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broad economy. These firms have matured from their earlier fast-growth phase. They
usually have steady cash flow and pay a generous dividend, indicating that the firm is
generating more cash than can be profitably reinvested in the firm.
2. Stalwarts. Large, well-known firms like Coca-Cola or Colgate-Palmolive. They grow
faster than the slow growers but are not in the very rapid growth start-up stage. They also
tend to be in noncyclical industries that are relatively unaffected by recessions.
3. Fast Growers. Small and aggressive new firms with annual growth rates in the
neighborhood of 20 to 25%. Company growth can be due to broad industry growth or to
an increase in market share in a more mature industry.
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404 Part FOUR Security Analysis


4. Cyclicals. These are firms with sales and profits that regularly expand and contract along
with the business cycle. Examples are auto companies (see Figure 11.10 again), steel
companies, or the construction industry.
5. Turnarounds. These are firms that are in bankruptcy or soon might be. If they can recover
from what might appear to be imminent disaster, they can offer tremendous investment
returns. A good example of this type of firm would be Chrysler in 1982, when it required
a government guarantee on its debt to avoid bankruptcy. The stock price rose fifteenfold
in the next five years.
6. Asset Plays. These are firms that have valuable assets not currently reflected in the stock
price. For example, a company may own or be located on valuable real estate that is
worth as much or more than the company™s business enterprises. Sometimes the hidden
asset can be tax-loss carryforwards. Other times the assets may be intangible. For
example, a cable company might have a valuable list of cable subscribers. These assets
do not immediately generate cash flow and so may be more easily overlooked by other
analysts attempting to value the firm.

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 between industry structure, competitive strategy,
and profitability. Michael Porter (1980, 1985) has highlighted these five determinants of com-
petition: threat of entry from new competitors, rivalry between existing competitors, price
pressure from substitute products, the bargaining power of suppliers, and the bargaining power
of buyers.

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, since
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 ex-
ample, 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 en-
trant 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 competi-
tors seek to expand their share of the market. Slow industry growth contributes to this com-
petition since expansion must come at the expense of a rival™s market share. High fixed costs
also create pressure to reduce prices since fixed costs put greater pressure on firms to operate
near full capacity. Industries producing relatively homogeneous goods also are subject to con-
siderable price pressure since 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 ex-
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405
11 Macroeconomic and Industry Analysis


ample, auto producers can put pressure on suppliers of auto parts. This reduces the profitabil-
ity 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 in-
dustry. 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 poten-
tial profits in the industry can be captured by the workforce.
The key factor determining the bargaining power of suppliers is the availability of substi-
tute products. If substitutes are available, the supplier has little clout and cannot extract higher
prices.




SUMMARY
• Macroeconomic policy aims to maintain the economy near full employment without
aggravating inflationary pressures. The proper trade-off between these two goals is a
source of ongoing debate.
• The traditional tools of macropolicy are government spending and tax collection, which
comprise fiscal policy, and manipulation of the money supply via monetary policy.
Expansionary fiscal policy can stimulate the economy and increase GDP but tends to
increase interest rates. Expansionary monetary policy works by lowering interest rates.
• The business cycle is the economy™s recurring pattern of expansions and recessions.
Leading economic indicators can be used to anticipate the evolution of the business cycle
because their values tend to change before those of other key economic variables.
• Industries differ in their sensitivity to the business cycle. More sensitive industries tend to
be those producing high-priced durable goods for which the consumer has considerable
discretion as to the timing of purchase. Examples are automobiles or consumer durables.
Other sensitive industries are those that produce capital equipment for other firms.
Operating leverage and financial leverage increase sensitivity to the business cycle.


KEY
budget deficit, 385 fundamental analysis, 382 peak, 391
TERMS
business cycles, 391 gross domestic product, 384 sector rotation, 400
cyclical industries, 391 industry life cycle, 402 SIC codes, 397
defensive industries, 391 inflation, 385 NAICS codes, 397
demand shock, 387 leading economic supply shock, 387
exchange rate, 383 indicators, 393 trough, 391
fiscal policy, 388 monetary policy, 389 unemployment rate, 385
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PROBLEM
1. What monetary and fiscal policies might be prescribed for an economy in a deep
SETS
recession?
2. Unlike other investors, you believe the Fed is going to dramatically loosen monetary
policy. What would be your recommendations about investments in the following
industries?
a. Gold mining
b. Construction
3. If you believe the U.S. dollar is about to depreciate more dramatically than do other
investors, what will be your stance on investments in U.S. auto producers?
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406 Part FOUR Security Analysis


