Economic and Industry Analysis

Timothy R. Mayes, Ph.D.

FIN 3600: Chapter 11

Fundamental Analysis

Fundamental analysts look for companies whose financial health is good and getting better, and which are undervalued by the market

They scour financial reports, calculate ratios, compare to other similar companies, etc

Fundamental analysts believe that “earnings drive stock prices” at least in the long run

Fundamentalists tend to be buy and hold investors, as opposed to technicians who tend to be shorter-term traders

Top Down Analysis

Traditionally, fundamental analysts perform a “top down” analysis to determine which stocks to buy or sell.

The top down method consists of: A macro economic analysis An industry analysis A company analysis

In this chapter we will cover the first two.

Macro Economic Analysis

There is a strong linkage between growth in the overall economy and growth in company earnings (which drive stock prices, at least in the long run).

The following graph shows that changes in nominal GDP explain about 37% of the changes in corporate profits on average.

Obviously, then, to know where earnings (and thus stock prices) are going, we need to know where GDP is going.

A GDP forecast is our starting point. This forecast can be had from a number of sources including brokerage firm analysts, bank economists, and the WSJ’s semi-annual survey.

Earnings & GDP

Corporate Earnings vs. Nominal GDP

y = 3.9195x - 0.0501

R2 = 0.3712

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

-3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%

% Nominal GDP

%

Cor

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te E

arni

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Data Source: http://www.freelunch.comData are from Q1 1946 to Q2 2001

Example of Economic Forecast

This forecast, from The Conference Board as of January 3, 2007 is an example of the freely available forecasts that can be obtained.

The U.S. Economic ForecastUpdated: January 3, 2007

2006 2007 2006 2007 2008III Q* IV Q I Q II Q III Q IV Q Annual Annual Annual

Real GDP 2.20 2.70 2.90 2.70 2.40 2.40 3.40 2.60 2.60CPI Inflation 2.90 -2.50 3.20 3.00 3.00 3.30 3.20 2.10 3.30Real Consumer Spending 2.90 3.60 3.50 3.50 2.80 3.00 3.20 3.30 2.80Unemployment Rate (%) 4.70 4.50 4.50 4.70 4.60 4.70 4.60 4.60 4.9090 Day T-Bills (%) 4.91 4.94 5.19 5.54 5.79 6.29 4.73 5.70 6.2910 Yr Treas Bonds (%) 4.90 4.60 4.80 5.00 5.00 5.25 4.78 5.01 5.23

* ActualSource: The Conference Board (http://www.conference-board.org/economics/stalk.cfm)

Example of Economic Forecast (cont.)

What Your Forecast Should Include

Any macro economic forecast should include estimates of all of the important economic numbers, including: Real GDP growth Inflation rates Interest rates Unemployment

And probably others, depending on your needs.

Types of Forecasts

There are two types of forecasts: Quantitative – based on econometric models. Qualitative – based on educated guesses.

Qualitative forecasting is less difficult, and probably as good as quantitative forecasting.

Furthermore, we can blend the two methods. There is another technique known as a

“barometric” forecast which is an average of the forecasts by many others.

Forecasting for the Layperson

The most important thing to do is to watch for releases of various economic statistics by the government and private sources. These are widely reported by the financial media (WSJ, CNBC, etc).

Especially, keep an eye out for the Index of Leading Economic Indicators, The Consumer Confidence Index, the Fed’s Beige Book, comments by the chairman of the Board of Governors of the Federal Reserve, unemployment rates, monthly inflation indices, etc.

Defining Recession and Depression

An old saw is that a recession is when your neighbor loses his job, and a depression is when you lose yours.

A better definition (but not exactly correct) is that a recession occurs when real GDP declines for two consecutive quarters.

The NBER Business Cycling Dating Committee is the official arbiter of the timing of recessions. Its definition (from http://www.nber.org/cycles.html) is: “The NBER does not define a recession in terms of two consecutive quarters of

decline in real GNP. Rather, a recession is a period of significant decline in total output, income, employment, and trade, usually lasting from six months to a year, and marked by widespread contractions in many sectors of the economy.”

“A growth recession is a recurring period of slow growth in total output, income, employment, and trade, usually lasting a year or more. A growth recession may encompass a recession, in which case the slowdown usually begins before the recession starts, but ends at about the same time. Slowdowns also may occur without recession, in which case the economy continues to grow, but at a pace significantly below its long-run growth.”

