Transcript Ch 12

CHAPTER 12
Macroeconomic and
Industry Analysis
Framework of Security Analysis
Security Analysis (or Fundamental analysis)
– The analysis to determine values of firms, by
predicting earnings and dividends with publicly
economic and accounting information
Three levels of security analysis
– Global and domestic economic analysis (Ch 12)
– Industry analysis (Ch 12)
– Company analysis (equity valuation in Ch 13 and
financial statement analysis in Ch 14)
Why use the top-down sequence
– Sometimes macroeconomic and industry
circumstances might have a greater influence on
profits than the firm’s relative competitiveness
within its industry
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The Goals of Chapter 12
International economic analysis
– Illustrate the global economic risk, regional or
country risks, and exchange rate risk
Domestic economic analysis
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Introduce key domestic economic variables
Interest rates analysis
Analysis of demand and supply shocks
Fiscal and monetary policies of the government
Business cycle analysis
Industry analysis
– Sensitivity of industry performance to business cycle
(sector rotation strategy)
– Life cycles of an industry
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12.1 THE GLOBAL ECONOMY
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Global Economic Analysis
Global economic risks
– Subprime and credit crises in 2008 (introduced in
Ch 2)
The subprime crisis in the U.S. spreads over the world
through MBS
Credit crisis: Financial institutions worldwide lose much
capital in the subprime crisis and stop the lending
business due to the doubt of the credit quality of other
banks and business firms
– The economies of most countries are affected by
the subprime and credit crises in 2008 (Table 12.1)
Stock markets in virtually all countries were deeply
affected, with average returns typically worse than –40%
Different performance in countries and regions implies
the existence of regional and country risks
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Table 12.1 Economic Performance, 2008
※ There is considerable variation in economic performance across countries, e.g.,
while China grew by 9.6% in GDP, the GDP in Japan grew by only 0.3%
※ Exchange rate risk: due to the depreciation of the Venezuela currency, there is a
substantial difference between the stock market return in local currency and in U.S.
dollars
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Global Economic Analysis
Regional or country risks – two crises
– Asian financial crisis in 1997
The boom of Thailand economy in 1996 and 1997
attracted international capital inflow, which resulted in the
highly sufficient currency supply in Thai economy
Thai banks extended credit to domestic firms beyond
what Thailand could support, which resulted in serious
depreciation of Thai baht and economic recession
The international speculators attacked not only Thailand
but also neighboring Asian nations, some with and some
without characteristics similar to Thailand, like Indonesia,
Philippines, Malaysia, South Korea, Taiwan, etc
※These events in different nations highlighted the close
interplay between politics and economics, and the
currency value and stock market performance
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Global Economic Analysis
– Russian financial crisis in 1998
From 1995 to 1998, Russian borrowers (both
government and non-governmental) had gone to the
international capital markets for large quantities of capital,
i.e., to borrow dollar-denominated Eurobonds
Falling global commodity prices reduced the trade
surplus of Russia since its exports were predominantly
commodity-based, e.g., oil sales were 45% of the amount
of exports in 1997
With the deterioration in general economic conditions
and the deficiency of currency reserves of the Russian
Central Bank in August of 1998, the Russian ruble
devaluated and Russian government rescheduled the
payment of sovereign (government) debt
It was the first time that the government debt defaulted
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Global Economic Analysis
Exchange rate risks
– Affect the international competitiveness of a
country’s industries and thus affect sales and
profits of business firms and stock returns of
investors
The depreciation of the local currency will benefit
exporters but hurt importers in that country
The gains for the investment in foreign stocks may be
enhanced or reduced after taking the exchange rate into
consideration
– The poor performance of the stock market of
Venezuela in U.S. dollars demonstrates the effect
of the exchange rate risk could be substantial
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12.2 THE DOMESTIC MACROECONOMY
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Key Economic Variables
In order to earn abnormal profits with the
macroeconomic analysis, you must forecast
the economic condition better than others
– Introduce some key economic variables to assess
the status of the macroeconomy
Gross domestic product (GDP) (國內生產毛額)
– The measure of the economy’s total production of
goods and services
– Rapidly growing GDP indicates an expanding
economy
Industrial production index (工業生產指數)
– A measure of economic activity narrowly focused
on the manufacturing side of the economy
