Download Economic and Industry Analysis

Economic and Industry Analysis
Timothy R. Mayes, Ph.D.
FIN 3600: Chapter 11
Fundamental Analysis
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Fundamental analysts look for companies whose
financial health is good and getting better, and which are
undervalued by the market
They scour financial reports, calculate ratios, compare to
other similar companies, etc
Fundamental analysts believe that “earnings drive stock
prices” at least in the long run
Fundamentalists tend to be buy and hold investors, as
opposed to technicians who tend to be shorter-term
traders
Top Down Analysis
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Traditionally, fundamental analysts perform a
“top down” analysis to determine which stocks
to buy or sell.
The top down method consists of:
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A macro economic analysis
An industry analysis
A company analysis
In this chapter we will cover the first two.
Macro Economic Analysis
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There is a strong linkage between growth in the overall
economy and growth in company earnings (which drive
stock prices, at least in the long run).
The following graph shows that changes in nominal GDP
explain about 37% of the changes in corporate profits on
average.
Obviously, then, to know where earnings (and thus stock
prices) are going, we need to know where GDP is going.
A GDP forecast is our starting point. This forecast can
be had from a number of sources including brokerage
firm analysts, bank economists, and the WSJ’s semiannual survey.
Earnings & GDP
Data Source: http://www.freelunch.com
Data are from Q1 1946 to Q2 2001
Example of Economic Forecast
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This forecast, from The Conference Board as of January
3, 2007 is an example of the freely available forecasts
that can be obtained.
III Q*
2.20
2.90
2.90
4.70
4.91
4.90
The U.S. Economic Forecast
Updated: January 3, 2007
2006
2007
IV Q
IQ
II Q
III Q
2.70
2.90
2.70
2.40
-2.50
3.20
3.00
3.00
3.60
3.50
3.50
2.80
4.50
4.50
4.70
4.60
4.94
5.19
5.54
5.79
4.60
4.80
5.00
5.00
IV Q
2.40
3.30
3.00
4.70
6.29
5.25
Real GDP
CPI Inflation
Real Consumer Spending
Unemployment Rate (%)
90 Day T-Bills (%)
10 Yr Treas Bonds (%)
* Actual
Source: The Conference Board (http://www.conference-board.org/economics/stalk.cfm)
2006
Annual
3.40
3.20
3.20
4.60
4.73
4.78
2007
Annual
2.60
2.10
3.30
4.60
5.70
5.01
2008
Annual
2.60
3.30
2.80
4.90
6.29
5.23
Example of Economic Forecast (cont.)
What Your Forecast Should Include
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Any macro economic forecast should include
estimates of all of the important economic
numbers, including:
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Real GDP growth
Inflation rates
Interest rates
Unemployment
And probably others, depending on your needs.
Types of Forecasts
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There are two types of forecasts:
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Quantitative – based on econometric models.
Qualitative – based on educated guesses.
Qualitative forecasting is less difficult, and
probably as good as quantitative forecasting.
Furthermore, we can blend the two methods.
There is another technique known as a
“barometric” forecast which is an average of the
forecasts by many others.
Forecasting for the Layperson
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The most important thing to do is to watch for releases of
various economic statistics by the government and
private sources. These are widely reported by the
financial media (WSJ, CNBC, etc).
Especially, keep an eye out for the Index of Leading
Economic Indicators, The Consumer Confidence Index,
the Fed’s Beige Book, comments by the chairman of the
Board of Governors of the Federal Reserve,
unemployment rates, monthly inflation indices, etc.
Defining Recession and Depression
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An old saw is that a recession is when your neighbor loses his job, and a
depression is when you lose yours.
A better definition (but not exactly correct) is that a recession occurs when
real GDP declines for two consecutive quarters.
The NBER Business Cycling Dating Committee is the official arbiter of the
timing of recessions. Its definition (from http://www.nber.org/cycles.html) is:
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“The NBER does not define a recession in terms of two consecutive quarters of
decline in real GNP. Rather, a recession is a period of significant decline in total
output, income, employment, and trade, usually lasting from six months to a
year, and marked by widespread contractions in many sectors of the economy.”
“A growth recession is a recurring period of slow growth in total output,
income, employment, and trade, usually lasting a year or more. A growth
recession may encompass a recession, in which case the slowdown usually
begins before the recession starts, but ends at about the same time. Slowdowns
also may occur without recession, in which case the economy continues to grow,
but at a pace significantly below its long-run growth.”
A depression is a recession that is major in both scale and duration.
