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Security Analysis
Prof Mahesh Kumar
Amity Business School
[email protected]
The Global Economy
Global Factors
a) Exchange Rate
b) Country Risk
c) Credit Risk
d) Protectionism and trade policy
e) Free Flow of Capital
f)
Status of Nation’s Workforce
The Domestic Macro Economy
Domestic Factors
a)
GDP: measure of the economy’s total production
of goods and services. Rapidly growing GDP
indicates an expanding economy with ample
opportunity for a firm to increase sales.
b)
Employment: The unemployment rate is the
percentage of the total labor force yet to find work.
The unemployment rate measures the extent to
which economy is operating at full capacity.
The Domestic Macro Economy
c)
d)
Inflation: is the rate at which the general level of
prices is rising. High rate of inflation is often
associated with ‘overheated’ economies i.e.
economies where demand of goods and services
is over stripping productive capacity, which leads
to upward pressure on prices.
Interest rates: High interest rates reduce the
present value of future cash flows, thereby
reducing the attractiveness of investment
opportunities.
The Domestic Macro Economy
e)
f)
Budget Deficit: The budget deficit of a government is the
difference between government spending and revenues. Any
budgetary shortfall must be offset by government borrowing
and large borrowings will increase the interest rates and thus
choking off the business opportunities.
Sentiments: Consumers’ and producers’ optimism or
pessimism is an important determinant of economic
performance. If consumers have confidence in their future
income levels, for example, they will be more willing to spend
on big ticket items. Similarly businesses will increase
production and inventory levels if they anticipate higher
demand for their products. In this way , beliefs influence how
much consumption and investment will be pursued and affect
the aggregate demand for goods and services.
Demand and Supply Shocks


A demand shock is an event that affects the
demand for goods and services in the economy.
Examples of positive demand shocks are reduction
in tax rates, increase in money supply, increase in
government spending, or increases in foreign export
demand.
A supply shock is an event that influences
production capacity and costs. Examples of supply
shocks are changes in the price of imported oil,
freezes, floods, droughts that might destroy large
quantities of agricultural crops; changes in the
educational level of economy’s work force; or
changes in the wage rates at which the labor force
is willing to work.
Demand and Supply Shocks


Demand shocks are usually characterized by
aggregate output (GDP) moving in the same
direction as interest rates and inflation.
Supply shocks are usually characterized by
aggregate output moving in the opposite
direction as interest rates and inflation.
Fiscal Policy
Fiscal policy refers to the government’s
spending and tax actions and is part of
‘demand side management’. A large budget
deficit means that the government is
spending considerably more than it is taking
by way of taxes. The net effect is to increase
the demand for goods (via spending) by more
than it reduces the demand of goods (via
taxes), thereby stimulating the company.
Monetary Policy

Monetary policy refers to the manipulation of money
supply to affect the macro economy and is the other
main leg side of demand–side policy. Monetary
policy works largely through its impact of interest
rates. Increase in money supply lower short term
interest rates , ultimately encouraging investment
and consumption demand. Over long periods,
however most economist believe higher money
supply leads to a higher price level and does not
have a permanent effect on economic activity.
Supply Side Policies


Supply side policies treat the issue of the productive
capacity of the economy. The goal is to create an
environment in which workers and the owners of
capital have the maximum incentive and ability to
produce and develop goods.
Supply side economists also pay considerable
attention to tax policy. Whereas demand siders look
at the effect of taxes on consumption demand,
supply siders focus on incentives and marginal tax
rates.
Business Cycle


The economy recurrently experiences periods of
expansions and contractions, although the length
and depth of those cycles can be irregular. This
irregular pattern of recession and recovery is called
the business cycle.
The transition points across cycles are called peaks
and troughs. A peak is the transition from the end of
an expansion to the start of contraction. A trough
occurs at the bottom of a recession just as the
economy enters a recovery.
Business Cycle


Performance of different industry groups behave
differently as the economy passes through different
stages of business cycle.
Example, at a trough, cyclical industries, those with
the above-average sensitivity to the state of
economy , would tend outperform other industries.
Examples of cyclical industries are producers of
durable goods such as automobiles or washing
machines and capital goods ( goods used by other
firms to produce their own goods). Because
purchases of these goods can be deferred during
recession, sales are particularly sensitive to macro
economic conditions.
Business Cycle

