investment analysis and portfolio management first canadian edition
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Investment Analysis and Portfolio Investment Analysis and Portfolio ManagementManagement
First Canadian EditionFirst Canadian EditionBy Reilly, Brown, Hedges, ChangBy Reilly, Brown, Hedges, Chang88
Copyright © 2010 by Nelson Education Ltd. 8-2
• An Overview of the Valuation Process• Why a Three-Step Valuation Process?• Economic Analysis• Industry Analysis
Chapter 8 Economic & Industry Analysis
Copyright © 2010 by Nelson Education Ltd. 8-3
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. 8-4
• Three-Step Top-Down 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
An Overview of the Valuation Process
Copyright © 2010 by Nelson Education Ltd. 8-5
• Finally turn to the analysis of individual firms in the preferred industries and to the common stock of these firms.
An Overview of the Valuation Process
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• 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 economy’s relationship with other economies
Why a Three-Step Valuation Approach?
Continued…
Copyright © 2010 by Nelson Education Ltd. 8-7
• 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
Why a Three-Step Valuation Approach?
Copyright © 2010 by Nelson Education Ltd. 8-8
• 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
Why a Three-Step Valuation Approach?
Continued…
Copyright © 2010 by Nelson Education Ltd. 8-9
• 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
Why a Three-Step Valuation Approach?
Copyright © 2010 by Nelson Education Ltd. 8-10
• Company Analysis• The purpose of company analysis to identify the
best companies in a promising industry• This involves examining a firm’s past
performance, but more important, its future prospects
Why a Three-Step Valuation Approach?
Continued…
Copyright © 2010 by Nelson Education Ltd. 8-11
• 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
Why a Three-Step Valuation Approach?
Copyright © 2010 by Nelson Education Ltd. 8-12
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, income, or production
Copyright © 2010 by Nelson Education Ltd. 8-13
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 stock’s industry
Copyright © 2010 by Nelson Education Ltd. 8-14
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. 8-15
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
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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. 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. 8-19
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. 8-20
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. 8-21
Economic Analysis:Inflation, Interest Rates & Stock Prices
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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. 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?
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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. 8-25
Operating Data• Return on Investment • Return on Equity (ROE)• Sales Growth• Trend in Operating Profit• Industrial life cycle
Comparative Results• Effects of bus cycles• Secular trends• Industry growth• Regulatory change
Characteristics of an Industry Operating Data & Results
Copyright © 2010 by Nelson Education Ltd. 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. 8-27
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
Copyright © 2010 by Nelson Education Ltd. 8-28
• 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
The Business Cycle & Industry Sectors: Economic Variables
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. 8-30
• Social Influences• Demographics• Lifestyles
• Technology• Politics and Regulations
• Economic reasoning• Fairness• Regulatory changes affect numerous industries• Regulations affect international commerce
Structural Economic Changes: Alternative Industries
Copyright © 2010 by Nelson Education Ltd. 8-31
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. 8-32
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. 8-33
• 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
Analysis of Industry Competition
Continued…
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• Porter’s Competitive Forces (Exhibit 8.13)• Bargaining power of buyers
• Volume discounts, quality demands• Bargaining power of suppliers
• Can suppliers increase prices or reduce quality?
Analysis of Industry Competition
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Analysis of Industry Competition
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