(ignoring services)
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Key Economic Variables
Employment (就業)
– The unemployment rate is the percentage of the
total labor force (those who are either working or
actively seeking employment) yet to find work
– The unemployment rate measures the extent to
which the economy is operating at full capacity
Capacity utilization rate (focusing on the
manufacturing side) (產能利用率)
– The ratio of actual output from factories to potential
output
– Measure the extent to which the manufacturing of
the economy is operating at full capacity
※Higher levels of these two rates imply that the
macroeconomy performs as could as it can
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Key Economic Variables
Inflation (通貨膨脹)
– The rate at which the general level of prices is rising
– High Inflation rates are often associated with
“overheated” economies, i.e., the demand for goods
and services exceeds productive capacity, which
leads to upward pressure on prices
– Trade-off between inflation and unemployment:
stimulate the economy enough to maintain nearly
full employment, but not so much as to bring
inflationary pressures
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Key Economic Variables
Budget Deficits (預算赤字)
– The budget deficit of the government is the
difference between government spending and taxes
– Any budgetary shortfall must be offset by
government borrowing (through issuing T-bonds)
– Large amounts of government borrowing could force
up the interest rate and thus “crowd out” private
borrowing and investing
Interest rates (利率)
– High interest rates reduce the PV of future CFs,
thereby reducing the attractiveness of investment
opportunities
Therefore, high interest rates could restrain the
overheated economy
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Key Economic Variables
Sentiment indicator (消費者心理因素指標)
– Consumers’ and producers’ optimism or pessimism
concerning the economy are important determinants
of economic performance
– Beliefs influence how much consumption and
investment will pursued and thus affect the
aggregate demand for goods and services
– For example, the consumer confidence index (CCI)
is calculated and published in many countries (in
Taiwan, the CCI survey is conducted by NCU)
The P/E ratio rule:
– For S&P 500 index, the P/E ratio tends to be in the
range of 12 to 25 (see Fig 12.2)
– The exact P/E ratios for market indexes vary with
the above mentioned economic variables
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Figure 12.2 S&P 500 versus EPS Estimate
25
12
※ EPS is defined as the earnings per share for the S&P 500 index portfolio
※ The series of S&P 500 is almost between the series of 12 × EPS and 25
× EPS, which implies that the P/E ratio is on average in the rage of 12 to
25
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12.3 INTEREST RATES
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Interest Rates
The level of IRs is one of the most important
macroeconomic factor to be considered in
one’s investment analysis
– Forecasts of IRs affect present values and thus
expected returns for investments (especially
fixed-income investments)
– For stock markets, increases in interest rates
tend to be bad news
High IRs reduce the PVs of stock investment
High IRs attract investors to deposit capital in banks (or
invest in fixed-income securities offering high yields)
and thus affect the incentive to invest in stocks
– However, forecasting IRs is one of the most
difficult parts of applied macroeconomics
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Interest Rates
Four factors determining the IRs
※The first three factors determine the level of real
interest rates (see Fig. 12.3) and the last factor is
the expected inflation rate
1. Supply of funds from savers
Supply ↑  the supply curve is shifted to the right (for the
same real IR, funds supply ↑)  equilibrium real IR ↓
2. Demand for funds from businesses
Demand ↑  the demand curve is shifted to the right (for
the same real IR, funds demand ↑)  equilibrium real IR ↑
(from point E to point E’)
3. Government’s net supply or demand for funds
Currency supply ↑  real IR ↓ (stimulate economic growth)
Government borrowing demand ↑  real IR ↑
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Figure 12.3 Determination of the Equilibrium
Real Rate of Interest
※ The fund-supply curve slopes up from left to right because the higher the real
interest rate, the greater the fund supply from household savings
※ The fund-demand curve slopes down from left to right because the lower the real
interest rate, the more projects firms will undertake, due to the lower capital cost
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Interest Rates
4. Expected rate of inflation
Interest rates contain a premium for expected inflation
The Federal Reserve (the central bank) typically raises
interest rates proactively when inflation is expected to
increase
※Short-run effect of money supply from the
government: to shift the supply curve to the right
and lower the equilibrium real IR
※Long-run effect of money supply from the
government: to increase prices of goods (thus
increase the inflation rate and the nominal IR), but
has no permanent impact on the real economic
activities (like aggregate output, consumption level,
and employment) and the real interest rates
