CHAPTER 11 Macroeconomic and Industry Analysis 12 1

CHAPTER 11 Macroeconomic and Industry Analysis 12 -1

13. 2 A Description of Efficient Capital Markets • An efficient capital market is one in which stock prices fully reflect available information. • The EMH has implications for investors and firms. – Since information is reflected in security prices quickly, knowing information when it is released does an investor no good. – Firms should expect to receive the fair value for securities that they sell. Firms cannot profit from fooling investors in an efficient market. 12 -2

Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Overreaction to “good news” with reversion Delayed response to “good news” Efficient market response to “good news” -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement 12 -3

Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Efficient market response to “bad news” -30 -20 -10 Overreaction to “bad news” with reversion Delayed response to “bad news” 0 +10 +20 +30 Days before (-) and after (+) announcement 12 -4

The Different Types of Efficiency • Weak Form Efficiency: Security prices reflect all information found in past prices and volume. If the weak form of market efficiency holds, then technical analysis is of no value. Often weak-form efficiency is represented as Pt = Pt-1 + Expected return + random error t – Since stock prices only respond to new information, which by definition arrives randomly, stock prices are said to follow a random walk. • Semi-Strong Form Efficiency: Security prices reflect all publicly available information. Publicly available information includes: • Historical price and volume information • Published accounting statements. • Information found in annual reports. • Strong Form Efficiency: Security prices reflect all information—public and private. Strong form efficiency incorporates weak and semi-strong form efficiency. Strong form efficiency says that anything pertinent to the stock and known to at least one investor is already incorporated into the security’s price. 12 -5

Stock Price Why Technical Analysis Fails Investor behavior tends to eliminate any profit opportunity associated with stock price patterns. Sell Buy If it were possible to make big money simply by finding “the pattern” in the stock price movements, everyone would do it and the profits would be competed away. Time 12 -6

Framework of Analysis • Fundamental Analysis vs. Technical Analysis – Significance of fundamental analysis over technical analysis in investment analysis • Approach to Fundamental Analysis – Domestic and global economic analysis – Industry analysis – Company analysis • Why use the top-down approach 12 -7

11. 1 THE GLOBAL ECONOMY 12 -8

International Agencies: IMF • IMF (1946): it aims – to promote international monetary cooperation and exchange stability; – to foster economic growth and high levels of employment; and – to provide temporary financial assistance to help ease imbalances of payments – To protect international traders from the evil forces of speculators • Over the period IMF has turned up as a disputed institution due to: • Fixed exchange rate system of controlling exchange rate was contradictory to the principle of the organization to patronize market mechanism • Incapability to ensure discipline during competitive depreciation of 1960 s by European countries • The system of exchange rate collapsed in 1971. Since then the importance of the institution has been questioned. • IMF financing was criticized on the grounds: – Common prescription for all countries – Highly conditional of contractionary nature – Increased growth with increased poverty 12 -9

International Agencies: World Bank Group: • IBRD International Bank for Reconstruction and Development (1944): To extend credit to the government of credit worthy poor countries • IDA International Development Association (1960): To lend to the governments of very poor developing nations on highly concessional terms. • IFC International Finance Corporation (1956): To promote sustainable private sector investment in developing countries, • MIGA Multilateral Investment Guarantee Agency (1988): To promote FDI in emerging economies, by offering political risk insurance to investors and lenders; and • ICSID International Centre for Settlement of Investment Disputes (1966): To facilitate the settlement of investment disputes between governments and foreign investors • Debtors’ Cartel of early 1980 s by Latin American Countries resulted in the failure of highest number of banks in USA since the great depression of 1930 s. 12 -10 • Debtor countries require to serve WB-IMF sponsored

International Agencies: WTO GATT (1947) and WTO (1995): • In the context of 200 years’ failure of beggar-thy-neighbor policy, GATT was introduced to ensure globalization by means of trade liberalization. • GATT failed due to non-cooperation of USA and other developed countries on issues like agricultural subsidies. WTO replaced GATT. • TRIM (Trade Related Investment Measures), and TRIPS (Trade Related Aspects of Intellectual Property Rights) were WTO introduction • Violence and blood sheds are common in all the ministerial summits casting doubts in the success of the multilateral trade talk • Countervailing duty of USA against Japanese automobile 12 -11 approved by WTO raised controversy.

