RMIT Classification: Trusted

Investment

Macroeconomic and
Industry Analysis

RMIT University
 RMIT Classification: Trusted

Reference

• Reilly, Frank K. , Keith C. Brown and

Sanford Leeds, Investment Analysis and
Portfolio Management (11th Edition),
Thomson South-Western, 2018.

• Chapter 9

RMIT University Slide 2

 RMIT Classification: Trusted

Learning Objectives
After studying this topic you should have a
better understanding of:

• What is the relationship between stock prices and the

economy (as represented by GDP)
• What are leading, coincident and lagging indicators?
• How do interest rates impact stock prices?
• What arguments support the importance of performing
industry analysis?
• How do the business cycle, structural issues, the industry life
cycle and competitive forces impact an industry?
• How do competitive strategies and SWOT analysis help
company analysis?

RMIT University Slide 3

 RMIT Classification: Trusted

Introduction to Market Analysis

• The first stage of top-down analysis is to
examine the attractiveness of a particular
market
• The two components:
1. The macroanalysis of the relationship
between the aggregate securities markets
and the aggregate economy
2. The specific microvaluation of the stock
market employing the valuation approaches
 RMIT Classification: Trusted

Introduction to Market Analysis

 RMIT Classification: Trusted

Introduction to Market Analysis

 RMIT Classification: Trusted

Aggregate Market Analysis

(Macroanalysis)
• Economic growth leads to higher stock
prices
• An easy conclusion: Study GDP growth to
predict stock prices
• Problems with this approach:
1. Preliminary GDP data is released
approximately one month after each quarter
ends
2. The preliminary GDP data will be revised
3. The stock market moves ahead of the economy
 RMIT Classification: Trusted

Aggregate Market Analysis

(Macroanalysis)
• Other measures of the economy:
1. The leading, coincident, and lagging
economic indicators
2. Sentiment indicators
3. Interest rates
 RMIT Classification: Trusted

Leading, Coincident, and Lagging Indicators

• Leading Indicators
– Includes economic series that usually reach
peaks or troughs before corresponding peaks or
troughs in aggregate economic activity
• Coincident indicators
– Includes four economic time series that have
peaks or troughs that roughly coincide with the
peaks and troughs in the business cycle
• Lagging indicators
– Includes seven series that experience their
peaks and troughs after those of the aggregate
economy
 RMIT Classification: Trusted

Leading, Coincident, and Lagging

Indicators
 RMIT Classification: Trusted

Leading, Coincident, and Lagging

Indicators
 RMIT Classification: Trusted

Leading, Coincident, and Lagging

Indicators
 RMIT Classification: Trusted

Leading, Coincident, and Lagging

Indicators
 RMIT Classification: Trusted

Leading, Coincident, and Lagging

Indicators
 RMIT Classification: Trusted

Leading, Coincident, and Lagging

Indicators
 RMIT Classification: Trusted

Sentiment and Expectations

Surveys
• Consumer expectations are considered relevant
as the economy approaches cyclical turning points
• The intuition is that consumers must have
confidence in order to spend
• Consumer spending accounts for approximately
70 percent of gross domestic product
• Two widely followed surveys of consumer
expectations are reported monthly:
– The University of Michigan Consumer Sentiment
Index
– The Conference Board Consumer Confidence Index
 RMIT Classification: Trusted

Sentiment and Expectations

Surveys
 RMIT Classification: Trusted

Interest Rates
• In addition to the leading economic indicator
series and sentiment indicators, the final
approach to tracking the economy is to follow
interest rates
• Specifically:
– The real federal funds rate
– The yield curve (the term spread)
– The risk premium between Treasury bonds and
BBB bonds
– The Fed model
 RMIT Classification: Trusted

Interest Rates
• The Real Federal Funds Rate
– Analysts want to know the level of the federal funds
rate and whether it is intended to stimulate the
economy or restrict the economy
– The natural rate, (the neutral rate), is the rate that
would be neither stimulative nor restrictive
– It is important to know whether Fed policy is
accommodative or restrictive
• If policy is accommodative, then the Fed is trying to increase
growth
• If policy is restrictive, then the Fed will be trying to slow the
economy to control inflation, which is not beneficial to stock
prices
– Exhibit 9.12
 RMIT Classification: Trusted

Interest Rates
 RMIT Classification: Trusted

Interest Rates
• The Yield Curve
– The yield curve is probably the single most
important economic indicator that an analyst can
watch
• A normal yield curve is one in which longer-term yields
are greater than short-term yields
• A flat yield curve occurs when long-term rates are
similar to short-term rates
• An inverted yield curve occurs when the long-term
yields are lower than short-term yields
– The yield curve has inverted prior to every
recession since 1970
• Exhibit 9.13
 RMIT Classification: Trusted

Interest Rates
 RMIT Classification: Trusted

Interest Rates
• Risk Premium
– Analysts also examine the risk premium on
bonds:
• The difference between BBB corporate bonds and
the yield on U.S. Treasury bonds
– A larger spread indicates fear in the markets
and indicates that investors are requiring
additional compensation for taking risk
– Exhibit 9.14
 RMIT Classification: Trusted