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12.4 DEMAND AND SUPPLY SHOCKS
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Demand Shocks
Demand shock
– An event that affects the demand for goods and
services
– Demand could increase due to, for example,
Reduction in tax rates
Increases in the money supply, governmental
spending, and foreign export demand
– Positive demand shocks is usually associated with
the increases of IRs and inflation rates
(demand ↑  demand > supply  price and thus
inflation rate ↑  nominal IR ↑; or demand ↑ 
funds needed by businesses ↑  IR ↑)
Increases of demand generally implies the expansion and
boom of the economy
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Supply Shocks
Supply shock
– An event that influences production capacity and
costs
– Supply decreases due to, for example,
Increases of prices of raw materials
Freezes, floods, or droughts that may destroy
agricultural crops
Decreases in the wage rates
– Negative supply shocks are usually associated
with the increases of IRs and inflation rates
(supply ↓  demand > supply  price and thus
inflation rate ↑  nominal IR ↑)
Negative supply shocks result in reduced output,
leading to slower economic growth
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Demand and Supply Shocks
How to relate the above knowledge to
investment analysis?
– Choose industries that will be helped by your
expectation about the change of the demand and
supply and avoid those that will be hurt
For example, positive demand shock  choose the
automobile or luxury producers, which benefit most from the
positive demand shock
(in contrast, food producers, for example, also benefit from
the positive demand shock but not much)
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12.5 FEDERAL GOVERNMENT POLICY
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Government Policy
Demand-side policy
– The economy will not by itself arrive at a full
employment equilibrium, so macroeconomic policies
are used to affect the demand for goods and
services to stimulate the economy toward this goal
– Most fiscal and monetary policies are based on this
demand-oriented argument
Supply-side policy
– The goal is to create an environment in which
workers and owners of capital have the maximum
incentive and ability to produce and develop goods
– For example, the proponents of this method argue
that lowering tax rates will elicit more investment
and improve incentives to work, thereby enhancing
economic growth
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Fiscal Policy
Fiscal policy
– The use of government spending and taxing
actions to stabilize or spur the economy
Increases in government spending directly inflate the
demand for goods and services
Increases in tax rates immediately siphon income from
consumers and result in fairly rapid decreases in
consumption
– With most direct impact on the economy
– However, slowly implemented because of the
requirement the negotiation and compromise
between executive and legislative branches
So, the fiscal policy cannot in practice be used to finetune the economy
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Fiscal Policy
– Government’s budget deficit or surplus:
Tax income < government spending  budget deficit
Tax income > government spending  budget surplus
The effect of budget deficits: increase the demand for
goods and services (via government spending) by more
than it reduces the demand for goods and services (via
taxes collection), and therefore stimulate the economy
(for most countries, they adopt the budget-deficit policy
to stimulate the economy)
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Monetary Policy
Monetary Policy
– Manipulation of the money supply to influence
economic activity
– Different from the direct influence from fiscal policies,
monetary policies work indirectly through their impact
on interest rates and thus on the incentive to
purchase and invest
– Short- and long-term effects on interest rates
Increases in the money supply lower short-term real and
thus nominal IRs, encouraging investment and consumption
Over longer periods, it is believed that a higher money
supply leads only to a higher price level and does not have
a permanent effect on economic activity
※The stimulation/inflation trade-off is the major consideration
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to determine how to use monetary policy
Monetary Policy
– Three tools of monetary policy
Open market operations: Central banks trade Treasury
securities for its own account (for fine-tune the monetary
policy daily) (The most direct and commonly used tool)
– Buy Treasury securities  increases in money supply
– Sell Treasury securities  decreases in money supply
Reserve requirements: The proportion of deposits that
banks must hold as cash on hand or as deposits in the
central bank
– Reserve requirements decreases  banks can lend more
loans to firms  effective money supply increases and the
economy is stimulated
Discount rate: The interest rate that the central bank
charges banks on short-term loans
– Discount rate ↓  expansionary monetary policy
– The rate is under the direct control of the central bank, and
is changed relatively infrequently
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Monetary Policy
Federal funds rate in the U.S.