Political Risk • Effect of globalization like Asian currency crisis of 1997 • Economic integration and free trade agreement (EU and NAFTA) • Risk of nationalization • Risk of terrorist attack • Growth rate and competition • Nature of protectionism • Lack of legal infrastructure (Guanxi effect of China) 12 -12

Foreign exchange risk exposure • The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure. If an exporter denominates its export in foreign currency, a 10% decline in the value of that currency (dollar) will reduce the taka value of its receivable by 10%. Transaction exposure includes export denominated in foreign currency, interest received from investment, import denominated in foreign currency, interest owed on foreign loan. • Economic exposure refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations. Cash flows that do not require conversion of currencies do not reflect transaction exposure. Yet, these cash flows may also be influenced significantly by exchange rate movements. • The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as 12 -13 translation exposure. In particular, subsidiary earnings

Managing Madison Inc. ’s Economic Exposure C$=$. 85 Sales: (Figures in Millions) C$=$. 75 (1) U. S. $300. 00 $304. 00 $307. 00 (2) Canadian (C$4) 3. 0 (3) Total $303. 00 $307. 20 $310. 40 Cost of gods sold: (4) U. S. $ 50. 00 (5) Canadian C$200= 150. 00 (6) Total $200. 00 $210. 00 $220. 00 (7) Gross profit $103. 00 $ 97. 20 Operating expenses: (8) U. S. - Fixed $ 30. 00 (9) U. S. – Variable (ex. , sales com) (10) Total $ 60. 30 $ 60. 72 (11) EBIT $ 42. 70 $ 36. 48 Interest expense: (12) U. S. $ 3. 00 7. 50 C$10= 8. 00 C$10= 8. 50 (14) Total $ 10. 50 $ 11. 00 (15) EBT $ 32. 20 $ 25. 48 3. 20 C$=$. 80 3. 40 C$200= 160. 00 C$200= 170. 00 $ 90. 40 $ 30. 00 30. 30 $ 61. 04 $ 29. 36 $ 30. 72 31. 04 3. 00 (13) Canadian C$10= $ 11. 50 $ 17. 86 *Non-transactional economic exposure *Transactional Economic Exposure *Translation Exposure 12 -14

Impact of globalization on an MNC’s Value National Income in Foreign Countries Trade Agreements Inflation in Foreign Countries Exchange Rate Movements Political Risk E (CFj, t ) = expected cash flows in currency j to be received by the U. S. parent at the end of period t E (ERj, t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent 12 -15

Example: Country risk • The US dollar rate now in Taka is 68. It is expected to be either Tk. 69 or Tk. 70 in the next year. What would be the effect of the PV of cash flows of the parent company which will have a cash flow of $100 million from USA and Tk. 7, 000 million from Bangladesh. The cost of capital of the parent company is 16%. • Note that the difference of $1. 3 million is only that of the next year. The value of the firm is composed of all the future flows including the one of the next year. Also note that a multinational company would have many subsidiaries in different countries making the equation even more difficult to comprehend the single value observed by the market capitalization of the parent company. 12 -16

Table 11. 1 Economic Performance, 2006 12 -17

11. 2 THE DOMESTIC MACROECONOMY: Factors • Gross domestic product: High growth of national income represents the potentiality of sales promotion that results in high stock market index • Employment rate: More employment indicates more effective demands. Unemployment of not only the workers but also other inputs particularly capital indicates the potential capacity • Inflation usually reflects higher demands for products resulting in more returns. Inflation controlling techniques are the choice of central bank (monetary policy) and the government (fiscal policy). Margin loans of banks influences supply of investable fund. • Interest rates: High interest rate (vis-à-vis cost of capital) reduces the present value of future cash flows, thereby reducing the attractiveness of investment opportunity. • Budget Deficits: Large amounts of government borrowing can force up interest rates by increasing total demand for credit (known as crowding out effect) 12 -18 • Consumer sentiment: Consumers’ and producers’ optimism

Figure 12. 2 S&P 500 versus EPS Estimate 12 -19

11. 3 INTEREST RATES Determination of equilibrium real interest rate: (Loanable Fund Theory) i S (Savings) k D (Investment) Quantity of Loanable Fund 12 -20

