Chapter 12
Macroeconomic and Industry Analysis

1. A top-down approach to security valuation begins with an analysis of the global and domestic economy. Analysts who follow a top-down approach then narrow their attention to an industry or sector likely to perform well, given the expected performance of the broader economy. Finally, the analysis focuses on specific companies within an industry or sector that has been identified as likely to perform well. A bottom-up approach typically emphasizes fundamental analysis of individual company stocks, and is largely based on the belief that undervalued stocks will perform well regardless of the prospects for the industry or the broader economy. The major advantage of the top-down approach is that it provides a structured approach to incorporating the impact of economic and financial variables, at every level, in to analysis of a company’s stock. One would expect, for example, that prospects for a particular industry are highly dependent on broader economic variables. Similarly, the performance of an individual company’s stock is likely to be greatly affected by the prospects for the industry in which the company operates.

2. The yield curve, by definition, incorporates future interest rates. As such, it reflects future expectations and is a leading indicator.

3. Stalwarts. They tend to be in noncyclical industries that are relatively unaffected by recessions.

4. A supply shock

5. Financial leverage increases the sensitivity of profits in the business cycle since it is a fixed cost. Firms with high fixed costs are said to have high operating leverage, as small swings in business conditions can have large impacts on profitability.

6. Asset play

7. A peak is the transition from the end of an expansion to the start of a contraction. A trough occurs at the bottom of a recession just as the economy enters a recovery. Contraction is the period from peak to trough. Expansion is the period from trough to peak.

8. Companies tend to pay very low, if any, dividends early in their business life cycle since these firms need to reinvest as much capital as possible in order to grow.

9. (1+n) = (1+r)x(1+i)… (1+.05) = (1+r)x(1+.03)… solving for r = .0194

10. DOL = 1 + (7/4) = 2.75

11. This exercise is left to the student

12. Expansionary (i.e., looser) monetary policy to lower interest rates would help to stimulate investment and expenditures on consumer durables. Expansionary fiscal policy (i.e., lower taxes, higher government spending, increased welfare transfers) would directly stimulate aggregate demand.

13. A depreciating dollar makes imported cars more expensive and American cars cheaper to foreign consumers. This should benefit the U.S. auto industry.

14. a. Gold Mining. Gold is traditionally viewed as a hedge against inflation. Expansionary monetary policy may lead to increased inflation, and could thus enhance the value of gold mining stocks.

b. Construction. Expansionary monetary policy will lead to lower interest rates which ought to stimulate housing demand. The construction industry should benefit.

15. a. The robotics process entails higher fixed costs and lower variable (labor) costs. Therefore, this firm will perform better in a boom and worse in a recession. For example, costs will rise less rapidly than revenue when sales volume expands during a boom. b. Because its profits are more sensitive to the business cycle, the robotics firm will have the higher beta.

16. Supply side economists believe that a reduction in income tax rates will make workers more willing to work at current or even slightly lower (gross-of-tax) wages. Such an effect ought to mitigate cost pressures on the inflation rate.

17.
|Deep recession |Health care (non-cyclical) |
|Superheated economy |Steel production (cyclical) |
|Healthy expansion |Housing construction (cyclical, but interest rate sensitive) |
|Stagflation |Gold mining (counter cyclical) |

18. a. General Autos. Pharmaceutical purchases are less discretionary than automobile purchases.

b. Friendly Airlines. Travel expenditures are more sensitive to the business cycle than movie consumption.

19.

|a. |Oil well equipment |Decline (environmental pressures, decline |
| | |in easily-developed oil fields) |
|b. |Computer hardware |Consolidation stage |
|c. |Computer software |Consolidation stage |
|d. |Genetic engineering |Start-up stage |
|e. |Railroads |Relative decline |

20. The index of consumer expectations is a useful leading economic indicator because, if consumers are optimistic about the future, then they are more willing to spend money, especially on consumer durables. This spending will increase aggregate demand and stimulate the economy.

