Competitive Advantage and Industry Classification

Canadian Securities - Chapter 13

• The chapter focuses on fundamental and technical analysis of securities.
• The agenda includes methods of equity analysis, fundamental macroeconomic analysis, industry analysis, and technical analysis.
• Learning objectives include differentiating between fundamental and technical analysis, comparing market theories, identifying macroeconomic factors, analyzing industries, calculating P/E ratios, and assessing technical analysis's value.
• Investment recommendations require an understanding of how to analyze and interpret fundamental and technical analysis information.
• Resources include market and economic data, stock charts, industry and company characteristics, and financial statistical data. This ample information can help investment decision-making but can also be overwhelming.
• Fundamental analysis assesses short-, medium-, and long-range prospects of industries and companies to understand security pricing and measure intrinsic/fundamental value.
• Technical analysis studies historical stock prices and market behavior to predict future prices and behavior.
• Fundamental analysis studies the causes of price movements while technical analysis studies the effects of supply and demand (reflected in price and volume).
• Factors analyzed in fundamental analysis include capital market conditions, economic conditions, industry conditions, and company conditions. The most important factor is the profitability of the issuer. The ultimate goal is comparing intrinsic value to current price to determine overvaluation or undervaluation.
• Technical analysis focuses on past price movements, patterns, quantitative analysis, market sentiment, and price/trading cycles to predict future prices. Technical analysts use market sentiment (investors' emotions and psychology) to analyze price action for predicting future events.
• Three theories explaining stock market behavior: efficient market hypothesis, random walk theory, and rational expectations hypothesis.
• Efficient Market Hypothesis: Investors react promptly to new information, reflecting intrinsic value in the stock price. All available information is embedded in the price, thus no consistent advantage to exceed market performance.
• Weak form: past market information reflected in current prices, technical analysis has little value.
• Semi-strong form: publicly available information reflected in current prices, both fundamental and technical analysis have little value. Those believing in this form think only non-public info boosts returns.
• Strong form: all information (including insider info) reflected in current prices; no investor gains an advantage.
• Application of Efficient Market Hypothesis: Investors believing in the strong form lean towards passive investment approaches (buy and hold, market indexes, exchange-traded funds). Conversely, those rejecting it tend to use a more active approach involving trading to exceed market returns.
• Random Walk Theory: New information is randomly distributed over time and bears no relation to past prices. Investors quickly interpret and act upon information, impacting immediate prices. Thus, past prices offer no predictive value for future price changes.
• Rational Expectations Theory assumes rational individuals with access to all information use it intelligently to make informed predictions and decisions, anticipating change. Past mistakes are avoided by using information to anticipate changes.

Fundamental Macroeconomic Analysis

• Macroeconomic factors (fiscal policy, monetary policy, inflationary impacts) affect investor expectations and security prices.
• Top-down analysis framework, starting from the global economy, focusing on the domestic economy, then the industry, sector, and ending with the specific company.
• Fiscal policy encompasses tax changes and government spending. Tax increases decrease disposable income, curtailing spending. Conversely, reductions have the opposite effect. Government spending, increasing short-term, has an opposite impact as a spending cutback.
• Monetary policy is used to maintain inflation low, stable, and predictable. During economic expansion, demand for credit and goods prices increase, causing inflationary pressures. To control this, the Bank of Canada may increase short-term interest rates. Conversely, to stimulate the economy in a downturn, the Bank may decrease interest rates to increase credit availability. Changes in monetary policy affect interest rates and corporate profits, significantly influencing security prices.
• Inflation creates uncertainty about the future, lowering confidence, increasing interest rates, decreasing corporate profits, and affecting the price-earnings multiples for common shares. Manufacturers attempt to pass these costs onto consumers, but that ability can't be maintained indefinitely. This causes a squeeze on profits that manifests as lower common share prices.
• Several unpredictable events can impact the economy and security prices. These include international crises, unexpected election outcomes, regulatory changes, innovation, and debt defaults, as well as commodity price fluctuations.

Fundamental Industry Analysis

• Industry structure is more critical than product types when assessing profitability.
• Industries' strategies shape their structures impacting companies’ competitive advantages, sustained growth, and sales/earnings volatility.
• Industry structure impacts a company's stock valuation due to these interconnected factors.
• Industry classification systems (e.g., Global Industry Classification Standard [GICS]) categorize companies by product/service, which defines how equity analysts cover industries. S&P and MSCI assign every company to be a sub-industry within one of 74 industries, which then are categorized into 25 industry groups and 11 sectors.
• Industry life cycles: industries experience different phases characterized by emerging growth, growth, mature, and declining stages. The duration and characteristics of these phases vary from industry to industry and company to company. Determining the industry's stage is important in the valuation process.
• Emerging industries often face unprofitable operations initially with significant start-up investments and uncertain long-term survival.
• Growth industries display consistently expanding sales and earnings, showcasing high profitability on invested capital, a strong control over costs, and growing consumer awareness. Cash flow might be negative.
• Mature industries demonstrate stable growth in sales and earnings, closely mirroring the broader economic growth rate. Both earnings and cash flow tend to be positive, and companies struggle to innovate.
• Declining industries encounter declining demand and exhibit stagnant or negative growth.
• A firm's strategies are sensitive to competitive rivalry pressures (existing companies), threat of substitutes (alternative products/services), buyers' bargaining power (ability to lower prices), and suppliers' bargaining power (resource pricing influences). Porter's five forces analysis is a useful consideration.
• Industries can also be classified based on their reactions to economic cycles (cyclical or defensive), or based on how speculative their prospects are.

Technical Analysis

• The process of analyzing historical market action to determine probable future trends. Fundamental data is considered too massive and complex to precisely predict price movements.
• Technical analysis uses price, volume, and time to derive information from market action, relying on assumptions that price reflects all available influences; trends persist; and the future repeats the past, reflecting investor psychology (optimism/pessimism, etc.).
• Common tools include chart analysis, quantitative analysis (using moving averages and other statistics), sentiment indicators, and cycle analysis.
• Chart Analysis: Analyzing graphical representations of market data (e.g., bar charts, candlestick charts) to project market direction and identify support/resistance levels (areas where demand/supply change, potentially influencing price reversal or trends). Identifying and understanding chart patterns is also central to this methodology.
• Quantitative Analysis: Using statistics and computer enhancements (e.g., moving averages) to supplement chart analysis and identify market trends over time. Useful tools for the smoothing of fluctuating values.
• Sentiment Indicators: Observing investor attitudes (bullish/bearish) to gather insights or gauge market direction.
• Cycle Analysis: Determining the timing of market peaks or troughs within cyclical movements. Four types of cycle lengths: long-term, seasonal, intermediate, and trading cycles.