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MACROECONOMIC AND INDUSTRY ANALYSIS To determine a proper price for a firm’s stock, the security analyst must forecast the dividend and earnings that can be expected from the firm. This is the heart of fundamental analysis—that is, the analysis of the determinants of value such as earnings prospects. Ultimately, the business success of the firm determines the dividends it can pay to shareholders and the price it will command in the stock market. Because the prospects of the firm are tied to those of the broader economy, however, fundamental analysis must consider the business environment in which the firm operates. For some firms, macroeconomic and industry circumstances might have a greater influence on profits than the firm’s relative performance within its industry. It often makes sense to do a “top-down” analysis of a firm’s prospects. One starts with the broad economic environment, examining the state of the aggregate economy and even the international economy. From there, one considers the implications of the outside environment on the industry in which the firm operates. Finally, the firm’s position within the industry is examined. This chapter treats the broad-based aspects of fundamental analysis— macroeconomic and industry analysis. The two chapters following cover firm-specific analysis. We begin with a discussion of international factors relevant to firm performance, and move on to an overview of the significance of the key variables usually used to summarize the state of the macroeconomy. We then discuss

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government macroeconomic policy. We conclude the analysis of the macroenvironment with a discussion of business cycles. Finally, we move to industry analysis, treating issues concerning the sensitivity of the firm to the business cycle, the typical life cycle of an industry, and strategic issues that affect industry performance.

17.1

THE GLOBAL ECONOMY A top-down analysis of a firm’s prospects must start with the global economy. The international economy might affect a firm’s export prospects, the price competition it faces from competitors, or the profits it makes on investments abroad. Certainly, despite the fact that the economies of most countries are linked in a global macroeconomy, there is considerable variation in the economic performance across countries at any time. Consider, for example, Table 17.1, which presents data on several so-called emerging economies. The table documents striking variation in growth rates of economic output in 1999. For example, while the South Korean economy grew by 12.3%, Venezuelan output fell by 9.6%. Similarly, there was considerable variation in stock market returns in these countries in 1999, ranging from a 25.8% loss in Colombia (in dollar terms) to a 203.8% gain in Russia. These data illustrate that the national economic environment can be a crucial determinant of industry performance. It is far harder for businesses to succeed in a contracting economy than in an expanding one. In addition, the global environment presents political risks of far greater magnitude than are typically encountered in U.S.-based investments. In the last decade, we have seen several instances where political developments had major impacts on economic prospects. For example, in 1992 and 1993, the Mexican stock market responded dramatically to changing assessments regarding the prospect of the passage of the North American Free Trade Association by the U.S. Congress. In 1997, the Hong Kong stock market was extremely sensitive

Table 17.1 Economic Performance in Selected Emerging Markets

Stock Market Return Growth in Real GDP

Local Currency

$ Terms

7.0 4.5 5.5 0.5 6.7 12.3 5.1 0.3 4.6 4.6 9.6 3.5 1.7 5.6 1.8

22.8 57.7 75.3 70.4 71.7 75.4 37.9 139.5 7.9 70.8 12.2 96.1 55.1 551.8 284.2

22.8 57.1 71.3 88.2 71.0 85.9 44.6 55.7 25.8 76.6 2.7 71.6 50.2 283.0 203.8

China Hong Kong India Indonesia Singapore South Korea Taiwan Brazil Colombia Mexico Venezuela Greece South Africa Turkey Russia Source: The Economist, January 8, 2000.


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18.4%

United Kingdom 5.8%

Italy

14.6%

Germany 9.3%

France

11.5%

Japan Canada

25% 20% 15% 10% 5%

0%

14.9% 5%

10%

15%

20%

to political developments leading up to the transfer of governance to China. The biggest international economic story in late 1997 and 1998 was the turmoil in several Asian economies, notably Thailand, Indonesia, and South Korea. The close interplay between politics and economics was also highlighted by these episodes, as both currency and stock values swung with enormous volatility in response to developments concerning the prospects for aid from the International Monetary Fund. In August 1998, the shockwaves following Russia’s devaluation of the ruble and its default on some of its debt created havoc in world security markets, ultimately requiring a rescue of the giant hedge fund Long Term Capital Management to avoid further major disruptions. In the immediate future, the degree to which the European Monetary Union is successful will again illustrate the important interaction between the political and economic arenas. Other political issues that are less sensational but still extremely important to economic growth and investment returns include issues of protectionism and trade policy, the free flow of capital, and the status of a nation’s work force. One obvious factor that affects the international competitiveness of a country’s industries is the exchange rate between that country’s currency and other currencies. The exchange rate is the rate at which domestic currency can be converted into foreign currency. For example, in late 2000, it took about 106 Japanese yen to purchase one U.S. dollar. We would say that the exchange rate is ¥106 per dollar or, equivalently, $.0094 per yen. As exchange rates fluctuate, the dollar value of goods priced in foreign currency similarly fluctuates. For example, in 1980, the dollar–yen exchange rate was about $.0045 per yen. Because the exchange rate today is $.0094 per yen, a U.S. citizen would need more than twice as many dollars in 2000 to buy a product selling for ¥10,000 than would have been required in 1980. If the Japanese producer were to maintain a fixed yen price for its product, the price expressed in U.S. dollars would have to double. This would make Japanese products more expensive to U.S. consumers, however, and result in lost sales. Obviously, appreciation of the yen creates a problem for Japanese producers that must compete with U.S. producers. Figure 17.1 shows the change in the purchasing power of the U.S. dollar relative to the purchasing power of the currencies of several major industrial countries in the period between 1986 and 1999. The ratio of purchasing powers is called the “real,” or inflation-adjusted, exchange rate. The change in the real exchange rate measures how much more or less expensive foreign goods have become to U.S. citizens, accounting for both exchange rate fluctuations and inflation differentials across countries. A positive value in Figure 17.1 means that the dollar has gained purchasing power relative to another currency; a negative number indicates a depreciating dollar. Therefore, the figure shows that goods priced in terms of the British pound have become far more expensive to U.S. consumers, but that goods priced in Canadian dollars have become cheaper. Conversely, goods priced in U.S. dollars have become more affordable to British consumers, but more expensive to Canadian consumers.

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Figure 17.2 S&P 500 index versus earnings per share forecast. 1,745 1,681 1,617 1,553 1,489 1,425 1,361 1,297 1,233 1,168 1,104 1,040 976 912 848 784 720 656 592 528 464 400 336 272 208 144 80

12/78

EPS x 26 EPS x 23 EPS x 17 EPS x 20 EPS x 14 EPS x 11 EPS x 8

12/80

12/82

12/84

12/86

12/88

12/90

12/92

12/94

12/96

12/98

12/00

S&P 500 Index

Source: I/B/E/S Inc., September 2000.

17.2

THE DOMESTIC MACROECONOMY The macroeconomy is the environment in which all firms operate. The importance of the macroeconomy in determining investment performance is illustrated in Figure 17.2, which compares the level of the S&P 500 stock price index to forecasts of earnings per share of the S&P 500 companies. The graph shows that stock prices tend to rise along with earnings. While the exact ratio of stock price to earnings varies with factors such as interest rates, risk, inflation rates, and other variables, the graph does illustrate that as a general rule the ratio has tended to be in the range of 10 to 20. Given “normal” price–earnings ratios, we would expect the S&P 500 index to fall within these boundaries. Although the earningsmultiplier rule clearly is not perfect—note the dramatic increase in the price-earnings multiple in recent years—it also seems clear that the level of the broad market and aggregate earnings do trend together. Thus the first step in forecasting the performance of the broad market is to assess the status of the economy as a whole. The ability to forecast the macroeconomy can translate into spectacular investment performance. But it is not enough to forecast the macroeconomy well. You must forecast it better than your competitors to earn abnormal profits. In this section, we will review some of the key economic statistics used to describe the state of the macroeconomy. Some of these key variables are: Gross Domestic Product. Gross domestic product, or GDP, is the 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. Another popular measure of the economy’s output is industrial production. This statistic provides a measure of economic activity more narrowly focused on the manufacturing side of the economy.


