Transcript Chapter 9: Investment Environment

Chapter 9
Investment
Environment
Dimensions of the Economy
Macroeconomic Environment
• Macroeconomics – Study of aggregate
measures of economic activity
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International
National
Regional
State
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Dimensions of the Economy
Macroeconomic Environment
• Gross Domestic Product (GDP) –
measures the final market value of goods
and services produced by all labor and
property located in the U.S.
– For Domestic Firms
– For a given period
– Does not reflect domestic production for
foreign-owned enterprises –
• i.e. Toyota Camrys produced in Kentucky
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Dimensions of the Economy
Macroeconomic Environment
• Macroeconomic Forecasts commonly reported include:
– Predictions of consumer spending
– Business investment
– Home building
– Exports
– Imports
– Federal purchases
– State and local government spending
• Widely followed by the press
• Difficult to develop: may involve thousands of
economic variables and hundreds of functional
relationships
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Dimensions of the Economy
Macroeconomic Environment
• Macroeconomic predictions are important
because they’re :
– Used by businesses and individuals to make day-to-day
and long-term investment decisions
• Interest rates projected to rise:
– Homeowners rush to refinance fixed-rate mortgages
– Businesses float new bond and stock offerings to refinance
existing debt
• If predictions are accurate – cost savings and revenue gains
become possible
• If predictions are inaccurate – higher costs and lost marketing
opportunities occur
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Dimensions of the Economy
Microeconomic Environment
• Microeconomics – is the study of economic data
at the industry, firm, plant, or product level
• Not widely followed by the press
• Microeconomic trends are much easier to
accurately forecast
– Narrower range of important factors to be considered
– However microeconomic forecasting is not easy and
not always precise:
• i.e. Actual new vehicles sold in 1994 =
– Ford forecasted demand –
– GM forecasted demand –
– Chrysler forecasted demand –
15.4 million
14.5 million
14 million
16 million
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Macroeconomic Forecasting
Business Cycles
• Common Stock Investing – gives investors the
opportunity to share in the benefits provided by
economic growth
– Profit and sales performance of all companies depends
to some extent on the vigor of the overall economy.
– Business activity in the U.S. expands at roughly 7.5%
per year in terms of GDP
– In inflation adjusted or real dollars = 3% expansion
• 7.5% less 4.5% inflation = 3%
• During robust expansions – real GDP 4 – 5%
• During severe recessions – GDP can decline
– Significant impact on highly leveraged companies
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Macroeconomic Forecasting
Business Cycles
• Business Cycle – Rhythmic pattern of contraction
and expansion in the overall economy.
– Troughs and Peaks
– Important consideration for investors
– Between Oct 1954 and March 1991:
• 9 complete business cycles
• Cycle contraction average duration – 11 months
• Cycle expansion average duration – 50 months
– Periods of economic expansion dominate
– Healthy and growing economy indicator
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Macroeconomic Forecasting
Business Cycles
• Despite intense interest and widespread
news coverage
– The causes of economic contractions and
expansions remain something of a mystery
• The economy shifts from boom to bust
• “Why” the economy shifts from boom to bust is
largely beyond our knowledge
• Changes in the pattern and pace of economic
activity remain a matter of intense debate
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Macroeconomic Forecasting
Economic Indicators
• Economic Indicators – data series that
describe the pattern of projected, current, or
past economic activity
– Leading Economic Indicators and Related
Composite Indexes (Figure 9.2, page 336)
– Indicators of business-cycle peaks broadly
relied on in business-cycle forecasting:
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Macroeconomic Forecasting
Economic Indicators
– Leading Index – cyclical turning points occur “before”
those in aggregate economic activity
• Building permits precede housing starts
• Orders for plant and equipment lead production in durable
goods industries
• Reflect plans or commitments for the activity that follows
• Common Stock prices reflect aggregate profit expectations by
investors –
• a consensus view of the likely course of future business
conditions
– Coincident Index – cyclical turning points tend to
occur at about “the same time” as those in aggregate
economic activity
– Lagging Index - cyclical turning points generally
occur “after” those in the aggregate economic activity 11
Macroeconomic Forecasting
Economic Indicators
• Composite Index – Weighted average of leading,
coincident, or lagging economic indicators
– Creates a forecasting series with less random
fluctuation (noise)
– Smoother than the underlying individual data series
– Produces false signals of change in economic
conditions less frequently
– Turns down just prior to the start of each recessionary
period
– Rises just prior to the start of each subsequent
economic expansion
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Macroeconomic Forecasting
Information about Economic Trends
• Leading business periodicals publish forecast data
and analysis
– Investors rely on data to make informed judgments
about vital economic trends
• Useful starting point in the development of their own future
expectations
• Barron’s –