Interest Rates
 RMIT Classification: Trusted

Interest Rates
• The Fed Model
– The Fed model came from Alan Greenspan’s
Monetary Report to Congress in the summer of
1997
– In this report, he showed a simple valuation
model that indicated stocks were overvalued
– The Fed model says that the S&P 500 should be
worth next year’s earnings divided by the yield on
the 10-year Treasury bond
– For a long period of time, the correlation between
this model’s predicted value for the S&P 500 and
actual stock prices was very high
– Exhibit 9.15
 RMIT Classification: Trusted

Interest Rates
 RMIT Classification: Trusted

Microvaluation Analysis
• After analyzing the health of the economy
and the trajectory of the business cycle,
the analyst’s goal is to calculate an actual
estimate of the value of the market
• Valuation techniques:
– A free cash flow to the equityholder (FCFE)
model
– Relative valuation
 RMIT Classification: Trusted

Macrovaluation and Microvaluation

of World Markets
• Each market is different—for example, economies are
growing at different rates, different economic data may
exist for each country, risks are different, accounting
standards are different, and different types of
companies may inhabit the public markets
• Three important factors:
1. The basic valuation model and concepts apply globally
2. While the models and concepts are the same, the input
values can and will vary dramatically across countries,
which means values will differ and opportunities will differ
3. The valuation of nondomestic markets will almost certainly
be more onerous because of several additional variables
or constraints that must be considered
• Exchange rate risk
• Country risk
 RMIT Classification: Trusted

Introduction to Industry Analysis: Why

Industry Analysis Matters
• Once an analyst has decided to make an
allocation to a particular market, she must
decide which industries are worthy of
investment
– Profit-seeking firms have determined that industry
analysis matters, as evidenced by the fact that
investment firms often assign analysts to cover a
particular industry
– While returns vary among industries and even for
stocks within an industry, and risk varies among
industries, it does seem that an industry’s overall
risk can be relatively stable over time
 RMIT Classification: Trusted

Industry Analysis
• For a macroanalysis of industries,
examine four components:
1. Cyclical impacts
2. Structural impacts
3. The life cycle of the industry
4. The competitive forces within an industry
(Porter analysis)
 RMIT Classification: Trusted

The Business Cycle and Industry Sectors

• The business cycle refers to the period of
time from which an economy’s output of
goods and services peaks, contracts (in a
recession), recovers from the prior expansion
to reach the prior peak (recovery), and then
grows further (expansion)
– Different industries tend to perform well or poorly
in different parts of the business cycle
– Some investors try to engage in sector rotation,
where they monitor economic trends and attempt
to move their investments from one sector (or
industry within a sector) to another sector (or
industry) as economic trends change
 RMIT Classification: Trusted

The Business Cycle and Industry Sectors

• Sector rotation examples:
– Toward the end of a recession, financial stocks often
recover first
• This did not happen in 2009, and it serves as evidence that
every cycle is different
– Consumer durable goods do well as the economy
recovers
– Capital goods tend to do well as the economy moves past
recovery and into expansion
– Cyclical companies tend to move in anticipation of the
business cycle, turning up in anticipation of recovery and
turning down at signs of economic weakness
– Consumer staples tend to outperform during an economic
slowdown
 RMIT Classification: Trusted

Structural Economic Changes Impact the Industry

(Noncyclical Factors)
• Demographics
– Crucial to both the demand side (consumption) and the
supply side (particularly labor)
• Lifestyles
– Deals with how people live, work, form households,
consume, enjoy leisure, and educate themselves
• Technology
– Can affect numerous industry factors, including a product
or service and how it is produced and delivered
– New technology can completely change an industry
• Politics and Regulation
– Can have a tremendous impact on industries
– Reflects social values, and the result is that today’s social
trend may be tomorrow’s law, regulation, or tax
 RMIT Classification: Trusted

Industry Life Cycle

• When predicting industry sales and
profitability, insight can be gained from
viewing the industry over time and dividing
its development into stages similar to
those that humans progress through
• It is important to ask how long the industry
will remain in a particular stage of the life
cycle
 RMIT Classification: Trusted

Industry Life Cycle

 RMIT Classification: Trusted

Industry Competition
• Industry competition has a tremendous
impact on profitability
• Michael Porter’s concept of competitive
strategy is described as the search by a firm
for a favorable competitive position in an
industry
• To create a profitable competitive strategy, a
firm must first examine the basic competitive
structure of its industry because the potential
profitability of a firm is heavily influenced by
the profitability of its industry
 RMIT Classification: Trusted

Industry Competition
 RMIT Classification: Trusted

Industry Competition
 RMIT Classification: Trusted

Company Analysis
• The final questions in the fundamental
analysis procedure are:
– Which are the best companies within these
desirable industries?
– What is the intrinsic value of the firm’s stock?
– How does the intrinsic value compare with the
market value?
 RMIT Classification: Trusted

