Macroeconomic and Industry Analysis

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1 Macroeconomic and Industry Analysis Understanding the Broad Picture To determine the intrinsic value of an equity share, the security analyst must forecast the earning and dividends expected from the stock and choose a discount rate which reflects the riskiness of the stock. This is what is involved in fundamental analysis, perhaps the most popular method used by investment professionals. The earning potential and riskiness of a firm are linked ot the prospects of the industry to which it belongs. The prospects of various industries, in turn, are largely influenced by the developments in the macro economy. Skills Required for Fundamental Analysis To succeed as a fundamental analyst you require a wide mix of skills. You need a good grasp of how the macro economy functions, a feel for the general direction of the market, an understanding of the profit potential of various industries, an ability to analyse financial statements, and an insight into the competitive advantage of individual firms. Obviously, these skills can be developed and honed over time with practical experience. This chapter lays out a basic framework to help you in getting started in a structured manner in your endeavour to become a fundamental analyst. The Global Economy In a globalised business environment, the top down analysis of the prospects of a firm must begin with the global economy. The global economy has a bearing on the export prospects of the firm, the competition it faces from international competitors, and the profitability of its overseas investments.

2 While monitoring the global macro economy bears in mind the following: Although the economies of most countries are linked, economic performance varies widely across countries at any time. From time to time countries may experience turmoil due to a complex interplay between political and economic factors. The currency and stock market crisis of Asian economies such as Thailand, Indonesia, and South Korea in 1997 and 1998 and the shock waves that followed the devaluation of the Russian rouble in 1998 are reminders of this phenomenon. The exchange rate between a country s currency and other currencies is a key factor affecting the international competitiveness of its industries. Many believe that Chinese industries are currently very competitive internationally because the Chinese currency is undervalued vis à vis the US dollar and other currencies. Fiscal Policy Fiscal policy is concerned with the spending and tax initiatives of the government. It is perhaps the most direct tool to stimulate of dampen the economy. An increase in government spending stimulated the demand for goods and services, whereas a decrease deflates the consumption of goods and services and an increase in tax rates decrease the consumption of goods and services. Although fiscal policy has the most immediate impact on the economy, its formulation and implementation is often cumbersome and involved because of the prolonged legislative process that precedes it. Moreover, a significant portion of government spending such as interest on outstanding debt, defence expenditure, and salaries of government employees is non discretionary. This may severely limit the flexibility in formulating fiscal policy. The deficit of surplus in the governmental budget summaries the net effect of fiscal policy. A large deficit may stimulate the economy and a large surplus may dampen the economy. Monetary Policy Monetary policy, which is concerned with the manipulation of money supply in the economy, is the other main plank of demand side economics. Monetary policy affects the economy mainly though its impact on interest rates. An expansionary monetary policy lowers short term interest rates, thereby stimulating investment and consumption demand. A contractionary monetary policy has the opposite effects. Most economists, however, believe that a higher money supply only raises the price level without a difficult balancing act between stimulating the economy in the short run and inflating the economy in the long run. Fiscal policy is cumbersome to formulate and implement but impacts the economy directly. Monetary policy, on other hand, is easy to formulate and implement but impacts the economy in a roundabout way.

3 The bank rate is the rate which the RBI provides financial accommodation to scheduled commercial and cooperative banks. It is essentially the rate at which the RBI buys or rediscounts bills of exchange and commercial paper. The bank rate presently is 6.00 percent. A reduction in bank rate signals an expansionary monetary policy and an increase in bank rate a contractionary monetary policy Reserve requirements in India are in the form of the cash resrve ratio and the statutory liquidity ratio. The cash reserve ratio (CRR) refers to the cash as a percentage of demand and time liabilities that banks maintain with the RBI. The statutory liquidity ratio (SLR) is the ratio of cash in hand (exclusive of cash balances under the (CRR), balances in current account with public sector banks and the RBI, gold, and approved securities to the demand and time liabilities. Of course, approved securities (central securities) loom large in this list. From time to time the RBI stipulates the required CRR and SLR. A decrease in CRR SLR signals an expansionary monetary policy and an increase a contractionary monetary policy. Macroeconomic Analysis The macro economy is the overall economic environment in which all firms operate. The key variables commonly used to describe the state of the macro economy are: Growth rate of gross domestic product. Industrial growth rate Agriculture and monsoons Saving and investments Government budget and deficit Price level and inflation Interest rates Balance of payment, forex reserves, and exchange rate Infrastructural facilities and arrangements Sentiments Forecasting the GDP Growth Rate A commonly employed procedure of forecasting the GDP growth rate is to (a) estimate the most likely growth rates of three sectors of the economy, viz. agriculture, industry, and weight of a sector being its share in the GDP. For example, if the most likely growth rates of agriculture, industry, and services are 2.0 percent, 8.0 percent, and 9.0 percent and the shares of these sectors in the GDP are 0.25, 0.25, and 0.50, the GDP growth rate forecast would be: 0.25 (2.0) (9.0) = 7.0 percent.