Post WWII Recessions
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There have been 11 recessions in the U.S. economy since
1945. The latest began in March 2001 (though many
indicators began peaking long before that, especially in
Q4 2000), and ended in November 2001.
Peak
Trough
February 1945 (Q1)
October 1945 (Q4)
November 1948 (Q4)
October 1949 (Q4)
July 1953 (Q2)
May 1954 (Q2)
August 1957 (Q3)
April 1958 (Q2)
April 1960 (Q2)
February 1961 (Q1)
December 1969 (Q4)
November 1970 (Q4)
November 1973 (Q4)
March 1975 (Q1)
January 1980 (Q1)
July 1980 (Q3)
July 1981 (Q3)
November 1982 (Q4)
July 1990 (Q3)
March 1991 (Q1)
March 2001 (Q1)
November 2001 (Q4)
Index of Leading Economic Indicators
The LEI has 10 components, each with a specific
weighting:
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Component
1
2
3
4
5
6
7
8
9
10
Leading Indicators
Interest rate spread, 10-year Treasury bonds less federal funds
Money supply, M2
Average weekly hours, manufacturing
Manufacturers' new orders, consumer goods and materials
Stock prices, S&P 500 common stocks
Vendor performance, slower deliveries diffusion index
Average weekly initial claims for unemployment insurance
Building permits, new private housing units
Index of consumer expectations
Manufacturers' new orders, nondefense capital goods
Total
Factor
2002
33.05%
30.38%
18.12%
4.96%
3.08%
2.76%
2.61%
1.91%
1.83%
1.30%
100.00%
Leading Indicators and the Economy
Index of Coincident Indicators
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The Coincident Indicators Index has 4 components,
each with a specific weighting:
Component
1
2
3
4
Coincident Index
Employees on nonagricultural payrolls
Personal income less transfer payments
Manufacturing and trade sales
Industrial production
Total
Factor
2002
52.30%
21.76%
11.87%
14.07%
100.00%
Coincident Indicators and the Economy
Index of Lagging Indicators
The Index of Lagging Indicators has 7 components,
each with a specific weighting:
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Component
1
2
3
4
5
6
7
Lagging Index
Average prime rate
Inventories to sales ratio, manufacturing and trade
Consumer installment credit to personal income ratio
Consumer price index for services
Commercial and industrial loans
Labor cost per unit of output, manufacturing
Average duration of unemployment
Total
Factor
2002
25.21%
12.57%
19.92%
19.29%
13.00%
6.24%
3.78%
100.01%
Lagging Index and the Economy
Consumer Confidence
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The Consumer Confidence index is released monthly.
It is a mail survey of 5,000 individuals with an average of 3,500
responses.
In the survey, respondents are asked 5 questions:
1.
2.
3.
4.
5.
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Respondents appraisal of current business conditions.
Respondents expectations regarding business conditions six months
hence.
Respondents appraisal of the current employment conditions.
Respondents expectations regarding employment conditions six months
hence.
Respondents expectations regarding their total family income six
months hence.
There are three possible responses: Positive, Neutral, Negative.
Consumer Confidence (cont.)
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The index has two components:
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Expectations (most important)
Present Situation
The overall index is calculated as the average of the relative
positive/negative responses to all 5 questions.
The expectations component is an average of the responses to questions 2, 4,
5.
The present situation component is an average of the responses to questions
1 and 3.
Before averaging, all responses are adjusted relative to their 1985 values.
The responses to each question are also seasonally adjusted.
Source:
http://www.consumerresearchcenter.org/consumer_confidence/methodology.htm
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There is also a consumer sentiment index published by the University of
Michigan.
Inflation Indicators
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There are many indicators of inflation in the
economy. (Inflation is defined as a general
increase in the level of prices.)
The four most-watched indicators are:
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The Consumer Price Index (CPI)
The Producer Price Index (PPI)
The GDP Deflator
The Employment Cost Index (ECI)
Consumer Price Index
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The CPI is published monthly by the Bureau of Labor Statistics
(http://www.bls.gov/cpi/).
There are many versions (even one for Denver-Boulder-Greeley area
which is published semiannually), but the most watched is the
Consumer Price Index for All Urban Workers (CPI-U).
The CPI measures the change in price of a “market basket” of goods
typically purchased by consumers. The items in this basket are
determined by periodic surveys of about 30,000 consumers around
the country.
It is broken into two components:
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The total CPI (often called the “Headline Number”)
The Core CPI (ex food and energy which are quite volatile)
Watch both numbers, but the core CPI is the best indicator.
