Chapter 12 investments macroeconomic and industry analysis

Expected rate of inflation • Interest rates contain a premium for expected infl ation • The Federal Reserve typically raises interest rates proactively when inflation is expected to incr

Chapter 12

Macroeconomic and Industry

Analysis

12.1 The Global Econom y

The Global Economy

• Fundamental Analysis

- Analysis of the determinants of firm value, specifically attempting to forecast the earnings and dividends of a firm

- Top down approach:

Analyze economy

Analyze industry

Analyze firm

• Performance in countries and regions is highly varia

ble

The Global Economy

• Politics affects the economy

EX) The biggest international economic story in late 1997 a

nd

1998 was the turmoil in several Asian economies

- Highlighted the close interplay between politics and

• Foreign exchange rates affect the international compet

itiveness of a country’s industries

-How are the following affected by a change in the value of t

he dollar?

EX) Yen profit on sale of Toyota cars in U.S

The Global Economy

The Global Economy

Figure 12.1 Change in Real Exchange Rate:

Dollar Versus Major Currencies 1999-2008

Appreciating dollar : Goods priced in U.S dollars became more expensive in U.K

12.2 The Domestic Macroeconomy

• Gross domestic product

- The market value of gods and services produced

domestically in a given time period

- Growing GDP indicates an expanding economy, providing a firm wit

h an opportunity to increase sales.

- The rate of change in the general price level as measured by some

price index such as Consumer Price Index or Producer Price Index.

- High rate of inflation are associated with overheated economies wh

Key Economic Variables

Exists trade-off between infla- tion & unem- ployment.

Key Economic Variables

- Budget deficits must be offset by government borrowing

- Large amounts of government borrowing can force up interest ra tes by increasing the total demand for credit in the economy  Ex cessive government borrowing will crowd out private borrowing and investing

Key Economic Variables

• Sentiment

- Consumers’ and Producers’ optimism or pessimism concerning the eco nomy

and job prospects.

- If consumers have confidence in their future income levels, they will be more

willing to spend on big-ticket items

- If firms predict higher demand for their products, businesses will increa

se

production and inventory levels

than the consensus view, you will want to avoid

longer term fixed-income securities

- Unpredicted increases in rates are associated wit

h

stock market declines

Factors Determining the Lev

el of Interest Rates

1 Supply of funds from savers

2 Demand for funds from businesses

3 Government’s net supply and/or demand for fun

ds

• Fiscal policy

• Monetary policy

4 Expected rate of inflation

• Interest rates contain a premium for expected infl

ation

• The Federal Reserve typically raises interest rates proactively when inflation is expected to increase

Figure 12.3 Determination of the Equilibrium Real Rate of Interest

Households ing

Sav-Firm’s mand

De-Budget Deficit

·E

’ ’

Increase in Money Supply

The higher the real interest rate, the greater the supply of household sav- ings.

The lower the real interest rate, the greater the loanable fund demand of firm.

12.4 Demand and Supply Shoc

ks

Demand Shocks

- An event that affects the demand for goods and services, som

e examples include:

• Change in tax rates

• Change in the money supply

• Change in government spending

• Change in foreign export demand

- Positive demand shocks  Increase interest rate  Increase inflation rate

Supply Shocks

- An event that influences production capacity and input costs, including labor costs, examples

include

• Changes in the price or availability of imported oil

• Freezes, Floods, or Droughts

• Changes in the educational level of an economy’s wor kforce

• Changes in wage rates

- Negative supply shocks tend to result in demand > supply, which is inflationary Negative supply shocks also may result in reduced output, leading to slower e

Tie to investments

Choose industries that will be helped by your expec ted economic scenario and avoid those that will be hurt.

• For example, choose consumer cyclical if the economy i

s projected to do well, but not if the economy will weaken,

• May choose consumer staples and necessities such as utilities if the economy is not expected to do well

To earn abnormal returns, you must have better inf ormation (unlikely) or better analysis than the comp

12.5 Federal Government Polic

y

Fiscal Policy

• Government spending and taxing actions to stab

ilize or spur growth in the economy (demand-sid

e management)

- Most direct policy method in terms of its effect on the econom

y (Keynesian policy).

- Often implemented too slowly due to political process.