A depression is a recession that is major in both scale and duration.

Post WWII Recessions

There have been 11 recessions in the U.S. economy since 1945. The latest began in March 2001 (though many indicators began peaking long before that, especially in Q4 2000), and ended in November 2001.

Peak Trough

February 1945 (Q1) October 1945 (Q4)

November 1948 (Q4) October 1949 (Q4)

July 1953 (Q2) May 1954 (Q2)

August 1957 (Q3) April 1958 (Q2)

April 1960 (Q2) February 1961 (Q1)

December 1969 (Q4) November 1970 (Q4)

November 1973 (Q4) March 1975 (Q1)

January 1980 (Q1) July 1980 (Q3)

July 1981 (Q3) November 1982 (Q4)

July 1990 (Q3) March 1991 (Q1)

March 2001 (Q1) November 2001 (Q4)

Index of Leading Economic Indicators

The LEI has 10 components, each with a specific weighting:

Component FactorLeading Indicators 2002

1 Interest rate spread, 10-year Treasury bonds less federal funds 33.05%2 Money supply, M2 30.38%3 Average weekly hours, manufacturing 18.12%4 Manufacturers' new orders, consumer goods and materials 4.96%5 Stock prices, S&P 500 common stocks 3.08%6 Vendor performance, slower deliveries diffusion index 2.76%7 Average weekly initial claims for unemployment insurance 2.61%8 Building permits, new private housing units 1.91%9 Index of consumer expectations 1.83%

10 Manufacturers' new orders, nondefense capital goods 1.30%Total 100.00%

Leading Indicators and the Economy

Index of Coincident Indicators

The Coincident Indicators Index has 4 components, each with a specific weighting:

Component FactorCoincident Index 2002

1 Employees on nonagricultural payrolls 52.30%2 Personal income less transfer payments 21.76%3 Manufacturing and trade sales 11.87%4 Industrial production 14.07%

Total 100.00%

Coincident Indicators and the Economy

Index of Lagging Indicators

The Index of Lagging Indicators has 7 components, each with a specific weighting:

Component FactorLagging Index 2002

1 Average prime rate 25.21%2 Inventories to sales ratio, manufacturing and trade 12.57%3 Consumer installment credit to personal income ratio 19.92%4 Consumer price index for services 19.29%5 Commercial and industrial loans 13.00%6 Labor cost per unit of output, manufacturing 6.24%7 Average duration of unemployment 3.78%

Total 100.01%

Lagging Index and the Economy

Consumer Confidence

The Consumer Confidence index is released monthly. It is a mail survey of 5,000 individuals with an average of 3,500

responses. In the survey, respondents are asked 5 questions:

1. Respondents appraisal of current business conditions. 2. Respondents expectations regarding business conditions six months

hence. 3. Respondents appraisal of the current employment conditions. 4. Respondents expectations regarding employment conditions six

months hence. 5. Respondents expectations regarding their total family income six

months hence. There are three possible responses: Positive, Neutral, Negative.

Consumer Confidence (cont.)

The index has two components: Expectations (most important) Present Situation

The overall index is calculated as the average of the relative positive/negative responses to all 5 questions.

The expectations component is an average of the responses to questions 2, 4, 5.

The present situation component is an average of the responses to questions 1 and 3.

Before averaging, all responses are adjusted relative to their 1985 values. The responses to each question are also seasonally adjusted. Source:

http://www.consumerresearchcenter.org/consumer_confidence/methodology.htm There is also a consumer sentiment index published by the University of

Michigan.

Inflation Indicators

There are many indicators of inflation in the economy. (Inflation is defined as a general increase in the level of prices.)

The four most-watched indicators are: The Consumer Price Index (CPI) The Producer Price Index (PPI) The GDP Deflator The Employment Cost Index (ECI)

Consumer Price Index

The CPI is published monthly by the Bureau of Labor Statistics (http://www.bls.gov/cpi/).

There are many versions (even one for Denver-Boulder-Greeley area which is published semiannually), but the most watched is the Consumer Price Index for All Urban Workers (CPI-U).

The CPI measures the change in price of a “market basket” of goods typically purchased by consumers. The items in this basket are determined by periodic surveys of about 30,000 consumers around the country.

