Chapter 7:Security

Analysis
 Macro-Economic Analysis

THE INTRINSIC VALUE OF A stock depends on the dividend and earnings that can be expected
from the firm. This is the heart of fundamental analysis—that is, the analysis of the
determinants of value.

Ultimately, the business success of the firm determines the dividends it can pay to
shareholders and the price it will command in the stock market. Because the prospects of the
firm are tied to those of the broader economy, fundamental analysis must consider the
business environment in which the firm operates.

For some firms, macroeconomic and industry circumstances might have a greater influence on
profits than the firm’s relative performance within its industry. In other words, investors need
to keep the big economic picture in mind.
Therefore, in analyzing a firm’s prospects, it often makes sense to start with the broad
economic environment, examining the state of the aggregate economy and even the
international economy. From there, one considers the implications of the outside environment
on the industry in which the firm operates.

Finally, the firm’s position within the industry is examined.

A top-down analysis of a firm’s prospects must start with the Macro-economic analysis.

The macroeconomy is the environment in which all firms operate.

In this section, we will review some of the key economic statistics used to describe
the state of the macroeconomy.

Key Economic Indicators

Gross Domestic Product
Employment
Inflation
Interest Rates
Budget Deficit
Sentiment
Fiscal Policy
Monetary Policy
Business Cycle
Economic Indicators
Source:

www.marketwatch.com/tools/calendars/economic
 Industry Analysis

Industry analysis is important for the same reason that macroeconomic analysis is.

Just as it is difficult for an industry to perform well when the macroeconomy is ailing, it
is unusual for a firm in a troubled industry to perform well.

Similarly, just as we have seen that economic performance can vary widely across countries,
performance also can vary widely across industries.
Return on equity by industry, 2018
Source: Professor Aswath Damadaran,
http://pages.stern.nyu.edu/~adamodar/.
Industry stock price performance, 2018

Source: Authors’ calculations using data from

Prof. Kenneth French’s Web site,
http://mba.tuck.dartmouth.edu/pages/
faculty/ken.french/Data_Library.
What Is an Industry?
An industry is a group of companies that are related based on their primary business
activities.

In modern economies, there are dozens of industry classifications.

Industry classifications are typically grouped into larger categories called sectors.

Individual companies are generally classified into an industry based on their largest sources
of revenue. For example, while an automobile manufacturer might have a financing division
that contributes 10% to the firm's overall revenues, the company would be classified in the
automaker industry by most classification systems.
Although the concept of an “industry” seems clear-cut, deciding where to draw the
line between one industry and another can be difficult in practice.

A useful way to define industry groups in practice is given by the North American Industry
Classification System, or NAICS codes. for statistical analysis.

The first two digits of the NAICS codes denote very broad industry classifications. For
example, the codes for all construction firms start with 23. The next digits define the industry
grouping more narrowly.

For example, codes starting with 236 denote building construction, 2361 denotes residential
construction, and 236115 denotes single-family construction.
Sensitivity to the Business Cycle
Once the analyst forecasts the state of the macroeconomy, it is necessary to
determine the implication of that forecast for specific industries. Not all industries are
equally sensitive to the business cycle.

Three factors determine the sensitivity of a firm’s earnings to the business cycle. First is the
sensitivity of sales.

Necessities show little sensitivity to business conditions. Examples of industries in this group
are food, drugs, and medical services. Other industries with low sensitivity are those for
which income is not a crucial determinant of demand. Tobacco products are an example of
this type of industry.
In contrast, firms in industries such as machine tools, steel, autos, and transportation are
highly sensitive to the state of the economy.
The second factor determining business cycle sensitivity is operating leverage, which
refers to the division between fixed and variable costs. (Fixed costs are those the firm
incurs regardless of its production levels. Variable costs are those that rise or fall as the
firm produces more or less product.)

Profits of firms with greater amounts of variable as opposed to fixed costs will be less
sensitive to business conditions. This is because in economic downturns, these firms
can reduce costs as output falls in response to falling sales.

Profits for firms with high fixed costs will swing more widely with sales because costs
do not move to offset revenue variability. These firms are said to have high operating
leverage because small swings in business conditions can have large impacts on
profitability.
The third factor influencing business cycle sensitivity is financial leverage, which is
the use of borrowing. Interest payments on debt must be paid regardless of sales. They
are fixed costs that also increase the sensitivity of profits to business conditions.

