and Expected Industry Returns Porter�s concept of competitive strategy is described as the search by a firm for a favorable competitive position in an industry To create a profitable competitive strategy, a firm must first examine the basic competitive structure of its industry The potential profitability of a firm is heavily influenced by the profitability of its industry

36. Forces Driving Industry Competition Porter�s believes that five competitive forces determine the intensity of competition, and the relative effect of each of these five factors can vary dramatically among industries. As shown in the illustration, these five factors are: Rivalry among existing competitors For each industry analyzed, you must judge if the rivalry among firms is currently intense and growing, or if it is polite and stable. Rivalry increases when many firms of relatively equal size compete in the same industry. Be sure to include foreign competitors in your analysis. Other factors that tend to increase competition include: slow growth, high fixed costs, and exit barriers. Threat of new entrants While an industry may have few firms, you have to determine the likelihood of firms entering the industry and increasing competition. Threat of substitute products Substitute products limit the prices firms in the industry can charge. Bargaining power of buyers Buyers can influence the profitability of an industry because they can bid down prices or demand higher quality or more services by bargaining among competitors. Bargaining power of suppliers Suppliers can alter future industry returns if they increase prices or reduce the quality or services they provide. The fewer suppliers, the more powerful they are. Porter�s believes that five competitive forces determine the intensity of competition, and the relative effect of each of these five factors can vary dramatically among industries. As shown in the illustration, these five factors are: Rivalry among existing competitors For each industry analyzed, you must judge if the rivalry among firms is currently intense and growing, or if it is polite and stable. Rivalry increases when many firms of relatively equal size compete in the same industry. Be sure to include foreign competitors in your analysis. Other factors that tend to increase competition include: slow growth, high fixed costs, and exit barriers. Threat of new entrants While an industry may have few firms, you have to determine the likelihood of firms entering the industry and increasing competition. Threat of substitute products Substitute products limit the prices firms in the industry can charge. Bargaining power of buyers Buyers can influence the profitability of an industry because they can bid down prices or demand higher quality or more services by bargaining among competitors. Bargaining power of suppliers Suppliers can alter future industry returns if they increase prices or reduce the quality or services they provide. The fewer suppliers, the more powerful they are.

37. Competitive Structure of an Industry Porter�s Competitive Forces Rivalry among existing competitors Threat of new entrants Threat of substitute products Bargaining power of buyers Bargaining power of suppliers

40. Firm Competitive Strategies-Merck Current rivalry Moderate and Growing Consolidation Trend Joint Venture Trend Generics Competition

41. Firm Competitive Strategies-Merck Suppliers� Bargaining Power Low Numerous suppliers available

42. Firm Competitive Strategies-Merck Threat of Substitutes Moderate and Growing Low Elasticity of Demand Increasing Generics Market Imports from Canada

43. Firm Competitive Strategies-Merck Threat of New Entrants Low High Barriers Long Patent Protection High R&D Requirements

44. Firm Competitive Strategies-Merck Buyers� Bargaining Power Moderate and Growing Still somewhat fragmented Growing power of HMOs Influence of Pharmacy Benefit Firms Role of Government � Medicare/Medicaid

45. Intra-Industry Analysis Directly compare two firms in the same industry An alternative use of T to determine a reasonable P/E ratio Factors to consider A major difference in the risk involved Inaccurate growth estimates Stock with a low P/E relative to its growth rate is undervalued Stock with high P/E and a low growth rate is overvalued

46. Sales Forecasting and Industry Life Cycle Pioneering development Rapidly accelerating industry growth Mature industry growth Stabilization and market maturity Deceleration of growth and decline

47. Forecasting Earnings Per Share Analysis of industry competition Analysis of competitive structure Porter�s concept of competitive strategy

48. Competitive Structure of an Industry Porter�s Competitive Forces Rivalry among existing competitors Threat of new entrants Threat of substitute products Bargaining power of buyers Bargaining power of suppliers

49. Porter�s Competitive Strategies Current rivalry Threat of new entrants Potential substitutes Bargaining power of suppliers Bargaining power of buyers

50. Identifying and Selecting Competitive Strategies Five conditions affecting the competitive structure and profits of an industry 1. Current rivalry 2. Threat of new entrants 3. Potential substitutes 4. Bargaining power of suppliers 5. Bargaining power of buyers In describing competition within industries, five conditions have been identified that would affect the competitive structure and profits of an industry. 1. current rivalry 2. threat of new entrants 3. potential substitutes 4. bargaining power of suppliers 5. bargaining power of buyers.In describing competition within industries, five conditions have been identified that would affect the competitive structure and profits of an industry. 1. current rivalry 2. threat of new entrants 3. potential substitutes 4. bargaining power of suppliers 5. bargaining power of buyers.