- Much of government spending such as Medicare or Social Sec urity is determined by formula rather than policy and cannot b

e changed in response to economic conditions

Demand-Side policies

Monetary Policy

• Manipulation of the money supply to influence ec

onomic activity by influencing the demand for go ods and services to be produced and consumed

- Works largely through its impact on interest rates : Increase in the money supply  lower short-term interest rates  encourage invest and consumption demand

: However, over longer periods, a higher money supp

ly  a higher price level

- Stimulation/inflation trade-off

Demand-Side policies

• Tools of monetary policy

 Open market operations

- Buy or sell Treasury bonds

 Discount rate, which is the interest rate it charges banks on short-t erm loans Decrease in discount rate  Expansionary monetary policy

 Reserve requirements, which is the fraction of deposits that bank

s must hold as cash on hand or as deposits with the Fed.

Lowering reserve requirement  Stimulate the economy

 Federal fund rate, which is the interest rate at which banks make short-term, usually overnight, loans to each other.

Monetary Policy

Demand-Side policies

Supply-Side Policies

• Supply-side policies treat the issue of the productive capac ity of the economy

• Purposed for creating an environment in which workers an

d owners of capital have the maximum incentive and abilit

y to produce and develop goods.

• Supply-siders focus on incentives and marginal tax rates.

• Lowering tax rates tends to

- Encourage more investment

12.6 Business Cycles

The Business Cycle

• Recurring patterns of recession and recovery

- Peak: the transition from the end of an expansion to the start of a c ontraction

- Trough: Occurs at the bottom of a recession just as the economy e

Cyclical Indicators

Economic Indicators (cont)

• Coincident Indicators - indicators that tend to cha

nge at the same time as the economy

Economic Indicators (cont)

• Lagging Indicators - indicators that tend to follow

or lag economic performance

Other Indicators

12.7 Industry Analysis

Figure 12.8 Industry Stock Price Performance, 2 011

Defining an Industry

• It can be difficult to define an industry

- North American Industry Classification System (NAICS) attemp

ts to define industry groups with a four or five digit code:

 The first two digits broadly define the industry group: NAIC code 23 = c onstruction

 The last two or three digits define the industry more narrowly

Example of NAICS Industry Co des

Figure 12.9 ROE of Application Software Firms, 20 12

Sensitivity to Business Cycle

Sensitivity to Business Cycle

• Factors affecting sensitivity of earnings to business cycle s

- Sensitivity of sales of the firm’s product to the business cycles

: Necessities will show little sensitivity to business conditions.

EX) food, drugs, and medical services

- Operating leverage, which refers to the division between fixed a

nd

variable costs

• Proportion of fixed operating costs as a percent of total costs

Sensitivity to Business Cycle

- Financial leverage, which is the use of borrowing

• Proportion of fixed financing costs (e.g interest payments) as a percent of total costs

• Greater financial leverage results in greater swings in profits over the busin ess

cycle

• Airlines, banks, investment banks

※ Investors should not always prefer industries with lower sensitivi

ty

to the business cycle.

- While industries with higher sensitivity swing lower in downturns, they also

Figure 12.11 A Stylized Depiction of the Business Cy cle

Sector Rotation

Sector Rotation

: Shift the portfolio more heavily into industry or sector groups that are

expected to outperform based on one’s assessment of the state of the

business cycle.

Selecting Industries in line with the stage of the business cycle:

Peak natural resource firms

Contraction defensive firms such as food and medical

Trough equipment, transportation & construction firms

Expanding cyclical industries such as luxury items

Sector Rotation Illustrated

Industry Life Cycles

Stage Sales Growth

Start-up Rapid & Increasing

Consolidation Stable

Maturity Slowing

Relative Decline Minimal or Negative

Figure 12.13 The Industry Life Cycle

Industry Structure and Performance (Porter Model)

: involves regular changes in the firm’s competitive environment

Determinants of Industry Competition and Profitab ility

• Threat of Entry

- New entrants reduce profitability

- Barriers to entry preserve profitability

• Large scale required to be profitable (autos)

• Secure distribution channels

• Brand loyalty, unique differentiated product

• Proprietary production technology

• Intellectual property protections

Industry Structure and Performance (Porte

r Model)

Determinants of Industry Competition and Profitab

ility

• Rivalry between existing competitors

- Equal competitors reduce profitability

- Slow industry growth,

- High fixed costs,

- Scale economies,

Pressure to Cut Prices

Industry Structure and Performance (Port

er Model)

Determinants of Industry Competition and Profitability

• Pressure from substitute products

- Substitutes limit profitability (propane, natural gas)

• Bargaining power of buyers

- A buyer that purchases a large percent of an industry’s output can

limit the selling industry’s profitability (auto parts suppliers)

• Bargaining power of suppliers

- A supplier that controls a key input can limit the buying industry’s