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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.
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.
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) + 0.25 (9.0) = 7.0 percent.
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
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 Unfavorable
A reasonably balanced budget A budget with a high surplus or deficit
A level of debt (both internal and A level of debt (both internal and
external) which can be serviced external) which is difficult to service
comfortably
A tax structure which provides
A tax structure which provides disincentive for stock market
incentive for stock market investment investment
Industry Life Cycle Analysis
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