Chapter 14

MACROECONOMIC AND INDUSTRY ANALYSIS

Outline

• The Economy-Industry-Company (E-I-C) Framework

• The Global Economy

• Central Government Policy

• Macroeconomic Analysis

• Industry Analysis

E - I - C FrameworkRESEARCHERS HAVE FOUND THAT STOCK PRICE CHANGES CAN BE ATTRIBUTED TO THE FOLLOWING FACTORS: ECONOMY-WIDE FACTORS : 30-35 PERCENT INDUSTRY FACTORS : 15-20 PERCENT COMPANY FACTORS : 30-35 PERCENT OTHER FACTORS : 15-25 PERCENT

BASED ON THE ABOVE EVIDENCE, A COMMONLY ADVOCATED PROCEDURE OF FUNDAMENTAL ANALYSIS INVOLVES A THREE-STEP EXAMINATION, WHICH CALLS FOR: UNDERSTANDING OF THE MACRO-ECONOMIC ENVIRONMENT AND DEVELOPMENTS ANALYSING THE PROSPECTS OF THE INDUSTRY TO WHICH THE FIRM BELONGS ASSESSING THE PROJECTED PERFORMANCE OF THE COMPANY.

The Global Economy

In a globalised business environment, the top down analysis of the

prospects of a firm must begin with the global economy. The global

economy has a bearing on the export prospects of the firm, the

competition it faces from international competitors, and the

profitability of its overseas investors.

The Global Economy

While monitoring the global economy bear in mind the following:

• Although the economies of most countries are linked, economic performance varies widely across countries at any time.

• From time to time countries may experience turmoil due to a complex interplay between political and economic factors.

• The exchange rate is a key factor affecting the international competitiveness of a country’s industries.

The Global Economy

• Global Economic Scene

• Changing Global Economic Order

• A Strange Global Equilibrium

• Global Financial Crisis

• European Sovereign Debt Crisis

• Need for Multi-Polar Reserve Currency

• China vs. India

Goldman Sachs Forecast*

Goldman Sachs, a leading international investment banking organisation, forecasts that BRIC countries, viz. Brazil, Russia, India, and China will grow rapidly in the coming decades and become a much larger force in the global economy by the year 2050. Thanks to their growth potential, Goldman Sachs report envisages that these countries will attract substantial foreign direct and portfolio investment that may prompt major currency alignments. Of course, as a note of caution, the report argues that these forecasts would materialise if these countries maintain macroeconomic stability and develop institutions that are conducive to growth.* Goldman Sachs, Dreaming with BRICS: The Path to 2050, Global Economics Paper No.99, October 2003. Available from www.gs.com/

Macroeconomic Analysis

• The government employs two broad classes of

macroeconomic policies, viz. Demand side policies and supply

side policies.

• Traditionally, the focus was mostly on fiscal and

monetary policies, the two major tools of demand-side

economics. From 1980s onward, however, supply-side

economics has received a lot of attention.

Fiscal Policy

• Fiscal policy is concerned with the spending and tax initiatives of the government. It is the most direct tool to stimulate or dampen the economy.

• An increase in government spending stimulates the demand for goods and services, whereas a decrease deflates the demand for goods and services.

• By the same token, a decrease in tax rates increases the consumption of goods and services and an increase in tax rates decreases the consumption of goods and services.

Monetary Policy

Monetary policy is concerned with the manipulation of money

supply in the economy. Monetary policy affects the economy mainly

through its impact on interest rates.

The main tools of monetary policy are:

• Open market operation

• Bank rate

• Reserve requirements

• Direct credit controls

Supply Side Policies

Demand side policies assume that the economy on its own is not likely to reach full employment equilibrium and, hence, macroeconomic policy intervention is required to achieve that goal. Supply side policies, on the other hand, focus on creating an environment in which the productive potential of the economy is increased.

Supply side economists pay attention to tax policy from a different angle. While the demand-siders focus on the impact of taxes on consumption demand, supply-siders look at the effect of taxes on incentives to work and invest. They believe that lower tax rates encourage investment and strengthen incentives to work, thereby stimulating economic growth. Some even argue that reduction in tax rates eventually leads to increase in tax revenues because the higher level of economic activity and tax base, induced by tax reduction, more than offsets the lower tax rate.