Factors Determining The Level of Interest Rates • Production opportunities: More attractive production opportunity shifts the demand curve right. Cost increases. • Time preferences for consumption: If present consumption gets more priority than deferred consumption, then supply curve shifts left. Cost increases. • Risk: Increased risk makes savings less attractive, supply curve shifts left. Risk and return are proportional. Increased risk leads to an upward shift of demand curve. Cost increases. • Government’s net supply and/or demand for funds: Government borrowing takes part in the demand. Cost increases. • Expected inflation: If expected inflation increases savers demand more return, supply curve shifts left. Cost increases. 12 -21

Figure 11. 3: Determination of the equilibrium Real Rate of Interest: Crowding out effect 12 -22

11. 4 DEMAND SUPPLY SHOCKS • Demand shocks: An event that affects the demand for goods and services. Examples of positive demand shocks: • Reduction in tax rates • Increases in the money supply • Increases in government spending • Increases in export demand by foreigners • Supply shocks: An event that influences production capacity and costs • Changes in the price of imported oil • Infrastructural facility • Floods • Droughts • Changes in the wage rates • Technological progress 12 -23

11. 6 BUSINESS CYCLES • Recurring patterns of recession and recovery—business cycles – Peak – Trough • Industry relationship to business cycles – Cyclical industries have above-average sensitivity to the state of economy. Examples include durable goods like automobile, TV, freeze, washing machines, etc. Systematic risk or beta estimator is high. – Defensive industries are less sensitive to the state of economy like food producers and processors, pharmaceutical firms, and public utilities. Low beta. 12 -24

12. 7 INDUSTRY ANALYSIS Figure 12. 7 Industry Analysis: Return on Equity Performance can vary widely across industries ROE can range from 10. 6% for electronic equipment to 29. 2% for the cigarette industry 12 -25

Figure 12. 8 Industry Stock Price Performance, 2006 12 -26

Figure 12. 9 ROE of Major Banks, 2007 12 -27

Industry Sensitivity to Business Cycle Factors affecting sensitivity of earnings to business cycles: – Sensitivity of sales of the firm’s product to the business cycles (Figure 11. 10 demonstrates that tobacco industry is insensitive and automobile industry is sensitive to business cycle) High sensitive: machine tools, steel, autos, transportation, etc. Low sensitive: food, drugs, medical equipment. – Operating leverage: Proportion of fixed cost to variable costs. Firms with high operating leverage (or proportion of fixed cost to total cost) are more sensitive to economic fluctuations as small swings in business conditions can have large impact on profitability. Firms with greater proportion of variable cost as opposed to fixed cost are less sensitive to business cycle. – Financial leverage: Interest on debt is fixed charge. More borrowing represents more interest payments even when sales and profitability has gone down. This increases the risk of bankruptcy. In case of inflation, sales increase, profitability increases, and due to nontaxable exemption of interest obligation EPS increases significantly. Firms having high 12 -28

Figure 11. 10 Industry Cyclicality 12 -29

Figure 11. 11 A Stylized Depiction of the Business Cycle 12 -30

Sector Rotation • Sector rotation is an investment strategy that entails shifting the portfolio into industry sectors that are expected to outperform others based on macroeconomic forecasts. – Peak observes high inflation & interest rates– natural resource extraction and processing such as minerals or petroleum – Contraction observes low inflation & interest rate– defensive firms like food, pharmaceutical products, basic necessities – At the trough of recession the economy is posed for recovery and subsequent expansion– capital assets & equipment, transportation and construction firms – Expansion observes rapid economic growth- cyclical industries like consumer durables (TV, Freeze, automobiles) and luxury items as well as banks 12 -31

Industry Life Cycles Concept: At present biotechnology industry goes through high rate of investment, high rate of return, low dividend payout; when electric utility industry goes through low investment, low return and high payout. This is due to the life cycle of industry. Biotechnology goes through start-up phase (TRIPS 1995) and electric utility follows decline phase of life cycle. Mobile telephone and personal computer industry goes through maturity. Stage Sales Growth Start-up Rapid & Increasing Consolidation Stable Maturity Slowing Relative Decline Minimal or Negative 12 -32