21. Labor cost per unit of output is a lagging indicator because wages typically start rising well into an economic expansion. At the beginning of an expansion, there is considerable slack in the economy and output can expand without employers bidding up the price of inputs or the wages of employees. By the time wages start increasing due to high demand for labor, the boom period has already progressed considerably.

22. a. Because of the very short average maturity (30 days), the rate of return on the money market fund will be affected only slightly by changes in interest rates. The fund might be a good place to "park" cash if you forecast an increase in interest rates, especially given the high liquidity of money market funds. The $5,000 can be reinvested in longer-term assets after rates increase.

b. If you are relatively neutral on rates, the one-year CD might be a reasonable "middle-ground" choice. The CD provides a higher return than the money market fund, unless rates rise considerably. On the other hand, the CD has far less interest rate risk (that is, a much lower duration) than the 20-year bond, and therefore less exposure to interest rate increases.

c. The long-term bond is the best choice for an investor who wants to speculate on a decrease in rates.

23. The expiration of the patent means that General Weedkillers will soon face considerably greater competition from its competitors. We would expect prices and profit margins to fall, and total industry sales to increase somewhat as prices decline. The industry will probably enter the consolidation stage in which producers are forced to compete more extensively on the basis of price.

24. [pic]

CFA 1 a. Relevant data items from the table that support the conclusion that the retail auto parts industry as a whole is in the maturity phase of the industry life cycle are: 1. The population of 18 to 29-year olds, a major customer base for the industry, is gradually declining. 2. The number of households with income less than $40,000, another important consumer base, is not expanding. 3. The number of cars 5 to 15 years old, an important end market, has experienced low annual growth (and actual declines in some years), so that the number of units potentially in need of parts is not growing. 4. Automotive aftermarket industry retail sales have been growing slowly for several years. 5. Consumer expenditures on automotive parts and accessories have grown slowly for several years. 6. Average operating margins of all retail auto parts companies have steadily declined.

b. Relevant items of data from the table that support the conclusion that Wigwam Autoparts Heaven, Inc. (WAH) and its major competitors are in the consolidation stage of their life cycle are: 1. Sales growth of retail auto parts companies with 100 or more stores have been growing rapidly and at an increasing rate. 2. Market share of retail auto parts stores with 100 or more stores has been increasing, but is still less than 20 percent, leaving room for much more growth. 3. Average operating margins for retail auto parts companies with 100 or more stores are high and rising.

Because of industry fragmentation (i.e., most of the market share is distributed among many companies with only a few stores), the retail auto parts industry apparently is undergoing marketing innovation and consolidation. The industry is moving toward the “category killer” format, in which a few major companies control large market shares through proliferation of outlets. The evidence suggests that a new “industry within an industry” is emerging in the form of the “category killer” large chain-store company. This industry subgroup is in its consolidation stage (i.e., rapid growth with high operating profit margins and emerging market leaders) despite the fact that the industry is in the maturity stage of its life cycle.

CFA 2 a. The concept of an industrial life cycle refers to the tendency of most industries to go through various stages of growth. The rate of growth, the competitive environment, profit margins and pricing strategies tend to shift as an industry moves from one stage to the next, although it is difficult to pinpoint exactly when one stage has ended and the next begun.

The start-up stage is characterized by perceptions of a large potential market and by high optimism for potential profits. In this stage, however, there is usually a high failure rate. In the second stage, often called rapid growth or consolidation, growth is high and accelerating, markets broaden, unit costs decline and quality improves. In this stage, industry leaders begin to emerge. The third stage, usually called the maturity stage, is characterized by decelerating growth caused by such things as maturing markets and/or competitive inroads by other products. Finally, an industry reaches a stage of relative decline, in which sales slow or even decline.

