2
Framework of Analysis
Fundamental Analysis– Top-down approach (“Three-Step” Valuation
ApproachDomestic and global economic analysis
Industry analysis
Company analysis
– Bottom-up approach
4
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
5
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
7
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.
11
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.
13
Key Economic Variables
Gross domestic product
Employment
Inflation
Interest rates
Budget Deficits
Consumer sentiment
23
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
26
Demand Shocks
Demand– An event that affects the demand for goods
and services in the economyReduction in tax rates
Increases in the money supply
Increases in government spending
Increases in foreign export demand
27
Supply Shocks
Supply– An event that influences production capacity
and production costsChanges in the price of imported oil
Commodity price changes
Floods, Droughts
Changes in the wage rates
Educational level of economic participants
29
Demand-side Policy
Fiscal policy – the government’s spending and taxing actions
Monetary policy – manipulation of the money supply
30
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)
31
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
32
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
34
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.
35
The Business Cycle
Cyclical 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
Defensive Industries
Little sensitivity to the business cycle
Examples include food producers and processors, pharmaceutical firms, and public utilities
Low betas
36
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.
37
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
Economic Indicators
38
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
41
Coincident Indicators - indicators that tend to change directly with the economy
Examples– Industrial production– Manufacturing and trade sales
Economic Indicators (cont)
42
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
Economic Indicators (cont)
47
Economic Calendar
Many sources, such as The Wall Street Journal and Yahoo! Finance, publish the public announcement dates of various economic statistics.
50
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
54
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
56
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)
58
Sensitivity to the Business Cycle
2. Operating leverageThe 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.
60
Sensitivity to the Business Cycle
3. Financial leverage: – the use of borrowing– Interest is a fixed cost that increases the
sensitivity of profits to the business cycle.
62
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
63
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
65
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
67
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
68
Industry Structure and Performance:Five Determinants of Competition
Michael Porter has highlighted five determinants of competition:
1. Threat of entry
2. Rivalry between existing competitors
3. Pressure from substitute products
4. Bargaining power of buyers
5. Bargaining power of suppliers
69
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.