– The federal funds rate is the interest rate at which banks
make short-term loans to meet the reserve requirement
from other banks who have excess funds
– It is determined by the monetary supply and demand
among banks and changes frequently, so it is a better
indicator to gauge the monetary policy adopted by the
central bank
If this rate rises, it indicates that the central bank contracts the
money supply
If this rate declines, in can be inferred that the central bank
expands the money supply
– Monetary policy is determined by the central bank,
and in the U.S., Board of Governors of the Federal
Reserve System (Fed) plays the same role as the
central banks in other nations
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12.6 BUSINESS CYCLES (景氣循環)
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The Business Cycle
Recurring patterns of recession and recovery
are called business cycles (see Fig. 12.11)
– Peak: The transition from the end of an expansion
to the start of a contraction
– Trough: Occurring at the bottom of a recession just
before the economy entering a recovery (expansion)
Industry relationship to business cycles (cyclical
vs. defensive industries)
– Cyclical industries
Industries with above average sensitivity to the state of the
economy
For example, the producers of durable goods (e.g., cars)
or capital goods (that are used by other firms to produce
their own products)
Firms in cyclical industries tend to have high betas
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Figure 12.11 Four Phases of the Business
Cycle
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The Business Cycle
– Defensive industries
Industries with below-average sensitivity to the state of the
economy
For example, food producers, pharmaceutical firms, and
public utilities
– The demand of food, drugs, electricity, and gas is consistent
regardless of the business cycle
Firms in defensive industries tend to have low betas
– The trading strategy based on the business cycle
Optimistic about the economy, hold cyclical stocks
Pessimistic about the economy, hold defensive (or
counter-cyclical) stocks
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Economic Indicators
Leading Indicators (領先指標) – economic series
tend to rise and fall in advance of the economy,
for example,
– Stock prices (S&P 500 stock index)
Stock prices are forward-looking estimates for future
profitability and thus able to be a leading indicator
Since the stock prices themselves are leading indicators,
the information of other leading indicators contributes less
for stock investment – by the time they predict an upturn,
the stock market has already made its move
Stock prices can be a leading indicator for the business
cycle, but there is no leading indictor for stock prices
– Money supply growth rate
Due to the indirect and lag influence of the monetary policy
on the economy
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Economic Indicators
Coincident Indicators (同期指標) – indicators
that tend to change at the same time with the
economy, e.g.,
– Industrial production
– Manufacturing and trade sales
Lagging Indicators (落後指標) – indicators that
tend to follow the lag economic performance,
e.g.,
– Ratio of inventories to sales (high inventories
suggest the economy is in recession)
– Ratio of consumer installment credit outstanding to
personal income
Cyclical indicators are summarized in Table 12.2
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Economic Indicators
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Economic Indicators
※ Ten series of leading indicators
are grouped to generate a
composite index of leading
economic index
※ The composite coincident and
lagging indexes are constructed
similarly
※ The gray bars represent 7 most
famous contraction periods in US
history, and the numbers near the
turning points indicate the length
of the lead time or lag time (in
months) from the peak and the
trough of the corresponding
business cycle
※ The leading index consistently
turns before the rest of the
economy, and the coincident and
lagging indexes in general
behave as expected
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Economic Indicators
※ A wide range of economic indicators are released to the public on a regular
“economic calendar”
※ The above table lists the release dates and sources for about 20 statistics
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12.7 INDUSTRY ANALYSIS
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Industry Analysis
The industry analysis is as important as the
macroeconomic analysis because it is
unusual for a firm in a troubled industry to
perform well
Performance can vary widely across
industries in 2008
– Returns of equity can range from 10.2% for the
electric utilities industry to 36.8% for the cigarette
industry (see Fig. 12.7)
Performance of firms in the same industry
varies substantially (ROEs of several firms in
application software are shown in Fig. 12.9)
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Figures 12.7 and 12.9
Returns on Equity, 2008
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Defining an Industry
Where to draw the line between one industry
and another
– North American Industry Classification System (北
美產業分類系統) or NAICS Codes
There are codes assigned to group firms for statistical
analysis (see Table 12.5)
Firms with the same 4-digit NAICS codes are commonly
taken to be in the same industry
– S&P classifies firms into about 100 industry groups,
and Value Line Investment Survey groups firms
into about 90 industries
– Industry classifications are never perfect
For example, both J.C. Penney (high-volume “value”
store) and Neiman Marcus (high-margin elite store) might
be classified as department stores
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Table 12.5 Examples of NAICS
Industry Codes
※The first two digits define the major industry group: NAICS code
23 = construction
※ The last two or three digits define the industry more narrowly
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Sensitivity to Business Cycle
It is interesting to see how business cycles affect
the performance of specific industries
Three factors affecting sensitivity of earnings to
business cycles
– Sensitivity of sales
Sales of necessities will show little sensitivity to business
conditions, e.g., food, drugs, medical services
Sales of luxuries or discretionary goods are more sensitive
to business conditions, e.g., jewelry, autos, recreational
services
Sale growths of jewelry stores vs. grocery stores in Fig.