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Employment. The unemployment rate is the percentage of the total labor force (i.e., those who are either working or actively seeking employment) yet to find work. The unemployment rate measures the extent to which the economy is operating at full capacity. The unemployment rate is a factor related to workers only, but further insight into the strength of the economy can be gleaned from the unemployment rate for other factors of production. Analysts also look at the factory capacity utilization rate, which is the ratio of actual output from factories to potential output. Inflation. Inflation is the rate at which the general level of prices is rising. High rates of inflation often are associated with “overheated” economies, that is, economies where the demand for goods and services is outstripping productive capacity, which leads to upward pressure on prices. Most governments walk a fine line in their economic policies. They hope to stimulate their economies enough to maintain nearly full employment, but not so much as to bring on inflationary pressures. The perceived trade-off between inflation and unemployment is at the heart of many macroeconomic policy disputes. There is considerable room for disagreement as to the relative costs of these policies as well as the economy’s relative vulnerability to these pressures at any particular time. Interest Rates. High interest rates reduce the present value of future cash flows, thereby reducing the attractiveness of investment opportunities. For this reason, real interest rates are key determinants of business investment expenditures. Demand for housing and high-priced consumer durables such as automobiles, which are commonly financed, also is highly sensitive to interest rates because interest rates affect interest payments. (In Chapter 5, Section 5.1, we examined the determinants of interest rates.) Budget Deficit. The budget deficit of the federal government is the difference between government spending and revenues. Any budgetary shortfall must be offset by government borrowing. Large amounts of government borrowing can force up interest rates by increasing the total demand for credit in the economy. Economists generally believe excessive government borrowing will “crowd out” private borrowing and investing by forcing up interest rates and choking off business investment. Sentiment. Consumers’ and producers’ optimism or pessimism concerning the economy 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. CONCEPT CHECK QUESTION 1

17.3

Consider an economy where the dominant industry is automobile production for domestic consumption as well as export. Now suppose the auto market is hurt by an increase in the length of time people use their cars before replacing them. Describe the probable effects of this change on (a) GDP, (b) unemployment, (c) the government budget deficit, and (d ) interest rates.

DEMAND AND SUPPLY SHOCKS A useful way to organize your analysis of the factors that might influence the macroeconomy is to classify any impact as a supply or demand shock. A demand shock is an event that affects the demand for goods and services in the economy. Examples of positive demand shocks are reductions in tax rates, increases in the money supply, increases in government spending, or increases in foreign export demand. A supply shock is an event that influences

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CONFLICTING ECONOMIC SIGNALS Despite last week’s return to optimism in the stock market, nagging recession concerns continue to confound Wall Street. With conflicting economic signals, investors find themselves in a quandary. Is the economy rapidly dropping into recession, or close to one? Or is it simply taking a modest breath before strengthening later this year? The recession quandary has split Wall Street strategists. One camp, which includes Charles Clough, chief strategist at Merrill Lynch & Co., argues that the economy is slowing much faster than realized. He says rising corporate inventories and a spent consumer are contributing to a steepening slowdown. Moreover, the Federal Reserve is moving too slowly to stave off a period of extended sluggishness, and earnings will probably suffer more than anticipated this year. The other camp, which includes Abby J. Cohen, market strategist at Goldman, Sachs & Co., believes that the economy will rebound later this year.

Emphasizing Financial Stocks The divergent views play a crucial role in near-term investing decisions. Mr. Clough has trimmed his exposure to the stock market in favor of bonds and emphasizes financial stocks, which would benefit in a low-rate environment. Ms. Cohen, conversely, maintains a healthy exposure to the stock market and emphasizes not just financials, but also economically sensitive stocks such as autos and housing-related stocks. She further expects to emphasize later-cyclical commodity stocks as the year unfolds and the economic pace quickens. James Weiss, deputy chief investment officer for growth equities at State Street in Boston, and David Shulman, chief strategist at Salomon Brothers, concur with much of Mr. Clough’s analysis of the economy. Mr. Weiss says the recent uptick in cyclical stocks should be mostly ignored, and he favors steadier growth in defensive sectors like health care and beverages.

Source: Dave Kansas, “Conflicting Economic Signals Are Dividing Strategists,” The Wall Street Journal, February 26, 1996. Excerpted by permission of The Wall Street Journal, © 1996 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

production capacity and costs. Examples of supply shocks are changes in the price of imported oil; freezes, floods, or droughts that might destroy large quantities of agricultural crops; changes in the educational level of an economy’s work force; or changes in the wage rates at which the labor force is willing to work. Demand shocks are usually characterized by aggregate output moving in the same direction as interest rates and inflation. For example, a big increase in government spending will tend to stimulate the economy and increase GDP. It also might increase interest rates by increasing the demand for borrowed funds by the government as well as by businesses that might desire to borrow to finance new ventures. Finally, it could increase the inflation rate if the demand for goods and services is raised to a level at or beyond the total productive capacity of the economy. Supply shocks are usually characterized by aggregate output moving in the opposite direction of inflation and interest rates. For example, a big increase in the price of imported oil will be inflationary because costs of production will rise, which eventually will lead to increases in prices of finished goods. The increase in inflation rates over the near term can lead to higher nominal interest rates. Against this background, aggregate output will be falling. With raw materials more expensive, the productive capacity of the economy is reduced, as is the ability of individuals to purchase goods at now-higher prices. GDP, therefore, tends to fall. How can we relate this framework to investment analysis? You want to identify the industries that will be most helped or hurt in any macroeconomic scenario you envision. For example, if you forecast a tightening of the money supply, you might want to avoid industries such as automobile producers that might be hurt by the likely increase in interest rates. We caution you again that these forecasts are no easy task. Macroeconomic predictions are notoriously unreliable. And again, you must be aware that in all likelihood your forecast will be made using only publicly available information. Any investment advantage you have will be a result only of better analysis—not better information.


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An example of how investment advice is tied to macroeconomic forecasts is given in the nearby box. The article focuses on the different advice being given by two prominent analysts with differing views of the economy. The relatively bearish strategists believe the economy is about to slow down. As a result, they recommend asset allocation toward the fixed-income market, which will benefit if interest rates fall in a recession. Within the stock market, they recommend industries with below-average sensitivity to macroeconomic conditions. Two recession-resistant, or “defensive,” investments specifically cited are beverage and health care stocks, both of which are expected to outperform the rest of the market as investors become aware of the slowdown in growth. Conversely, the optimistic analysts recommend investments with greater sensitivity to the business cycle.

17.4

FEDERAL GOVERNMENT POLICY As the previous section would suggest, the government has two broad classes of macroeconomic tools—those that affect the demand for goods and services and those that affect the supply. For much of postwar history, demand-side policy has been of primary interest. The focus has been on government spending, tax levels, and monetary policy. Since the 1980s, however, increasing attention has been focused on supply-side economics. Broadly interpreted, supply-side concerns have to do with enhancing the productive capacity of the economy, rather than increasing the demand for the goods and services the economy can produce. In practice, supply-side economists have focused on the appropriateness of the incentives to work, innovate, and take risks that result from our system of taxation. However, issues such as national policies on education, infrastructure (such as communication and transportation systems), and research and development also are properly regarded as part of supply-side macroeconomic policy.

Fiscal Policy Fiscal policy refers to the government’s spending and tax actions and is part of “demandside management.” Fiscal policy is probably the most direct way either to stimulate or to slow the economy. Decreases in government spending directly deflate the demand for goods and services. Similarly, increases in tax rates immediately siphon income from consumers and result in fairly rapid decreases in consumption. Ironically, although fiscal policy has the most immediate impact on the economy, the formulation and implementation of such policy is usually painfully slow and involved. This is because fiscal policy requires enormous amounts of compromise between the executive and legislative branches. Tax and spending policy must be initiated and voted on by Congress, which requires considerable political negotiations, and any legislation passed must be signed by the president, requiring more negotiation. Thus, although the impact of fiscal policy is relatively immediate, its formulation is so cumbersome that fiscal policy cannot in practice be used to fine-tune the economy. Moreover, much of government spending, such as that for Medicare or social security, is nondiscretionary, meaning that it is determined by formula rather than policy and cannot be changed in response to economic conditions. This places even more rigidity into the formulation of fiscal policy. A common way to summarize the net impact of government fiscal policy is to look at the government’s budget deficit or surplus, which is simply the difference between revenues and expenditures. A large deficit means the government is spending considerably more than it is taking in by way of taxes. The net effect is to increase the demand for goods (via spending) by more than it reduces the demand for goods (via taxes), thereby stimulating the economy.

