Fundamental Analysis: Economic Analysis, Industry Analysis, Company Analysis

In security selection process, a traditional approach of Economic Industry Company analysis is employed. EIC analysis is the abbreviation of economic, industry and company. The person conducting EIC analysis examines the conditions in the entire economy and then ascertains the most attractive industries in the light of the economic conditions. At last the most attractive companies within the attractive industries are pointed out by the analyst.

EIC Analysis of a Company

Below are the further details of the components of EIC analysis, which analyst always consider before choosing or reaching any decision about any business.

• Economic Analysis
• Industry Analysis
• Company Analysis

Economic Analysis:

Every common stock is susceptible to the market risk. This feature of almost all types of common stock indicates their combined movement with the fluctuations in the economic conditions towards the improvement or deterioration.

Stock prices react favorably to the low inflation, earnings growth, a better balance of trade, increasing gross national product and other positive macroeconomic news. Indications that unemployment is rising, inflation is picking up or earnings estimates are being revised downward will negatively affect the stock prices. This relationship is reasonably reliable that the US economy is better represented by the Standard & Poor 500 stock index, which is famous market indicator. The stock market will forecast an economic boom or recession properly from the signs in front of average citizen. The Federal bank of New York has conducted a research that describes that the slope of the yield curve is the perfect indicator of the economic growth more than three months out. Recession is indicated by negative slope while positive slope is considered as good one.

The implications of market risk should be clear to the investor. When there is recession in the economy, the prices of stocks moves downward. All the companies suffer the effects of recession despite of the fact that these are high performing companies or low performing ones. Similarly the stock prices are positively affected by the boom period of the economy.

Industry Analysis:

It is clear there is certain level of market risk faced by every stock and the stock price decline during recession in the economy. Another point to be remembered is that the defensive kind of stock is affected less by the recession as compared to the cyclical category of stock. In the industry analysis, such industries are highlighted that can stand well in front of adverse economic conditions.

In 1980, Michael Porter proposed a standard approach to industry analysis which is referred to as competitive analysis frame work. Threats of new entrants evaluate the expected reaction of current competitors to new competitors and obstacles to entry into the industry. In certain industries it is quite difficult for new company to compete successfully.

For example new producers in the automobile industry face difficulty in competing the established companies, like General Motors and Ford etc. There are certain other industries where the entry of new company is easier like financial planning industry. No extraordinary efforts are required in such kind of industries to establish any new company. The growth in the industry is slowed down through the rivalry among the current competitors. Profits of the company are reduced when it tries to cover more market share because under existing rivalry the company has to invest a large portion of its earnings in this enhancing market share. The industry where the rivalry is friendly or modest among competitors provides greater opportunity for product differentiation & increased profits. The intense competition is favorable for the customer but not good for the producer of the product. In case of airline industry there are common fare price wars among the competitors. When one airline company reduces its price then the other must also adjust its price accordingly in order to retain the existing customers.

Another threat faced by company in industry is the treat of substitutes which prevents the companies to enhance the price of their products. When there is much increase in the price of particular product, then the consumer simply switches to other alternative product which has lower price. For example there are two different video games named Sega and Nintendo. These games competes each other directly in the market. If the price of Nintendo is enhanced then the new video game customers are switch toward the Sage which has relatively lower price. The investor conducting industry analysis should focus the level of risk of product substitution which seriously affects the future growth of company.

Another aspect of the industry analysis is the bargaining power of buyers which can greatly influence the large percentage of sales of seller. In this condition the profit margins are lower. Concessions are necessary to be offered by the seller because it is not affordable for him to lose customer. For example there is ship building company and the US Navy is its main customer. Only two to three ships are produced by the company every year and so it is very harmful for the firm to lose the Navy contract. On the other hand in case of departmental store, there is large number of customers and so the bargaining power of customers is low. In this business, losing one or two customers will not much affect the sales or profitability of the retail store.

The only capital intensive industry should not be focused. There are other industries that are not capital intensive like consultants required in retail computer store. There is need that is present which force the computer technician to solve the problems of the computer systems of people. In recent year, consumers are usually more sophisticated in area of personal computers. So they are better guided and they try to make their own decisions in the needs of software and hardware aspects. In fact they possess high power when they contact the sales staff.    

The bargaining power of suppliers has also substantial influence over the profitability of the company. The supplies for manufacturing products are required by the company and it does not have sufficient control over the costs. It is not possible for the company to increase the price of its finished products in order to cover the increased costs due to the presence of powerful buyer groups in market of substitute products. So while conducing industry analysis, the presence of powerful suppliers should be considered as negative for the company.

The above considerations of industry structure should be analyzed by the investor in order to make an estimate about the future trends of the industry in the light of the economic conditions. When potential industry is identified then comes the final step of EIC analysis which is narrower relating to companies only.

Company Analysis:

In company analysis different companies are considered and evaluated from the selected industry so that most attractive company can be identified. Company analysis is also referred to as security analysis in which stock picking activity is done. Different analysts have different approaches of conducting company analysis like

• Value Approach to Investing
• Growth Approach to Investing

Additionally in company analysis, the financial ratios of the companies are analyzed in order to ascertain the category of stock as value stock or growth stock. These ratios include price to book ratio and price-earnings ratio. Other ratios like return on equity etc. can also be analyzed to ascertain the potential company for making investment.

