Investment Analysis and Portfolio
Management
8
First Canadian Edition
By Reilly, Brown, Hedges, Chang
Chapter 8
Economic & Industry Analysis
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An Overview of the Valuation Process
Why a Three-Step Valuation Process?
Economic Analysis
Industry Analysis
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An Overview of the Valuation Process
• Two General Approaches
• Top-down, three-step approach
• Bottom-up, stock valuation, stock picking
approach
• The difference between the two approaches is the
perceived importance of economic and industry
influence on individual firms and stocks
• Both of these approaches can be implemented by
either fundamentalists or technicians
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An Overview of the Valuation Process
• Three-Step TopDown Process
• First examine the
influence of the
general economy on
all firms and the
security markets
• Then analyze the
prospects for various
global industries with
the best outlooks in
this economic
environment
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An Overview of the Valuation Process
• Finally turn to the
analysis of individual
firms in the preferred
industries and to the
common stock of these
firms.
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Why a Three-Step
Valuation Approach?
• General Economic Influences
• Fiscal policy initiatives, such as tax credits or tax
cuts, can encourage spending
• Monetary policy though controlling money supply
growth or interest rate therefore affects all
segments of an economy and that economy’s
relationship with other economies
Continued…
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Why a Three-Step
Valuation Approach?
• General Economic Influences
• Inflation causes changes the spending and
savings behaviour of consumers and corporations
• Other events such as war, political upheavals in
foreign countries, or international monetary
devaluations exert strong effects on the
economies
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Why a Three-Step
Valuation Approach?
• Industry Influences
• Identify global industries that will prosper or
suffer in the long run or during the expected
near-term economic environment
• Different industries react to economic changes at
different points in the business cycle
Continued…
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Why a Three-Step
Valuation Approach?
• Industry Influences
• Alternative industries have different responses to
the business cycle
• Demographic factor and international exposure
will also have different impacts on different types
of industries
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Why a Three-Step
Valuation Approach?
• Company Analysis
• The purpose of company analysis to identify the
best companies in a promising industry
• This involves examining a firm’s past
performance, but more important, its future
prospects
Continued…
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Why a Three-Step
Valuation Approach?
• Company Analysis
• It needs to compare the estimated intrinsic value
to the prevailing market price of the firm’s stock
and decide whether its stock is a good
investment
• The final goal is to select the best stock within a
desirable industry and include it in your portfolio
based on its relationship (correlation) with all
other assets in your portfolio
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Does the Three Step Process Work?
• Studies indicate that most changes in an
individual firm’s earnings can be attributed
to changes in aggregate corporate earnings
and changes in the firm’s industry
• Studies have also found a relationship
between aggregate stock prices and various
economic series such as employment,
income, or production
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Does the Three Step Process Work?
• An analysis of the relationship between rates
of return for the aggregate stock market,
alternative industries, and individual stocks
showed that most of the changes in rates of
return for individual stock could be explained
by changes in the rates of return for the
aggregate stock market and the stock’s
industry
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Economic Analysis:
Understanding Business Cycles
• Leading Indicators:
Economic series
that usually reach
peaks or troughs
before
corresponding
peaks or troughs in
aggregate economy
activity
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Economic Analysis:
Understanding Business Cycles
• Coincident Indicators:
• Economic series that have peaks and troughs that
roughly coincide with the peaks and troughs in
the business cycle
• Lagging Indicators:
• Economic series that experience their peaks and
troughs after those of the aggregate economy
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Economic Analysis:
Composite Leading Indicator Series
• Developed by
Statistics Canada
• Overall gauge of
the future
direction of the
Canadian
economy
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Economic Analysis: Money Supply
• Friedman and Schwartz (1963) showed:
• Declines in the rate of growth of the money
supply have preceded business contraction
• Increases in the rate of growth of the money
supply have preceded economic expansions
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Economic Analysis: Money Supply
• Friedman (1969) suggested:
• A transmission mechanism through which
changes in the growth rate of the money supply
affect the aggregate economy
• Federal Reserve plays the central role through
the open market operation
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Economic Analysis: Money Supply
• History shows that each recession since 1915 was
preceded by a decline in the growth of money supply
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Economic Analysis:
Inflation, Interest Rates, & Stock Prices
• Inflation and Interest Rates
• Generally move together
• Investors are not good at predicting inflation
• Inflation Rates and Bond Prices
• Negative relationship
• More effect on longer term bonds
• Inflation, Interest Rates and Stock Prices
• Not direct and not consistent
• Effect varies over time
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Economic Analysis:
Inflation, Interest Rates & Stock Prices
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Analysis of World Security Markets
• Leading economic series are available for virtually
all the developed countries, and the empirical
relationships to the economy are quite similar to
those of the United States
• Real GDP growth is typically consistent with what is
implied by the leading series
• Other factors include
• The monetary environment
• The inflation outlook
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Industry Analysis
• What is an Industry?