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Monetary Policy Monetary policy refers to the manipulation of the money supply to affect the macroeconomy and is the other main leg of demand-side policy. Monetary policy works largely through its impact on interest rates. Increases in the money supply lower short-term interest rates, ultimately encouraging investment and consumption demand. Over longer periods, however, most economists believe a higher money supply leads only to a higher price level and does not have a permanent effect on economic activity. Thus the monetary authorities face a difficult balancing act. Expansionary monetary policy probably will lower interest rates and thereby stimulate investment and some consumption demand in the short run, but these circumstances ultimately will lead only to higher prices. The stimulation/inflation trade-off is implicit in all debate over proper monetary policy. Fiscal policy is cumbersome to implement but has a fairly direct impact on the economy, whereas monetary policy is easily formulated and implemented but has a less direct impact. Monetary policy is determined by the Board of Governors of the Federal Reserve System. Board members are appointed by the president for 14-year terms and are reasonably insulated from political pressure. The board is small enough, and often sufficiently dominated by its chairperson, that policy can be formulated and modulated relatively easily. Implementation of monetary policy also is quite direct. The most widely used tool is the open market operation, in which the Fed buys or sells bonds for its own account. When the Fed buys securities, it simply “writes a check,” thereby increasing the money supply. (Unlike us, the Fed can pay for the securities without drawing down funds at a bank account.) Conversely, when the Fed sells a security, the money paid for it leaves the money supply. Open market operations occur daily, allowing the Fed to fine-tune its monetary policy. Other tools at the Fed’s disposal are the discount rate, which is the interest rate it charges banks on short-term loans, and the reserve requirement, which is the fraction of deposits that banks must hold as cash on hand or as deposits with the Fed. Reductions in the discount rate signal a more expansionary monetary policy. Lowering reserve requirements allows banks to make more loans with each dollar of deposits and stimulates the economy by increasing the effective money supply. Monetary policy affects the economy in a more roundabout way than fiscal policy. Whereas fiscal policy directly stimulates or dampens the economy, monetary policy works largely through its impact on interest rates. Increases in the money supply lower interest rates, which stimulates investment demand. As the quantity of money in the economy increases, investors will find that their portfolios of assets include too much money. They will rebalance their portfolios by buying securities such as bonds, forcing bond prices up and interest rates down. In the longer run, individuals may increase their holdings of stocks as well and ultimately buy real assets, which stimulates consumption demand directly. The ultimate effect of monetary policy on investment and consumption demand, however, is less immediate than that of fiscal policy. CONCEPT CHECK QUESTION 2

Suppose the government wants to stimulate the economy without increasing interest rates. What combination of fiscal and monetary policy might accomplish this goal?

Supply-Side Policies Fiscal and monetary policy are demand-oriented tools that affect the economy by stimulating the total demand for goods and services. The implicit belief is that the economy will not by itself arrive at a full employment equilibrium, and that macroeconomic policy can push


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the economy toward this goal. In contrast, supply-side policies treat the issue of the productive capacity of the economy. The goal is to create an environment in which workers and 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. They argue that lowering tax rates will elicit more investment and improve incentives to work, thereby enhancing economic growth. Some go so far as to claim that reductions in tax rates can lead to increases in tax revenues because the lower tax rates will cause the economy and the revenue tax base to grow by more than the tax rate is reduced. CONCEPT CHECK QUESTION 3

17.5

Large tax cuts in the 1980s were followed by rapid growth in GDP. How would demand-side and supply-side economists differ in their interpretations of this phenomenon?

BUSINESS CYCLES We’ve looked at the tools the government uses to fine-tune the economy, attempting to maintain low unemployment and low inflation. Despite these efforts, economies repeatedly seem to pass through good and bad times. One determinant of the broad asset allocation decision of many analysts is a forecast of whether the macroeconomy is improving or deteriorating. A forecast that differs from the market consensus can have a major impact on investment strategy.

The Business Cycle The economy recurrently experiences periods of expansion and contraction, although the length and depth of those cycles can be irregular. This recurring pattern of recession and recovery is called the business cycle. Figure 17.3 presents graphs of several measures of production and output for the years 1967–1998. The production series all show clear variation around a generally rising trend. The bottom graph of capacity utilization also evidences a clear cyclical (although irregular) pattern. The transition points across cycles are called peaks and troughs, labeled P and T at the top of the graph. A peak is the transition from the end of an expansion to the start of a contraction. A trough occurs at the bottom of a recession just as the economy enters a recovery. The shaded areas in Figure 17.3 all represent periods of recession. As the economy passes through different stages of the business cycle, the relative performance of different industry groups might be expected to vary. For example, at a trough, just before the economy begins to recover from a recession, one would expect that cyclical industries, those with above-average sensitivity to the state of the economy, would tend to outperform other industries. Examples of cyclical industries are producers of durable goods such as automobiles or washing machines. Because purchases of these goods can be deferred during a recession, sales are particularly sensitive to macroeconomic conditions. Other cyclical industries are producers of capital goods, that is, goods used by other firms to produce their own products. When demand is slack, few companies will be expanding and purchasing capital goods. Therefore, the capital goods industry bears the brunt of a slowdown but does well in an expansion. In contrast to cyclical firms, defensive industries have little sensitivity to the business cycle. These are industries that produce goods for which sales and profits are least sensitive to the state of the economy. Defensive industries include food producers and processors,

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Figure 17.3 Cyclical indicators 1967–1998.

Source: The Conference Board, Business Cycle Indicators, February 1999.

pharmaceutical firms, and public utilities. These industries will outperform others when the economy enters a recession. The cyclical/defensive classification corresponds well to the notion of systematic or market risk introduced in our discussion of portfolio theory. When perceptions about the health of the economy become more optimistic, for example, the prices of most stocks will increase as forecasts of profitability rise. Because the cyclical firms are most sensitive to such developments, their stock prices will rise the most. Thus firms in cyclical industries will tend to have high-beta stocks. In general, then, stocks of cyclical firms will show the best results when economic news is positive but the worst results when that news is bad.


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A. Leading indicators 1. Average weekly hours of production workers (manufacturing) 2. Initial claims for unemployment insurance 3. Manufacturers’ new orders (consumer goods and materials industries) 4. Vendor performance—slower deliveries diffusion index 5. New orders for nondefense capital goods 6. New private housing units authorized by local building permits 7. Yield curve slope: 10-year Treasury minus federal funds rate 8. Stock prices, 500 common stocks 9. Money supply (M2) 10. Index of consumer expectations B. Coincident indicators 1. Employees on nonagricultural payrolls 2. Personal income less transfer payments 3. Industrial production 4. Manufacturing and trade sales C. Lagging indicators 1. Average duration of unemployment 2. Ratio of trade inventories to sales 3. Change in index of labor cost per unit of output 4. Average prime rate charged by banks 5. Commercial and industrial loans outstanding 6. Ratio of consumer installment credit outstanding to personal income 7. Change in consumer price index for services Source: The Conference Board, Business Cycle Indicators, February 2000.

Conversely, defensive firms will have low betas and performance that is relatively unaffected by overall market conditions. If your assessments of the state of the business cycle were reliably more accurate than those of other investors, you would simply choose cyclical industries when you are relatively more optimistic about the economy and defensive firms when you are relatively more pessimistic. Unfortunately, it is not so easy to determine when the economy is passing through a peak or a trough. It if were, choosing between cyclical and defensive industries would be easy. As we know from our discussion of efficient markets, however, attractive investment choices will rarely be obvious. It usually is not apparent that a recession or expansion has started or ended until several months after the fact. With hindsight, the transitions from expansion to recession and back might be apparent, but it is often quite difficult to say whether the economy is heating up or slowing down at any moment.

