ECONOMIC AND INDUSTRY ANALYSIS

Economic Analysis and Efficient Markets

If markets are efficient, should we bother with analysis?

Yes! In fact, in an efficient market, likely the only way to outperform market averages is to forecast the future better than the consensus.

General Approaches to Security Analysis

Two basic approaches:Emphasize history, looking for trendsFocusing on the future

Still look at some historical information, but focus on looking forward to future trends

Top-down approachBottom-up approach

General Approaches to Security Analysis

Top-Down Approach (Our focus)1. Review the macro-economy2. Analyze different industries and sectors3. Determine buy/sell candidates

Bottom-up Approach Focus primarily on the firm-specific

factors that will lead to success, regardless of industry or macroeconomic factors

A Three-Step Process

Within the three-step process of the top-down approach, all steps are crucialGeneral economic influences Government policies strongly influence the

economic environment, leading to profound effects on industries

Market analysis We can see the influence of changes in the overall

economy on various classes of investments Some investments do better than others before,

during, and after recessions, for instance

A Three-Step Process

Industry Influences We seek to determine which industries will likely

do better than others in the expected economic environment

Also, changing demographic factors have different effects across industries

Company Analysis Individual investments will either make or break

portfolio performance Once well-positioned industries are determined,

find well-positioned firms within those industries

A Three-Step Process

There is academic support for this top-down approach Most changes in individual earnings related to

changes in aggregate earnings and changes in a firm’s industry

There is a relationship between stock and bond prices and macroeconomic variables

Rates of return for individual stocks can be explained by the aggregate stock market and the firm’s industry

A Three-Step Process

Bottoms up to the top down approach! It works!

A Quick Review of Economic Concepts

Domestic Economic ActivityForecasting trends in major economic variables such as GDP, inflation, interest ratesGDP (Gross Domestic Product) components Consumption spending Investment spending Government expenditures Export and import activity

A Quick Review of Economic Concepts

Domestic Economic ActivityDomestic Economic Policies Monetary policy

Policies of the Fed to control the money supply and thereby affect the overall economy

Open market operations Discount rate changes Reserve requirement changes

Fiscal policy Government taxing and spending policies to influence

the economy and pursue other public interests

A Quick Review of Economic Concepts

The Global EconomyDomestic firms impacted by global competition and a global business environmentThe health of foreign economies impacts domestic firms who exportTrade impacted by exchange rates Exchange rates impacted by relative interest rates,

inflation rates, and real economic growth within a country and across countries

Economic and Security Market Influences

As we forecast economic growth, a number of factors will influence our expectations

Influences on Long-term Expectations Technology Population Labor force participation Productivity Resource availability Incentives to expand

Economic and Security Market Influences

Influences on Short-term Expectations Influences caused by fluctuations in demand Liquidity and bank lending Monetary policy Inflation Interest rates International influences Consumer sentiment Tax and other fiscal policy Economic “shocks”

Forecasting Tools

Searching for leading indicators that will provide signals of future economic directionsInflation Indicators Inflation at times is related to turning points in the

business cycle Inflation destroys the purchasing power of wealth Federal Reserve actions indicate likely trends in

inflation Money supply and money growth rates relative to

measures of economic growth Commodity prices

Forecasting Tools

Monetary Indicators Impact both inflation and liquidity Federal Reserve policy

Differences in Interest Rates The Treasury yield curve can sometimes give

indications about future economic growth

Cyclical Economic Indicators Tracking “official” leading economic indicators

Econometric Modeling Models developed to forecast economic variables

Risks in Economic Forecasting

Dominated by “group think” Always using consensus numbers ensures no

better than average forecasts Forecasts must be different (often) and yet still

correct (usually) to create value

Many analysts are short-sightedLots of data can overwhelm usTry to support a positionOver-reliance on expected “normal” changes without regard to the possibility of “shocks”

Expectational Analysis

Underlying concept:

Forecasting should take into account:The current environmentAssumptions behind estimatesA procedure for monitoring both changes in

the environment and violations of the assumptions being made

Expectational Analysis

In the top-down approach:1. Analyze the current macro-economy and make

assumptions about future monetary and fiscal policies.

Apply the analysis to sectors of the economy, identifying key assumptions made about the link between macroeconomic variables and sectors.

2. Apply to industries, linking macro and sector variables and monitoring values over time.

3. Apply to firms, noting Economy-Industry-Firm assumptions that affect recommendations.

Industry Analysis

Many stock research firms organized analysts by industry grouping Industry-specific expertise is valuable

Industry: a set of businesses that produce similar products used by customers for similar purposesSometimes useful to use various industry numerical classifications

Links Between the Economy and IndustriesEconomic trends affect industry performanceEconomic trends: Cyclical changes

Ups and down of the business cycle Different industries experience unique results depending

on the point within the business cycle May call for a “rotation” strategy

Structural changes Changes in government institutions, regulatory

environment, changes in technology, many more Need to anticipate structural changes and analyze the

likely impact on various industries

The Stock Market and the Business Cycle

Financial Stocks Excel

trough

peakConsumer Durables

Excel

Capital Goods Excel

Basic Industries

Excel

Consumer Stapes Excel

Structural Influences

In addition to economic changes, various other trends also represent structural influences that will having varying effects across industries Social Influences

Demographics: baby boom and beyond Lifestyles: changing definition of “traditional” Social values: environment, alcohol, tobacco

Technology Politics and Regulation Theme Investing

Competitive Structure of an Industry

Porter’s competitive forces are factors that determine a firm’s competitive environment Rivalry among existing competitors

Both price-based and non-price-based competition Threat of new entrants

Are there barriers to entry? Threat of substitute products Bargaining power of buyers

Volume discounts, quality demands Bargaining power of suppliers

Can suppliers increase prices or reduce quality?

Industry Life Cycle

Another tool: 5-stage industry life cycle model:1. Pioneering development

After marketing or technological breakthrough

2. Rapidly accelerating industry growthMarket develops, strong demand, new entrants

3. Mature industry growthGrowth starts to flatten

4. Stabilization and market maturityGrowth matches industry growth

5. Deceleration of growth and declineDeclining profits, some losses, exit from industry

Conducting an Industry Analysis

Common problem: paralysis of analysis Lots of data with no defined way of looking at it

Solution: get organized Define the industry Determine who is in the industry Identify and investigate the leading competitors

Read annual reports, industry publications Collect other relevant data from SEC filings, published

information Field interviews with management, customers, etc.