Consumer Price Index (cont.)
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The expenditure items are from 200 categories arranged into 8 major
groups:
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FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full
service meals and snacks);
HOUSING (rent of primary residence, owners' equivalent rent, fuel oil,
bedroom furniture);
APPAREL (men's shirts and sweaters, women's dresses, jewelry);
TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle
insurance);
MEDICAL CARE (prescription drugs and medical supplies, physicians'
services, eyeglasses and eye care, hospital services);
RECREATION (televisions, cable television, pets and pet products, sports
equipment, admissions);
EDUCATION AND COMMUNICATION (college tuition, postage, telephone
services, computer software and accessories);
OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and
other personal services, funeral expenses).
Producer Price Index
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Like the CPI, the PPI is published monthly by
the Bureau of Labor Statistics
(http://www.bls.gov/ppi/).
The PPI measures changes in wholesale prices.
There are over 10,000 versions of the PPI
published every month for individual products
and services.
Investors watch the PPI, but mostly focus on the
CPI.
GDP Deflator
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The GDP Deflator is published quarterly by the Bureau
of Economic Analysis (http://www.bea.doc.gov/) in the
GDP report.
The GDP Deflator measures changes in the prices of all
domestically produced products, and is the broadest of all
inflation indicators.
It includes many things (trains, planes, etc) that
consumers do not buy as well as everything they do buy.
This measure of inflation is less-watched than the CPI,
but it can be important and it tends to be less volatile.
Employment Cost Index
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Like the CPI and PPI, the ECI is published by
the Bureau of Labor Statistics
(http://www.bls.gov/ncs/ect).
The ECI measures changes in the cost of
employee compensation (wages and benefits),
and is published quarterly as part of the National
Compensation Survey .
The ECI is reported to be one of Alan
Greenspan’s favorite inflation measures.
The Beige Book
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The Beige Book
(http://www.federalreserve.gov/FOMC/BeigeBook/2001/
default.htm) is a summary of current economic
conditions around the country published by the Federal
Reserve Board.
The Beige Book is published 8 times per year and is
based on anecdotal evidence gathered through interviews
with bank directors, economists, business contacts, etc.
It contains an overall summary, plus reports from each of
the 12 districts (Colorado is in the 10th district, Kansas
City).
Unemployment
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As part of its monthly Current Population Survey
(http://www.bls.gov/cps/home.htm), the Bureau of Labor Statistics
produces the Unemployment Rate.
The unemployment rate is determined by a survey of individuals
who are then placed into one of three categories:
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Employed
Unemployed and seeking work
Unemployed and not seeking work (“discouraged” workers)
The unemployment rate is the ratio of unemployed to the total
number in the workforce (discouraged workers are not counted).
Note that the “labor force” is actually the civilian labor force, it does
not include those in the military.
Forecasting Is Hard
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“Forecasting is difficult, especially if it concerns the
future.”
That phrase has apparently been uttered by many famous
people, and I can’t track down the original. However,
truer words have never been spoken.
Economic forecasting is especially difficult, and the
forecasts are wrong almost by definition.
There are many reasons why this is the case:
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Old or bad data
Unexpected shocks (the Sept 11 tragedy is a perfect example)
Using historical data which gives no clues about major structural
changes about to occur
Blindly following trends
Forecasting Is Hard (cont.)
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John Casti in his 1990 book Searching for Certainty: What Scientists
Can Know About the Future evaluated forecasters from many fields
and gave economists a “D.” Stock market forecasters got a very
generous “C+” and physicists got an “A.”
Probably the most notoriously wrong forecast of all time came in the
early fall of 1929 when the great economist Irving Fisher said,
"Stock prices have reached what looks like a permanently high
plateau."
So, you see, forecasting is hard and your efforts are nearly always
wrong.
The next slide shows an analysis of just how “accurate” a group of
professional economists were at predicting various indicators about 6
months ahead in 2004.
Forecasting Is Hard (cont.)
Forecasting Is Hard (cont.)
Why Forecast Economic Aggregates?
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We don’t have a choice. We are making decisions whose outcomes
depend on the future, and we must make these decisions using the
best available information that we have.
Otherwise, all decisions may as well be made by a coin toss (and
even bad forecasts are usually better than that).
It is probably best not to pay too much attention to the point
estimates of the forecast, instead look for trends (is GDP expected to
grow slower, faster, or about the same?).
