TOPIC 4

ECONOMIC AND INDUSTRY

ANALYSIS
Refer to:
Reilly, Brown & Leeds
Chapter 9

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 At the end of this topic, students should be able to
answer the following questions:

• What are the relationship between stock prices and

the economy?
• What are leading economic indicators, coincident
indicators, and lagging indicators?
• Why is performing industry analysis important?
• How do business cycle, structural issues, the industry
cycle, and competitive forces impact an industry?
• What are the various stages in the industry life cycle?

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 INTRODUCTION
• Before making any investment decision, a
portfolio manager needs to evaluate the
market/ economic and industry condition.

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• It involves the following aggregate
analysis (Top-down approach), three-step
market-industry-company investment
process :
1. Economic/ Market Analysis
2. Industry Analysis
3. Firm/ Company Analysis Economic Analysis

Industry
4. Portfolio Management. Analysis

Company
Analysis

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 ECONOMIC ANALYSIS
• Process of assessing the general state of the
economy and its potential effects on security
returns.

• For economic analysis, the relationship of

alternative economic series (i.e. leading,
coincident and lagging indicator) as well as
other monetary variables are examined
against the behavior of the entire economy.

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• Stock price of a firm is significantly affected by
the state of economy and economic events.

• As a rule, stock prices tend to move up when

the economy is strong and retreat when the
economy is weakening.

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 Key Economic Variables
• Gross Domestic Product (GDP)
• Industrial Production
• Inflation
• Interest rate
• Employment
• Budget deficit
• Fiscal policy
• Monetary Policy.
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Economic Analysis and Business Cycle
• Economy of a nation faces different periods of
expansion and contraction with different
degree of depth and length.

• The recurring pattern of recession and recovery

is called business cycle.

• The transition points across cycles are called

peaks and troughs.
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Economic Analysis and Business Cycle

• Peak and trough (depression) in stock prices tend to occur

prior to peaks and troughs in the economy
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• Economy analysis thus concentrate on the :

1) Cyclical Indicator Approach (National Bureau of

Economic Research)
2) Alternative monetary series influenced by the
Central Bank

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 1) Cyclical Indicator Approach
• It is built on the belief that the aggregate economy
experiences periods of expansion and contraction
that can be identified by the movements in economic
activity reflected in specific economic series.

• Cyclical indicator categories (based on relationship to

the business cycle):
– Leading indicators
– Coincident indicators
– Lagging indicators
– Selected series.

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 Leading indicators
• This indicator refers to
- the events that happen before any changes in the
aggregate economic level.
• It is the economic series that usually reach peaks or
troughs before corresponding peaks or troughs in
aggregate economic activity.
• Example of Leading indicator:
- Stock market, Money supply, Consumer
Expectations, Supplier Deliveries, New consumer
orders
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 Leading indicators
• Leading Index
- Average weekly hours of manufacturing workers
- Average weekly initial claims for unemployment
insurance
- Stock Price Index
- Housing statistics

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 Coincident indicators
• The economic series that have peaks and troughs
that roughly coincide with the peaks and troughs
in the business cycle or events that happen during
market change.
• they change about the same time and in the same
direction with the economy
• Coincident index:
– Disposal Income.
– Number of employees on nonagricultural
payrolls
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 Lagging indicators
• Economic series that experience their peaks and
troughs after those of aggregate economy or
events happen after the market change.
• It occurs at the same time as the conditions they
signify
• Example of lagging indicators
- Increase in labour cost, increase in inflation rate,
• Lagging Index
- Average duration of unemployment
- Ratio of manufacturing and trade inventories to
sales.
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 Selected Series
• Economic series that are expected to
influence aggregate economic activity but do
not fall neatly into one of the three main
groups above:

– Balance of payment
– Federal surplus or deficit.

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 Why stock prices lead the economy?
• Stock prices reflect expectations of earnings,
dividends and interest rates.
• Stock market reacts to various leading
indicator series: corporate earnings, corporate
profit margins, interest rates, changes in the
growth rate of the money supply.

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 Monetary variables, the Economy and
the Stock Prices

• Money supply and the Economy:

– Research has shown that declines in the
rate of growth of the money supply have
preceded business contractions, while
increases in the growth rate of the money
supply have consistently preceded
economic expansions.
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 INDUSTRY ANALYSIS
• Industry performance tends to be affected by the
stage of economy.
• Deals with the:
– industry within which a particular company
operates,
– how the company stacks up against the major
competitors in the industry,
– the general outlook for that industry.

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• Industry analysis is an essential responsibility for an
equity research analyst. As an equity research
analyst, you need to analyze a particular industry,
see its past trends, demand-supply mechanics, and
future outlook.
https://www.financewalk.com/industry-analysis/

• Types of Industry:
– Plantation, Industrial Products, Hotel, Finance
– Manufacturing, Construction, Technology, Mining
– Healthcare, Utilities
– Staples, essentials
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Industry and Business Cycle

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 Industry and Business Cycle
• An industry’s performance will be affected by the
different stage of the economic cycles.
• At a trough:
– Cyclical industries (industry with above-average
sensitivity to the state of economy) would tend to
outperform other industries.
– Defensive industries have little sensitivity to the
business cycle (economy). It tends to outperform
others when the economy enters a recession.
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• Investors should not always prefer industries with
lower sensitivity to the business cycle:

– Even firms with high sensitivity are riskier, but

they
• move little in downturn and
• swing higher during economy upturn.

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 Industrial Life Cycle
• A stage through which firms pass as they mature.
• It gives the understanding of the nature and operating
characteristics of an INDUSTRY:
– Used to form judgments about the prospects for
the industry growth.
Stage
Sales 1. Pioneering
(Development)
2. Rapid Accelerating
3. Mature Growth
4. Stabilization
5. Declining

1 2 3 4 5 24
1. Pioneering Development Stage
- Early stage of an industry.
- New technology/ product.
- Difficult to predict which firms will emerge as
industries leader.
- market share is still low; high level of risk

2. Rapid Accelerating Stage

- A market is developed for the products &
services.
- Demand is high
- Sales and profit margin are increasing but more
Competition
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3. Mature Growth Stage
- The success in the stage 2 has satisfied most of
the demand for the industry goods or services.
- Competition are more, that can affect future
sales
- Supply increase, demand constant, prices
reduce

4. Stabilization & Market Maturity

- Probably the longest stage of an industry
- stable growth
- Investors can estimate growth easily

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5. Deceleration of Growth and Decline Stage

- Sales growth decline

- Profit margin:
Remaining firms will show low rate of return
on capital.

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 To perform Industry Analysis

• Quantitative measure:
-Industry indexes
-Competition
-Government policy
-Structural change in the economy
-Life cycle of the industry.

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Forces Driving Industry Competition

See Reilly, Brown & Leeds (pg. 322)

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Characteristics of Each of the 5 Forces

See Reilly, Brown & Leeds (pg. 323) 30