Investment Analysis and Portfolio

Management

First Canadian Edition

By Reilly, Brown, Hedges, Chang

Chapter 8
Economic & Industry Analysis

An Overview of the Valuation Process

Why a Three-Step Valuation Process?
Economic Analysis
Industry Analysis

Copyright 2010 by Nelson Education Ltd.

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An Overview of the Valuation Process

Two General Approaches
Top-down, three-step approach
Bottom-up, stock valuation, stock picking
approach
The difference between the two approaches is the
perceived importance of economic and industry
influence on individual firms and stocks
Both of these approaches can be implemented by
either fundamentalists or technicians

Copyright 2010 by Nelson Education Ltd.

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An Overview of the Valuation Process

Three-Step TopDown Process
First examine the
influence of the general
economy on all firms
and the security
markets
Then analyze the
prospects for various
global industries with
the best outlooks in this
economic environment

Copyright 2010 by Nelson Education Ltd.

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An Overview of the Valuation Process

Finally turn to the
analysis of individual
firms in the preferred
industries and to the
common stock of these
firms.

Copyright 2010 by Nelson Education Ltd.

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Why a Three-Step
Valuation Approach?
General Economic Influences
Fiscal policy initiatives, such as tax credits or tax
cuts, can encourage spending
Monetary policy though controlling money supply
growth or interest rate therefore affects all
segments of an economy and that economys
relationship with other economies

Continued
Copyright 2010 by Nelson Education Ltd.

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Why a Three-Step
Valuation Approach?
General Economic Influences
Inflation causes changes the spending and
savings behaviour of consumers and corporations
Other events such as war, political upheavals in
foreign countries, or international monetary
devaluations exert strong effects on the
economies

Copyright 2010 by Nelson Education Ltd.

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Why a Three-Step
Valuation Approach?
Industry Influences
Identify global industries that will prosper or
suffer in the long run or during the expected
near-term economic environment
Different industries react to economic changes at
different points in the business cycle

Continued
Copyright 2010 by Nelson Education Ltd.

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Why a Three-Step
Valuation Approach?
Industry Influences
Alternative industries have different responses to
the business cycle
Demographic factor and international exposure
will also have different impacts on different types
of industries

Copyright 2010 by Nelson Education Ltd.

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Why a Three-Step
Valuation Approach?
Company Analysis
The purpose of company analysis to identify the
best companies in a promising industry
This involves examining a firms past
performance, but more important, its future
prospects

Continued
Copyright 2010 by Nelson Education Ltd.

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Why a Three-Step
Valuation Approach?
Company Analysis
It needs to compare the estimated intrinsic value
to the prevailing market price of the firms stock
and decide whether its stock is a good investment
The final goal is to select the best stock within a
desirable industry and include it in your portfolio
based on its relationship (correlation) with all
other assets in your portfolio

Copyright 2010 by Nelson Education Ltd.

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Does the Three Step Process Work?

Studies indicate that most changes in an
individual firms earnings can be attributed
to changes in aggregate corporate earnings
and changes in the firms industry
Studies have also found a relationship
between aggregate stock prices and various
economic series such as employment,
income, or production
Copyright 2010 by Nelson Education Ltd.

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Does the Three Step Process Work?

An analysis of the relationship between rates
of return for the aggregate stock market,
alternative industries, and individual stocks
showed that 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 stocks
industry

Copyright 2010 by Nelson Education Ltd.

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Economic Analysis:
Understanding Business Cycles
Leading Indicators:
Economic series
that usually reach
peaks or troughs
before
corresponding
peaks or troughs in
aggregate economy
activity

Copyright 2010 by Nelson Education Ltd.

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Economic Analysis:
Understanding Business Cycles
Coincident Indicators:
Economic series that have peaks and troughs that
roughly coincide with the peaks and troughs in the
business cycle

Lagging Indicators:
Economic series that experience their peaks and
troughs after those of the aggregate economy

Copyright 2010 by Nelson Education Ltd.

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Economic Analysis:
Composite Leading Indicator Series
Developed by
Statistics Canada
Overall gauge of
the future
direction of the
Canadian
economy

Copyright 2010 by Nelson Education Ltd.

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Economic Analysis: Money Supply

Friedman and Schwartz (1963) showed:
Declines in the rate of growth of the money
supply have preceded business contraction
Increases in the rate of growth of the money
supply have preceded economic expansions

Copyright 2010 by Nelson Education Ltd.