Economic Indicators Given the cyclical nature of the business cycle, it is not surprising that to some extent the cycle can be predicted. A set of cyclical indicators computed by the Conference Board helps forecast, measure, and interpret short-term fluctuations in economic activity. Leading economic indicators are those economic series that tend to rise or fall in advance of the rest of the economy. Coincident and lagging indicators, as their names suggest, move in tandem with or somewhat after the broad economy. Ten series are grouped into a widely followed composite index of leading economic indicators. Similarly, four coincident and seven lagging indicators form separate indexes. The composition of these indexes appears in Table 17.2.

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Figure 17.4 Indexes of leading, coincident, and lagging indicators.

CYCLICAL INDICATORS Composite Indexes Apr T

110 100

Apr Feb P T

Index: 1992=100 Dec Nov P T

Nov P

Mar T

Jan July July Nov P T P T

July Mar P T

110

910. Composite index of 10 leading indicators (series 1,5, 8, 19, 27, 29, 32, 83, 106, 129)

–6 100 –15

–9

–3

–8

90

80

90

80

–11 Dec

110 120 110 100

920. Composite index of 4 coincident indicators (series 41,47, 51, 57)

90 100 80

120 110 100

–1 0

0

90

0

80

0

70 90

+1

0

–2

60

70 60

0

80 50

0 50

0 0

Dec

40

110

40

930. Composite index of 7 lagging indicators (series 62,77, 91, 95, 27, 101, 109, 120)

+3

–12

110

+2

+13

+3 100

100

+3 +15

+21

+6

+22

+3

90

90

+9

Dec

80 110

80 110

940. Ratio, coincident index to lagging index 0

100

100

90

90 –10

80

80

–11

70

–2

–2

60 50

–2

–8

–11 –4

59

60

70

–10

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0

548

–10

62

64

66

68

70

Dec 72

74

76

78

80

82

84

86

88

90

92

94

96

50

98

Note — Series 910,920, 930 and 940 are plotted on a ratio scale

Source: The Conference Board, Business Cycle Indicators, February 1999.

Figure 17.4 graphs these three series over the period 1958–1998. The numbers on the charts near the turning points of each series indicate the length of the lead time or lag time (in months) from the turning point to the designated peak or trough of the corresponding business cycle. Although the index of leading indicators consistently turns before the rest of the economy, the lead time is somewhat erratic. Moreover, the lead time for peaks is consistently longer than that for troughs. The stock market price index is a leading indicator. This is as it should be, as stock prices are forward-looking predictors of future profitability. Unfortunately, this makes the series of leading indicators much less useful for investment policy—by the time the series


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Statistic

Release Date*

Source

Auto and truck sales Business inventories Construction spending Consumer confidence Consumer credit Consumer price index (CPI) Durable goods orders Employment cost index Employment record (unemployment, average workweek, nonfarm payrolls) Existing home sales

2nd of month 15th of month 1st business day of month Last Tuesday of month 5th business day of month 13th of month 26th of month End of first month of quarter 1st Friday of month

Commerce Department Commerce Department Commerce Department Conference Board Federal Reserve Board Bureau of Labor Statistics Commerce Department Bureau of Labor Statistics Bureau of Labor Statistics

25th of month

Factory orders Gross domestic product Housing starts Industrial production Initial claims for jobless benefits International trade balance Index of leading economic indicators Money supply New home sales Producer price index Productivity and costs

1st business day of month 3rd–4th week of month 16th of month 15th of month Thursdays

National Association of Realtors Commerce Department Commerce Department Commerce Department Federal Reserve Board Department of Labor

20th of month Beginning of month

Commerce Department Conference Board

Thursdays Last business day of month 11th of month 2nd month in quarter (approx. 7th day of month) 13th of month 1st business day of month

Federal Reserve Board Commerce Department Bureau of Labor Statistics Bureau of Labor Statistics

Retail sales Survey of purchasing managers

Commerce Department National Association of Purchasing Managers

*Many of these release dates are approximate. Source: Charter Media, Inc., http://biz.yahoo.com/c/terms/terms.html.

predicts an upturn, the market his already made its move. Although the business cycle may be somewhat predictable, the stock market may not be. This is just one more manifestation of the efficient markets hypothesis. The money supply is another indicator. This makes sense in light of our earlier discussion concerning the lags surrounding the effects of monetary policy on the economy. An expansionary monetary policy can be observed fairly quickly, but it might not affect the economy for several months. Therefore, today’s monetary policy might well predict future economic activity. Other leading indicators focus directly on decisions made today that will affect production in the near future. For example, manufacturers’ new orders for goods, contracts and orders for plant and equipment, and housing starts all signal a coming expansion in the economy. A wide range of economic indicators are released to the public on a regular “economic calendar.” Table 17.3 is an “economic calendar,” listing the public announcement dates and sources for about 20 statistics of interest. These announcements are reported in the financial

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Figure 17.5 Economic calendar at Yahoo! Economic Calendar Last Week

Apr. 13–Apr. 16 Next Week

Time (ET)

Statistic

Apr 13

8:30 am 8:30 am 8:30 am

CPI CPI ex-food & energy Retail Sales

Mar Mar Mar

0.2% 0.1% 0.2%

0.4% 0.2% 0.2%

0.3% 0.2% 0.4%

0.1% 0.1% 1.7%

0.1% 0.1% 0.9%

Apr 14

8:30 am

Business Inventories

Feb

0.4%

0.4%

0.2%

Unch

0.1%

Apr 15

8:30 am 4:30 pm

Intial Claims M2 (Money Supply)

04/10 04/05

– –

305K NA

295K NA

299K $8.8B

– –

Apr 16

8:30 am 8:30 am 9:15 am 9:15 am 10:00 am

Building Permits Housing Starts Capacity Utilization Industrial Production Michigan Sentiment

Mar Mar Mar Mar Apr

– – – – –

1.730M 1.770M 80.0% Unch 107.0

1.730M 1.750M 80.2% 0.2% 106.0

1.745M 1.799M 80.3% 0.2% 105.7

– – – – –

Date

For

Actual

Briefing Forecast

Market Expects

Prior

Revised From

press, for example The Wall Street Journal, as they are released. They also are available on the World Wide Web, for example, at the Yahoo! website. Figure 17.5 is an excerpt from the Economic Calendar page at Yahoo! The page gives a list of the announcements to appear during the week. (The page was printed on April 14, so it gives actual values for statistics released on April 13 and 14, but not those to be released later in the week.) Notice that recent forecasts of each variable are provided along with the actual value of each statistic. This is useful, because in an efficient market, security prices already will reflect market expectations. The new information in the announcement will determine the market response.

17.6

INDUSTRY ANALYSIS Industry analysis is important for the same reason that macroeconomic analysis is. Just as it is difficult for an industry to perform well when the macroeconomy is ailing, it is unusual for a firm in a troubled industry to perform well. Similarly, just as we have seen that economic performance can vary widely across countries, performance also can vary widely across industries. Figure 17.6 illustrates the dispersion of industry performance. It shows projected growth in earnings per share in 2000 and 2001 for several major industry groups. The forecasts for 2001, which come from a survey of industry analysts, range from 5.1% for energy to 37.9% for technology firms. Industry groups show even more dispersion in their stock market performance. Figure 17.7 illustrates the performance of the 10 best- and 10 worst-performing industries in 1999. The spread in performance is remarkable, ranging from an 222% return for the mobile communication industry to a 54.4% loss in the tobacco industry. Even small investors can easily take positions in industry performance using mutual funds with an industry focus. For example, Fidelity offers about 40 Select Funds, each of which is invested in a particular industry.


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Figure 17.6 Earnings growth estimates in several industries.

60 107.7 2001

2000

50 41.4 40

37.9

37.1 29.3

30 21.6

27.1 20.2

20.1

18.7

20 13.5 10

22.9

22.8

22.7

20.4

12.5

12.9 13.3

13.8

7.1 7.8

6.9

5.1

3.0

0 I/B/E/S* No. of firms: 4762

Basic industries 250

Capital Consumer Consumer Consumer Energy goods durables nonservices durables 339

163

211

935

198

Financial services

Health care

803

530

Public Technology Transporutilities tation 198

1042

93

*Institutional Brokers Estimate System. Source: U.S. Comments, Institutional Brokers Estimate System (I/B/E/S), September 2000.