Investors should not always prefer industries with lower sensitivity to the business cycle.

Firms in sensitive industries will have high-beta stocks and are riskier. But while they
swing lower in downturns, they also swing higher in upturns.

As always, the key issue is whether the expected return on the investment is fair
compensation for the risks borne.
Sector Rotation
One way that many analysts think about the relationship between industry analysis and the
business cycle is the notion of sector rotation.

The idea is to shift the portfolio more heavily into industry or sector groups that are expected
to outperform others based on one’s
assessment of the state of the business cycle.

Near the peak of the business cycle, the economy might be overheated, with high inflation and
interest rates and price pressures on basic commodities. This might be a good time to invest in
firms engaged in natural resource extraction and processing such as minerals or petroleum.

Following a peak, when the economy enters a contraction or recession, one would
expect defensive industries that are less sensitive to economic conditions, for example,
pharmaceuticals, food, and other necessities, to be the best performers.
At the height of the contraction, financial firms will be hurt by shrinking loan volume and
higher default rates.

Toward the end of the recession, however, contractions induce lower inflation and
interest rates, which favor financial firms.

At the trough of a recession, the economy is poised for recovery and subsequent
expansion. Firms might thus be spending on purchases of new equipment to meet
anticipated increases in demand.

This, then, would be a good time to invest in capital goods industries, such as
equipment, transportation, or construction
Finally, in an expansion, the economy is growing rapidly. Cyclical industries such as
consumer durables and luxury items will be most profitable in this stage of the cycle.
Banks might also do well in expansions because loan volume will be high and default
exposure low when the economy is growing rapidly.

When investors are relatively pessimistic about the economy, they will shift into
noncyclical industries such as consumer staples or health care.

When anticipating an expansion, they will prefer more cyclical industries such as
materials and technology.
Don’t forget that sector rotation, like any other form of market timing, will be successful
only if one anticipates the next stage of the business cycle better than other investors.
The business cycle depicted in Figure BELOW is highly stylized.

In real life, it is never as clear how long each phase of the cycle will last, nor how
extreme it will be. These forecasts are where analysts need to earn their keep.
Industry Life Cycles
Examine the software application industry and you will find many firms with high rates of
investment, high rates 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 should this be?

Software application firms have many opportunities for highly profitable investment of
resources. New products are protected by patents, and profit margins are high. With such
lucrative investment opportunities, 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 fall, and entry
becomes even easier. As internal investment opportunities become less attractive, a
lower fraction of profits is reinvested in the firm. Cash dividends increase.

Ultimately, in a mature industry, we observe “cash cows,” firms with stable dividends
and cash flows and little risk. Growth rates might be similar to that of the overall
economy.

Industries in early stages of their life cycles offer high-risk/high-potential-return

investments. Mature industries offer lower-risk, lower-return profiles
This analysis suggests that a typical industry life cycle might be described by four
stages: a start-up stage, characterized by extremely rapid growth; a consolidation
stage, characterized by growth that is less rapid but still faster than that of the general
economy; a maturity stage, characterized by growth no faster than the general
economy; and a stage of relative decline, in which the industry grows less rapidly
than the rest of the economy, or actually shrinks

Start-Up Stage
The early stages of an industry are often characterized by a new technology or product such
as desktop personal computers in the 1980s, cell phones in the 1990s, or touchscreen
smartphones introduced in 2007. At this stage, it is difficult to predict which firms will
emerge as industry leaders. Some firms will turn out to be wildly successful, and others will
fail altogether.
Therefore, there is considerable risk in selecting one particular firm within the industry.

For example, in the smartphone industry, there continues to be a battle among competing
technologies, such as Android versus iPhone.

At the industry level, however, it is clear that sales and earnings will grow at an extremely
rapid rate because the new product has not yet saturated its market.

For example, in 2010, relatively few households had smartphones. The potential market for
the product therefore was huge. In contrast, consider the market for a mature product like
refrigerators. Almost all households in the United States already have refrigerators, so the
market for this good is primarily composed of households replacing old ones,which obviously
limits the potential growth rate
Consolidation Stage
After a product becomes established, industry leaders begin to emerge. The survivors from
the start-up stage are more stable and market share is easier to predict.