It is also important to constantly be on the lookout for solid reasons
to revise your forecast, and change your decision.
Its no sin to be wrong, but failing to admit it and adjust is.
Industry Analysis
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Once we have done a thorough economic
analysis, we ask the question “which industries
will benefit most from the upcoming economic
environment?”
This will lead to several industries, and our
analysis will lead us to choose the one that we
find to be best positioned.
What is an Industry?
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An industry is a group of companies which produce similar goods
and/or services.
Until recently (and often still), industries were classified by
Standardized Industrial Classification (SIC) codes, but this was
replaced by the North American Industry Classification System
(NAICS, http://www.census.gov/epcd/www/naics.html) which is
much more detailed than SIC.
SIC codes were 4-digit, while the NAICS uses 6 digits for a much
finer, and more useful, breakdown of industries.
NAICS will also facilitate comparisons of companies in the US,
Canada, and Mexico (it was developed by all three countries for this
purpose).
Components of Industry Analysis
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The purpose of industry analysis is to identify which industries will
be good for investors in the upcoming environment.
Your textbook has an excellent discussion of 9 issues that should be
addressed:
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Competitive Structure
Permanence
Phase of Life Cycle
Vulnerability to External Shocks
Regulatory and Tax Conditions
Labor Conditions
Historical Financial Performance
Financial and Financing Issues
Industry Stock Price Valuation
Competitive Structure
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Some of the questions to be answered are:
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What companies are in the industry?
What are their market shares?
Which are publicly traded?
Has the number of competitors been rising, fallen, or
remained stable?
Permanence
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Some of the questions to be answered are:
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Is the industry likely to survive in the long-run?
Are there any major technological threats (such as
laser printer was to the dot matrix printer)?
Are there regulatory threats?
Phase of Life Cycle
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Some of the questions to be answered are:
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Where is the industry in its life cycle? The best
returns and most risk tend to occur early in the cycle.
The possible phases are:
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Birth Phase
Growth Phase
Mature Growth Phase
Stabilization or Decline Phase
Vulnerability to External Shocks
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Some of the questions to be answered are:
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Could major portions of the industry be nationalized
by foreign governments?
Are they dependent on supplies of key commodities
(such as oil)?
Are they subject to external political whims? (South
Africa’s gold industry suffered when Apartheid
became an international issue.)
Are they subject to fashion trends that may soon
change?
Regulatory and Tax Conditions
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Some of the questions to be answered are:
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What are the current regulations that the industry
faces?
Are there likely to be new regulations?
Are the industry’s products subject to special taxes
(such as “sin taxes” on alcohol and tobacco products
or the “windfall profits” tax on oil companies in the
1970’s)?
Are there special tax breaks offered to the industry?
Labor Conditions
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Some of the questions to be answered are:
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What percentage of the industry’s workers are
unionized?
Are the unions generally hostile or complacent?
Is unionization increasing or decreasing?
Are qualified workers easily obtainable, or are they
difficult to find? This has been a particular problem
for the high-tech industries.
Historical Financial Performance
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Some of the questions to be answered are:
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What is the historical record of industry revenue,
earnings and dividends?
Are these financial variables cyclical, countercyclical?
Have they been growing slowly, rapidly, or about
average?
What is the average cost structure in the industry?
Heavy on fixed costs? Or, are variable costs the
lion’s share?
Financial and Financing Issues
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Some of the questions to be answered are:
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How much debt does the average firm have?
What is the mix between fixed assets and current
assets? Is it labor intensive or capital intensive?
What is the average age of the fixed assets? Will they
have to be replaced soon?
Industry Stock Price Valuation
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Some of the questions to be answered are:
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What is the historical average P/E for the industry?
How high has it been? What were the economic
conditions when the highs were hit?
How low has it been? What were the economic
conditions when the lows were hit?
Where is it now? Where should it be, based on
historical economic comparisons?
What kinds of capital gains and dividend yields have
historically been generated?
Sources of Industry Information
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The primary sources of industry-wide information are trade groups,
for example:
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Semiconductor Industry Association (http://www.semichips.org/)
Wards (automobiles, http://www.wardsauto.com/)
Electronics Industry Association (http://www.eia.org/)
Software Publishers Association (http://www.spa.org/)
There are also many trade magazines that may, or may not, be
published by the trade associations.
Additionally, Value Line Investment Survey
(http://www.valueline.com/) publishes an analysis of each of the
industries that they cover.
Finally, research analysts at brokerage firms often provide reports on
the industries that they cover.