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CHAPTER 11
Macroeconomic and
Industry Analysis
12-1
13.2 A Description of Efficient
Capital Markets
• An efficient capital market is one in which stock
prices fully reflect available information.
• The EMH has implications for investors and firms.
– Since information is reflected in security prices quickly,
knowing information when it is released does an investor
no good.
– Firms should expect to receive the fair value for
securities that they sell. Firms cannot profit from fooling
investors in an efficient market.
12-2
Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Stock
Price
Overreaction to “good
news” with reversion
Delayed
response to
“good news”
Efficient market
response to “good news”
-30
-20
-10
0
+10
+20 +30
Days before (-) and
after (+) announcement
12-3
Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
Stock
Price
Efficient market
response to “bad news”
-30
-20
-10
Overreaction to “bad
news” with reversion
Delayed
response to
“bad news”
0
+10
+20
+30
Days before (-) and
after (+) announcement
12-4
The Different Types of Efficiency
• Weak Form Efficiency: Security prices reflect all information found in
past prices and volume. If the weak form of market efficiency holds, then
technical analysis is of no value. Often weak-form efficiency is
represented as
Pt = Pt-1 + Expected return + random error t
– Since stock prices only respond to new information, which by
definition arrives randomly, stock prices are said to follow a random
walk.
• Semi-Strong Form Efficiency: Security prices reflect all publicly available
information. Publicly available information includes:
• Historical price and volume information
• Published accounting statements.
• Information found in annual reports.
• Strong Form Efficiency: Security prices reflect all information—public
and private. Strong form efficiency incorporates weak and semi-strong
form efficiency. Strong form efficiency says that anything pertinent to the
stock and known to at least one investor is already incorporated into the
security’s price.
12-5
Stock Price
Why Technical Analysis Fails
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Sell
Sell
Buy
Buy
If it were possible to make
big money simply by
finding “the pattern” in the
stock price movements,
everyone would do it and
the profits would be
competed away.
Time
12-6
Framework of Analysis
• Fundamental Analysis vs. Technical Analysis
– Significance of fundamental analysis over technical analysis
in investment analysis
• Approach to Fundamental Analysis
– Domestic and global economic analysis
– Industry analysis
– Company analysis
• Why use the top-down approach
12-7
11.1 THE GLOBAL ECONOMY
12-8
International Agencies: IMF
• IMF (1946): it aims
– to promote international monetary cooperation and exchange
stability;
– to foster economic growth and high levels of employment; and
– to provide temporary financial assistance to help ease imbalances
of payments
– To protect international traders from the evil forces of speculators
• Over the period IMF has turned up as a disputed institution due to:
• Fixed exchange rate system of controlling exchange rate was
contradictory to the principle of the organization to patronize
market mechanism
• Incapability to ensure discipline during competitive depreciation
of 1960s by European countries
• The system of exchange rate collapsed in 1971. Since then the
importance of the institution has been questioned.
• IMF financing was criticized on the grounds:
– Common prescription for all countries
– Highly conditional of contractionary nature
– Increased growth with increased poverty
12-9
International Agencies: World Bank Group:
• IBRD International Bank for Reconstruction and Development (1944): To
extend credit to the government of credit worthy poor countries
• IDA International Development Association (1960): To lend to the
governments of very poor developing nations on highly concessional terms.
• IFC International Finance Corporation (1956): To promote sustainable
private sector investment in developing countries,
• MIGA Multilateral Investment Guarantee Agency (1988): To promote FDI in
emerging economies, by offering political risk insurance to investors and
lenders; and
• ICSID International Centre for Settlement of Investment Disputes (1966): To
facilitate the settlement of investment disputes between governments and
foreign investors
• Debtors’ Cartel of early 1980s by Latin American Countries resulted in the
failure of highest number of banks in USA since the great depression of
1930s.
• Debtor countries require to serve WB-IMF sponsored stabilization package
which is the most disputed reform package of the world.
12-10
International Agencies: WTO
GATT (1947) and WTO (1995):
• In the context of 200 years’ failure of beggar-thy-neighbor policy, GATT
was introduced to ensure globalization by means of trade liberalization.
• GATT failed due to non-cooperation of USA and other developed
countries on issues like agricultural subsidies. WTO replaced GATT.
• TRIM (Trade Related Investment Measures), and TRIPS (Trade
Related Aspects of Intellectual Property Rights) were WTO introduction
• Violence and blood sheds are common in all the ministerial summits
casting doubts in the success of the multilateral trade talk
• Countervailing duty of USA against Japanese automobile approved by
WTO raised controversy.