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Market Laboratory - Economic Indicators (Figure 9.3, Page 338)
Level of production – (what is made)
Distribution (what is sold)
Inventory (what is on hand)
New orders received, Unfilled orders, Purchasing power,
Employment, Construction Activity
• Forbes, Fortune, and Business Week magazines
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Macroeconomic Forecasting
Problem of Changing Expectations
• The expectations of purchasing agents and other
managers can become a self-fulfilling prophecy
– If business purchasing agents are optimistic about
future trends in the economy:
• Boost inventories in anticipation of surging customer demand
– Inventory buildup can contribute to economic growth
– If purchasing agents fear an economic recession:
• Cut back on orders and inventory growth
– The cut back can contribute to any resulting economic downturn
– Business leaders can help lead to a growing economy
– Government-employed and / or politically motivated
economists often actively seek to manage economic
expectations of business leaders and the general public
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Population Growth and Demographics
Population Growth
• Growing Value of the stock market is tied to
economic growth
– Population growth is a prime contributor to economic
growth
– With annual GDP growth of 7.5% consisting of:
• 4.5% inflation + 3% real business activity expansion
– Population growth - 1% of real GDP growth per year
– Productivity growth – 2% of real GDP growth per year
• Ability of a fixed amount of labor, capital, and equipment to
produce a growing amount of output (increased efficiency)
– As long as economic or productivity growth exceeds
the population growth, economic well-being is
increased
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Population Growth and Demographics
Demographics
• 1946 – 1964 the U.S. population growth
rate reached 1.8% per year
– Baby Boom
– Just after WWII
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Population Growth and Demographics
Demographics
• By 2020, the nation’s Baby Boomers will range in
age from 56 – 74
– “Benefits” of a maturing population:
• Increased savings – stock market investments
• Added productivity
– “Concerns”
• Market crash as they dump stocks and bonds to finance their
retirement
• Strain on Social Security (funded by fewer current workers)’
• Strain on Medicare
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Population Growth and Demographics
Demographics
– However:
• Many Baby Boomers will not retire at 65 (as their parents)
• The concept of retirement as we know it today may go out of
style
– Boomers are apt to stay on the payroll because:
• They like to work
• The “golden years” concept is long dead
• Demand a vital role in American life
• Staying healthy longer
• Can’t afford to retire – haven’t set aside enough for
comfortable retirement
• The age at which one qualifies for full Social Security
System benefits is gradually rising
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Population Growth and Demographics
Demographics
– Even a slight delay in the average retirement age:
• Large tax windfall for the Social Security and Medicare
• Combined output of experienced workers could keep fueling
economic growth
• Delay in selling financial assets
– IRS – offers senior citizens huge incentives to avoid realizing
capital gains
• Retain financial assets to death Heirs pay taxes only on
any appreciation earned after the time of inheritance
– Creates huge benefits for stock and bond markets and the overall
economy
– Therefore, it’s safe to bet that negative economic and
financial market effects tied to the aging of the Baby
Boom generation have been greatly exaggerated
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Productivity Growth
Productivity Surveys
• The U.S. Commerce Department conducts mandatory annual surveys
regarding detailed annual statistics:
– The annual study takes the form of a mail
survey
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Productivity Growth
Productivity Surveys
• Annual Survey of Manufacturers basic data
obtained include:
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Kind of business
Location
Ownership
Value of shipments
Payroll
Employment
Cost of materials
Inventories
New capital expenditures
Fuel and energy costs
Hours worked
Payroll supplements
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Productivity Growth
Productivity Surveys
– Statistics collected for industry groups
– Geographic area reports
– Reports on Exports
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Productivity Growth
Productivity Surveys
• The Bureau of Labor Statistics uses info to:
– Calculate annual productivity series
– Update producer price indexes
– Calculate weights for new index components
• The Federal Reserve Board uses to:
– Prepare the Index of Industrial Production
• The Bureau of Economic Analysis uses to:
– Prepare annual GDP updates
– Weights for GDP deflators
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Productivity Growth
Productivity Surveys
• The Department of Commerce’s International
Trade Administration uses export data to:
– Evaluate and forecast industrial activity
• State and Local agencies use the data to:
– Design trade and economic policies
• Private industry and trade associations us data to:
– Plan operations, analyze markets, and make investment
and production decisions
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Productivity Growth
Changes in Productivity Growth
• Productivity Growth –
– Pace of economic betterment
– The rate of increase in output per unit of input
• One of the most prominent uses of economic survey
information is to track the pace of economic betterment, or
productivity growth, in the overall economy.
