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Investment Analysis and Portfolio

Management

8

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. 8-4 .

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. 8-5 . Copyright © 2010 by Nelson Education Ltd.

8-6 . can encourage spending • Monetary policy though controlling money supply growth or interest rate therefore affects all segments of an economy and that economy’s relationship with other economies Continued… Copyright © 2010 by Nelson Education Ltd. such as tax credits or tax cuts.Why a Three-Step Valuation Approach? • General Economic Influences • Fiscal policy initiatives.

political upheavals in foreign countries. 8-7 .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. or international monetary devaluations exert strong effects on the economies Copyright © 2010 by Nelson Education Ltd.

8-8 .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.

8-9 .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.

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 firm’s past performance. its future prospects Continued… Copyright © 2010 by Nelson Education Ltd. but more important. 8-10 .

Why a Three-Step Valuation Approach? • Company Analysis • It needs to compare the estimated intrinsic value to the prevailing market price of the firm’s 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. 8-11 .

or production Copyright © 2010 by Nelson Education Ltd. 8-12 . income.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 also found a relationship between aggregate stock prices and various economic series such as employment.

alternative industries. 8-13 . 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 stock’s industry Copyright © 2010 by Nelson Education Ltd.Does the Three Step Process Work? • An analysis of the relationship between rates of return for the aggregate stock market.

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. 8-14 .

8-15 .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.

8-16 .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.

8-17 .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.

8-18 .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.

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. 8-19 .

Economic Analysis: Inflation. & 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. 8-20 . Interest Rates.

Interest Rates & Stock Prices Copyright © 2010 by Nelson Education Ltd.Economic Analysis: Inflation. 8-21 .

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. 8-22 .

8-23 .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.

8-24 .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.

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. 8-25 .

8-26 .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.

financial and housing industries will be adversely affected by high interest rates Copyright © 2010 by Nelson Education Ltd. 8-27 .The Business Cycle & Industry Sectors: Economic Variables • Inflation • Higher inflation is generally negative for stocks • Interest Rates • For example.

8-28 .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 Copyright © 2010 by Nelson Education Ltd.

8-29 .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.

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. 8-30 .

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 Copyright © 2010 by Nelson Education Ltd. 8-31 .

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 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. 8-32 .

Analysis of Industry Competition • Porter’s 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… Copyright © 2010 by Nelson Education Ltd. 8-33 .

13) • Bargaining power of buyers • Volume discounts. 8-34 .Analysis of Industry Competition • Porter’s Competitive Forces (Exhibit 8. quality demands • Bargaining power of suppliers • Can suppliers increase prices or reduce quality? Copyright © 2010 by Nelson Education Ltd.

Analysis of Industry Competition Copyright © 2010 by Nelson Education Ltd. 8-35 .