investment analysis and portfolio management first canadian edition

Investment Analysis and Portfolio Investment Analysis and Portfolio ManagementManagement

First Canadian EditionFirst Canadian EditionBy Reilly, Brown, Hedges, ChangBy Reilly, Brown, Hedges, Chang88

Copyright © 2010 by Nelson Education Ltd. 8-2

• An Overview of the Valuation Process• Why a Three-Step Valuation Process?• Economic Analysis• Industry Analysis

Chapter 8 Economic & Industry Analysis


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


• Three-Step Top-Down 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



• Finally turn to the analysis of individual firms in the preferred industries and to the common stock of these firms.



• 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

Why a Three-Step Valuation Approach?

Continued…


• 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



• 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…


• 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



• 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…


• 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



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


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


Economic Analysis: Understanding Business Cycles

• Leading Indicators: Economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity


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


Economic Analysis: Composite Leading Indicator Series

• Developed by Statistics Canada

• Overall gauge of the future direction of the Canadian economy


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



• 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



• History shows that each recession since 1915 was preceded by a decline in the growth of money supply


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


Economic Analysis:Inflation, Interest Rates & Stock Prices


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


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?


Characteristics of an Industry Price History

• Price History• P/E ratios• Common Stock Yields• Price/Book Ratios• Price/Cash Flow Ratios• Price/sales Ratios


Operating Data• Return on Investment • Return on Equity (ROE)• Sales Growth• Trend in Operating Profit• Industrial life cycle

Comparative Results• Effects of bus cycles• Secular trends• Industry growth• Regulatory change

Characteristics of an Industry Operating Data & Results


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


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


• 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

The Business Cycle & Industry Sectors: Economic Variables


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


• Social Influences• Demographics• Lifestyles

• Technology• Politics and Regulations

• Economic reasoning• Fairness• Regulatory changes affect numerous industries• Regulations affect international commerce

Structural Economic Changes: Alternative Industries


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


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


• 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…


• 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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