FINC3017 Investments and Portfolio Management Tutorial 9 Solutions Macroeconomic and Industry Analysis

1.

What are the differences between bottom-up and top-down approaches to security valuation? What are the advantages to a top-down approach?

A top-down approach to security valuation begins with an analysis of the global and domestic economy. Analysts who follow a top-down approach then narrow their attention to an industry or sector likely to perform well, given the expected performance of the broader economy. Finally, the analysis focuses on specific companies within an industry or sector that has been identified as likely to perform well. A bottom-up approach typically emphasizes fundamental analysis of individual company stocks, and is largely based on the belief that undervalued stocks will perform well regardless of the prospects for the industry or the broader economy. The major advantage of the top-down approach is that it provides a structured approach to incorporating the impact of economic and financial variables, at every level, into analysis of a companys stock. One would expect, for example, that prospects for a particular industry are highly dependent on broader economic variables. Similarly, the performance of an individual companys stock is likely to be greatly affected by the prospects for the industry in which the company operates.

2.

How important is forecasting the business cycle in the investment process? In your answer discuss how returns vary across the business cycle.

The ability to forecast business cycles is extremely important so as to facilitate top-down analysis. This is because if the business cycle does not follow some form of random walk-like process, it is possible that leading indicators exist. If investors were able to predict turning points and changes in these leading variables, then substantial profits can be made. The standard approach to analysis of the business cycle involves the estimation of a broad trend in the economy, with some adjustments for fluctuation around this trend. The trend component of the business cycle is determined by real effects including changes in technology, population growth and capital accumulation. Fluctuations around the trend are claimed to be generated by demand-side and supply-side demand shocks (factors such as unexpected changes in the money supply, rigidity in the labour and product market). Returns fluctuate around expansionary and contractionary economic periods across the business cycle. Expansion is defined from 'trough to peak' and contraction as 'peak to trough'. As we can see in Table 12.1, which describes the Australian equity markets across different economic periods, returns are much higher in expansionary periods (15%) compared to contractionary periods (2.2%). Furthermore, we can see that when the yield curve was upward sloping, the market return was higher (11.7%) compared to when the yield curve was negatively sloped (6.0%). Thus, the direction of the yield curve could be a good candidate as a leading indicator.

3.

How does risk vary across the business cycle? Use industry betas to support your conclusion.

In the CAPM framework, the beta is the key determinant of an assets risk and expected return. Cyclical companies record performance that is positively related to the business cycle. Defensive companies are little affected by the business cycle and maintain steady performance regardless of the level of economic activity. Therefore, for a defensive stock, the companys risk-return prospects (as measured by beta) are less affected by the business cycle compared with stocks from cyclical industries. Table 12.8 presents the empirical evidence around industry beta movements from April 2000 to December 2009 in expansionary and contractionary periods. Expansionary periods are defined as the economic cycle moving from trough to peak, whereas contractionary periods are where the economic cycle is moving from peak to trough. We can see that industries like consumer discretionary are highly cyclical given a beta of 1.426 (0.877) in the expansionary (contractionary) environments. On the other hand, defensive industries such as consumer staples, telecommunications and utilities have similar betas across the business cycle.

4.

Given the industry betas in the table above and an expectation that economy is going to be in recession over the next 12 months, explain how you could use a sector rotation strategy to attempt to outperform the market. What are the implications if your forecast of negative economic growth is incorrect and the economy continues in an expansionary phase?

In a recessionary environment a sector rotation strategy would want to shift the portfolios investments into defensive industries that have low betas. From the table above, this would involve investing in Health Care, Telecommunications and Utilities. If the forecast is incorrect, investors would likely underperform the market as they have exposures to lower beta industries. In an expansionary phase, a sector rotation strategy would advocate holding stocks in the Consumer Discretionary and Materials industry. The key point here is that the performance of the portfolio still relies on being able to accurately forecast economic conditions.

5.

Unlike other investors, you believe the US Federal Reserve is going to loosen monetary policy. What would be your recommendations about investments in the following industries? a) Gold mining b) Construction

a. Gold Mining. Gold traditionally is viewed as a hedge against inflation. Expansionary monetary policy may lead to increased inflation, and thus could enhance the value of gold mining stocks. b. Construction. Expansionary monetary policy will lead to lower interest rates which ought to stimulate housing demand. The construction industry should benefit.

6.

Consider two firms producing smart phones. One uses a highly automated robotics process, whereas the other uses workers on an assembly line and pays overtime when there is heavy production demand. a) Which firm will have higher profits in a recession? In a boom? b) Which firms stock will have a higher beta? a. The robotics process entails higher fixed costs and lower variable (labor) costs. Therefore, this firm will perform better in a boom and worse in a recession. For example, costs will rise less rapidly than revenue when sales volume expands during a boom. Because its profits are more sensitive to the business cycle, the robotics firm will have the higher beta. Below are four industries and four forecasts of the macroeconomy. Match the industry to the scenario in which it is likely to be the best performer. Economic Forecast i) deep recession: falling inflation, interest rates and GDP ii) superheated economy: rapidly rising GDP, increasing inflation and interest rates iii) healthy expansion: rising GDP, mild inflation, low unemployment iv) stagflation: falling GDP, high inflation

b.

7.

Industry a) Housing construction b) Health care c) Gold mining d) Steel production

a. b.

Housing construction (cyclical but interest-rate sensitive): (iii) Healthy expansion Health care (a non-cyclical industry): (i) Deep recession

c. d.

Gold mining (counter-cyclical): (iv) Stagflation Steel production (cyclical industry): (ii) Superheated economy

8.

What characteristics will give firms greater sensitivities to business cycles?

Firms with greater sensitivity to business cycles are in industries that produce durable consumer goods or capital goods. Consumers of durable goods (e.g., automobiles, major appliances) are more likely to purchase these products during an economic expansion, but can often postpone purchases during a recession. Business purchases of capital goods (e.g., purchases of manufacturing equipment by firms that produce their own products) decline during a recession because demand for the firms end products declines during a recession.