4. According to supply-side economists, what will be the long-run impact on prices of a
reduction in income tax rates?
5. Consider two firms producing videocassette recorders. One uses a highly automated
robotics process, while the other uses human 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 firm™s stock will have a higher beta?
6. Here are four industries and four forecasts for the macroeconomy. Choose the industry
that you would expect to perform best in each scenario.
Industries: Housing construction, health care, gold mining, steel production.
Economic Forecasts:
Deep recession: Falling inflation, falling interest rates, falling GDP.
Superheated economy: Rapidly rising GDP, increasing inflation and interest rates.
Healthy expansion: Rising GDP, mild inflation, low unemployment.
Stagflation: Falling GDP, high inflation.
7. In which stage of the industry life cycle would you place the following industries?
(Warning: There is often considerable room for disagreement concerning the “correct”
answers to this question.)
a. Oil well equipment.
b. Computer hardware.
c. Computer software.
d. Genetic engineering.
e. Railroads.
8. For each pair of firms, choose the one that you think would be more sensitive to the
business cycle.
a. General Autos or General Pharmaceuticals.
b. Friendly Airlines or Happy Cinemas.
9. Choose an industry and identify the factors that will determine its performance in the
next three years. What is your forecast for performance in that time period?
10. Why do you think the index of consumer expectations is a useful leading indicator of
the macroeconomy? (See Table 11.2.)
11. Why do you think the change in the index of labor cost per unit of output is a useful
lagging indicator of the macroeconomy? (See Table 11.2.)
11. You have $5,000 to invest for the next year and are considering three alternatives:
a. A money market fund with an average maturity of 30 days offering a current yield of
6% per year.
b. A one-year savings deposit at a bank offering an interest rate of 7.5%.
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c. A 20-year U.S. Treasury bond offering a yield to maturity of 9% per year.
What role does your forecast of future interest rates play in your decisions?
13. As a securities analyst you have been asked to review a valuation of a closely held
business, Wigwam Autoparts Heaven, Inc. (WAH), prepared by the Red Rocks Group
(RRG). You are to give an opinion on the valuation and to support your opinion by
analyzing each part of the valuation. WAH™s sole business is automotive parts retailing.
The RRG valuation includes a section called “Analysis of the Retail Auto Parts
Industry,” based completely on the data in Table 11.4 and the following additional
information:
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407
11 Macroeconomic and Industry Analysis



TA B L E 11.4
Selected retail auto parts industry data

1999 1998 1997 1996 1995 1994 1993 1992 1991 1990

Population 18“29 years old
(percentage change) 1.8% 2.0% 2.1% 1.4% 0.8% 0.9% 1.1% 0.9% 0.7% 0.3%
Number of households with
income more than $35,000
(percentage change) 6.0% 4.0% 8.0% 4.5% 2.7% 3.1% 1.6% 3.6% 4.2% 2.2%
Number of households with
income less than $35,000
(percentage change) 3.0% 1.0% 4.9% 2.3% 1.4% 2.5% 1.4% 1.3% 0.6% 0.1%
Number of cars 5“15 years
old (percentage change) 0.9% 1.3% 6.0% 1.9% 3.3% 2.4% 2.3% 2.2% 8.0% 1.6%
Automotive aftermarket
industry retail sales
(percentage change) 5.7% 1.9% 3.1% 3.7% 4.3% 2.6% 1.3% 0.2% 3.7% 2.4%
Consumer expenditures on
automotive parts and
accessories (percentage
change) 2.4% 1.8% 2.1% 6.5% 3.6% 9.2% 1.3% 6.2% 6.7% 6.5%
Sales growth of retail auto
parts companies with 100 or
more stores 17.0% 16.0% 16.5% 14.0% 15.5% 16.8% 12.0% 15.7% 19.0% 16.0%
Market share of retail auto
parts companies with 100 or
more stores 19.0% 18.5% 18.3% 18.1% 17.0% 17.2% 17.0% 16.9% 15.0% 14.0%
Average operating margin
of retail auto parts
companies with 100 or
more stores 12.0% 11.8% 11.2% 11.5% 10.6% 10.6% 10.0% 10.4% 9.8% 9.0%
Average operating margin
of all retail auto parts
companies 5.5% 5.7% 5.6% 5.8% 6.0% 6.5% 7.0% 7.2% 7.1% 7.2%


• WAH and its principal competitors each operated more than 150 stores at year-end
1999.
• The average number of stores operated per company engaged in the retail auto parts
industry is 5.3.
• The major customer base for auto parts sold in retail stores consists of young owners
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of old vehicles. These owners do their own automotive maintenance out of economic
necessity.
a. One of RRG™s conclusions is that the retail auto parts industry as a whole is in the
maturity stage of the industry life cycle. Discuss three relevant items of data from
Table 11.4 that support this conclusion.
b. Another RRG conclusion is that WAH and its principal competitors are in the
consolidation stage of their life cycle. Cite three items from Table 11.4 that suggest
this conclusion. How can WAH be in a consolidation stage while its industry is in a
maturity stage?
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