Product pricing, profitability and industry competitive structure often vary by phase. Thus, for example, the first phase usually encompasses high product prices, high costs (R&D, marketing, etc.) and a (temporary) monopolistic industry structure. In phase two (consolidation stage), new entrants begin to appear and costs fall rapidly due to the learning curve. Prices generally do not fall as rapidly, however, allowing profit margins to increase. In phase three (maturity stage), growth begins to slow as the product or service begins to saturate the market, and margins are eroded by significant price reductions. In the final stage, cumulative industry production is so high that production costs have stopped declining, profit margins are thin (assuming competition exists), and the fate of the industry depends on the extent of replacement demand and the existence of substitute products/services.

b. The passenger car business in the United States has probably entered the final stage in the industrial life cycle because normalized growth is quite low. The information processing business, on the other hand, is undoubtedly earlier in the cycle. Depending on whether or not growth is still accelerating, it is either in the second or third stage.

c. Cars: In the final phases of the life cycle, demand tends to be price sensitive. Thus, Universal can not raise prices without losing volume. Moreover, given the industry’s maturity, cost structures are likely to be similar for all competitors, and any price cuts can be matched immediately. Thus, Universal’s car business is boxed in: Product pricing is determined by the market, and the company is a “price-taker.”

Idata: Idata should have much more pricing flexibility given that it is in an earlier phase of the industrial life cycle. Demand is growing faster than supply, and, depending on the presence and/or actions of an industry leader, Idata may price high in order to maximize current profits and generate cash for product development, or price low in an effort to gain market share.

CFA 3 a. A basic premise of the business cycle approach to investing is that stock prices anticipate fluctuations in the business cycle. For example, there is evidence that stock prices tend to move about six months ahead of the economy. In fact, stock prices are a leading indicator for the economy.

Over the course of a business cycle, this approach to investing would work roughly as follows. As the top of a business cycle is perceived to be approaching, stocks purchased should not be vulnerable to a recession. When a downturn is perceived to be at hand, stock holdings should be reduced, with proceeds invested in fixed-income securities. Once the recession has matured to some extent, and interest rates fall, bond prices will rise. As it is perceived that the recession is about to end, profits should be taken in the bonds and proceeds reinvested in stocks, particularly stocks with high beta that are in cyclical industries.

Abnormal returns will generally be earned only if these asset allocation switches are timed better than those of other investors. Switches made after the turning points may not lead to excess returns.

b. Based on the business cycle approach to investment timing, the ideal time to invest in a cyclical stock like a passenger car company would be just before the end of a recession. If the recovery is already underway, Adams’s recommendation would be too late. The equities market generally anticipates changes in the economic cycle. Therefore, since the “recovery is underway,” the price of Universal Auto should already reflect the anticipated improvements in the economy.

CFA 4 a. • The industry-wide ROE is leveling off, indicating that the industry may be approaching a later stage of the life cycle. • Average P/E ratios are declining, suggesting that investors are becoming less optimistic about growth prospects. • Dividend payout is increasing, suggesting that the firm sees less reason to reinvest earnings in the firm. There may be fewer growth opportunities in the industry. • Industry dividend yield is also increasing, even though market dividend yield is decreasing.

b. • Industry growth rate is still forecast at 10 ( 15%, higher than would be true of a mature industry. • Non-U.S. markets are still untapped, and some firms are now entering these markets. • Mail order sale segment is growing at 40% a year. • Niche markets are continuing to develop. • New manufacturers continue to enter the market.

CFA 5 The Threat of New Entrants – Wade will have a somewhat strong position for the coming year and up to three years since they have a three year license from the owners of the patent on the new technology. After three years, both the license expires and the similar products will be in the market. In five years they will likely experience a weak position relative to the threat of new entrants.

Threat of Substitute Products – For the near term, Wade should experience relatively low threats from substitute products. It will take about one year for competitors to incorporate the automatic language conversion feature and thus create substitute products. At five years Wade will likely have a weak position relative to substitute products. For now, their position is strong, but will become much weaker in one year.

The Intensity of Competitive Rivalry – The switch from pari-copper to ordinary copper offers Wade a short term competitive advantage in both product differentiation and pricing. Since ordinary copper costs less than pari-copper, they are able to produce their product cheaper and thus be more competitive. As the license expires it is possible that someone else will enter the market or the license will be sold to numerous companies. Thus, at five years, the advantage in this area will likely be very weak or disappear.

CFA 6 a. (4) b. (3) c. (3) d. (2) e. (4) f. (3) g. (1)