• Trade dispute between USA and Europe reached the pick as WTO
supported Europe against USA on FSC the act related to tax break of
US exporting giants including Boeing and GE
12-11
Political Risk
• Effect of globalization like Asian currency crisis of
1997
• Economic integration and free trade agreement (EU
and NAFTA)
• Risk of nationalization
• Risk of terrorist attack
• Growth rate and competition
• Nature of protectionism
• Lack of legal infrastructure (Guanxi effect of China)
12-12
Foreign exchange risk exposure
• The degree to which the value of future cash transactions can be affected
by exchange rate fluctuations is referred to as transaction exposure. If an
exporter denominates its export in foreign currency, a 10% decline in the
value of that currency (dollar) will reduce the taka value of its receivable
by 10%. Transaction exposure includes export denominated in foreign
currency, interest received from investment, import denominated in
foreign currency, interest owed on foreign loan.
• Economic exposure refers to the degree to which a firm’s present value
of future cash flows can be influenced by exchange rate fluctuations.
Cash flows that do not require conversion of currencies do not reflect
transaction exposure. Yet, these cash flows may also be influenced
significantly by exchange rate movements.
• The exposure of the MNC’s consolidated financial statements to
exchange rate fluctuations is known as translation exposure. In particular,
subsidiary earnings translated into the reporting currency on the
consolidated income statement are subject to changing exchange rates.
12-13
Managing Madison Inc.’s Economic Exposure
(Figures in Millions)
C$=$.75
Sales:
(1) U.S.
$300.00
(2) Canadian (C$4)
3.0
(3) Total
$303.00
Cost of gods sold:
(4) U.S.
$ 50.00
(5) Canadian
C$200= 150.00
(6) Total
$200.00
(7) Gross profit
$103.00
Operating expenses:
(8) U.S. - Fixed
$ 30.00
(9) U.S. – Variable (ex., sales com) 30.30
(10) Total
$ 60.30
(11) EBIT
$ 42.70
Interest expense:
(12) U.S.
$ 3.00
(13) Canadian
C$10=
7.50
(14) Total
$ 10.50
(15) EBT
$ 32.20
*Non-transactional economic exposure
*Transactional Economic Exposure
*Translation Exposure
C$=$.80
C$=$.85
$304.00
3.20
$307.20
$307.00
3.40
$310.40
$ 50.00
C$200= 160.00
$210.00
$ 97.20
$ 50.00
C$200= 170.00
$220.00
$ 90.40
$ 30.00
30.72
$ 60.72
$ 36.48
$ 30.00
31.04
$ 61.04
$ 29.36
$
$
3.00
C$10=
8.00
$ 11.00
$ 25.48
3.00
C$10=
8.50
$ 11.50
$ 17.86
12-14
Impact of globalization on an MNC’s Value
National Income in Foreign Countries
Trade Agreements
Inflation in Foreign Countries
Exchange Rate Movements
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 

Political

 Risk
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
12-15
Example: Country risk
• The US dollar rate now in Taka is 68. It is expected to be either
Tk.69 or Tk.70 in the next year. What would be the effect of the
PV of cash flows of the parent company which will have a cash
flow of $100 million from USA and Tk.7,000 million from
Bangladesh. The cost of capital of the parent company is 16%.
100  (7000 / 69)
If , $1  Tk .69 :: PV (CF1 ) 
 $173.7m
1.16
100  (7000 / 70)
If , $1  Tk .70 :: PV (CF1 ) 
 $172.4m
1.16
• Note that the difference of $1.3 million is only that of the next
year. The value of the firm is composed of all the future flows
including the one of the next year. Also note that a multinational
company would have many subsidiaries in different countries
making the equation even more difficult to comprehend the
single value observed by the market capitalization of the parent
company.
12-16
Table 11.1 Economic Performance, 2006
12-17
11.2 THE DOMESTIC MACROECONOMY: Factors
• Gross domestic product: High growth of national income represents the
potentiality of sales promotion that results in high stock market index
• Employment rate: More employment indicates more effective demands.
Unemployment of not only the workers but also other inputs particularly
capital indicates the potential capacity
• Inflation usually reflects higher demands for products resulting in more
returns. Inflation controlling techniques are the choice of central bank
(monetary policy) and the government (fiscal policy). Margin loans of
banks influences supply of investable fund.
• Interest rates: High interest rate (vis-à-vis cost of capital) reduces the
present value of future cash flows, thereby reducing the attractiveness of
investment opportunity.
• Budget Deficits: Large amounts of government borrowing can force up
interest rates by increasing total demand for credit (known as crowding
out effect)
• Consumer sentiment: Consumers’ and producers’ optimism or pessimism
concerning the economy are important determinants of economic
performances. Rational expectation theory focuses more on expectation
12-18
rather than realization.
