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Macroeconomic and
Industry Analysis
CHAPTER 11
1
Framework of Analysis


Fundamental Analysis
Approach to Fundamental Analysis
 Domestic
and global economic analysis
 Industry analysis
 Company analysis

Why use the top-down approach
Global Economic Considerations
Performance in countries and regions is highly
variable
 Political risk
 Exchange rate risk

Performance in countries

Countries
Australia
Belgium
Canada
France
Italy
Netherlands
Sweden

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
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Growth in GDP(%)
2.6
0.7
1.0
-0.2
0.5
-1.1
2.0
Countries
Growth in GDPP(%)
Austria
Britain
Denmark
Germany
Japan
Spain
U.S.
Considerable variation in performance across countries
expanding economies: more chance to succeed
contracting economies: less chance to succeed
Based on these performance, form expectation for your investment
 economies growing
 economies slowing down
0.7
2.0
-0.8
-0.2
1.8
2.4
3.5
Political risk
Consider 2 investors: A, an American wishing to invest in Indonesian stocks and an
Indonesian wishing to invest in U.S. stocks
Which one would face a more difficult task when doing macroeconomic analysis?
Exchange rate risk
US investors:
2006: invest $1000 in Japan, exchange rate 1USD = 100 Yen, $1000 is
worth 100,000 Yen
In 2007: 1 USD = 110 Yen, 100,000 Yen = 909 USD
Lose $91
Domestic Economy

Gross domestic product


Unemployment rates

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inflation is the rate at which the general level of prices is rising.
High inflation is associated with overheated economy
Trade-off between inflation and unemployment
Budget Deficits


The ratio of number of people classified as unemployed to the
total labor force
Interest rates & inflation


Market value of goods and services produced over a period of
time
Government spending > government revenue
Consumer sentiment

consumers’ optimism and pessimism about the economy
Interest rate
4 Factors that can influence interest rates
(1)
Supply of fund (savers)
(2)
Demand of fund (borrowers)
(3)
Government net supply/fund
(4)
Expected inflation
Demand and Supply Shocks

Demand shock - an event that affects demand for goods and
services in the economy
 Tax rate cut
 Increases in government spending

Supply shock - an event that influences production capacity or
production costs
 Commodity price changes
 Educational level of economic participants
Federal Government Policy

Fiscal Policy - government spending and taxing
actions
 Increase
spending: increase demand
 tax increase: reduce demand
 Net impact:


budget deficit
budget surplus
Federal Government Policy (cont.)
Monetary Policy - manipulation of the
money supply to influence economic
activity
 Tools of monetary policy

 Open
market operations
 Discount rate
 Reserve requirements

If government wants to tighten money
supply, what should it do?
Business Cycle
Business Cycles

Business Cycle
 Peak
 Trough

Industry relationship to business cycles
 Cyclical

above average sensitivity to states of economy
 Defensive

below sensitivity to states of economy
Business Cycles (examples)

At trough, right before recovery, one would expect cyclical
industries to outperform others




(economy increases (decreases) by 1%, the industry increases
(decreases) by > 1%)
Example: durable goods: auto, washing machine, financial industries
Cyclical firms: betas > 1 or < 1, high or low betas?
Economy enters recession:


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cyclical or defensive
example: food, public utilities, pharmaceutical
Low or high betas?
performance is stable, unaffected by market conditions
NBER Cyclical Indicators: Leading
Leading Indicators - tend to rise and fall
in advance of the economy
Examples
 Avg.
weekly hours of production workers
 Stock Prices
 Initial claims for unemployment
 Manufacturer’s new orders
NBER Cyclical Indicators: Coincident
Coincident Indicators - indicators that tend
to change directly with the economy
Examples
 Industrial
production
 Manufacturing and trade sales
NBER Cyclical Indicators: Lagging
Lagging Indicators - indicators that tend
to follow the lag economic performance
Examples
 Ratio
of trade inventories to sales
 Ratio of consumer installment credit
outstanding to personal income
Industry Analysis
Estimates of Earnings Growth Rates in Several Industries,
2004
Industry stock performance in 2003
Industry
Telecommunication
Pharmaceuticals
Food products
Insurance
Health care
Software
Energy
Retailing
Entertainment
Investment services
Banking
Wireless
Communications technology
Semiconductors

Stock return (%)
3.6
7.2
7.7
16.5
17.7
21.1
22.9
28.1
38.2
40.1
40.5
49
79.7
93.9
Industry Analysis
Sensitivity to business cycles
 Sector Rotation
 Industry life cycles

Sensitivity to Business Cycle

Factors affecting sensitivity of earnings to
business cycles
 Sensitivity
of sales of the firm’s product to the
business cycles
 Operating leverage
 Financial leverage
Figure 11.9 Industry Cyclicality
Sensitivity of sales of the firm’s product to the business cycles
Operating leverage


Operating leverage = fixed cost / variable cost
If operating leverage is high
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
fixed cost dominates variable cost
When economy changes, cost do not move enough to offset change in
sale

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economy goes down, sale decreases, variable cost also decreases, but is
dominated by fixed cost, total cost is quite stable, therefore, earning goes
down more than the economy
Sale increases, variable cost increases, but still dominated by fixed cost,
total cost is quite stable, earning goes up more than economy
Earning is very sensitive to economy
If operating leverage is low: variable cost >> fixed cost

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sale goes down, total cost goes down
sale goes up, total cost goes up
earning is stable
Financial leverage

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Use of borrowing
Similar to fixed cost
High financial leverage, earning is more sensitive to economy
Low financial leverage, earning is more stable
Sector Rotation
Sector Rotation
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Selecting Industries in line with the stage of the business cycle
Near peak – natural resource firms: Minerals, Gas, etc
Contraction – defensive firms: food, pharmaceutical, etc.
Trough – equipment, transportation and construction firms
Expanding – cyclical industries: consumer durables, luxury
items
Sector Rotation Gains
Industry Life Cycles
Stage
Sales Growth
Start-up
Consolidation
Maturity
Relative Decline
Rapid & Increasing
Stable
Slowing
Minimal or Negative
Figure 11.11 The Industry Life Cycle
Industry Life Cycle
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Example: VCR
Start-up: new, so sale and earnings go up rapidly
Consolidation stage:


Maturity stage

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product is established, more firms enter, growth rate is stable, and
higher than economy
product reach full potential use by consumers
market is very competitive
pay more dividends
less on reinvestment
Relative decline


new better products come in, e.g., DVD
Substitute for old products