Defining an Industry Although we know what we mean by an “industry,” it can be difficult in practice to decide where to draw the line between one industry and another. Consider, for example, the financial services industry. Figure 17.6 shows that the forecast for 2001 growth in industry earnings per share was 13.3%. But the financial services “industry” contains firms with widely differing products and prospects. Figure 17.8 breaks down the industry into seven subgroups. The forecasted performance on these more narrowly defined groups differs widely, suggesting that they are not members of a homogeneous industry. Similarly, most of these subgroups in Figure 17.8 could be divided into even smaller and more homogeneous groups. A useful way to define industry groups in practice is given by Standard Industry Classification, or SIC codes. These are codes assigned by the U.S. government for the purpose of grouping firms for statistical analysis. The first two digits of the SIC codes denote very broad industry classifications. For example, the SIC codes assigned to any type of building contractor all start with 15. The third and fourth digits define the industry grouping more narrowly. For example, codes starting with 152 denote residential building contractors, and group 1521 contains single-family building contractors. Firms with the same four-digit SIC code, therefore, are commonly taken to be in the same industry. Many statistics are computed for even more narrowly defined five-digit SIC groups. SIC industry classifications are not perfect. For example, both J.C. Penney and Neiman Marcus are in group 5311, Department Stores. Yet the former is a high-volume “value” store, whereas the latter is a high-margin elite retailer. Are they really in the same industry? Still, SIC classifications are a tremendous aid in conducting industry analysis since they provide a means of focusing on very broad or fairly narrowly defined groups of firms.

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Figure 17.7 Industry stock price performance, 1999. Mobile communication

222.22

Industrial technology

168.01

Aluminum

107.30

Communications technology

102.88

Software

88.93

Cable/broadcasting

79.32

Biotechnology

70.81

Semiconductors

69.42

Advertising

69.31

Specialty retailers

67.68

Clothing/fabric

24.33

Insurance, property

24.85

Savings and loan

26.86

Food retailers

34.46

Home construction

37.04

Drug retailers Tires and rubber

38.09

1999 return

40.79

Office equipment

48.71

Pollution control

50.00

Tobacco

54.40 100

50

0

+50 +100 Percent return

+150

+200

+250

Source: The Wall Street Journal, January 3, 1998. © 1998 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

Several other industry classifications are provided by other analysts; for example, Standard & Poor’s reports on the performance of about 100 industry groups. S&P computes stock price indexes for each group, which is useful in assessing past investment performance. The Value Line Investment Survey reports on the conditions and prospects of about 1,700 firms, grouped into about 90 industries. Value Line’s analysts prepare forecasts of the performance of industry groups as well as of each firm.

Sensitivity to the Business Cycle Once the analyst forecasts the state of the macroeconomy, it is necessary to determine the implication of that forecast for specific industries. Not all industries are equally sensitive to the business cycle. For example, consider Figure 17.9, which is a graph of automobile production and shipments of cigarettes, both scaled so that 1963 has a value of 100. Clearly, the cigarette industry is virtually independent of the business cycle. Demand for cigarettes does not seem affected by the state of the macroeconomy in any meaningful way. This is not surprising. Cigarette consumption is determined largely by habit and is a small enough part of most budgets that it will not be given up in hard times.


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Figure 17.8 Earnings estimates for financial services industries. 40

37.5 2000

2001

35 30

24.9

24.6

25 18.4

20 15.3 15

12.9 13.3

16.3 12.8

12.0

11.7

10.7

9.5 10

9.4 8.1

5

3.4

0

No. of firms:

Financial services

Banking

Finance and Loan

Financial Services

803

261

48

57

Insurance Investments Savings and Loans 144

76

204

Leasing

11

Source: U.S. Comments, I/B/E/S Inc., September 2000.

Auto production, by contrast, is highly volatile. In recessions, consumers can try to prolong the lives of their cars until their income is higher. For example, the worst year for auto production, according to Figure 17.9, was 1982. This was also a year of deep recession, with the unemployment rate at 9.5%. Three factors will determine the sensitivity of a firm’s earnings to the business cycle. First is the sensitivity of sales. Necessities will show little sensitivity to business conditions. Examples of industries in this group are food, drugs, and medical services. Other industries with low sensitivity are those for which income is not a crucial determinant of demand. As we noted, tobacco products are examples of this type of industry. Another industry in this group is movies, because consumers tend to substitute movies for more expensive sources of entertainment when income levels are low. In contrast, firms in industries such as machine tools, steel, autos, and transportation are highly sensitive to the state of the economy. The second factor determining business cycle sensitivity is operating leverage, which refers to the division between fixed and variable costs. (Fixed costs are those the firm incurs regardless of its production levels. Variable costs are those that rise or fall as the firm produces more or less product.) Firms with greater amounts of variable 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 falling sales. Profits for firms with high fixed costs will swing more widely with sales because costs do not move to offset revenue variability. Firms with high fixed costs are said to have high operating leverage, as small swings in business conditions can have large impacts on profitability.

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Figure 17.9 Industry cyclicality. 140 Annual sales (1963 = 100)

120 100 80 60

Cigarette sales

40

Passenger cars sales

20

1993

1991

1989

1987

1985

1983

1981

1979

1977

1975

1973

1971

1969

1967

1965

0 1963

554

Source: Passenger car sales: Ward’s Automobile Yearbook, 1994. Cigarette sales: Department of Alcohol, Tobacco, and Firearms Statistical Releases.

An example might help illustrate this concept. Consider two firms operating in the same industry with identical revenues in all phases of the business cycle: recession, normal, and expansion. Firm A has short-term leases on most of its equipment and can reduce its lease expenditures when production slackens. It has fixed costs of $5 million and variable costs of $1 per unit of output. Firm B has long-term leases on most of its equipment and must make lease payments regardless of economic conditions. Its fixed costs are higher, $8 million, but its variable costs are only $.50 per unit. Table 17.4 shows that Firm A will do better in recessions than Firm B, but not as well in expansions. A’s costs move in conjunction with its revenues to help performance in downturns and impede performance in upturns. We can quantify operating leverage by measuring how sensitive profits are to changes in sales. The degree of operating leverage, or DOL, is defined as DOL 

Percentage change in profits Percentage change in sales

DOL greater than 1 indicates some operating leverage. For example, if DOL  2, then for every 1% change in sales, profits will change by 2% in the same direction, either up or down. We have seen that the degree of operating leverage increases with a firm’s exposure to fixed costs. In fact, one can show that DOL depends on fixed costs in the following manner:1 DOL  1 

Fixed costs Profits

As a concrete example of operating leverage, return to the two firms illustrated in Table 17.4 and compare profits and sales in the “normal” scenario for the economy with those in a recession. Profits of Firm A fall by 100% (from $1 million to zero) when sales fall by 16.7% (from $6 million to $5 million): DOL(Firm A) 

1

Percentage change in profits 100%  6 Percentage change in sales 16.7%

Operating leverage and DOL are treated in more detail in most corporate finance texts.


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Table 17.4 Operating Leverage

Scenario:

Recession

Firm:

Normal

Expansion

A

B

A

B

A

B

Sales (million units) Price per unit Revenue ($ million) Fixed costs ($ million) Variable costs ($ million)

5 $ 2 10 5 5

5 $ 2 10 8 2.5

6 $ 2 12 5 6

6 $ 2 12 8 3

7 $ 2 14 5 7

7 $ 2 14 8 3.5

Total costs ($ million) Profits

$10 $ 0

$10.5 $ (0.5)

$11 $ 1

$11 $ 1

$12 $ 2

$11.5 $ 2.5

We can confirm the relationship between DOL and fixed costs as follows: DOL(Firm A)  1 

Fixed costs $5 million 1 6 Profits $1 million

Firm B has higher fixed costs, and its operating leverage is higher. Again, compare data for a normal scenario to a recession. Profits for Firm B fall by 150%, from $1 million to –$.5 million. Operating leverage for Firm B is therefore DOL(Firm B) 

Percentage change in profits  150%  9 Percentage change in sales  16.7%

which reflects its higher level of fixed costs: DOL(Firm B)  1 

$8 million Fixed costs 1 9 Profits $1 million

The third factor influencing business cycle sensitivity is financial leverage, which is 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. (We will have more to say about financial leverage in Chapter 19.) Investors should not always prefer industries with lower sensitivity to the business cycle. Firms in sensitive industries will have high-beta stocks and are riskier. But while they swing lower in downturns, they also swing higher in upturns. As always, the issue you need to address is whether the expected return on the investment is fair compensation for the risks borne. CONCEPT CHECK QUESTION 4

What will be profits in the three scenarios for Firm C with fixed costs of $2 million and variable costs of $1.50 per unit? What are your conclusions regarding operating leverage and business risk?