12.10
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Figure 12.10 Industry Cyclicality
※ Sales of jewelry, which is a luxury good, fluctuate more widely than
those of grocery stores
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Sensitivity to Business Cycle
– Financial leverage
Since interest expenses on debt must be paid regardless of
sales, they will increase the sensitivity of profits to sales
Profits for high-financial-leverage industries swing more widely
with sales (business cycles)
– Operating leverage
The degree to which the operating costs are fixed
Fixed operating costs are those the firm incurs regardless of it
production level; Variable operating costs are those that rise
or fall as the firm produces more or less products
Fixed costs ↑  the costs is without flexibility with sales 
profits for high-fixed-costs industries swing more widely with
sales (business cycles)  using high fixed costs is equivalent
to increase operating leverage (similar to the effect of using
financial leverage)
※ The above inference is based on the assumption that sales are
positively correlated with business conditions
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Sector Rotation (產業循環)
To select industries in different phases of the
business cycle
– Peak – natural resource firms
The economy might be overheated with high inflation
Invest in natural resource firms to against the inflation
– Contraction – defensive firms, e.g., food, drugs, or
other necessities
These firms are less affected by the contraction
Lower inflation and IR rates favor financial firms
– Trough – equipment, transportation and
construction firms
Firms might purchase new equipment to meet anticipated
increases in demand in the following expansion
– Expansion – cyclical industries, e.g., consumer
durables and luxury items
These firms are the most profitable in this phase
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Sector Rotation
※ The typical sector rotation across different states of the business cycle is
shown in the above figure
※ Each sector historically had their “day in the sun” during a typical
economic cycle
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Life Cycles of an Industry
Stage
Sales Growth
Start-up
Rapid & Increasing
Consolidation
Stable
Maturity
Slowing
Relative Decline
Minimal or Negative
(Next I will discuss each stage in details)
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Life Cycles of an Industry
Start-up stage
– The early stages of an industry are often
characterized by a new technology or product,
e.g., PC in the 1980s, cell phone in 1990s
– At this stage, sales and earnings grow at an rapid
rate since the new product has not yet saturated
in market
Consolidation stage
– The industry survivors and leaders begin to
emerge
– The performance of the surviving firms will closely
tract the performance of the overall industry
– The industry will grow faster than the rest of the
economy
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Life Cycles of an Industry
Maturity stage
–
–
–
–
The product is used extensively in the market
The product has become far more standardized
There is price competition among firms in the industry
Firms at this stage are called as “cash cows,” which
are with stable CF but offering little opportunity for
profitable expansion
Relative decline
– The industry might grow as less than the rate of the
overall economy, or it might even shrink
– This could be due to the product being out of date or
the competition from new products
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Life Cycles of an Industry
The logic behind the progression from one
stage of the industry life cycle to another
– High growth and fat profits bring new competitors
and thus generate new sources of supply to
reduce prices, profits, and growth finally
Are high-growth industries good investment
targets?
– The historical records tells us they are, as long as
they offer high enough expected return to
compensate the risks you bear
– But if the security prices already reflect the
likelihood for high growth, then it is too late to
make money from this strategy
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