51. Firm Competitive Strategies Defensive strategy involves positioning firm so that it its capabilities provide the best means to deflect the effect of competitive forces in the industry Offensive strategy involves using the company�s strength to affect the competitive industry forces, thus improving the firm�s relative industry position Porter suggests two major strategies: low-cost leadership and differentiation

52. Porter's Competitive Strategies Low-Cost Strategy The firm seeks to be the low-cost producer, and hence the cost leader in its industry Differentiation Strategy firm positions itself as unique in the industry

53. Focusing a Strategy Select segments in the industry Tailor strategy to serve those specific groups Determine which strategy a firm is pursuing and its success Evaluate the firm�s competitive strategy over time

54. Select one or several segments in the industry to which it tailors its strategy. Firm�s Questions? � Do unique cost or need opportunities exists? � Are they are being served by another firm? � Can they be priced to generate abnormal returns to the firm? Focusing a Strategy Whichever strategy a firm selects, it must determine where it should be focused. A firm must select one or several segments in the industry and tailor its strategy to serve this specific group. For example, a cost focus typically would exploit cost advantages for certain segments of the market. Similarly, a differentiation focus would attempt to serve the special needs of buyers in specific segments. For example, athletic shoe companies have attempted to differentiate based on the type of sport associated with their shoe products. When focusing a strategy a firm must answer several questions. Are there any special costs or need possibilities to serve? If so, are they being served by another firm? And, can this service be priced to generate abnormal returns to the firm? Next the analyst must consider several questions. Which strategy is being pursued? Is the firm successful in pursuit of its strategy? And if the strategies are being sustained? Finally, evaluate a firm�s competitive strategy overtime because strategies need to change as the industry evolves. Different strategies work during different phases of an industry�s life-cycle. Whichever strategy a firm selects, it must determine where it should be focused. A firm must select one or several segments in the industry and tailor its strategy to serve this specific group. For example, a cost focus typically would exploit cost advantages for certain segments of the market. Similarly, a differentiation focus would attempt to serve the special needs of buyers in specific segments. For example, athletic shoe companies have attempted to differentiate based on the type of sport associated with their shoe products. When focusing a strategy a firm must answer several questions. Are there any special costs or need possibilities to serve? If so, are they being served by another firm? And, can this service be priced to generate abnormal returns to the firm? Next the analyst must consider several questions. Which strategy is being pursued? Is the firm successful in pursuit of its strategy? And if the strategies are being sustained? Finally, evaluate a firm�s competitive strategy overtime because strategies need to change as the industry evolves. Different strategies work during different phases of an industry�s life-cycle.

55. Analyst�s Questions? � Which strategy is being pursued? � Is the firm successful? � Are strategies are being sustained? � Does strategy need to be changed? Focusing a Strategy Whichever strategy a firm selects, it must determine where it should be focused. A firm must select one or several segments in the industry and tailor its strategy to serve this specific group. For example, a cost focus typically would exploit cost advantages for certain segments of the market. Similarly, a differentiation focus would attempt to serve the special needs of buyers in specific segments. For example, athletic shoe companies have attempted to differentiate based on the type of sport associated with their shoe products. When focusing a strategy a firm must answer several questions. Are there any special costs or need possibilities to serve? If so, are they being served by another firm? And, can this service be priced to generate abnormal returns to the firm? Next the analyst must consider several questions. Which strategy is being pursued? Is the firm successful in pursuit of its strategy? And if the strategies are being sustained? Finally, evaluate a firm�s competitive strategy overtime because strategies need to change as the industry evolves. Different strategies work during different phases of an industry�s life-cycle. Whichever strategy a firm selects, it must determine where it should be focused. A firm must select one or several segments in the industry and tailor its strategy to serve this specific group. For example, a cost focus typically would exploit cost advantages for certain segments of the market. Similarly, a differentiation focus would attempt to serve the special needs of buyers in specific segments. For example, athletic shoe companies have attempted to differentiate based on the type of sport associated with their shoe products. When focusing a strategy a firm must answer several questions. Are there any special costs or need possibilities to serve? If so, are they being served by another firm? And, can this service be priced to generate abnormal returns to the firm? Next the analyst must consider several questions. Which strategy is being pursued? Is the firm successful in pursuit of its strategy? And if the strategies are being sustained? Finally, evaluate a firm�s competitive strategy overtime because strategies need to change as the industry evolves. Different strategies work during different phases of an industry�s life-cycle.

56. Company Analysis

57. SWOT Analysis Examination of a firm�s: Strengths Weaknesses Opportunities Threats

58. SWOT Analysis Examination of a firm�s: Strengths Weaknesses Opportunities Threats

59. SWOT Analysis Examination of a firm�s: Strengths Weaknesses Opportunities Threats

60. Measures of Value-Added Consider economic profit � NPV in capital budgeting Uses � Measure management performance � Indicators of future returns Economic Value-Added (EVA) Market Value-Added (MVA) There has been a growing interest in a set of performance measures referred to as �value-added.� These measures consider economic profit, which is analogous to the net present value (NPV) technique used in capital budgeting. These value-added measures are mainly used to measure management performance. Similarly, they are also being used by security analysts as possible indicators of future equity returns. We will consider two measures of value-added: Economic Value-Added, and Market Value Added. There has been a growing interest in a set of performance measures referred to as �value-added.� These measures consider economic profit, which is analogous to the net present value (NPV) technique used in capital budgeting. These value-added measures are mainly used to measure management performance. Similarly, they are also being used by security analysts as possible indicators of future equity returns. We will consider two measures of value-added: Economic Value-Added, and Market Value Added.