Variables to Describe the State of the

MacroeconomyThe macroeconomy is the overall economic environment in which all firms operate. The key variables commonly used to describe the state of the macroeconomy are:

• Growth rate of gross domestic product• Industrial growth rate • Agriculture and monsoons• Savings and investments• Government budget and deficit• Price level and inflation• Interest rates• Balance of payment, forex reserves, and exchange rate• Foreign investment• Infrastructural facilities and arrangements• Sentiments

A Flow Diagram Of Stock Price Determination

EXOGENOUS VARIABLES ENDOGENOUS VARIABLES

Corporate tax rate tx

Changes in government

spending Δ G

Changes in nominal

money Δ M

Potential output Y*

Changes in total spending

Δ Y

Changes in price level Δ P

Changes in real money Δ

M*

Nominal corporate earnings E

Real corporate

earnings E*

Expected corporate earnings

E*e

Changes in real output

Δ X Interest rate R

Stock price SP

Source : Michael W.Keran, “Expectations, Money, and the Stock Market, “Review Jan. 1971

Sensitivity to the Business Cycle

Once you have a forecast of the state of the macroeconomy, you can examine its implications for different industries.

Industries vary in their sensitivity to the business cycle. For example, the automobile industry is more responsive to the business cycle. During expansionary periods, the demand for automobiles tends to rise sharply and during recessionary periods the demand for automobiles tends to fall sharply.

By contrast, the cigarette industry is more or less independent of the business cycle. The demand for cigarettes is hardly affected by the state of the macroeconomy. This is not surprising because cigarette consumption is largely a matter of habit and hence is not responsive to the business cycle.

The sensitivity of a firm’s earnings to the business cycle is determined by three factors: the sensitivity of the firm’s sales to business conditions, the operating leverage, and the financial leverage.

Illustration of Operating Leverage A numerical example may be given to illustrate the concept of operating leverage. Consider two firms, P and Q which have identical revenues under different phases of the business cycle, viz. recession, normal, and expansion. The two firms, however, differ in their operating leverage. Firm Q has higher fixed costs compared with firm P; on the other hand, firm P has higher variable costs compared with firm Q. Exhibit 14.2 presents the financial performance of the two firms under different economic scenarios.

Exhibit 14.2 Financial Performance under Different Economic Scenarios

Recession Normal Expansion

P Q P Q P Q

Sales (million units) 8 8 10 10 12 12

Price per unit Rs. 50 Rs. 50 Rs. 50 Rs. 50 Rs. 50 Rs. 50

Revenues (Rs. in million) 400 400 500 500 600 600

Fixed costs (Rs. in million) 200 320 200 320 200 320

Variable costs (Rs. in million) 200 100 250 125 300 150

Total costs (Rs. in million) 400 420 450 445 500 470

Profit 0 (20) 50 55 100 130

Industry Life Cycle Analysis

Many industrial economists believe that the development of almost

every industry may be analysed in terms of a life cycle with four

well-defined stages:

• Pioneering stage

• Rapid growth stage

• Maturity and stabilisation stage

• Decline stage

Investment Implications

The experience of most industries suggest that they go through the four phases of the industry life cycle, though there are considerable variations in terms of the relative duration of various stages and the rates of growth during these stages. Because of these variations it may not be easy to define what the current stage is, how long it will last, and what would be its precise growth rate.

The broad validity of this theory and its general message that there is a definite trend towards retardation of growth rates has several implications for you as an investor.

• Give industry analysis prior attention in your investment selection process.• Display caution during the pioneering stage—this stage has an appeal primarily for speculators.• Respond quickly and expand your commitments during the rapid growth stage.•Moderate your investment during the maturity stage.•Sensibly disinvest when signals of decline are evident.

Study of the Structure and Characteristics of an Industry

• Structure of the industry and nature of competition

• Nature and prospects of demand

• Cost, efficiency, and profitability

• Technology and research

Profit Potential of Industries: Porter Model

Potential entrants

Treat of new entrantsBargaining

Buyers SuppliersBargaining

Power of Buyers

Power of Suppliers

IndustryRivalryAmongFirms

Substitutes

Threat ofsubstitute products

Industry Analysis

Industry life cycle analysis

• Pioneering stage

• Rapid growth stage

• Maturity & stabiliz’n stage

• Decline stage

Profit potential of industries

• Forces driving competition porter model

Summing Up• A commonly advocated procedure for fundamental analysis involves a 3 – step analysis: macroeconomic analysis, industry analysis, and company analysis.

• In a globalised business environment, the top-down analysis of the prospects of a firm must begin with the global

economy.

• There are two broad classes of macroeconomic policies, viz. demand side policies and supply side policies.

• Fiscal and monetary policies are the two major tools of demand side economics.

• Fiscal policy is concerned with the spending and tax initiatives of the government.

• Monetary policy is concerned with money supply and interest rates.

• The macroeconomy is the overall economic environment in which all firms operate.

• Almost every industry goes through a life cycle consisting of four stages viz., pioneering stage, rapid growth stage, maturity and stabilisation stage, and decline stage.

• Michael Porter has argued that the profit potential of an industry depends on the combined strength of five basic competitive forces.