• Example: if output grows by 5% following only a 2% increase
in the quantity of inputs, then the overall rate of productivity
growth would be roughly 3% (Increased efficiency)
• Robust productivity growth:
– Economic welfare rises quickly
– Superior efficiency is suggested
– Exceptional profitability often ensues
• Sluggish productivity growth:
– Economic welfare improves slowly
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Competitive Environment
Investment Strategy in
Hotly Competitive Markets
• The firm’s competitive environment is described
by the market structure it faces
• Market Structure – Characterized on the basis of
four important industry characteristics:
– 1. Number and size distribution of active buyers and
sellers and potential entrants – individuals or firms
posing a sufficiently credible threat of market entry to
affect the price / output decisions of incumbent firms
– 2. The degree of product differentiation
– 3. The amount and cost of information about product
price and quality
– 4. Conditions of market entry and exit
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Competitive Environment
Investment Strategy in
Hotly Competitive Markets
• Effects of Market Structure are measured
in terms of:
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Firm profits
Investor rates of return
Prices paid by consumers
Availability and quality of output
Pace of product innovation
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Competitive Environment
Investment Strategy in
Hotly Competitive Markets
• Disequilibrium Profits – Above-normal
returns earned in the interval between
– the time when a favorable influence on industry
demand or cost conditions first occurs and
– when competition fully develops
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Competitive Environment
Investment Strategy in
Hotly Competitive Markets
• Disequilibrium losses – are below-normal
returns suffered in the time interval that
can arise between:
– When an unfavorable influence on industry
demand or cost conditions first transpires and
– When exit or downsizing finally occurs
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Competitive Environment
Investment Strategy in
Hotly Competitive Markets
• When barriers to entry and exit are
significant:
– Competitor reactions tend to be slow
– Disequilibrium profits can persist for extended
periods
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Competitive Environment
Investment Strategy in
Hotly Competitive Markets
• The greater the number of market participants:
– The more vigorous the price and product quality
competition, which tend to lead to:
• Meager business profits
• Poor investor returns
• Exception: superior efficiency can sometimes
lead to superior profits even in competitive
markets
– McDonald’s Corp
– Wal-Mart Stores
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Competitive Environment
Investment Strategy in
Imperfectly Competitive Markets
• Imperfectly Competitive Markets – some blend
of competition and monopoly
– Never ending search for uniquely attractive products
• Monopoly – A single seller
• Oligopoly – Few Sellers
• Only difficult-to-enter monopoly and oligopoly
markets hold the potential for long-lasting abovenormal returns
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Competitive Environment
Investment Strategy in
Imperfectly Competitive Markets
• Not all industries offer the same potential for
sustained profitability
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Number and size distribution of competitors
Degree of product differentiation
Level of information available in the marketplace
Conditions of entry when assessing the investment
merits of a given company
• All this contributes to the difficulty of correctly
assessing the profit potential of current products or
prospective lines of business.
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Competitive Environment
Investment Strategy in
Imperfectly Competitive Markets
• An effective investment strategy in imperfectly
competitive markets must be based on the search
for firms with a clear competitive advantage.
• Competitive Advantage – is a unique or rare
ability to create, distribute, or service products
valued by customers.
– Long-lasting above-normal rates of return require a
sustainable competitive advantage that cannot be easily
duplicated
• Product differentiation
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How are Markets Measured?
Economic Census
• Economic Census – Comprehensive statistical
profile of the economy from the national to the
state, to the local level.
– Measures the percentage market share concentrated in
(or held by) an industry’s top firms
• Leading-firm market share data calculated from sales
information for various clusters of top firms
– Primary source of detailed public facts about the
nation’s economy
– Taken at five-year intervals during years ending with
the digits 2 and 7
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How are Markets Measured?
Economic Census
• Companies use census data to:
– Lay out territories
– Allocate advertising
– Locate new stores of offices
• Firms supplying goods and services to other
businesses use census date to:
– Target industries for business-to-business marketing
• Manufacturers look at stats on:
– Materials consumed:
• To learn more about industries that use their products
• To gain insight concerning industry growth potential
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How are Markets Measured?