Therefore, the performance of the surviving firms will more closely track the performance of
the overall industry. The industry still grows faster than the rest of the economy as the
product penetrates the marketplace and becomes more commonly used.
Maturity Stage
At this point, the product has reached its full potential for use by consumers. Further
growth might merely track growth in the general economy.

The product has become far more standardized, and producers are forced to compete
to a greater extent on the basis of price.

This leads to narrower profit margins and further pressure on profits.Firms at this stage
sometimes are characterized as cash cows, providing reasonably stable cash flow but
offering little opportunity for profitable expansion.

The cash flow is best “milked from” rather than reinvested in the company.
We pointed to desktop PCs as a start-up industry in the 1980s. By the mid-1990s it
was a mature industry, with high market penetration, considerable price competition,
low profit margins, and slowing sales.

By the 1990s, desktops were progressively giving way to laptops, which were in their
own start-up stage. Within a dozen years, laptops had in turn entered a maturity
stage, with standardization, low profit margins, and new competition from tablets and
large-screen smartphones.
Relative Decline
In this stage, the industry might grow at less than the rate of the overall economy, or it might
even shrink. This could be due to obsolescence of the product, competition from new low-cost
suppliers, or competition from new products; consider, for example, the steady displacement
of desktops, first by laptops and now by tablets.
At which stage in the life cycle are investments in an industry most attractive?

Conventional wisdom is that investors should seek firms in high-growth industries. This
recipe for success is simplistic, however. If the security prices already reflect the likelihood for
high
growth, then it is too late to make money from that knowledge.

Moreover, high growth and fat profits encourage competition from other producers. The
exploitation of profit opportunities brings about new sources of supply that eventually
reduce prices, profits, investment returns, and finally growth.

This is the dynamic behind the progression from one stage of the industry life cycle to
another.
Industry Structure and Performance
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 competition: threat of entry from
new competitors, rivalry between existing competitors, price pressure from substitute
products, bargaining power of buyers, and bargaining power of suppliers.
Threat of Entry
New entrants to an industry put pressure on price and profits. Even if a firm has not 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 take many forms.

For example, existing firms may already have secure distribution channels for their products
based on long-standing 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 or patent protection
also may give firms advantages in serving a market. Finally, an existing firm’s experience in a
market may give it cost advantages due to the learning that takes place over time.
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 they put greater pressure on firms to operate near full capacity.

Industries producing relatively homogeneous goods are also subject to considerable price
pressure because firms cannot compete on the basis of product differentiation.
Pressure from Substitute Products
Substitute products means that the industry faces competition from firms in related
industries. For example, sugar producers compete with corn syrup producers. Wool
producers compete with synthetic fiber producers.

The availability of substitutes limits the prices that can be charged to customers.

Bargaining Power of Buyers

If a buyer purchases a large fraction of 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.
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 of the potential profits in
the industry can be captured by the workforce.

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
 Company Analysis

How can we measure how well the firm is actually performing? Financial analysts have
come up with a mind-numbing list of financial ratios that measure many aspects of firm
performance.
 Technical Analysis

As an approach to investment analysis, technical analysis is radically different from

fundamental analysis .

Technical analysts don’t evaluate a large number of fundamental factors relating to the
company, the industry, and the economy.

Instead, they analyze internal market data with the help of charts and graphs.

They view the investment game as an exercise in anticipating the behavior of market
participants.

They look at charts to understand what the market participants have been doing and believe
that this provides a basis for predicting future behavior.
Although technical analysis can be applied to commodities, currencies, bonds, and
equity stocks, our discussion is restricted to equity stocks.

Technical analysis involves a study of market generated data like prices and volumes to
determine the future direction of price movement.
Differences between Technical Analysis and Fundamental Analysis
The key differences between technical analysis and fundamental analysis are as follows:
1. Technical analysis mainly seeks to predict short-term price movements, whereas fundamental
analysis tries to establish long-term values.
2. The focus of technical analysis is mainly on internal market data, particularly price and volume
data. The focus of fundamental analysis is on fundamental factors relating to the economy, the
industry, and the firm.
3. Technical analysis appeals mostly to short-term traders, whereas fundamental analysis
appeals primarily to long-term investors.
CHARTING TECHNIQUES
Technical analysts use a variety of charting techniques.

The most popular ones seem to be the Dow theory, bar and line charts, the point and figure
chart, the moving average line, and the relative strength line. We will examine these techniques
in this section.

