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Investments: Analysis and Behavior Chapter 9- Business Environment ©2008 McGraw-Hill/Irwin Learning Objectives Know the major forces driving economic growth. Define the economic environment. Identify industries and sectors. Learn the impact of regulation. Analyze the level of corporate governance in a firm. 9-2 Dimensions of the Economy As the economy goes, so goes the businesses and their stock… Macroeconomic Environment aggregate economic activity Gross Domestic Product Interest rates Consumer spending, consumer income employment Microeconomic Environment industry, firm, plant, or product level Industry specific regulation Material prices (aluminum, wheat, oil, etc.) 9-3 Forces Driving the Economy 1) Demographics Baby boom generation Born 1946 through 1964 Significant impact on society: Figure 9.1 U.S. 2005 Population Distribution • spending 25,000 Population in Age Group (in thousands) Baby Boom Generation • saving 20,000 • working/retirement • housing 15,000 10,000 5,000 0 <5 5 to 9 10 to 15 to 20 to 25 to 30 to 35 to 40 to 45 to 50 to 55 to 60 to 65 to 70 to 75 to 80 to > 84 14 19 24 29 34 39 44 49 54 59 64 69 74 79 84 Age (in years) 9-4 2) Productivity The ability to produce more products and services with the same number of people. When productivity growth is robust, the standard of living increases. Gains are often made from advances in technology Computers, Internet, etc. Figure 9.3 Actual and Trend in Labor Productivity 150 Index, 1992 = 100 Trend = 2.5% per year 130 110 Trend = 1.28% per year 90 Actual 70 Trend = 2.51% per year Source: US Bureau of Labor Statistics 2005 2000 1995 1990 1985 1980 1975 1970 1965 50 1960 9-5 Quarterly Trade Deficits -200 Jan-05 Quarter Trade Surplus/Deficit 3) International Trade Imports Exports Jan-04 Jan-03 Jan-02 Jan-01 Jan-00 Jan-99 Jan-98 Jan-97 Jan-96 Jan-95 Jan-94 Jan-93 Jan-92 Jan-91 Jan-90 -1 Jan-75 Jan-74 Jan-73 Jan-72 Jan-71 Jan-70 Jan-69 Jan-68 Jan-67 Jan-66 Jan-65 Jan-64 Jan-63 Jan-62 Jan-61 Jan-60 5 4 3 2 1 0 -2 -3 0 -20 -40 -60 -80 -100 -120 -140 -160 -180 9-6 Business Cycles Pattern of economic recession and expansion Periods of economic expansion are followed by periods of contractions Recession 2 or more concessive quarters of contraction Higher unemployment Restricted credit Reduced output Depression Severe recession (no official definition) 9-7 9-8 Economic Indicators Data series that successfully describe the pattern of projected, current, or past economic activity. Leading indicators Lagging Indicators Money Supply, building permits, manufacturer’s new orders, initial claims for unemployment Consumer price index, inventories, labor cost Coincident Indicators Industrial production, personal income, payrolls 9-9 Sentiment Surveys What people say about their economic plans: 9-10 Grouping and Classifying the Economy and Companies Code Industry Classifications Categorize companies by the principal activity in which they are engaged. North American Industry Classification System (NAICS) US Census Bureau Two to six digits Industry 11 Agriculture, Forestry, Fishing, and Hunting 21 Mining 22 Utilities 23 Construction 31 Manufacturing 42 Wholesale Trade 44-45 Retail Trade 48-49 Transportation and Warehousing 51 Information 52 Finance and Insurance 53 Real Estate and Rental and Leasing 54 Professional, Scientific and Technical Services 55 Management of Companies and Enterprises 56 Admin. and Support, Waste Mgmt, and Remediation 61 Educational Services 62 Health Care and Social Assistance 71 Arts, Entertainment and Recreation 72 Accommodation and Food Services 81 Other Services (except Public Administration) 92 Public Administration 9-11 Standard & Poor’s Sectors 9-12 Competitive Environment Industry’s market structure Number and size of competitors Monopoly Oligopoly Competitive advantage 9-13 Michael Porter characterizes the competitive environment -- five forces Rivalry among existing competitors Threat of new entrants Pressure from substitute products Bargaining power of customers Bargaining power of suppliers 9-14 Measuring Competitiveness Concentration ratios Measures the percentage market share concentrated in an industry’s top four, eight, twenty, or more firms. 0 to 100 Low numbers indicate vigorous competition: greater than 80% means highly concentrated n CR n Firm Sales i 1 i Industry Sales 100 Herfindahl Hirschmann Index (HHI) A measure of competitor size inequality 0 to 10,000 n HHI % Industry Market Share i i 1 2 9-15 Consider an industry with $1 million in sales. The largest firm in the industry has sales of $400,000, the second largest firm has sales of $300,000, the third largest firm has sales of $200,000, and the smallest firm has sales of $100,000. Calculate the CR1, CR2, and CR4 for this industry. Is this industry competitive? Solution: From the formula for the CRn: CR1 400,000 100 40.0 1,000,000 400,000 300,000 CR2 100 70.0 1,000,000 400,000 300,000 200,000 100,000 CR4 100 100.0 1,000,000 9-16 Consider an industry with $1 million in sales. The largest firm in the industry has sales of $400,000, the second largest firm has sales of $300,000, the third largest firm has sales of $200,000, and the smallest firm has sales of $100,000. Calculate the HHI for this industry. Is this industry competitive? Solution: From the formula for the HHI: HHI = ∑ [(Firm Salesi/Industry Sales) 100]2 = [($400,000/$1,000,000) 100]2 + [($300,000/$1,000,000) 100]2 + [($200,000/$1,000,000) 100]2 + [($100,000/$1,000,000) 100]2 = 402 + 302 + 202 + 102 = 3,000 The HHI of 3,000 indicates that firms within this industry are operating in a low competition environment and may have significant market power. 9-17 Legal Environment Regulation All sectors of the US economy are regulated to some degree. OSHA, EPA, etc. Some industries have high regulation Banks, utilities, etc. Costs of regulation are very high 9-18 Antitrust Policy Government promotes competition Reviews mergers for impact on competition Bureau of Competition, Federal Trade Commission Antitrust Division, Department of Justice Figure 9.5 Mergers and Antitrust Activity Merger Announced 4,926 FTC or DOF Investigated Number of Cases 4,728 4,642 3,702 3,087 2,816 2,376 2,305 1,454 1,187 73 1994 101 1995 99 1996 122 1997 125 1998 113 1999 1,014 98 70 49 35 89 2000 2001 2002 2003 2004 Source: 2005 Annual Report to Congress, Federal Trade Commission and Department of Justice 9-19 Corporate Governance Principle-agent problem Separation of ownership and control Stockholders own the firm with little control Managers control the firm with little ownership Why should the managers care about the stockholders? Corporate governance is the monitoring devices and incentives in place to protect stockholders. 9-20 Executive Compensation Aligning managerial incentives Salary Fixed amount Bonus Additional pay for meeting various accounting targets Incentive pay Options, stock, restricted stock Benefits and Perks 9-21 9-22 Monitoring Executives Board of Directors Active shareholders Institutional investors Auditors Analysts Investment banks Credit rating agencies SEC 9-23 Sarbanes-Oxley Act July of 2002 New oversight body to regulate auditors Created laws pertaining to corporate responsibility Boards Independence, structure Managers Responsibility for financial reports Increased punishments for corporate white-collar crime 9-24 Ownership Structure Inside equity Shares held by top management. Does high inside equity mean managers: Are aligned with shareholders? Are entrenched? 9-25