61. The Earnings Multiple Technique Estimating earnings per share start with forecasting sales per share Industrial life cycle Input-output analysis Industry-aggregate economy relationship earnings forecasting and analysis of industry competition competitive strategy competitive environment industry operating profit margin industry earnings estimate industry earnings multiplier

62. Company Analysis Peter Lynch Warren Buffett

63. Categorizing Companies-Lynch 1. Slow growers 2. Stalwart 3. Fast growers 4. Cyclicals 5. Turnarounds 6. Asset plays

64. Peter Lynch�s Stock Types 1. Slow grower grows with GDP- Dividend yield, not PE 2. Stalwarts- they grow faster (10-12%) than a slow grower, but not fast- PE ratio important 3. Fast grower, 20-25% growth --Lynch ratio=g/PE>1.0 Must understand the product. 4. Turnaround-battered, depressed, HIGH RISK 5. Asset Plays-value that Wall Street does not recognize 6. Cyclical-�timing is everything� two decision stock, buy high PE and sell low PE

65. Favorable Attributes of Firms 1. Firm�s product is not faddish 2. Company has competitive advantage over rivals 3. Industry or product has potential for market stability 4. Firm can benefit from cost reductions 5. Firm is buying back its own shares or managers (insiders) are buying

66. Tenets of Warren Buffet Business Tenets Management Tenets Financial Tenets Market Tenets

67. Business Tenets Is the business simple and understandable? Does the business have a consistent operating history? Does the business have favorable long-term prospects?

68. Management Tenets Is management rational in allocation capital? Is management candid with with its shareholders? Does management resist the institutional imperative? Does management just do what others are doing or do they think and act independently?

69. Financial Tenets Focus on return on equity, not earnings per share Calculate �owner earnings� including the effects on cash flow of capital expenditures Look for companies with high profit margins For every dollar retained, make sure the company has created at least one dollar of market value

70. Market Tenets INTRINSIC VALUE---What is the value of the business? MARGIN OF SAFETY---Can the business be purchased at a significant discount to its fundamental intrinsic value?

71. Growth Rate Estimates Compound Average Historical Dividend Growth Rate (or use PV and FV and I/Y) Sustainable Growth Rate = RR X ROE

72. An Alternate Measure of Growth g = (RR)(ROIC) where: RR = the average retention rate ROIC = EBIT (1-Tax Rate)/Total Capital

73. Analysis of Growth Companies Generating rates of return greater than the firm�s cost of capital is considered to be temporary Earnings higher the required rate of return are pure profits How long can they earn these excess profits? Is the stock properly valued?

74. Measures of Value-Added page 593 The Franchise Factor Breaks P/E into two components P/E based on ongoing business (base P/E) Franchise P/E the market assigns to the expected value of new and profitable business opportunities Franchise P/E = Observed P/E - Base P/E Incremental Franchise P/E = Franchise Factor X Growth Factor =((IRR � k) / (ROE x k)) x (PV new growth projects/PV firm)

75. Growth Duration Evaluate the high P/E ratio by relating P/E ratio to the firm�s rate and duration of growth � T model (see p 594) P/E is function of expected rate of growth of earnings per share stock�s required rate of return firm�s dividend-payout ratio

76. Intra-Industry Analysis Directly compare two firms in the same industry An alternative use of T to determine a reasonable P/E ratio Factors to consider A major difference in the risk involved Inaccurate growth estimates Stock with a low P/E relative to its growth rate is undervalued Stock with high P/E and a low growth rate is overvalued

77. Intrinsic Value Self assigned Value Variety of models are used for estimation Market Price Consensus value of all potential traders Trading Signal IV > MP Buy IV < MP Sell or Short Sell IV = MP Hold or Fairly Priced Intrinsic Value and Market Price

78. Site Visits and the Art of the Interview Focus on management�s plans, strategies, and concerns Restrictions on nonpublic information �What if� questions can help gauge sensitivity of revenues, costs, and earnings Management may indicate appropriateness of earnings estimates Discuss the industry�s major issues Review the planning process Talk to more than just the top managers

79. Influences on Analysts Investment bankers may push for favorable evaluations Corporate officers may try to convince analysts Analyst must maintain independence and have confidence in his or her analysis

80. When to Sell Holding a stock too long may lead to lower returns than expected If stocks decline right after purchase, is that a further buying opportunity or an indication of incorrect analysis? Continuously monitor key assumptions Evaluate closely when market value approaches estimated intrinsic value Know why you bought it and watch for that to change

81. Efficient Markets Opportunities are mostly among less well-known companies To outperform the market you must find disparities between stock values and market prices - and you must be correct Concentrate on identifying what is wrong with the market consensus and what earning surprises may exist