It is broken into two components: The total CPI (often called the “Headline Number”) The Core CPI (ex food and energy which are quite volatile)

Watch both numbers, but the core CPI is the best indicator.

Consumer Price Index (cont.)

The expenditure items are from 200 categories arranged into 8 major groups: FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full

service meals and snacks); HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom

furniture); APPAREL (men's shirts and sweaters, women's dresses, jewelry); TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle

insurance); MEDICAL CARE (prescription drugs and medical supplies, physicians'

services, eyeglasses and eye care, hospital services); RECREATION (televisions, cable television, pets and pet products, sports

equipment, admissions); EDUCATION AND COMMUNICATION (college tuition, postage, telephone

services, computer software and accessories); OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts

and other personal services, funeral expenses).

Producer Price Index

Like the CPI, the PPI is published monthly by the Bureau of Labor Statistics (http://www.bls.gov/ppi/).

The PPI measures changes in wholesale prices. There are over 10,000 versions of the PPI

published every month for individual products and services.

Investors watch the PPI, but mostly focus on the CPI.

GDP Deflator

The GDP Deflator is published quarterly by the Bureau of Economic Analysis (http://www.bea.doc.gov/) in the GDP report.

The GDP Deflator measures changes in the prices of all domestically produced products, and is the broadest of all inflation indicators.

It includes many things (trains, planes, etc) that consumers do not buy as well as everything they do buy.

This measure of inflation is less-watched than the CPI, but it can be important and it tends to be less volatile.

Employment Cost Index

Like the CPI and PPI, the ECI is published by the Bureau of Labor Statistics (http://www.bls.gov/ncs/ect).

The ECI measures changes in the cost of employee compensation (wages and benefits), and is published quarterly as part of the National Compensation Survey .

The ECI is reported to be one of Alan Greenspan’s favorite inflation measures.

The Beige Book

The Beige Book (http://www.federalreserve.gov/FOMC/BeigeBook/2001/default.htm) is a summary of current economic conditions around the country published by the Federal Reserve Board.

The Beige Book is published 8 times per year and is based on anecdotal evidence gathered through interviews with bank directors, economists, business contacts, etc.

It contains an overall summary, plus reports from each of the 12 districts (Colorado is in the 10th district, Kansas City).

Unemployment

As part of its monthly Current Population Survey (http://www.bls.gov/cps/home.htm), the Bureau of Labor Statistics produces the Unemployment Rate.

The unemployment rate is determined by a survey of individuals who are then placed into one of three categories: Employed Unemployed and seeking work Unemployed and not seeking work (“discouraged” workers)

The unemployment rate is the ratio of unemployed to the total number in the workforce (discouraged workers are not counted).

Note that the “labor force” is actually the civilian labor force, it does not include those in the military.

Forecasting Is Hard

“Forecasting is difficult, especially if it concerns the future.”

That phrase has apparently been uttered by many famous people, and I can’t track down the original. However, truer words have never been spoken.

Economic forecasting is especially difficult, and the forecasts are wrong almost by definition.

There are many reasons why this is the case: Old or bad data Unexpected shocks (the Sept 11 tragedy is a perfect example) Using historical data which gives no clues about major

structural changes about to occur Blindly following trends

Forecasting Is Hard (cont.)

John Casti in his 1990 book Searching for Certainty: What Scientists Can Know About the Future evaluated forecasters from many fields and gave economists a “D.” Stock market forecasters got a very generous “C+” and physicists got an “A.”

Probably the most notoriously wrong forecast of all time came in the early fall of 1929 when the great economist Irving Fisher said, "Stock prices have reached what looks like a permanently high plateau."

So, you see, forecasting is hard and your efforts are nearly always wrong.

The next slide shows an analysis of just how “accurate” a group of professional economists were at predicting various indicators about 6 months ahead in 2004.

Forecasting Is Hard (cont.)

Forecasting Is Hard (cont.)

Why Forecast Economic Aggregates?

We don’t have a choice. We are making decisions whose outcomes depend on the future, and we must make these decisions using the best available information that we have.

Otherwise, all decisions may as well be made by a coin toss (and even bad forecasts are usually better than that).

It is probably best not to pay too much attention to the point estimates of the forecast, instead look for trends (is GDP expected to grow slower, faster, or about the same?).

