In security selection process, a traditional approach of Economic Industry Company analysis is employed. EIC 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.
Levels of EIC Analysis
- 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.