Industry Life Cycles Examine the biotechnology industry and you will find many firms with high rates of investment, high rates of return on investment, and low dividend payout rates. Do the same for the public utility industry and you will find lower rates of return, lower investment rates, and higher dividend payout rates. Why should this be? The biotech industry is still new. Recently, available technologies have created opportunities for highly profitable investment of resources. New products are protected by patents, and profit margins are high. With such lucrative investment opportunities, firms find it advantageous to put all profits back into the firm. The companies grow rapidly on average.


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Figure 17.10 The industry life cycle.

Sales

Rapid and increasing growth

Stable growth

Slowing growth

Minimal or negative growth

Start-up

Consolidation

Maturity

Relative decline

Eventually, however, growth must slow. The high profit rates will induce new firms to enter the industry. Increasing competition will hold down prices and profit margins. New technologies become proven and more predictable, risk levels fall, and entry becomes even easier. As internal investment opportunities become less attractive, a lower fraction of profits are reinvested in the firm. Cash dividends increase. Ultimately, in a mature industry, we observe “cash cows,” firms with stable dividends and cash flows and little risk. Growth rates might be similar to that of the overall economy. Industries in early states of their life cycles offer high-risk/high-potential-return investments. Mature industries offer lower-risk, lower-return combinations. This analysis suggests that 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 that of the general economy; a maturity state, 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. This industry life cycle is illustrated in Figure 17.10. Let us turn to an elaboration of each of these stages. Start-Up Stage The early stages of an industry are often characterized by a new technology or product such as VCRs or personal computers in the 1980s, or wireless communication in recent years. At this stage, it is difficult to predict which firms will emerge as industry leaders. Some 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. For example, in 1980 very few households had VCRs. The potential market for the product therefore was the entire set of television-watching households. In contrast to this situation, consider the market for a mature product like refrigerators. Almost all households in the United States already have refrigerators, so the market for this good is primarily comprised of households replacing old refrigerators. Obviously, the growth rate in this market will be far less than for VCRs. 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


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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. Maturity Stage At this point, the product has reached its full potential for use by consumers. Further growth might merely track growth in the 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 narrower 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. Relative Decline In this stage, the industry might grow at 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. At which stage in the life cycle are investments in an industry most attractive? Conventional wisdom is that investors should seek firms in high-growth industries. This recipe for success is simplistic, however. If the security prices already reflect the likelihood for high growth, then it is too late to make money from that knowledge. Moreover, high growth and fat profits encourage competition from other producers. The exploitation of profit opportunities brings about new sources of supply that eventually reduce prices, profits, investment returns, and finally growth. This is the dynamic behind the progression from one stage of the industry life cycle to another. The famous portfolio manager Peter Lynch makes this point in One Up on Wall Street: Many people prefer to invest in a high-growth industry, where there’s a lot of sound and fury. Not me. I prefer to invest in a low-growth industry. . . . In a low-growth industry, especially one that’s boring and upsets people [such as funeral homes or the oil-drum retrieval business], there’s no problem with competition. You don’t have to protect your flanks from potential rivals . . . and this gives you the leeway to continue to grow. [p. 131]

In fact, Lynch uses an industry classification system in a very similar spirit to the lifecycle approach we have described. He places firms in the following six groups: Slow Growers Large and aging companies 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 a generous dividend, indicating that the firm is generating more cash than can be profitably reinvested in the firm. Stalwarts Large, well-known firms like Coca-Cola, Hershey’s, or Colgate-Palmolive. They grow faster than the slow growers, but are not in the very rapid growth start-up stage. They also tend to be in noncyclical industries that are relatively unaffected by recessions. Fast Growers Small and aggressive new firms with annual growth rates 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. Cyclicals These are firms with sales and profits that regularly expand and contract along with the business cycle. Examples are auto companies (see Figure 17.9 again), steel companies, or the construction industry. Turnarounds These are 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

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returns. A good example of this type of firm would be Chrysler in 1982, when it required a government guarantee on its debt to avoid bankruptcy. The stock price rose fifteenfold in the next five years. Asset Plays These are firms that have valuable assets not currently reflected in the stock price. For example, a company may own or be located on valuable real estate that is worth as much or more than the company’s business enterprises. Sometimes the hidden asset can be tax-loss carryforwards. Other times the assets may be intangible. For example, a cable company might have a valuable list of cable subscribers. These assets do not immediately generate cash flow, and so may be more easily overlooked by other analysts attempting to value the firm.

Industry Structure and Performance The maturation of an industry involves regular changes in the firm’s competitive environment. As a final topic, we examine the relationship among industry structure, competitive strategy, and profitability. Michael Porter2 has highlighted these five determinants of competition: threat of entry from new competitors, rivalry between existing competitors, price pressure from substitute products, bargaining power of buyers, and bargaining power of suppliers. Threat of Entry New entrants to an industry put pressure on price and profits. Even if a firm has not yet entered an industry, the potential for it to do so places pressure on prices, because high prices and profit margins will encourage entry by new competitors. Therefore, barriers to entry can be a key determinant of industry profitability. Barriers can take many forms. For example, existing firms may already have secure distribution channels for their products based on longstanding relationships with customers or suppliers that would be costly for a new entrant to duplicate. Brand loyalty also makes it difficult for new entrants to penetrate a market and gives firms more pricing discretion. Proprietary knowledge or patent protection also may give firms advantages in serving a market. Finally, an existing firm’s experience in a market may give it cost advantages due to the learning that takes place over time. Rivalry between Existing Competitors When there are several competitors in an industry, there will generally be more price competition and lower profit margins as competitors seek to expand their share of the market. Slow industry growth contributes to this competition, because expansion must come at the expense of a rival’s market share. High fixed costs also create pressure to reduce prices, because fixed costs put greater pressure on firms to operate near full capacity. Industries producing relatively homogeneous goods are also subject to considerable price pressure, because firms cannot compete on the basis of product differentiation. Pressure from Substitute Products Substitute products means that the industry faces competition from firms in related industries. For example, sugar producers compete with corn syrup producers. Wool producers compete with synthetic fiber producers. The availability of substitutes limits the prices that can be charged to customers. Bargaining Power of Buyers If a buyer purchases a large fraction of an industry’s output, it will have considerable bargaining power and can demand price concessions. For 2

Michael Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985).


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example, auto producers can put pressure on suppliers of auto parts. This reduces the profitability of the auto parts industry. Bargaining Power of Suppliers If a supplier of a key input has monopolistic control over the product, it can demand higher prices for the good and squeeze profits out of the industry. One special case of this issue pertains to organized labor as a supplier of a key input to the production process. Labor unions engage in collective bargaining to increase the wages paid to workers. When the labor market is highly unionized, a significant share of the potential profits in the industry can be captured by the work force. The key factor determining the bargaining power of suppliers is the availability of substitute products. If substitutes are available, the supplier has little clout and cannot extract higher prices.

SUMMARY

1. Macroeconomic policy aims to maintain the economy near full employment without aggravating inflationary pressures. The proper trade-off between these two goals is a source of ongoing debate. 2. The traditional tools of macropolicy are government spending and tax collection, which comprise fiscal policy, and manipulation of the money supply via monetary policy. Expansionary fiscal policy can stimulate the economy and increase GDP but tends to increase interest rates. Expansionary monetary policy works by lowering interest rates. 3. The business cycle is the economy’s recurring pattern of expansions and recessions. Leading economic indicators can be used to anticipate the evolution of the business cycle because their values tend to change before those of other key economic variables. 4. Industries differ in their sensitivity to the business cycle. More sensitive industries tend to be those producing high-priced durable goods for which the consumer has considerable discretion as to the timing of purchase. Examples are automobiles or consumer durables. Other sensitive industries are those that produce capital equipment for other firms. Operating leverage and financial leverage increase sensitivity to the business cycle.