Growth Companies and Growth

Stocks
• Growth Companies
– Historically, consistently experience above-
average increases in sales and earnings
– Theoretically, yield rates of return greater than
the firm’s required rate of return
• Growth Stocks
– Necessarily the stocks of growth companies
– A growth stock has a higher rate of return than
other stocks with similar risk
– Superior risk-adjusted rate of return occurs
because of market undervaluation compared to
other stocks
 RMIT Classification: Trusted

Defensive Companies and Stocks

• Defensive Companies
– The firms whose future earnings are more likely
to withstand an economic downturn
– Low business risk
– No excessive financial risk
– Typical examples are public utilities or grocery
chains—firms that supply basic consumer
necessities
• Defense Stocks
– The rate of return is not expected to decline or
decline less than the overall market decline
– Stocks with low or negative systematic risk
 RMIT Classification: Trusted

Cyclical Companies and Stocks

• Cyclical Companies
– They are the companies whose sales and
earnings will be heavily influenced by
aggregate business activity
– Examples would be firms in the steel, auto, or
heavy machinery industries
• Cyclical Stocks
– They will have greater changes in rates of
return than the overall market rates of return
– They would be stocks that have high betas
 RMIT Classification: Trusted

Speculative Companies and Stocks

• Speculative Companies
– They are the firms whose assets involve great
risk but those that also have a possibility of great
gain
– A good example of a speculative firm is one
involved in oil exploration
• Speculative Stocks
– Stocks possess a high probability of low or
negative rates of return and a low probability of
normal or high rates of return
– For example, an excellent growth company
whose stock is selling at an extremely high P/E
ratio
 RMIT Classification: Trusted

Connecting Industry Analysis to Company

Analysis

• Company analysis is the final step in the

top-down approach to investing
– Search for companies that will be favorably
influenced by these economic and structural
factors
– The company must have an attractive
valuation
 RMIT Classification: Trusted

Firm Competitive Strategies

• A company’s competitive strategy can either
be defensive or offensive
– A defensive competitive strategy involves
positioning the firm to deflect the effect of the
competitive forces in the industry
– An offensive competitive strategy is one in which
the firm attempts to use its strengths to affect the
competitive forces in the industry
• Porter (1980a, 1985) suggests two major
competitive strategies: low-cost leadership
and differentiation
 RMIT Classification: Trusted

Firm Competitive Strategies

• Low-Cost Strategy
– The firm that pursues this strategy is determined to
become the low-cost producer and, hence, the cost
leader in its industry
• Differentiation Strategy
– With the differentiation strategy, a firm seeks to
identify itself as unique in its industry in an area that is
important to buyers
• Focusing a Strategy
– Whichever strategy it selects, a firm must determine
where it will focus this strategy
– A firm must select segments in the industry and tailor
its strategy to serve these specific groups
 RMIT Classification: Trusted

SWOT Analysis
• Internal Analysis
– Strengths
 Give the firm a comparative advantage in the
marketplace
 Perceived strengths can include good customer
service, high-quality products, strong brand
 image, customer loyalty, innovative R&D, market
leadership, or strong financial resources
– Weaknesses
 Weaknesses result when competitors have
potentially exploitable advantages over the firm
 RMIT Classification: Trusted

SWOT Analysis
• External Analysis
– Opportunities
 These are environmental factors that favor the firm
 They may include a growing market for the firm’s
products (domestic and international), shrinking
competition, favorable exchange rate shifts, or
identification of a new market or product segment
– Threats
 They are environmental factors that can hinder the firm
in achieving its goals
 Examples would include a slowing domestic economy,
additional government regulation, an increase in
industry competition, threats of entry, etc.
 RMIT Classification: Trusted

Calculating Intrinsic Value

• After analyzing the company from
qualitative and quantitative perspectives,
the analyst must calculate the stock’s
intrinsic value
• Most analysts will create a discounted
cash flow model (using either dividends,
FCFE, or FCFF) and will also use relative
valuation
 RMIT Classification: Trusted

Some Additional Insights on Valuation—For

Individual Companies
• Additional concepts to consider with respect
to valuation:
– Blindly using historic growth rates or margins is
incorrect
– When examining the sales of a company, always
study how the sales mix is changing
– The growth rate of a company is going to be
influenced by where the industry is in its life cycle,
structural changes, industry competition, and
economic trends
– When looking at historic growth, always try to
distinguish between organic growth and acquired
growth
 RMIT Classification: Trusted

Some Additional Insights on Valuation—For

Individual Companies
– Remember what your cost of equity represents
– When estimating the profit margin of a specific
company, be sure to understand the competitive
strategy (low cost or differentiation)
– Realize that it is important for you to have
quarterly estimates for the next year
– When doing relative valuation, compare the
company to its historic multiple, competitors in the
industry, an overall industry multiple, and the
market multiple
 RMIT Classification: Trusted

Topic Summary
Concepts reviewed in this topic:
• The relationship between stock prices and the economy (as
represented by GDP)
• Leading, coincident and lagging indicators
• Interest rates and its impact on stock prices
• The importance of performing industry analysis
• Business cycle, structural issues, the industry life cycle and
competitive forces that impact an industry
• Competitive strategies and SWOT analysis

RMIT University Slide 52

 RMIT Classification: Trusted

All the best !!!

RMIT University Slide 53