Advantages:

Fundamental analysis is good for long-term investments based on long-term trends, very long-term. The ability to identify and predict long-term economic, demographic, technological or consumer trends can benefit patient investors who pick the right industry groups or companies.

Sound fundamental analysis will help identify companies that represent a good value. Some of the most legendary investors think long-term and value. Graham and Dodd, Warren Buffett and John Neff are seen as the champions of value investing. Fundamental analysis can help uncover companies with valuable assets, a strong balance sheet, stable earnings, and staying power.

One of the most obvious, but less tangible, rewards of fundamental analysis is the development of a thorough understanding of the business. After such painstaking research and analysis, an investor will be familiar with the key revenue and profit drivers behind a company. Earnings and earnings expectations can be potent drivers of equity prices. Even some technicians will agree to that. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. In addition to understanding the business, fundamental analysis allows investors to develop an understanding of the key value drivers and companies within an industry. A stock’s price is heavily influenced by its industry group. By studying these groups, investors can better position themselves to identify opportunities that are high-risk (tech), low- risk (utilities), growth oriented (computer), value driven (oil), non-cyclical (consumer staples), cyclical (transportation) or income-oriented (high yield).

Stocks move as a group. By understanding a company’s business, investors can better position themselves to categorize stocks within their relevant industry group. Business can change rapidly and with it the revenue mix of a company. This happened to many of the pure Internet retailers, which were not really Internet companies, but plain retailers. Knowing a company’s business and being able to place it in a group can make a huge difference in relative valuations.

Disadvantages:

The main disadvantage for me is that if used on its own, fundamental analysis (FA) doesn’t take into consideration the “herd mentality” phenomenon. In the long run, the price per share (PPS) of companies is driven by their earnings, i.e., the profit they’re yielding. In the short term, the momentum can be quite influential on the PPS; I’m sure you’ve noticed that some stock are considered market darlings and, to a certain degree, it doesn’t matter what their quarterly results are; people keep on buying. The same applies for companies that, all of a sudden, fall out of favor for whatever reason, genuine or not. They keep getting hammered regardless of the results the company pumps out, until one day it reverses. FA doesn’t consider this irrational behavior.

Fundamental analysis may offer excellent insights, but it can be extraordinarily time-consuming. Time-consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. When this happens, the analyst basically claims that the whole street has got it wrong. This is not to say that there are not misunderstood companies out there, but it is quite brash to imply that the market price, and hence Wall Street, is wrong.

Valuation techniques vary depending on the industry group and specifics of each company. For this reason, a different technique and model is required for different industries and different companies. This can get quite time-consuming, which can limit the amount of research that can be performed.

Fair value is based on assumptions. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation, a best-case valuation and a worst-case valuation. However, even on a worst-case valuation, most models are almost always bullish, the only question is how much so.

The majority of the information that goes into the analysis comes from the company itself. Companies employ investor relations managers specifically to handle the analyst community and release information. As Mark Twain said, “there are lies, damn lies, and statistics.” When it comes to massaging the data or spinning the announcement, CFOs and investor relations managers are professionals. Only buy-side analysts tend to venture past the company statistics. Buy-side analysts work for mutual funds and money managers. They read the reports written by the sell-side analysts who work for the big brokers (CIBC, Merrill Lynch, Robertson Stephens, CS First Boston, Paine Weber, DLJ to name a few). These brokers are also involved in underwriting and investment banking for the companies. Even though there are restrictions in place to prevent a conflict of interest, brokers have an ongoing relationship with the company under analysis. When reading these reports, it is important to take into consideration any biases a sell-side analyst may have. The buy-side analyst, on the other hand, is analyzing the company purely from an investment standpoint for a portfolio manager. If there is a relationship with the company, it is usually on different terms. In some cases this may be as a large shareholder.

When market valuations extend beyond historical norms, there is pressure to adjust growth and multiplier assumptions to compensate. If Wall Street values a stock at 50 times earnings and the current assumption is 30 times, the analyst would be pressured to revise this assumption higher. There is an old Wall Street adage: the value of any asset (stock) is only what someone is willing to pay for it (current price). Just as stock prices fluctuate, so too do growth and multiplier assumptions. Are we to believe Wall Street and the stock price or the analyst and market assumptions? It used to be that free cash flow or earnings were used with a multiplier to arrive at a fair value. In 1999, the S&P 500 typically sold for 28 times free cash flow. However, because so many companies were and are losing money, it has become popular to value a business as a multiple of its revenues. This would seem to be OK, except that the multiple was higher than the PE of many stocks! Some companies were considered bargains at 30 times revenues.

To conclude, fundamental analysis can be valuable, but it should be approached with caution. If you are reading research written by a sell-side analyst, it is important to be familiar with the analyst behind the report. We all have personal biases, and every analyst has some sort of bias. There is nothing wrong with this, and the research can still be of great value. Learn what the ratings mean and the track record of an analyst before jumping off the deep end. Corporate statements and press releases offer good information, but they should be read with a healthy degree of skepticism to separate the facts from the spin. Press releases don’t happen by accident; they are an important PR tool for companies. Investors should become skilled readers to weed out the important information and ignore the hype.