Figure 12.2
S&P 500 versus EPS Estimate
12-19
11.3 INTEREST RATES
Determination of equilibrium real interest rate:
(Loanable Fund Theory)
i
S (Savings)
k
D (Investment)
Quantity of Loanable Fund
12-20
Factors Determining
The Level of Interest Rates
• Production opportunities: More attractive production
opportunity shifts the demand curve right. Cost increases.
• Time preferences for consumption: If present consumption
gets more priority than deferred consumption, then supply
curve shifts left. Cost increases.
• Risk: Increased risk makes savings less attractive, supply
curve shifts left. Risk and return are proportional. Increased
risk leads to an upward shift of demand curve. Cost
increases.
• Government’s net supply and/or demand for funds:
Government borrowing takes part in the demand. Cost
increases.
• Expected inflation: If expected inflation increases savers
demand more return, supply curve shifts left. Cost
increases.
12-21
Figure 11.3: Determination of the equilibrium
Real Rate of Interest: Crowding out effect
12-22
11.4 DEMAND AND SUPPLY SHOCKS
• Demand shocks: An event that affects the demand for goods
and services. Examples of positive demand shocks:
• Reduction in tax rates
• Increases in the money supply
• Increases in government spending
• Increases in export demand by foreigners
• Supply shocks: An event that influences production capacity
and costs
• Changes in the price of imported oil
• Infrastructural facility
• Floods
• Droughts
• Changes in the wage rates
• Technological progress
12-23
11. 6 BUSINESS CYCLES
• Recurring patterns of recession and recovery—business
cycles
– Peak
– Trough
• Industry relationship to business cycles
– Cyclical industries have above-average sensitivity to
the state of economy. Examples include durable
goods like automobile, TV, freeze, washing machines,
etc. Systematic risk or beta estimator is high.
– Defensive industries are less sensitive to the state of
economy like food producers and processors,
pharmaceutical firms, and public utilities. Low beta.
12-24
12.7 INDUSTRY ANALYSIS
Figure 12.7 Industry Analysis: Return on Equity
Performance can vary widely across industries
ROE can range from 10.6% for electronic equipment to 29.2% for
the cigarette industry
12-25
Figure 12.8
Industry Stock Price Performance, 2006
12-26
Figure 12.9 ROE of Major Banks, 2007
12-27
Industry Sensitivity to Business Cycle
Factors affecting sensitivity of earnings to business cycles:
– Sensitivity of sales of the firm’s product to the business cycles (Figure 11.10
demonstrates that tobacco industry is insensitive and automobile industry is
sensitive to business cycle) High sensitive: machine tools, steel, autos,
transportation, etc. Low sensitive: food, drugs, medical equipment.
– Operating leverage: Proportion of fixed cost to variable costs. Firms with
high operating leverage (or proportion of fixed cost to total cost) are more
sensitive to economic fluctuations as small swings in business conditions
can have large impact on profitability. Firms with greater proportion of
variable cost as opposed to fixed cost are less sensitive to business cycle.
– Financial leverage: Interest on debt is fixed charge. More borrowing
represents more interest payments even when sales and profitability has
gone down. This increases the risk of bankruptcy. In case of inflation, sales
increase, profitability increases, and due to nontaxable exemption of
interest obligation EPS increases significantly. Firms having high financial
leverage are more sensitive than all equity firms in case of business cycle.
12-28
Figure 11.10 Industry Cyclicality
12-29
Figure 11.11 A Stylized Depiction
of the Business Cycle
12-30
Sector Rotation
• Sector rotation is an investment strategy that entails
shifting the portfolio into industry sectors that are
expected to outperform others based on macroeconomic
forecasts.
– Peak observes high inflation & interest rates– natural
resource extraction and processing such as minerals
or petroleum
– Contraction observes low inflation & interest rate–
defensive firms like food, pharmaceutical products,
basic necessities
– At the trough of recession the economy is posed for
recovery and subsequent expansion– capital assets &
equipment, transportation and construction firms
– Expansion observes rapid economic growth- cyclical
industries like consumer durables (TV, Freeze,
automobiles) and luxury items as well as banks
12-31
Industry Life Cycles
Concept: At present biotechnology industry goes through
high rate of investment, high rate of return, low dividend
payout; when electric utility industry goes through low
investment, low return and high payout. This is due to the life
cycle of industry. Biotechnology goes through start-up phase
(TRIPS 1995) and electric utility follows decline phase of life
cycle. Mobile telephone and personal computer industry
goes through maturity.
