Advanced Portfolio Management
ADMS 4501 – Winter 2012 – Lois King
Lecture 7 – Chapter 8 – Economic and Industry Analysis – Feb 16
An Overview of the Valuation Process
- Two general approaches
o Top-down, three-step approach.
o Bottom-up, stock valuation, stock picking approach.
- The difference between the two approaches is the perceived importance of
economic and industry influence on individual firms and stocks.
- Both of these approaches can be implemented by either fundamentalists or
- Three-step top-down process
o First examine the influence of the general economy on all firms and the
o Then analyze the prospects for various global industries with the best
outlooks in this economic environment.
- Cone-shaped diagram:
o Top layer
Analysis of alternative economies and security markets
• Objective: decide how to allocate investment funds among
countries and within countries to bonds, stocks and cash.
o Middle layer
Analysis of alternative industries
• Objective: based upon the economic and market analysis,
determine which industries will prosper and which industries
will suffer on a global basis and within countries.
o Bottom layer
Analysis of individual companies and stocks
• Objective: following the analysis of the industries, determine
which companies within these industries will prosper and
which stocks are undervalued.
Why a Three-Step Approach?
- General economic influences
o Fiscal policy initiatives, such as tax credits or tax cuts, can encourage
o Monetary policy though controlling money supply growth or interest rate
therefore affects all segments of an economy and that economy’s
relationship with other economies.
o Inflation causes changes the spending and saving behaviour of
consumers and corporations.
o Other events such as war, political upheavals in foreign countries, or
international monetary devaluations exert strong effects on the
economies. - Industry influences
o Identify global industries that will prosper or suffer in the long run or during
the expected near-term economic environment.
o Different industries react to economic changes at different points in the
o Alternative industries have different responses to the business cycle.
o Demographic factor and international exposure will also have different
impacts on different types of industries.
- Company analysis
o The purpose of company analysis to identify the best companies in a
promising industry (or worst companies).
o This involves examining a firm’s past performance, but more important, its
o Compare the estimated intrinsic value to the prevailing market price of the
firm’s stock and decide whether its stock is a good investment.
o Compare estimates relative value to other firms in the same industry.
o The final goal is to select the best stock within a desirable industry and
include it in your portfolio based on its relationship (correlation) with all
other assets in your portfolio.
Does the Three Step Process Work?
- Studies indicate that most changes in an individual firm’s earnings can be
attributed to changes in aggregate corporate earnings and changes in the firm’s
- Studies have also found a relationship between aggregate stock prices and
various economic series such as employment, income, or production.
Economic Analysis: Understanding Business Cycles
- Leading indicators
o Economic series that usually reach peaks or troughs before corresponding
peaks or troughs in aggregate economy activity.
- Leading indicators for Canada
o Average work week, manufacturing.
o Housing index.
o United States composite leading index.
o Money supply.
o New orders, durable goods.
o Retail trade, furniture and appliances.
o Durable goods sales excluding furniture and appliances.
o Shipment to inventory ratio, finished products.
o Stock price index, S&P/TSX.
o Business and personal services employment.
- Coincident indicators
o Economic series that have peaks and troughs that roughly coincide with
the peaks and tro