Economic Census
• Investors:
– Compare operating ratios to census averages to see how
they stack up against competitive norms
• Consultants, government researchers, and job
seekers use census data to:
– Analyze changes in industrial structure, location, and
the pace of growth in job opportunities
• Industry trade associations and news media study
census data to:
– Learn key business facts and to project trends
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How are Markets Measured?
Economic Census
• North American Industry Classification
System (NAICS) – is a method for
categorizing establishments by the principal
economic activity in which they are
engaged.
– Classifies North America’s economic activities
at 2, 3, 4, 5, and 6 digit levels of detail
– Table 9.4 and 9.5, Page 350
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How are Markets Measured?
Concentration Ratios
• Concentration Ratios – Data that show the
percentage market share held by a group of
leading firms
– When concentration ratios are low:
• Industries tend to include many firms and competition tends to
be vigorous
– When concentration ratios are high:
• Leading firms dominate
• Concentration Ratio Weakness:
• Ignores domestic sales for foreign competition (imports)
• Ignores exports by domestic firms
• National totals – while an economic market may be national,
regional, or local in scope.
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Legal Environment
Regulation
of the Competitive Environment
• Regulation – Government Control
– Operating regulations:
• Pollution emissions
• Product packaging and labeling
• Worker safety and health
– Financial regulations:
• Interest rates, fees, lending policies, and capital requirements
• Regulation compliance:
– Drives up administrative costs and product prices, most
of which are passed on to the consumer
• An important concern to investors
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Legal Environment
Antitrust Policy
• Antitrust Policy – Laws and rules designed to
promote competition
– Regulates merger activity:
• Evaluate expected cost savings / efficiencies vs.possible harm
to competition
• May restrict pricing of a merged firm or force the firm to divest
a product line
• Does market entry seem likely to offset the effects of increased
concentration
– And will consumers incur switching costs
– The narrower the market, the more likely a merger will
be investigated:
• Staples and Office Depot – the two largest firms in their
market
– Stifle competition and increase prices - anticompetitive
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Legal Environment
Antitrust Policy
– Attempts to eliminate anticompetitive practices
• Cartels – Price fixing and monitoring among few
competitors
– Airline and Nasdaq Market Makers – Secret Cartel
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Corporate Governance
Corporate Governance Inside the Firm
• Corporate Governance – Control system that
helps corporations effectively administer
economic resources
– Failure to effectively command the firms economic
resources can be blamed on a failure of Corporate
Governance
– Useful means for eliminating any potential divergence
of interests between managers and stockholders
• Incentive Pay – Compensation according to measurable
performance
– Profit Increase
– Sales Increase
– Stock Price Increase
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Corporate Governance
Ownership Structure
• Capital Structure – the breakdown of debt and
equity used to finance total assets
• Ownership Structure – Divergent claims on the
value of the firm:
– Inside equity – Common stock held by management
and other employees (info contained in the annual
Proxy Stmt)
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CEO
Top managers
Members of the board of directors.
Employees – (ESOP)
• When insider holdings are “large”, substantial self-interest in
the ongoing performance of the firm can be presumed
– Incentive to run the firm in a value maximizing manner
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Corporate Governance
Ownership Structure
– Widely dispersed outside equity
• top management can sometimes become insulated
from the threat of stockholder sanctions following
poor operating performance
– Widely dispersed outside debt
– Bank debt
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Corporate Governance
Ownership Structure
– Institutional equity – Common stock held by mutual
funds, pension plans, and other large investors
• Increasing Trend
• Managers have strong incentives to maximize corporate
performance
• Institutional investors have a high probability of managerial
inefficiency or malfeasance discovery
– Fiduciary responsibilities forces institutional investors to tender
shares in the event of an above-market tender offer or takeover
bid. Managers are more susceptible to unfriendly takeover bids
if not acting in the best interest of the shareholders
– Many must liquidate holdings in the event of dividend omissions
or bankruptcy filings
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Answers to Selected
End of Chapter 9 Questions
and Suggested Study
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Study the following
end-of-chapter
questions:
2. (b)
3. (a)
5. (c)
6. (c)
7. (d)
8. (c)
9. (b)
10. (a)
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11. (b)
12. (d)
13. (d)
14. (d)
18. (d)
19. (a)
20. (b)
Read the Chapter
Read the Chapter
“Summary”
Review the Power Point
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