In contrast to cyclical firms, defensive
industries have little sensitivity to the
business cycle. These are the industries that
produce goods for which sales and profits are
least sensitive to the state of economy.
Defensive industries include food producers
and processors, pharmaceutical firms and
public utilities. These industries will
outperform others when the economy enters
a recession.
Business Cycle

When perception about the health of the economy
becomes more optimistic, for example, the prices of
most stocks will increase as forecasts of profitability
rise. Because cyclical firms are most sensitive to
such developments, their stock prices will rise the
most. Thus the firms in cyclical industries tend
to have high beta stocks. In general, stocks of
cyclical firms will show the best results when
the economic news is positive but the worst
results when that news is bad. Conversely,
defensive firms will have low betas and
performance that is relatively unaffected by
overall market conditions.
Industry Analysis


Just as it is difficult for an industry to perform
well when the macro economy is ailing, it is
unusual for a firm in troubled industry to
perform well.
Just as we have seen that the economic
performance can vary widely across
countries, performance also can vary widely
across industries.
Sensitivity of Industry to the Business Cycle
a)
Three factors will determine the sensitivity of firm’s/
industry earnings to the business cycle.
The sensitivity of sales: Necessities will show
little sensitivity to business conditions. e.g. food,
drugs and medical services. Other industries with
low sensitivity are those for which income is not a
crucial determinant of demand. e.g. tobacco
products, movie industry. In contrast, firms in
industries such as machine tools, steel, autos, and
transportation are highly sensitive to the state of
the economy.
Sensitivity of Industry to the Business Cycle
b)
Operating leverage: refers to the division between
fixed and variable costs. Firms with greater amount
of variable costs as opposed to fixed costs will be
less sensitive to business conditions. This is
because in economic downturns, these firms can
reduce costs as output falls in response to the
falling sales. Firms with high fixed costs are said to
have high operating leverage, as small swings in
business conditions can have large impacts on
profitability.
Sensitivity of Industry to the Business Cycle
c)
Financial Leverage: which refers to the
use of borrowing. Interest payments on debt
must be paid regardless of sales. They are
fixed costs that also increase the sensitivity
of profits to business conditions.
Sector Rotation as Portfolio Management Strategy


On the basis of relationship between industry analysis and the
business cycle, analyst can draw a portfolio on the basis of
sector rotation.
Near the peak of business cycle, the economy might be
overheated with high inflation and interest rates and price
pressures on basic commodities. This might be a good time to
invest in firms engaged in natural resource extraction and
processing such as minerals and petroleum.
Following peak, when the economy enters a contraction or
recession, one should expect defensive industries that are less
sensitive to economic conditions to be the best performers. At the
height of the contraction, financial firms will be hurt by shrinking
loan volume and higher default rates. Towards the end of the
recession, however, contraction induces lower inflation and
interest rates, which favor financial firms.
Sector Rotation as Portfolio Management Strategy


At the trough of recession, the economy is poised
for recovery and subsequent expansion. Firms might
thus be spending on purchases of new equipment to
meet anticipated demand. This, then, would be good
time to invest in capital good industries, such as
equipment, transportation or construction.
Finally, in an expansion, the economy is growing
rapidly. Cyclical industries such as consumer
durables and luxury items will be most profitable in
this stage of the cycle. Banks might also do well in
expansions, since loan volume will be high and
default exposure low when the economy is growing
rapidly.
Industry Life Cycles

A typical industry life cycle might be described by
four stages: a start up stage, characterized by
extremely rapid growth; a consolidation stage,
characterized by growth that is less rapid but still
faster than the general economy; a maturity stage,
characterized by growth no faster than the general
economy ; and a stage of relative decline, in which
the industry grows less rapidly than the rest of the
economy , or actually shrinks.
Industry Life Cycles

Start up stage: The early stages of an industry are
characterized by a new technology or product. At
this stage, it is difficult to predict which firms will turn
out to be wildly successful, and others will fail
altogether. Therefore there is considerable risk in
selecting one particular firm within the industry. At
the industry level, however sales and earnings will
grow at an extremely rapid rate, because the new
product has not yet saturated its market.
Industry Life Cycles