Stage
Sales Growth
Start-up
Rapid & Increasing
Consolidation
Stable
Maturity
Slowing
Relative Decline
Minimal or Negative
12-32
Figure 12.12 The Industry Life
Cycle
12-33
Industry Structure and Profitability
DEGREE OF ACTUAL AND POTENTIAL COMPETITION
1. Rivalry Among
Existing Firms
2. Threat of New
Entrants
Industry growth
Scale economies
Concentration
First mover advantage
Differentiation
Distribution access
Switching costs
Relationships
Scale/learning economies
Legal barriers
3. Threat of
Substitute Products
Relative price and
performance
Buyers willingness to
switch
Fixed variable costs
Excess capacity
Exit barriers
Industry
Profitability
BARGAINING POWER OF INPUT AND OUTPUT MARKETS
4. Bargaining Power of Buyers
5. Bargaining Power of Suppliers
Switching costs
Switching costs
Differentiation
Differentiation
Importance of product for cost and
quality
Importance of product for cost and
quality
Number of buyers
Number of suppliers
Volume per buyers
Volume of suppliers
12-34
1. Rivalry among existing firms
depends on:
• i. Industry Growth rate: The competitive behavior of a firm with high
growth industry and stagnant industry is different.
• ii. Concentration and balance of competitors: Concentration of the
number of firms in the industry shapes the competitive behavior of
the firm. (Example: Microsoft or Coke-Pepsi)
• iii. Degree of Differentiation and switching costs: If the products are
very similar the switching cost of customers is low and price
competition is common. If the products are differentiated switching
cost is high and rivalry is less acute.
• iv. Scale or Learning Economies and Ratio of Fixed Cost to Variable
Cost: For steep learning curve and large economies of scale there
are incentives for aggressive competition. Similarly, for high fixed
cost to variable cost ratio there is incentive to reduce price to utilize
the installed capacity. (example: airline industry)
• v. Excess Capacity and exit barriers: Specialized assets with excess
capacity makes a firm aggressive in price cut. Exit becomes then
difficult. There may be regulations restricting the exit.
12-35
2. Threat of New Entrants
depends on:
• i. Economies of Scale: Large scale economies is a constraint for new
entrants. The existing firm is motivated to handle this risk by a large
investment in research and development (pharmaceutical or jet engines),
in brand advertising (soft-drink), or in physical plant and equipment
(telecommunication)
• ii. First Mover Advantage: The first mover might be able to set industry
standard, to enter into exclusive arrangements with suppliers of cheap
raw materials, or to acquire scarce government licenses. He may
capitalize learning economies or significant switching costs. This makes
new entrance difficult. (example: switching cost of Microsoft’s DOS
operating system is quite high)
• iii. Access to channels of Distribution and Relationship: Limited capacity
of distribution channels and high costs of developing new channels can
act as powerful barriers to new entry. Existing relationship between firms
and customers in an industry also make it difficult for new firms to enter
an industry.
• iv. Legal Barriers: Patents, copyrights limit new entries. Similarly,
licensing regulations limit entry into taxi services, medical services,
broadcasting, telecommunications industries, etc.
12-36
3. Threat of substitute products
• Substitute products are not necessarily similar products
rather the products that perform the same function. For
example, car rental and air lines may be substitutes, Jute
and synthetics are substitutes. Technological innovation
may introduce substitute like computer for type writers. It
depends on:
• i. Relative price and performance
• Ii. Customers’ willingness to switch
12-37
Relative Bargaining Power in Input and
Output Markets
• While degree on competition in an industry determines
whether or not there is potential to earn abnormal profits,
the actual profits are influenced by the industry's
bargaining power with its suppliers and customers. On
the input side there is labor, raw materials and
components, and finances. On the output side firm may
either sell directly to the final customers, or enter into
contract with intermediaries in the distribution chain.
There is a competition among all these factors called
relative bargaining
12-38
4. Bargaining Power of buyers
Depends on:
• 1. Price sensitivity: Buyers are more price sensitive when
the products are undifferentiated and switching cost is
low.
• 2. Relative bargaining power: In a monopoly market
there is low bargaining power of the buyers and in a
perfect market there is high bargaining power of the
buyers. This in turn, depends on number of buyers
relative to number of sellers, as well as the volume per
buyer.
12-39
5. Bargaining Power of Suppliers
• Suppliers’ bargaining power is the opposite to the
bargaining power of the buyers. In a monopsony there is
one buyer and many sellers. Such imperfection can be
extended to a number of few buyers and many sellers.
(Example: bargaining power of Coke-Pepsi on bottlers)
On the other hand, in a perfect market they do not have
a bargaining power as they have to accept the market
price. (Example: can producers lack power). Market of
intermediate goods also determines the bargaining
power when they are the exclusive suppliers for the next
sequence of producers. (IBM’s unique position as
mainframe suppliers dominates computer leasing
business)
12-40