Fundamental Macroeconomic and Industry Analysis

Question 1

Briefly describe and provide an overview of fundamental and technical analysis:

Answer 1

• Two methods of analysis are used to evaluate equities: fundamental analysis and technical analysis. Fundamental analysis is a method of assessing the short-, medium-, and long-range prospects of different industries and companies to shed light on security prices. Technical analysis is the study of historical stock prices and stock market behaviour to predict future prices and behaviour.
• Fundamental analysis is a method of evaluating capital market conditions, economic conditions (both domestic and global), industry conditions, and the condition of individual companies in an attempt to measure the intrinsic or fundamental value of a security. The ultimate goal is to compare the intrinsic value against a security’s current price so that you can determine whether the security is overvalued or undervalued.
• Technical analysis is a method of determining the future price direction of a security based on past price movements. Essentially, technical analysts attempt to understand the market sentiment behind the trend in a stock’s price instead of its fundamental attributes. They look for recurring patterns that allow them to predict future stock price movements. Technical analysts believe that, by studying the “price action” of the market, they will have better insights into the emotions and psychology of investors. They contend that, because most investors fail to learn from their mistakes, identifiable patterns exist.
• The technical analyst studies the effects of supply and demand, which are reflected in price and volume. The fundamental analyst, on the other hand, studies the causes of price movements. Both types of analysts might come to the same conclusion based on very different observations.

Question 2

Discuss the macroeconomic analysis as it pertains to fiscal policy (Government spending, tax, debt) and monetary policy (on inflation):

Answer 2

• TAX CHANGES By changing tax levels, governments can alter the spending power of individuals and businesses. When governments increase sales or personal income tax levels, people have less disposable income, which curtails their spending. A reduction in tax levels has the opposite effect. Keep in mind tax changes on different industries as it may impact the profitability of companies operating in those industries. For example, if there is a new tax relief introduced by the government for green AI companies, you know that those companies will benefit from having more money to spend on growth, and therefore, will likely see an increase in common share prices.
• On the simplest level, an increase in government spending stimulates the economy in the short run, whereas a spending cutback has the opposite effect. Conversely, tax increases lower consumer spending and business profitability, whereas tax cuts boost profits and common share prices. This type of expansionary fiscal policy of tax cuts and spending initiatives can help to spur the economy.
• Higher levels of government debt have a tendency to restrict both fiscal and monetary policy options. Fiscal and monetary decisions affect the overall level of interest rates, the rate of economic growth, and the rate of corporate profit growth. All these factors affect the valuation of stocks.
• THE IMPACT OF INFLATION Inflation creates widespread uncertainty and undermines confidence in the future. These factors tend to result in higher interest rates, lower corporate profits, and lower price-earnings multiples. Inflation leads to higher inventory and labour costs for manufacturers. To maintain their profitability, manufacturers generally try to pass these higher costs on to consumers in the form of higher prices. But higher costs cannot be passed on indefinitely; buyers eventually resist. The resulting squeeze on corporate profits is reflected in lower common share prices.

Question 3

Industry classification by life cycle – what is the emerging growth, growth, mature, and declining industries, how do you identify them?

Answer 3

• New industries are continually developing to provide products and services that meet society’s changing needs and demands. These industries are known as emerging growth industries. Today, rapid innovation is particularly evident in software and hardware development in the computer industry. Emerging growth industries, and companies within them, tend to share certain financial characteristics. Typically, they are unprofitable at first, although future prospects may be promising. Large start-up investments may even lead to negative cash flows. It is sometimes impossible to predict which companies will ultimately survive in a new industry.
• A growth industry is one in which sales and earnings are consistently expanding at a faster rate than in most other industries. Companies in these industries are called growth companies, and their common shares are called growth stocks. A growth company should have an above-average rate of earnings on invested capital over a period of several years. The company should also be able to continue to achieve similar or better earnings on additional invested capital. It should show increasing sales in terms of both dollars and units, coupled with a firm control of costs. These companies generally do not pay out large dividends because their growth is often financed through retained earnings. Growth companies therefore tend to exhibit high price-to-earnings ratios and low dividend yields.
• Mature industries usually experience slower, more stable growth in sales and earnings that more closely matches the overall rate of economic growth. During recessions, stable growth companies usually demonstrate a decline in earnings that is less than that of the average company. Companies in the mature stage usually have sufficient financial resources to weather difficult economic conditions.
• As industries move from the mature/stable to the declining stage, they tend to stop growing and begin to decline. Declining industries produce products for which demand has declined because of changes in technology, an inability to compete on price, or changes in consumer tastes. Cash flow may be large, because there is no need to invest in new plant and equipment. At the same time, profits may be low.

Question 4

Explain the five forces, definitions, and key influencing factors for classifying industries by competitive forces:

Answer 4

Force Definition Key Influencing Factors
1. Threat of new entry The ease of entry for new competitors to that industry. Capital requirements, economies of scale, distribution channels, regulations, product differentiation.
2. Competitive rivalry The degree of competition between existing firms. Number of competitors, industry growth, product uniqueness, relative strength of rivals.
3. Threat of substitutes The potential for pressure from substitute products. Availability of similar products from other industries.
4. Bargaining power of buyers The extent to which buyers can pressure the company to lower prices. Buyers’ price sensitivity, buyer concentration, availability of alternatives.
5. Bargaining power of suppliers The extent to which suppliers can pressure the company to pay more. Supplier concentration, cost of raw materials, availability of substitute inputs.