KEY TERMS

fundamental analysis exchange rate gross domestic product unemployment rate inflation budget deficit demand shock

WEBSITES

supply shock fiscal policy monetary policy business cycle peak trough

cyclical industries defensive industries leading economic indicators SIC codes degree of operating leverage industry life cycle

The site listed below is a comprehensive site with complete analysis of economic indicators for the U.S. and global economy. http://www.yardeni.com/sitemap.asp The banks of the Federal Reserve System provide significant economic data for the domestic and international economy. Most of the individual banks also provide regional

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economic analysis. The site listed below gives you access to each of the regional banks by clicking on the map. http://www.federalreserve.gov/otherfrb.htm Current news and analysis on the economy, industries, and individual companies are available on an online subscription basis to The Wall Street Journal. Subscribers gain access to all of Barron’s and Smart Money as well. Limited information is freely available at the sites listed below. http://public.wsj.com http://smartmoney.com http://www.barrons.com Information on the economy can also be found at the sites listed below. http://economics.about.com http://investormap.com/data-econ.htm http://moneycentral.msn.com/investor/research/profile.asp http://www.bloomberg.com http://www.hoovers.com

PROBLEMS

CFA ©

CFA ©

1. What monetary and fiscal policies might be prescribed for an economy in a deep recession? 2. Unlike other investors, you believe the Fed is going to loosen monetary policy. What would be your recommendations about investments in the following industries? a. Gold mining. b. Construction. 3. Briefly discuss what actions the U.S. Federal Reserve would likely take in pursuing an expansionary monetary policy using each of the following three monetary tools: a. Reserve requirements. b. Open market operations. c. Discount rate. 4. An unanticipated expansionary monetary policy has been implemented. Indicate the impact of this policy on each of the following four variables: a. Inflation rate. b. Real output and employment. c. Real interest rate. d. Nominal interest rate. 5. If you believe the U.S. dollar will depreciate more dramatically than do other investors, what will be your stance on investments in U.S. auto producers?

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6. According to supply-side economists, what will be the long-run impact on prices of a reduction in income tax rates? 7. Consider two firms producing videocassette recorders. One uses a highly automated robotics process, whereas the other uses workers on an assembly line and pays overtime when there is heavy production demand. a. Which firm will have higher profits in a recession? In a boom? b. Which firm’s stock will have a higher beta? 8. Here are four industries and four forecasts for the macroeconomy. Match the industry to the scenario in which it is likely to be the best performer.

CFA ©

Industry

Economic Forecast

a. Housing construction b. Health care c. Gold mining d. Steel production

(i.) Deep recession: falling inflation, interest rates, and GDP (ii.) Superheated economy: rapidly rising GDP, increasing inflation and interest rates (iii.) Healthy expansion: rising GDP, mild inflation, low unemployment (iv.) Stagflation: falling GDP, high inflation

9. In which stage of the industry life cycle would you place the following industries? (Note: There is often considerable room for disagreement concerning the “correct” answers to this question.) a. Oil well equipment. b. Computer hardware. c. Computer software. d. Genetic engineering. e. Railroads. 10. For each pair of firms, choose the one that you think would be more sensitive to the business cycle. a. General Autos or General Pharmaceuticals. b. Friendly Airlines or Happy Cinemas. 11. Choose an industry and identify the factors that will determine its performance in the next three years. What is your forecast for performance in that time period? 12. Why do you think the index of consumer expectations is a useful leading indicator of the macroeconomy? (See Table 17.2.) 13. Why do you think the change in the index of labor cost per unit of output is a useful lagging indicator of the macroeconomy? (See Table 17.2.) 14. Universal Auto is a large multinational corporation headquartered in the United States. For segment reporting purposes, the company is engaged in two businesses: production of motor vehicles and information processing services. The motor vehicle business is by far the larger of Universal’s two segments. It consists mainly of domestic U.S. passenger car production, but it also includes small truck manufacturing operations in the United States and passenger car production in other countries. This segment of Universal has had weak operating results for the past several years, including a large loss in 1996. Although the company does not reveal the operating results of its domestic passenger car segments, that part of Universal’s business is generally believed to be primarily responsible for the weak performance of its motor vehicle segment. Idata, the information processing services segment of Universal, was started by Universal about 15 years ago. This business has shown strong, steady growth that has been entirely internal; no acquisitions have been made.

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CFA ©

An excerpt from a research report on Universal prepared by Paul Adams, a CFA candidate, states: “Based on our assumption that Universal will he able to increase prices significantly on U.S. passenger cars in 1997, we project a multibillion dollar profit improvement.” a. Discuss the concept of an industrial life cycle by describing each of its four phases. b. Identify where each of Universal’s two primary businesses—passenger cars and information processing—is in such a cycle. c. Discuss how product pricing should differ between Universal’s two businesses, based on the location of each in the industrial life cycle. 15. Adams’s research report (see the preceding problem) continued as follows: “With a business recovery already under way, the expected profit surge should lead to a much higher price for Universal Auto stock. We strongly recommend purchase.” a. Discuss the business cycle approach to investment timing. (Your answer should describe actions to be taken on both stocks and bonds at different points over a typical business cycle.) b. Assuming Adams’s assertion is correct (that a business recovery is already under way), evaluate the timeliness of his recommendation to purchase Universal Auto, a cyclical stock, based on the business cycle approach to investment timing. 16. General Weedkillers dominates the chemical weed control market with its patented product Weed-ex. The patent is about to expire, however. What are your forecasts for changes in the industry? Specifically, what will happen to industry prices, sales, the profit prospects of General Weedkillers, and the profit prospects of its competitors? What stage of the industry life cycle do you think is relevant for the analysis of this market? Problem 17 has two parts. 17. Janet Ludlow is preparing a report on U.S.-based manufacturers in the electric toothbrush industry and has gathered the information shown in Table 1 and Exhibit 1.

Table 1 Ratios for Electric Toothbrush Industry Index and Broad Stock Market Index Year Return on equity Electric toothbrush industry index

1996

1997

1998

1999

2000

2001

12.5%

12.0%

15.4%

19.6%

21.6%

21.6%

10.2

12.4

14.6

19.9

20.4

21.2

Average P/E Electric toothbrush industry index Market index

28.5 10.2

23.2 12.4

19.6 14.6

18.7 19.9

18.5 18.1

16.2 19.1

Dividend payout ratio Electric toothbrush industry index Market index

8.8% 39.2

8.0% 40.1

12.1% 38.6

12.1% 43.7

14.3% 41.8

17.1% 39.1

0.3% 3.8

0.3% 3.2

0.6% 2.6

0.7% 2.2

0.8% 2.3

1.0% 2.1

Market index

Average dividend yield Electric toothbrush industry index Market index

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558 Exhibit 1 Characteristics of the Electric Toothbrush Manufacturing Industry

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PART V Security Analysis

• Industry Sales Growth—Industry sales have grown at 15–20% per year in recent years and are expected to grow at 10–15% per year over the next three years. • Non-U.S. Markets—Some U.S. manufacturers are attempting to enter fast-growing non-U.S. markets, which remain largely unexploited. • Mail Order Sales—Some manufacturers have created a new niche in the industry by selling electric toothbrushes directly to customers through mail order. Sales for this industry segment are growing at 40% per year. • U.S. Market Penetration—The current penetration rate in the United States is 60% of households and will be difficult to increase.

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• Price Competition—Manufacturers compete fiercely on the basis of price, and price wars within the industry are common. • Niche Markets—Some manufacturers are able to develop new, unexploited niche markets in the United States based on company reputation, quality, and service. • Industry Consolidation—Several manufacturers have recently merged, and it is expected that consolidation in the industry will increase. • New Entrants—New manufacturers continue to enter the market.