However, as a prelude to that it is helpful to briefly explain the basic concepts underlying
chart analysis.
Basic Concepts Underlying Chart Analysis

The basic concepts underlying chart

analysis are:
(a) persistence of trends
(b) relationship between volume and trend; and
(c) resistance and support levels.

Trends
The key belief of the chartists is that stock prices tend to move in fairly persistent
trends. Stock price behavior is characterized by inertia: the price movement continues
along a certain path (up, down, or sideways) until it meets an opposing force, arising
out of an altered supply–demand relationship.
Relationship between Volume and Trends
Chartists believe that generally volume and trend go hand in hand.

When a major upturn begins, the volume of trading increases as the price advances and
decreases as the price declines. In a major downturn, the opposite happens: the volume
of trading increases as the price declines and decreases as the price rallies.

Support and Resistance Levels

Chartists assume that it is difficult for the price of a share to rise above a certain level called the
resistance level and fall below a certain level called a support level. Why?
The explanation for the first claim goes as follows.

If investors find that prices fall after their purchases, they continue to hang on to their shares
in the hope of a recovery. And when the price rebounds to the level of their purchase price,
they tend to sell and heave a sigh of relief as they break even.

Such a behavioral tendency on the part of investors stimulates considerable supply when the
price rebounds to the level at which substantial purchases were made by the investors.
As a result, the share is not likely to rise above this level, the resistance level.
The level at which a declining share may evoke a substantial increase in demand is called the
support level. This typically represents the level from which the share rose previously with large
trading volumes.

As the price falls to this level, there is a lot of demand from several quarters: those who ‘missed
the bus’ on the previous occasion and have regrets for their failure to partake in the earlier
advance; short-sellers who, having sold short, at higher levels, want to book profits by squaring
their position; and valueoriented investors.
The Dow Theory
Originally proposed in the late nineteenth century by Charles H. Dow, the editor of The Wall
Street Journal, the Dow theory is perhaps the oldest and best known theory of technical
analysis.

In the words of Charles Dow:

“The market is always considered as having three movements, all going at the same time. The
first is the narrow movement from day to day. The second is the short swing, running from two
weeks to a month or more; the third is the main movement, covering at least four years in its
duration.”

Proponents of the Dow theory refer to the three movements as: (a) daily fluctuations that are
random day-to-day wiggles; (b) secondary movements or corrections that may last for a few
weeks to some months; and (c) primary trends representing bull and bear phases of the market
An upward primary trend represents a bull market, whereas a downward primary trend
represents a bear market. A major upward move is said to occur when the high point of
each rally is higher than the high point of the preceding rally and the low point of each
decline is higher than the low point of the preceding decline. Likewise, a major
downward move is said to occur when the high point of each rally is lower than the high
point of the preceding rally and the low point of each decline is lower than the low point
of the preceding decline.

The secondary movements represent technical correction. They represent adjustments to the
excesses that may have occurred in the primary movements. These movements are considered
quite significant in the application of the Dow Theory. The daily fluctuations are considered to
be minor significance. Even zealous technical analysts do not usually try to forecast day-to-day
movements in the market.
The above picture illustrates the concept of Dow Theory.
Bar and Line Charts
The bar chart, one of the simplest and most commonly used tools of technical analysis,
depicts the daily price range along with the closing price. In addition, it may show the
daily volume of transactions.

The upper end of each bar represents the day’s highest price and the lower end the
day’s lowest price. The small cross across the bar marks the day’s closing price.