Consolidation stage: After a product becomes
established, industry leaders begin to emerge. The
survivors from the start up stage are more stable,
and market share is easier to predict. Therefore, the
performance of the surviving firms will more closely
track the performance of the overall industry. The
industry still grows faster than the rest of the
economy as the product penetrates the marketplace
and becomes more commonly used.
Industry Life Cycles
•
Maturity Stage: At this point , the product has
reached its full potential for use by consumers.
Further growth might merely track growth in general
economy. The product has become far more
standardized, and producers are forced to compete
to a greater extent on the basis of price. This leads
to narrow profit margins and further pressure on
profits. Firms at this stage sometimes are
characterized as cash cows, having reasonably
stable cash flow but offering little opportunity for
profitable expansion. The cash flow is best ‘milked
from’ rather than reinvested in the company.
Industry Life Cycles
•
Relative Decline: In this stage, the industry
might grow less than the rate of the overall
economy, or it might even shrink. This could
be due to obsolescence of the product,
competition
from
new
products,
or
competition from new low cost suppliers.
Peter Lynch’s classification of Industries


Slow Growers: Large and aging firms that will grow
only slightly faster than the broad economy. These
firms have matured from their earlier fast-growth
phase. They usually have steady cash flow and pay
generous dividend, indicating that the firm is
generating more cash than can be profitably
reinvested in the firm. e.g. Hindalco, Bajaj Auto etc.
Stalwarts: They grow faster than the slow growers,
but are not in the very rapid growth start up stage.
They also tend to be in non cyclical industries that
are relatively unaffected by recession.
Peter Lynch’s classification of Industries


Fast Growers: Small and aggressive new firms with
annual growth rate in the neighborhood of 20% to
25%. Company growth can be due to broad industry
growth or to an increase in market share in a more
mature industry.
Cyclical: These are firms with sales and profits that
regularly expand and contract along with the
business cycle. Examples are auto companies, steel
companies or the construction industry.
Peter Lynch’s classification of Industries


Turnarounds: These are the firms that are in
bankruptcy or soon might be. If they can recover
from what might appear to be imminent disaster,
they can offer tremendous investment returns.
Asset Plays: These are the firms that have valuable
asset not currently reflected in the stock price.
These assets do not immediately generate cash
flow, and so may be more easily overlooked by other
analysts attempting to value the firm.
Profit Potential of Industries: Porter Model
a)
b)
c)
d)
e)
According to this model there are five determinants of competition and profit
potential of industry:
Threat of Entry: Add capacity, inflate costs, push prices down and reduce
profitability. High entry barriers reduce this risk.
Rivalry between existing competitors: If the rivalry between the firms in an
industry is strong, competitive moves and counter moves dampen the
average profitability of the industry.
Pressure from substitute products:
Bargaining Power of Buyers: Buyers can bargain for price cut, ask for
superior quality and better service and induce rivalry among competitors.
If they are powerful they can depress the profitability of supplier industry.
Bargaining Power of Suppliers: Suppliers like buyers can also raise
prices, lower quality and curtail the range of free services they provide.
Technical Analysis


Technical Analysis is essentially the search
for recurrent and predictable patterns in stock
prices. The key to successful technical
analysis is a sluggish response of stock
prices to fundamental supply-and-demand
factors.
Technical analysts are also called as chartists
because they study records or charts of past
stock prices hoping to find patterns they can
exploit to make profit.
The Dow Theory for Technical Analysis

a)
b)
c)
The
Dow
Theory
posits
three
forces
simultaneously affecting stock prices:
The primary trend is the long term movement of
prices, lasting from several months to several
years.
Secondary or intermediate trends are caused by
short term deviation of prices from the underlying
trend line. These deviations are eliminated via
corrections, when prices revert back to trend
value.
Territory or minor trends are daily fluctuations of
little importance.
Technical Analysis involving moving averages

In one version of this approach average prices over
the past several months are taken as indicators of
the ‘true value’ of the stock. If the stock price is
above the value , it may be expected to fall. In
another version, the moving average is taken as
indicative of long term trends. If the trend has been
downward and if the current stock price is below the
moving average then a subsequent increase in
stock price above the moving average line might
signal a reversal of downward trend.
Technical Analysis involving relative strength approach

The chartists compares stock performance
over a recent period to performance of the
market or other stocks in the same industry. A
simple version of relative strength takes the
ratio of the stock price to market indicator
such BSE Sensex. If the ratio increases over
time, the stock is said to exhibit relative
strength because its price performance is
better than that of the broad market.
Technical Analysis involving resistance levels and
support levels

Resistance levels and support levels are the
price levels above which it is difficult for stock
prices to rise , or below which it is unlikely for
them to fall, and they are believed to be
determined by market psychology.
Technical Analysis on the
basis of trading volume

As per this analysis, a price decline
accompanied by heavy trading volume
signals a more bearish market than if volume
were smaller, because the price decline is
taken as representing broader-based selling
pressure