It is also important to constantly be on the lookout for solid reasons to revise your forecast, and change your decision.

Its no sin to be wrong, but failing to admit it and adjust is.

Industry Analysis

Once we have done a thorough economic analysis, we ask the question “which industries will benefit most from the upcoming economic environment?”

This will lead to several industries, and our analysis will lead us to choose the one that we find to be best positioned.

What is an Industry?

An industry is a group of companies which produce similar goods and/or services.

Until recently (and often still), industries were classified by Standardized Industrial Classification (SIC) codes, but this was replaced by the North American Industry Classification System (NAICS, http://www.census.gov/epcd/www/naics.html) which is much more detailed than SIC.

SIC codes were 4-digit, while the NAICS uses 6 digits for a much finer, and more useful, breakdown of industries.

NAICS will also facilitate comparisons of companies in the US, Canada, and Mexico (it was developed by all three countries for this purpose).

Components of Industry Analysis

The purpose of industry analysis is to identify which industries will be good for investors in the upcoming environment.

Your textbook has an excellent discussion of 9 issues that should be addressed: Competitive Structure Permanence Phase of Life Cycle Vulnerability to External Shocks Regulatory and Tax Conditions Labor Conditions Historical Financial Performance Financial and Financing Issues Industry Stock Price Valuation

Competitive Structure

Some of the questions to be answered are: What companies are in the industry? What are their market shares? Which are publicly traded? Has the number of competitors been rising, fallen, or

remained stable?

Permanence

Some of the questions to be answered are: Is the industry likely to survive in the long-run? Are there any major technological threats (such as

laser printer was to the dot matrix printer)? Are there regulatory threats?

Phase of Life Cycle

Some of the questions to be answered are: Where is the industry in its life cycle? The best

returns and most risk tend to occur early in the cycle. The possible phases are:

Birth Phase Growth Phase Mature Growth Phase Stabilization or Decline Phase

Vulnerability to External Shocks

Some of the questions to be answered are: Could major portions of the industry be nationalized

by foreign governments? Are they dependent on supplies of key commodities

(such as oil)? Are they subject to external political whims? (South

Africa’s gold industry suffered when Apartheid became an international issue.)

Are they subject to fashion trends that may soon change?

Regulatory and Tax Conditions

Some of the questions to be answered are: What are the current regulations that the industry

faces? Are there likely to be new regulations? Are the industry’s products subject to special taxes

(such as “sin taxes” on alcohol and tobacco products or the “windfall profits” tax on oil companies in the 1970’s)?

Are there special tax breaks offered to the industry?

Labor Conditions

Some of the questions to be answered are: What percentage of the industry’s workers are

unionized? Are the unions generally hostile or complacent? Is unionization increasing or decreasing? Are qualified workers easily obtainable, or are they

difficult to find? This has been a particular problem for the high-tech industries.

Historical Financial Performance

Some of the questions to be answered are: What is the historical record of industry revenue,

earnings and dividends? Are these financial variables cyclical, counter-

cyclical? Have they been growing slowly, rapidly, or about

average? What is the average cost structure in the industry?

Heavy on fixed costs? Or, are variable costs the lion’s share?

Financial and Financing Issues

Some of the questions to be answered are: How much debt does the average firm have? What is the mix between fixed assets and current

assets? Is it labor intensive or capital intensive? What is the average age of the fixed assets? Will

they have to be replaced soon?

Industry Stock Price Valuation

Some of the questions to be answered are: What is the historical average P/E for the industry? How high has it been? What were the economic

conditions when the highs were hit? How low has it been? What were the economic

conditions when the lows were hit? Where is it now? Where should it be, based on

historical economic comparisons? What kinds of capital gains and dividend yields have

historically been generated?

Sources of Industry Information

The primary sources of industry-wide information are trade groups, for example: Semiconductor Industry Association (http://www.semichips.org/) Wards (automobiles, http://www.wardsauto.com/) Electronics Industry Association (http://www.eia.org/) Software Publishers Association (http://www.spa.org/)

There are also many trade magazines that may, or may not, be published by the trade associations.

Additionally, Value Line Investment Survey (http://www.valueline.com/) publishes an analysis of each of the industries that they cover.

Finally, research analysts at brokerage firms often provide reports on the industries that they cover.