Why analyse the industry?
Critical to understanding equity valuation in that it gives an opportunity to understand the industry in which a company operates.
Issues affected by the international economy:
o Company’s Export Prospects
o Export and local prices
o External and internal competition from foreign companies
o Profits on investments abroad.
Key variables in the domestic economy.
o Gross Domestic Product o Unemployment o Inflation o Interest Rates o Budget Deficit
Cyclical Industry
- Above-average sensitivity to the state of the economy.
- Ex. Producers of durable goods (cars, washing machines), producers of capital goods.
- Would tend to outperform other industries at a trough, just before recovery.
Defensive Industry
- Little sensitivity to the business cycle, state of the economy.
- Ex. Food producers and processors, pharmaceutical companies and public utilities.
- Would tend to outperform other industries when the economy enters a recession.
Marking the Cycle
Refers to investors’ ability to determine exact points in time when a recession is expected.
Common assumption for a recession
Assumed that a recession occurs when real GDP declines for two consecutive quarters.
Timing the Cycle
Refers to investors’ ability to use their knowledge of recession times to switch out of specific investment securities, like shares, into other investment securities and then return to shares when prospects for recovery look good.
Excess Returns for investors who lead the investment cycle.
Excess returns are calculated by assuming that investors who lead the business cycle switch out of shares and into bills before the peak of business expansions and switch back before the trough of recessions.
Excess returns for investors who lag the investment cycle
The excess returns are measured relative to a buy-and-hold share strategy of the same risk and timing strategies.
Excess return is minimal over a buy-and-hold strategy if investors switch into bills at the peak and into shares at the trough of the business cycle.
Investors who lag the business cycle
Investors who switch out of shares and into bills after the cycle peak and back into shares after the cycle trough.
Leading Indicators:
- Average weekly hours of production workers (manufacturing)
- Average weekly initial claims for unemployment insurance
- Manufacturers’ new orders (consumer goods and materials industries)
- Vendor performance lower deliveries diffusion index
- Contracts and orders for plant and equipment.
- New private housing units authorised by local building permits.
- Change in manufacturers’ unfilled orders (durable goods industries)
- Change in sensitive materials prices
- Share prices, 500 ordinary shares
- Money supply (M2)
- Index of consumer expectations
Coincident Indicators:
- Employees on non-agricultural payrolls
- Personal income less transfer payments
- Industrial production
- Manufacturing and trade sales
Lagging Indicators:
- Average duration of unemployment
- Ratio of trade inventories to sales
- Change in index of labour cost per unit of output
- Average prime rate charged by banks
- Commercial and industrial loans outstanding
- Ratio of consumer instalment credit outstanding to personal income
- Change in consumer price index for services
Industry
A collection of companies with similar products and/or distribution strategies.
3 Factors Determining Sensitivity of Company Earnings to the Business Cycle
- Sensitivity of sales
- Operating leverage
- Financial leverage
Degree of Operating Leverage:
DOL = (%∆Profits) / (%∆Sales)
Industry Life Cycle
4 Stages:
- Start-up
- Consolidation
- Maturity
- Relative decline
6 Groups of Companies
- Slow growers
- Stalwarts
- Fast Growers
- Cyclicals
- Turnarounds
- Asset plays
• Stalwarts
o Large, well-known companies.
o Grow faster than the slow growers, but are not in the rapid growth stage.
o Tend to be in non-cyclical industries, that are unaffected by recessions.
• Asset plays
Have valuable assets not currently reflected in the share price.
5 Determinants of Competition:
- Threat from new competitors
- Rivalry between existing competitors
- Price pressure from substitute products
- Bargaining power of suppliers
- Bargaining power of buyers
4 Competitive Strategies:
- Cost leadership
- Broad-market differentiation
- Focus Cost
- Focus Differentiation
SWOT Analysis
- Strengths
- Weaknesses
- Opportunities
- Threats