Figure 12. 12 The Industry Life Cycle 12 -33

Industry Structure and Profitability DEGREE OF ACTUAL AND POTENTIAL COMPETITION 1. Rivalry Among Existing Firms 2. Threat of New Entrants Industry growth Scale economies Concentration First mover advantage Differentiation Distribution access Switching costs Relationships Scale/learning economies Legal barriers 3. Threat of Substitute Products Relative price and performance Buyers willingness to switch Fixed variable costs Excess capacity Exit barriers Industry Profitability BARGAINING POWER OF INPUT AND OUTPUT MARKETS 4. Bargaining Power of Buyers 5. Bargaining Power of Suppliers Switching costs Differentiation Importance of product for cost and quality Number of buyers Number of suppliers Volume per buyers Volume of suppliers 12 -34

1. Rivalry among existing firms depends on: • i. Industry Growth rate: The competitive behavior of a firm with high growth industry and stagnant industry is different. • ii. Concentration and balance of competitors: Concentration of the number of firms in the industry shapes the competitive behavior of the firm. (Example: Microsoft or Coke-Pepsi) • iii. Degree of Differentiation and switching costs: If the products are very similar the switching cost of customers is low and price competition is common. If the products are differentiated switching cost is high and rivalry is less acute. • iv. Scale or Learning Economies and Ratio of Fixed Cost to Variable Cost: For steep learning curve and large economies of scale there are incentives for aggressive competition. Similarly, for high fixed cost to variable cost ratio there is incentive to reduce price to utilize the installed capacity. (example: airline industry) • v. Excess Capacity and exit barriers: Specialized assets with excess capacity makes a firm aggressive in price cut. Exit becomes then difficult. There may be regulations restricting the exit. 12 -35

2. Threat of New Entrants depends on: • i. Economies of Scale: Large scale economies is a constraint for new entrants. The existing firm is motivated to handle this risk by a large investment in research and development (pharmaceutical or jet engines), in brand advertising (soft-drink), or in physical plant and equipment (telecommunication) • ii. First Mover Advantage: The first mover might be able to set industry standard, to enter into exclusive arrangements with suppliers of cheap raw materials, or to acquire scarce government licenses. He may capitalize learning economies or significant switching costs. This makes new entrance difficult. (example: switching cost of Microsoft’s DOS operating system is quite high) • iii. Access to channels of Distribution and Relationship: Limited capacity of distribution channels and high costs of developing new channels can act as powerful barriers to new entry. Existing relationship between firms and customers in an industry also make it difficult for new firms to enter an industry. • iv. Legal Barriers: Patents, copyrights limit new entries. Similarly, licensing regulations limit entry into taxi services, medical services, broadcasting, telecommunications industries, etc. 12 -36

3. Threat of substitute products • Substitute products are not necessarily similar products rather the products that perform the same function. For example, car rental and air lines may be substitutes, Jute and synthetics are substitutes. Technological innovation may introduce substitute like computer for type writers. It depends on: • i. Relative price and performance • Ii. Customers’ willingness to switch 12 -37

Relative Bargaining Power in Input and Output Markets • While degree on competition in an industry determines whether or not there is potential to earn abnormal profits, the actual profits are influenced by the industry's bargaining power with its suppliers and customers. On the input side there is labor, raw materials and components, and finances. On the output side firm may either sell directly to the final customers, or enter into contract with intermediaries in the distribution chain. There is a competition among all these factors called relative bargaining 12 -38

4. Bargaining Power of buyers Depends on: • 1. Price sensitivity: Buyers are more price sensitive when the products are undifferentiated and switching cost is low. • 2. Relative bargaining power: In a monopoly market there is low bargaining power of the buyers and in a perfect market there is high bargaining power of the buyers. This in turn, depends on number of buyers relative to number of sellers, as well as the volume per buyer. 12 -39

5. Bargaining Power of Suppliers • Suppliers’ bargaining power is the opposite to the bargaining power of the buyers. In a monopsony there is one buyer and many sellers. Such imperfection can be extended to a number of few buyers and many sellers. (Example: bargaining power of Coke-Pepsi on bottlers) On the other hand, in a perfect market they do not have a bargaining power as they have to accept the market price. (Example: can producers lack power). Market of intermediate goods also determines the bargaining power when they are the exclusive suppliers for the next sequence of producers. (IBM’s unique position as mainframe suppliers dominates computer leasing business) 12 -40