CHAPTER 4 - ECONOMIC AND INDUSTRY ANALYSIS

CHAPTER 4

ECONOMIC ANALYSIS & INDUSTRY ANALYSIS

1.0 ECONOMIC ANALYSIS

• Concerned with assessing / generalize the general state of the economy and its potential
effects on security / stock returns (imagine we are investor) – we want to analyze and nak
tengok potential effect on security/stock returns.

• Approaches to security analysis (based on FA)
✓ TOP-DOWN APPROACH – It begins with economy analysis and then moves to
industry analysis and finally to company analysis
✓ BOTTOM-UP APPROACH – It starts with company analysis and then to industry
and finally economic analysis

1.1 Key Economic Variables
• GDP – It 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.
• Industrial Production (IP) – IP index changes in the physical output of country’s factories.
The index tends to move in the same direction as the economy, which makes it a good
guide to business conditions.
• Employment – The employment rate is the percentage of the total labor (that is, those
who are either working or actively seeking employment) yet to find work. The employment
rate measures the extent to which economy is operating at full capacity.
• Inflation – is the rate at which the general level of prices is rising. High interest rate of
inflation often associated with “overhead: economic. That is, economies where the
demand for goods and services is outpricing productive capacity, which leads to an
upward pressure on prices.
• Interest rate – Hight interest rate reduces the present value of future cash flows, thereby
reducing the attractiveness of investment opportunities.

• Fiscal policy – Refers to the government’s spending and tax actions and is the most
direct way either to stimulate or to slow the economy.

• Monetary policy – Refers to the manipulation of the money supply to affect the
macroeconomy. Monetary works through its impact on interest rates. Increase in the
money supply lower short-term interest rate, encouraging investment and consumption
demand. Over longer period, most economies believe a higher money supply leads to a
higher price level.

1.2 Economic Variables and Effects on the stock market

Economic Variables Effects on the stock market

Real growth in GDP Positive impact and it’s good for the market

Industrial Position Continued increases are a sign of strength, which is good for the
Inflation market
Detrimental to the stock prices. Higher inflation leads to a higher
Unemployment interest rates and lower PE multiplier and generally makes equity
Budget deficit securities less attractive
An increase in unemployment rate means business is starting to slow
down
Maybe positive for a depressed economy but can lead to inflation in a
stronger economic environment and therefore have a negative impact

Interest rate Another downer-rising interest rate tend to have a negative effect on
Money supply the market for stocks
Moderate growth can have a positive impact on the economy and the
Weak dollar market. Rapid growth, however, is inflationary and therefore
detrimental to the stock market
A weak dollar has a negative effect on the market because the market
less attractive to the foreign investors. On the other hand, weak dollar
makes products more affordable and cheaper in overseas markets and
therefore have a positive impact on economy.

2.0 INDUSTRY ANALYSIS (IA)

• Once the analyst forecasts the state of the economy, it is necessary to determine the
application of the forecast for specific industries

• IA is important for the same reason as economy analysis
• It is difficult for industry to perform well when the economy is wailing
• It is unusual for a firm in a troubled industry to perform well
• Similarly, economic performance varies widely across countries, performance also can

vary widely across industries

2.2 Key Characteristics in an Industry Analysis
• Past sales and earnings performance

✓ One of the most effective steps in forecasting is assessing the historical
performance of the industry in questions

✓ Certainly, 2 factors with a central role in the ultimate success of any security
investment are sales and earnings, therefore, in order to gain a perspective from
which to forecast, it is helpful to look at the historical performance of sales and
earnings.

• Permanence
✓ Another impact factor in IA is the relative permanence of the industry. Permanence
related to the products and technology of the industry.
✓ It the analyst feels that the need for this particular industry will vanish in an
extremely short period of time, it would seem foolish to invest funds in the industry.
Sometimes in an industry fades from the scene because of a replacement industry
that eliminates or diminishes the need for the original industry
✓ EXAMPLE – The growth of popularity of margarine hurt the demand for butter. In
this age of rapid technological advance, the degree of permanence of an industry
has become an ever more important consideration in industry analysis

• The attitude government toward the industry
✓ It is important for the analyst or prospective investor to consider the probable role
government will play in the industry
✓ Will it provide support – financial or otherwise? Or will it restrain the industry’s
development through restrictive legislation and legal enforcement?

✓ As government becomes more influential in attempting to regulate business and
to advocate consumer protection, the permanence of the industry might well be
affected – not in that government interference will necessarily drive it out of
business, but in that profits of the industry can be substantially lessened

✓ Sometimes in an industry declines in importance because of legal restrictions that
are placed upon it.

• Labor conditions
✓ As unions grow in power in our economy, the state of labor conditions in the
industry under analysis becomes ever more important
✓ That is, we are dealing with a very labor-intensive production process or a very
mechanized capital -intensive process where labor performs crucial operations,
the possibility of strike looms as an important factor to be reckoned with.

• Competitive conditions
✓ Competitor analysis is the process where you identify your greatest competitors
and evaluate their strategies to find out what their strength and weaknesses are
and how they relate to your product or service. This analysis removes you from
your comfort zone but also places you on the path to success of you do it well.
✓ Industry rivalry (degree of competition among existing firms) – intense
competition leads to reduced profit potential for companies in the same industry
✓ Threat of substitutes (products/services) – availability of substitute products will
limit your ability to raise prices

2.3 Industry Life Cycle (ILC)

• ILC is a stage through which firms pass as they mature. This analysis suggests that a
typical industry life cycle have five stages:
✓ Pioneering development
✓ Rapid accelerating growth
✓ Mature growth
✓ Stabilization and market maturity
✓ Deceleration of growth and decline