4 Professional economics, however, find this procedure simplistic and unsatisfactory as it does not build on the fundamentals that drive a country s economic performance and ignores the close inter linkages among major parts of the economy. Notwithstanding this criticism, for short time horizons of a year or so, a forecast derived from a simplistic method described above may not be a year or so, a forecast derived from a simplistic this criticism, for short time horizons of a year or so, a forecast derived from a simplistic method described above may not be inferior to a forecast based on underlying economic forces. Industrial Growth Rate The GDP growth rate represents the average of the growth rates of the three principal sectors of the economy, viz. The services sector, the industrial sector, and the agricultural sector. Publicly listed companies play a major role in the industrial sector but only a minor role in the industrial sector and the agricultural sector. Hence stock market analysts focus more on the industrial sector. They look at the overall industrial growth rate as well as the growth rates of different industries. Agriculture and Monsoons Agriculture accounts for about a quarter of the Indian economy and has important linkages, direct and indirect, with industry. Hence, the increase or decrease of agricultural production has a significant bearing on industrial production and corporate performance. Companies using agricultural raw material production and corporate inputs to agriculture are directly affected by the changes in agricultural production. Other companies also tend to be affected due to indirect linkages. A spell of good monsoons imparts dynamism to the industrial sector and buoyancy to the stock market. Likewise, a streak of bad monsoons casts its shadow over the industrial sector and the stock market. Saving and Investment The demand for corporate securities has an important beading on stock price movements. So investment analysts should know what the level of investment in the economy is and what proportion of that investment is directed toward the capital market. The level of investment in the economy is equal to: Domestic saving + inflow of domestic savings is the dominant component in this expression. The even early 1970s. During the decade of 1980s the rate of saving in India hovered around 21 percent. Currently it is about 26 percent. This rate compares favorably with the saving rate in most of the other countries in the world. Given a reasonably high level of saving rate in India, it appears that there is very little scope for further increase. In

5 addition to knowing what the savings are you should also know how the same are allocated over various instruments like equities, bonds, bank deposits, small saving schemes, and bullion. Government Budget and Deficit Governments play and important role in most economies, including the Indian economy. The central budget (as well as the state budgets) prepared annually provides information on revenues, expenditures, and deficit (or surplus, in rare cases). In India, governmental revenues come more from indirect taxes such as excise duty and customs duty and less from direct taxes such as income tax. The bulk of the governmental expenditures goes toward administration, interest payment, defence, and subsidies, leaving very little for public investment. The excess of governmental expenditures over governmental revenues represents the deficit. While there are several measures of deficit, the most popular measure is the fiscal deficit. The fiscal deficit as to be financed with government borrowing whish is done in leads to increase in money supply which has an inflationary impact on the economy Second; the government can resort to borrowing in domestic capital market. This tends to push up domestic interest rates and crowd out private sector investment. Third, the government may borrow from abroad. Borrowing per se is not bad but if the borrowed money is not put to productive purpose, servicing the debt becomes very onerous leading to fiscal crisis. Investment analysts examine the government budget to assess how it is likely to impact on the stock market. They generally classify favorable and unfavorable influences as follows: Favorable A reasonably balanced budget Unfavorable A budget with a high surplus or deficit A level of debt (both internal and external) which can be serviced comfortably A level of debt (both internal and external) which is difficult to service A tax structure which provides incentive for stock market investment A tax structure which provides disincentive for stock market investment Industry Life Cycle Analysis

6 Many industrial economists believe that the developments of almost every industry may be analyzed in terms of a life cycle with four well defined stages: Pioneering stage Rapid growth stage Maturity and stabilization stage Decline Stage

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