Ludlow’s report concludes that the electric toothbrush industry is in the maturity (i.e., late) phase of its industry life cycle. a. Select and justify three factors from Table 1 that support Ludlow’s conclusion. b. Select and justify three factors from Exhibit 1 that refute Ludlow’s conclusion. 18. Your business plan for your proposed start-up firm envisions first-year revenues of $120,000, fixed costs of $30,000, and variable costs equal to one-third of revenue. a. What are expected profits based on these expectations? b. What is the degree of operating leverage based on the estimate of fixed costs and expected profits? c. If sales are 10% below expectation, what will be the decrease in profits? d. Show that the percentage decrease in profits equals DOL times the 10% drop in sales. e. Based on the DOL, what is the largest percentage shortfall in sales relative to original expectations that the firm can sustain before profits turn negative? What are break-even sales at this point? f. Confirm that your answer to (e) is correct by calculating profits at the break-even level of sales. 19. As a securities analyst you have been asked to review a valuation of a closely held business, Wigwam Autoparts Heaven, Inc. (WAH), prepared by the Red Rocks Group (RRG). You are to give an opinion on the valuation and to support your opinion by analyzing each part of the valuation. WAH’s sole business is automotive parts retailing. The RRG valuation includes a section called “Analysis of the Retail Autoparts Industry,” based completely on the data in Table 19A and the following additional information: • WAH and its principal competitors each operated more than 150 stores at year-end 1999. • The average number of stores operated per company engaged in the retail autoparts industry is 5.3. • The major customer base for auto parts sold in retail stores consists of young owners of old vehicles. These owners do their own automotive maintenance out of economic necessity.

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Table 19A Selected Retail Autoparts Industry Data

Population 18–29 years old (percentage change) Number of households with income more than $35,000 (percentage change) Number of households with income less than $35,000 (percentage change) Number of cars 5–15 years old (percentage change) Automotive aftermarket industry retail sales (percentage change) Consumer expenditures on automotive parts and accessories (percentage change) Sales growth of retail autoparts companies with 100 or more stores Market share of retail autoparts companies with 100 or more stores Average operating margin of retail autoparts companies with 100 or more stores Average operating margin of all retail autoparts companies

CFA ©

1999

1998

1997

1996

1995

–1.8%

–2.0%

–2.1% –1.4%

–0.8%

6.0%

4.0%

8.0%

4.5%

2.7%

3.1%

1.6%

3.6%

4.2%

2.2%

3.0%

–1.0%

4.9%

2.3%

–1.4%

2.5%

1.4%

–1.3%

0.6%

0.1%

0.9%

–1.3%

–6.0%

1.9%

3.3%

2.4% –2.3%

–2.2% –8.0%

1.6%

5.7%

1.9%

3.1%

3.7%

4.3%

2.6%

1.3%

0.2%

3.7%

2.4%

2.4%

1.8%

2.1%

6.5%

3.6%

9.2%

1.3%

6.2%

6.7%

6.5%

17.0%

16.0%

16.5% 14.0%

15.5%

16.8% 12.0%

15.7% 19.0%

16.0%

19.0%

18.5%

18.3% 18.1%

17.0%

17.2% 17.0%

16.9% 15.0%

14.0%

12.0%

11.8%

11.2% 11.5%

10.6%

10.6% 10.0%

10.4%

9.8%

9.0%

5.5%

5.7%

7.2%

7.1%

7.2%

5.6%

5.8%

6.0%

1994

1993

–0.9% –1.1%

6.5%

7.0%

1992

1991

1990

–0.9% –0.7%

–0.3%

a. One of RRG’s conclusions is that the retail autoparts industry as a whole is in the maturity stage of the industry life cycle. Discuss three relevant items of data from Table 19A that support this conclusion. b. Another RRG conclusion is that WAH and its principal competitors are in the consolidation stage of their life cycle. i. Cite three relevant items of data from Table 19A that support this conclusion. ii. Explain how WAH and its principal competitors can be in a consolidation stage while their industry as a whole is in the maturity stage. 20. The following problems appeared on past CFA examinations. a. The supply-side view stresses that: i. Aggregate demand is the major determinant of real output and aggregate employment. ii. An increase in government expenditures and tax rates will cause real income to rise. iii. Tax rates are a major determinant of real output and aggregate employment. iv. Expansionary monetary policy will cause real output to expand without causing the rate of inflation to accelerate. b. In macroeconomics, the crowding-out effect refers to: i. The impact of government deficit spending on inflation. ii. Increasing population pressures and associated movements toward zero population growth.

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c.

©

d.

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17. Macroeconomics and Industry Analysis

e.

f.

g.

h.

iii. A situation where the unemployment rate is below its natural rate. iv. The impact of government borrowing on interest rates and private investment. Based on historical data and assuming less-than-full employment, periods of sharp acceleration in the growth rate of the money supply tend to be associated initially with: i. Periods of economic recession. ii. An increase in the velocity of money. iii. A rapid growth of gross domestic product. iv. Reductions in real gross domestic product. If the exchange rate value of the British pound goes from U.S.$1.80 to U.S.$1.60, then the pound has: i. Appreciated and the British will find U.S. goods cheaper. ii. Appreciated and the British will find U.S. goods more expensive. iii. Depreciated and the British will find U.S. goods more expensive. iv. Depreciated and the British will find U.S. goods cheaper. The consumer price index is: i. A measure of the increase in the prices of the goods that are included in the calculation of GDP. ii. The ratio of the average price of a typical market basket of goods compared to the cost of producing those goods during the previous year. iii. A comparison of the cost of a typical bundle of goods during a given period with the cost of the same bundle during a prior base period. iv. Computed in the same manner as the GDP deflator. Changes in which of the following are likely to affect interest rates? I. Inflation expectations. II. Size of the federal deficit. III. Money supply. i. I and II only. ii. II and III only. iii. I and III only. iv. I, II, and III. According to the supply-side view of fiscal policy, if the impact of tax revenues is the same, does it make any difference whether the government cuts taxes by either reducing marginal tax rates or increasing the personal exemption allowance? i. No, both methods of cutting taxes will exert the same impact on aggregate supply. ii. No, people in both cases will increase their saving expecting higher future taxes and thereby offset the stimulus effect of lower current taxes. iii. Yes, the lower marginal tax rates alone will increase the incentive to earn marginal income and thereby stimulate aggregate supply. iv. Yes, interest rates will increase if marginal tax rates are lowered, whereas they will tend to decrease if the personal exemption allowance is raised. If the Federal Reserve wanted to reduce the supply of money as part of an antiinflation policy, it might: i. Increase the reserve requirements. ii. Buy U.S. securities on the open market. iii. Lower the discount rate. iv. Buy U.S. securities directly from the Treasury.

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SOLUTIONS TO CONCEPT CHECKS

1. The downturn in the auto industry will reduce the demand for the product of this economy. The economy will, at least in the short term, enter a recession. This would suggest that: a. GDP will fall. b. The unemployment rate will rise. c. The government deficit will increase. Income tax receipts will fall, and government expenditures on social welfare programs probably will increase. d. Interest rates should fall. The contraction in the economy will reduce the demand for credit. Moreover, the lower inflation rate will reduce nominal interest rates. 2. Expansionary fiscal policy coupled with expansionary monetary policy will stimulate the economy, with the loose monetary policy keeping down interest rates. 3. A traditional demand-side interpretation of the tax cuts is that the resulting increase in after-tax income increased consumption demand and stimulated the economy. A supply-side interpretation is that the reduction in marginal tax rates made it more attractive for businesses to invest and for individuals to work, thereby increasing economic output. 4. Firm C has the lowest fixed cost and highest variable costs. It should be least sensitive to the business cycle. In fact, it is. Its profits are highest of the three firms in recessions but lowest in expansions. Recession Revenue Fixed cost Variable cost Profits

E-INVESTMENTS: ECONOMIC INDICATORS

Normal

Expansion

$10 2 7.5

$12 2 9

$14 2 10.5

$ 0.5

$ 1

$ 1.5

Go to the economic site listed below. Go to the information on the latest leading indicators that can be found under the U.S. Economy information. Under the latest information, request the charts for the leading, lagging, and coincident indicators. What do those graphs show? http://www.yardeni.com/sitemap.asp On the same page is an item that allows you to request articles on leading indicators (listed below). Obtain the article “Forecasting Recessions.” Examine the performance and describe false signals associated with the indicators. http.//www.tcb-indicators.org/lei/leilatest.htm

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