A line chart, a simplification over the bar chart, shows the line connecting successive
closing prices.
Technical analysts believe that certain formations or patterns observed on the bar
chart or line chart have predictive value. The more important formations and their
indications are described below.
Head and Shoulders Top (HST) Pattern
As the name suggests, the HST formation has a left shoulder, a head, and a right
shoulder, as shown in the above picture. The HST formation represents a bearish
development. If the price falls below the neckline (the line drawn tangentially to the left
and right shoulders), a price decline is expected. Hence, it is a signal to sell.
Inverse Head and Shoulders Top (IHST) Pattern
As the name indicates, the IHST formation is the inverse of the HST formation, as
shown in the above picture. Hence, it reflects a bullish development. If the price rises
above the neck line, a price rise is expected. Hence, it is a signal to buy.
Triangle or Coil Formation
This formation represents a pattern of uncertainty. Hence, it is difficult to predict which
way the price will break out.
Flags and Pennants Formation
It typically signifies a pause after which the previous price trend is likely to continue.
Double Top Formation
It represents a bearish development, signaling that the price is expected to fall.
Double Bottom Formation
It reflects a bullish development, signaling that the price is expected to rise
Point and Figure Chart
More complex than a bar chart, a point and figure chart (PFC) has the following
features.
1. On a PFC only significant price changes are recorded. For example, for a stock
that has a price in the range of, say 30 to 50, price changes of one or more only
may be posted.
2. While the vertical scale on a PFC represents the price of the stock, the horizontal
scale does not represent the time scale in the usual sense.
3.Each column on the horizontal scale of a PFC represents a significant reversal of
price movement and not a trading day.
These features of the PFC may be illustrated with a hypothetical PFC. The daily closing price of ABC stock for
the last 30 trading days have been as follows: 31, 31.50, 32,32.50, 33.00, 33.50, 33.75, 34, 33.50, 33.75, 34, 33,
32.5, 32.25, 32, 32.50, 33, 33.50, 34,34.25, 34.50, 35, 36, 35.50, 35, 34.5, 34.75, 34.5, 34, 33.5.

Using a one-point scale (this means that a price is recorded only when the change in
price is one ), the PFC for ABC stock is constructed as shown in the above picture. It
may not be noted that:
1. When the price of ABC stock rises by one over the previously recorded price, an X is
recorded to reflect the increase.
2. When the price of ABC stock falls by one over the previously recorded price, an O is
recorded to reflect the decrease.
3. When the direction of price change reverses (a decline after previous increases or a
rise after previous declines), the price is recorded in the next column to the right.
By eliminating the time scale and small changes, the PFC condenses the recording
of price changes. This helps in identifying patterns and changes more easily.
Technical analysts focus their attention on ‘congestion areas’ on a PFC.
A ‘congestion area’ represents a horizontal band of Xs and Os on a PFC which
develops because of a series of reversals around a certain price level.
A ‘congestion area’ arises when demand and supply are more or less equal. A breakout from
the top of a congestion area heralds an upward price movement. On the other hand, a
penetration through the bottom of a congestion area signals a downward price movement.
Moving Average Analysis
A moving average is calculated by taking into account the most recent n observations.
To illustrate its calculation, consider the closing price of a
stock on 10 successive trading days:
 A 5-day moving average of daily closing prices is calculated as follows:

To identify trends, technical analysts use moving averages analysis: a 200-day moving
average of daily prices (or alternatively, 30-week moving average of weekly prices)
may be used to identify a long-term trend; a 60-day moving average of daily prices may
be used to discern an intermediate term trend; a 10-day moving average of daily prices
may be used to detect a short-term trend.
 Buy signal Sell signal

Stock price line rises through the moving Stock price line falls through the moving
average line when the graph of the moving average average line when the graph of the moving average
line is flattening out. line is flattening out.

Stock price line falls below the moving

average line which is rising. Stock price line rises above the moving
average line which is falling.

Stock price line, which is above the Stock price line, which is below the moving average
moving average line, falls but begins to line, rises but begins to fall again before reaching
rise again before reaching the moving the moving average line.
average line
Relative Strength Analysis
The relative strength analysis is based on the assumption that prices of some securities
rise rapidly during the bull phase but fall slowly during the bear phase in relation to the
market as a whole.

Put differently, such securities possess greater relative strength and hence outperform
the market.

Technical analysts measure relative strength in different ways. A simple approach

calculates rates of return and classifies securities that have earned superior historical
returns as having relative strength. More commonly, technical analysts look at certain
ratios to judge whether a security or, for that matter, an industry has relative strength.
In addition to the chart, which forms the mainstay of technical analysis, technicians
also use certain indicators to gauge the overall market situation.

New Highs and Low

As part of stock market reporting, information is provided on the 52-week high and low prices
for each stock. Technical analysts consider the market as bullish when a significant number of
stocks hit the 52-week high each day. On the other hand, if market indices rise but few stocks
hit new highs, technical analysts view this as a sign of trouble.
Volume
Volume analysis is an important part of technical analysis. Other things being equal, a high
trading volume is considered a bullish sign. If heavy volumes are accompanied by rising prices,
it is considered even more bullish.
END