CHAPTER FIVE
SECURITY ANALYSIS
5.1 Macro -Economic Analysis:-The government uses to fine – tune the economy, attempting to
maintain low unemployment and low inflation. Despite these efforts, economies reputedly
seem to pass through good or bad times. One determinant of the broad asset allocation
decision of many analysts is a forecast of whether the macro economy is improving or
deteriorating. A forecast that differs from the market consensus can have a major impact on
investment strategy.
The Business Cycle:-The economy recurrently experiences periods of expansion and
contraction, although the length and depth of those cycles can be irregular. This recurring
pattern of recession and recovery is called the business cycle. The production series all show
clear variation around a generally rising trend.
The transition points across cycles are called peaks and troughs, 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.
As the economy passes through different stages of the business cycle, the relative performance
of different industry groups might be expected to vary. For example, a trough, just before the
economy begins to recover from a recession, one would expect that cyclical industries, those
with above average sensitivity to the state of the economy, would lead to outperform other
industries.
Examples of cyclical industries are producers of durable goods such as automobiles or washing
machines. Because purchases of these goods can be differed during a recession, sales are
particularly sensitive to macroeconomic conditions. Other cyclical industries are producers of
capital goods, that is , goods used by other firms to produce their own products. When
demand is slack, few companies will be expanding and purchasing capital goods. Therefore, the
capital goods industry bears the brunt of a slow down but does well in an expansion.
In contrast to cyclical firms, defensive industries have little sensitivity to the business cycle.
There are industries that produce goods for which sales and profits are least sensitive to the
state of the economy. Defensive industries include food products and processors,
pharmaceutical firms, and public utilities. These industries will outperform others when the
economy enters a recession.
5.2 Industry Analysis:-industry analysis is important for the same reason that macroeconomic
analysis is just as is difficult for an industry to perform well when the macro economy is ailing, it
is unusual for a firm in troubled industry to perform well. Similarly, just as we have seen that
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economic performance can vary widely across countries, performance also can vary widely
across industries.
Industry groups show even more dispersion in their stock market performance.
Industry Life Cycle:-Examine the biotechnology industry and you will find many firms with high
rates of investment, high rate of return on investment, and low dividend payout rates. Do the
same for the public utility industry and you will find lower rates of return , lower investment
rates and higher dividend payout rates . Why this should be?
The biotech industry is still new. Recently available technologies have created opportunities for
highly profitable investment of resources. New products are protected by patents, and profit
margins are high. With lucrative investment opportunities are, firms find it advantageous to put
all profits back into the firm. The companies grow rapidly on average.
Eventually, however, growth must slow. The high profit rates will induce new firms to enter the
industry. Increasing competition will hold down prices and profit margins. New technologies
become proven and more predictable, risk levels will fall, and entry becomes even easier. As
internal investment opportunities become less attractive, a lower fraction of profits are
reinvested in the firm. Cash dividends increase.
Ultimately, in a mature industry, we observe “cash cows”, firms with stable dividends & cash
flow & little risk. Growth rates might be similar to that of the overall economy. Industries in
early stage of their life cycles offer high-risk/ high –potential - return investments. Mature
industries offer lower- risk , lower return combinations.
This analysis suggests that a typical industry life cycle might be described by four stages:
1. a start up stage; characterized by extremely rapid growth;
2. a consolidation stage; characterized by growth that is less rapid but still faster than that
of the general economy;
3. a maturity state; characterized by growth no faster than the general economy and
4. a stage of relative decline; in which the industry grows less rapidly than the rest of the
economy or actually shrinks. This industry life cycle is illustrated as follows:
Sales
Rapid & increasing Stable slowing Minimal or
growth growth growth negative growth
Start -up Consolidation Maturity Relative decline
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5.3 Company Analysis:-The maturation of an industry involves regular changes in the firm’s
competitive environment. As a final topic, we examine the relationship among industry
structure, competitive strategy, and profitability. Michael Porter has highlighted these five
determinants of completion: threat of entry from new competitors, rivalry between existing
competitors, price pressure from substitute products, bargaining power of buyers, and
bargaining power of suppliers.
1. Threat of entry: - New entrants to an industry put pressure on price and profits. Even if a
firm has yet entered an industry. The potential for it to do so places pressure on prices, because
high prices and profit margins will encourage entry by new competitors. Therefore, barriers to
entry can be a key determinant of industry profitability. Barriers can be in many. For example,
existing firms may already have secure distribution channels for their products based on
longstanding relationships with customers or suppliers that would be costly for a new entrant
to duplicate. Brand loyalty also makes it difficult for new entrants to penetrate a market and
gives firms more pricing discretion. Proprietary knowledge of patent protection also may give
firms advantages in securing a market. Finally, an existing firm’s experience in a market may
give in cost advantages due to the learning that takes place over time.
2. Rivalry between existing competitors:- When there are several competitors in an industry ,
there will generally be more price competition and lower profit margins as competitors seek to
expand their share of the market. Slow industry growth contributes to this competition,
because expansion must come at the expense of a rival’s market share. High fixed costs also
create pressure to reduce prices, because fixed costs put greater pressure on firm’s to operate
near full capacity.
3. Pressure from Substitute Products:- Substitute products means that the industry faces
competition from firms in related industries. For example, sugar producers complete with corn
syrup producers. Wool producers compete with synthetic fiber producers. The availability of
substitutes limits the prices that can be charged to customers.
4. Bargaining Power of Buyers:- if a buyer purchases a large fraction an industry’s output, it
will have considerable bargaining power and can demand price concessions . For example, auto
producers can put pressure on suppliers of auto parts. This reduces the profitability of the auto
parts industry.
5. Bargaining Power of Suppliers: - If a supplier of a key input, has monopolistic control over
the product, it can demand higher prices for the good and squeeze profits out of the industry.
One special case of this issue pertains to organized labor as a supplier of a key input to the
production process. Labor Unions engage in collective bargaining to increase the wages paid to
workers. When the labor market is highly unionized, a significant share the potential profits in
the industry can be captured by the work force.
The key factor determining the bargaining power of suppliers is the availability of substitute
products. If substitutes are available, the supplier has little clout and cannot extract higher
prices.
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The business cycle is the economies recurring pattern of expansion and recession.
Leading economic indicators can be used to anticipate the evolution of the business
cycle because their values tend to change before those of others key economic
variables.
Industries differ in their sensitivity durable goods to the business cycle. More sensitive
industries tend to be those producing high priced for which the consumers has
considerable discretion as to the timing of purchase. Examples are automobiles or
consumer durables. Other sensitive industries those that produce capital equipment for
other firms. Operating leverages and financial leverage increase sensitivity to the
business cycle.
Macroeconomic policy aims to maintain the economy near full employment without
aggravating inflationary pressures. The proper trade-off between these two goals is a
source of ongoing debate.
The traditional tools of macro policy are government spending and tax collections which
comprise fiscal policy , and manipulation of the money supply via monetary policy .
Expansionary fiscal policy can estimate the economy and increase GDP but tends to
increase interest rates. Expansionary monetary policy works by lowering interest rates.