• Identifying an industry can be difficult
• Clearly airlines, railroads and utilities are easy to
categorize
• How do we deal with manufacturing firms that
have three different divisions none of which are
dominant?
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Characteristics of an Industry
Price History
• Price History
• P/E ratios
• Common Stock Yields
• Price/Book Ratios
• Price/Cash Flow Ratios
• Price/sales Ratios
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Characteristics of an Industry
Operating Data & Results
Operating Data
Comparative Results
• Return on Investment
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• Return on Equity (ROE)
• Sales Growth
• Trend in Operating Profit
Effects of bus cycles
Secular trends
Industry growth
Regulatory change
• Industrial life cycle
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The Business Cycle & Industry Sectors
• Cyclical or Structural Changes
• Cyclical changes in the economy arise from the
ups and downs of the business cycle
• Structure changes occur when the economy
undergoes a major change in organization or how
it functions
• Rotation strategy is when one switches from one
industry group to another over the course of a
business cycle
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The Business Cycle & Industry Sectors:
Economic Variables
• Inflation
• Higher inflation is generally negative for stocks
• Interest Rates
• For example, financial and housing industries
will be adversely affected by high interest rates
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The Business Cycle & Industry Sectors:
Economic Variables
• International Economics
• Economic growth in world regions or
specific countries benefits industries with a
large presence in the areas
• Consumer Sentiment
• The performance of consumer cyclical
industries will be affected by changes in
consumer sentiment
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Structural Economic Changes:
Alternative Industries
• Social Influences
• Demographics
• Lifestyles
• Technology
• Politics and Regulations
• Economic reasoning
• Fairness
• Regulatory changes affect numerous industries
• Regulations affect international commerce
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Structural Economic Changes:
Alternative Industries
• Social Influences
• Demographics
• Lifestyles
• Technology
• Politics and Regulations
• Economic reasoning
• Fairness
• Regulatory changes affect numerous industries
• Regulations affect international commerce
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The Industry Life Cycle
• The Five-Stage Model
• Pioneering
development
• Rapidly
accelerating
industry growth
• Mature industry
growth
• Stabilization and
market maturity
• Deceleration of
growth and
decline
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Analysis of Industry Competition
• Competition and Expected Industry Returns
• Porter’s concept of competitive strategy is
described as the search by a firm for a favourable
competitive position in an industry
• To create a profitable competitive strategy, firm
must first examine basic competitive structure of
its industry
• Potential profitability of firm is heavily influenced
by profitability of its industry
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Analysis of Industry Competition
• Porter’s Competitive Forces (Exhibit 8.13)
• Rivalry among existing competitors
• More rivalry means intense competition
• Threat of new entrants
• Are there barriers to entry?
• Threat of substitute products
• Substitute products limit the profit potential of an
industry
Continued…
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Analysis of Industry Competition
• Porter’s Competitive Forces (Exhibit 8.13)
• Bargaining power of buyers
• Volume discounts, quality demands
• Bargaining power of suppliers
• Can suppliers increase prices or reduce quality?
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Analysis of Industry Competition
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