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Economic Analysis: Money Supply

Friedman (1969) suggested:
A transmission mechanism through which
changes in the growth rate of the money supply
affect the aggregate economy
Federal Reserve plays the central role through the
open market operation

Copyright 2010 by Nelson Education Ltd.

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Economic Analysis: Money Supply

History shows that each recession since 1915 was
preceded by a decline in the growth of money supply

Copyright 2010 by Nelson Education Ltd.

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Economic Analysis:
Inflation, Interest Rates, & Stock 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

Inflation, Interest Rates and Stock Prices

Not direct and not consistent
Effect varies over time
Copyright 2010 by Nelson Education Ltd.

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Economic Analysis:
Inflation, Interest Rates & Stock Prices

Copyright 2010 by Nelson Education Ltd.

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Analysis of World Security Markets

Leading economic series are available for virtually all
the developed countries, and the empirical
relationships to the economy are quite similar to
those of the United States
Real GDP growth is typically consistent with what is
implied by the leading series
Other factors include
The monetary environment
The inflation outlook

Copyright 2010 by Nelson Education Ltd.

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Industry Analysis
What is an Industry?
Identifying an industry can be difficult
Clearly airlines, railroads and utilities are easy to
categorize
How do we deal with manufacturing firms that
have three different divisions none of which are
dominant?

Copyright 2010 by Nelson Education Ltd.

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Characteristics of an Industry
Price History
Price History
P/E ratios
Common Stock Yields
Price/Book Ratios
Price/Cash Flow Ratios
Price/sales Ratios

Copyright 2010 by Nelson Education Ltd.

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Characteristics of an Industry
Operating Data & Results
Operating Data

Comparative Results

Return on Investment

Return on Equity (ROE)

Sales Growth
Trend in Operating Profit

Effects of bus cycles

Secular trends
Industry growth
Regulatory change

Industrial life cycle

Copyright 2010 by Nelson Education Ltd.

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The Business Cycle & Industry Sectors

Cyclical or Structural Changes
Cyclical changes in the economy arise from the ups
and downs of the business cycle
Structure changes occur when the economy undergoes
a major change in organization or how it functions
Rotation strategy is when one switches from one
industry group to another over the course of a
business cycle

Copyright 2010 by Nelson Education Ltd.

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The Business Cycle & Industry Sectors:

Economic Variables
Inflation
Higher inflation is generally negative for stocks

Interest Rates
For example, financial and housing industries
will be adversely affected by high interest rates

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The Business Cycle & Industry Sectors:

Economic Variables
International Economics
Economic growth in world regions or
specific countries benefits industries with a
large presence in the areas

Consumer Sentiment
The performance of consumer cyclical
industries will be affected by changes in
consumer sentiment
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Structural Economic Changes:

Alternative Industries
Social Influences
Demographics
Lifestyles

Technology
Politics and Regulations
Economic reasoning
Fairness
Regulatory changes affect numerous industries
Regulations affect international commerce
Copyright 2010 by Nelson Education Ltd.

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Structural Economic Changes:

Alternative Industries
Social Influences
Demographics
Lifestyles

Technology
Politics and Regulations
Economic reasoning
Fairness
Regulatory changes affect numerous industries
Regulations affect international commerce
Copyright 2010 by Nelson Education Ltd.

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The Industry Life Cycle

The Five-Stage Model
Pioneering
development
Rapidly
accelerating
industry growth
Mature industry
growth
Stabilization and
market maturity
Deceleration of
growth and
decline
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Analysis of Industry Competition

Competition and Expected Industry Returns
Porters concept of competitive strategy is
described as the search by a firm for a favourable
competitive position in an industry
To create a profitable competitive strategy, firm
must first examine basic competitive structure of
its industry
Potential profitability of firm is heavily influenced
by profitability of its industry

Copyright 2010 by Nelson Education Ltd.

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Analysis of Industry Competition

Porters Competitive Forces (Exhibit 8.13)
Rivalry among existing competitors
More rivalry means intense competition

Threat of new entrants

Are there barriers to entry?

Threat of substitute products

Substitute products limit the profit potential of an
industry
Continued
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Analysis of Industry Competition

Porters Competitive Forces (Exhibit 8.13)
Bargaining power of buyers
Volume discounts, quality demands

Bargaining power of suppliers

Can suppliers increase prices or reduce quality?

Copyright 2010 by Nelson Education Ltd.

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Analysis of Industry Competition

Copyright 2010 by Nelson Education Ltd.

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