Principles of economics the investment function
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Producers independently make investment decisions based on factors like replacing machinery, expanding production, and building new facilities. The level of national income does not decisively determine investment in the way it determines consumption. Four key factors influence autonomous investment: 1) the technology level, 2) the interest rate, 3) expectations of future economic growth, and 4) the rate of capacity utilization. Investment spending in the US economy is volatile as these factors can both work together to increase growth or pull in opposing directions. Unlike stable consumption, investment is subject to erratic fluctuations over short periods as shown in the annual rates of change from 1960 to 1995.
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Equity Research 16 December 2002AmericasUnited Stat.docx
Equity Research
16 December 2002
Americas/United States
Strategy
Investment Strategy
Assessing the Magnitude and
Sustainability of Value Creation
Illustration by Sente Corporation.
• Sustainable value creation is of prime interest to investors who seek to
anticipate expectations revisions.
• This report develops a systematic way to explain the factors behind a
company’s economic moat.
• We cover industry analysis, firm-specific analysis, and firm interaction.
Investors should assume that CSFB is seeking or will seek investment banking or other business from the covered
companies.
For important disclosure information regarding the Firm's ratings system, valuation methods and potential conflicts of interest,
please visit the website at www.csfb.com/researchdisclosures or call +1 (877) 291-2683.
research team
Michael J. Mauboussin
212 325 3108
[email protected]
Kristen Bartholdson
212 325 2788
[email protected]
Measuring the Moat 16 December 2002
2
Executive Summary
• Sustainable value creation has two dimensions—how much economic profit a
company earns and how long it can earn excess returns. Both are of prime interest to
investors and corporate executives.
• Sustainable value creation is rare. Competitive forces—including innovation—drive
returns toward the cost of capital. Investors should be careful about how much they
pay for future value creation.
• Warren Buffett consistently emphasizes that he wants to buy businesses with
prospects for sustainable value creation. He suggests that buying a business is like
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fend off all competition. According to Buffett, economic moats are almost never stable;
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earn returns above their opportunity cost of capital. If a company’s share price already
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economic profitability, and that firm-specific effects represent another 20-40%. So a
firm’s strategic positioning has a significant influence on the long-term level of its
economic profits.
• Industry analysis is the appropriate place to start an investigation into sustainable
value creation. We recommend getting a lay of the land—understanding the players, a
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Principles of economics the investment function
- 2. Producers in the economy must decide how much income to spend on new investment.
- 3. Producers may invest in replacing used up or obsolete machinery, expanding production, increasing raw material or finished goods inventories, and building new facilities for new products.
- 4. Each producer makes investment decisions independently of others.
- 5. Intended Investment •Investment spending that producers intend to undertake. These intended investments do not always end up being realized.
- 6. The level of national income doesn’t play the decisive role in determining investment that it plays in determining consumption spending.
- 7. Autonomous Investment •Investment that is independent of the level of income.
- 8. EXHIBIT 6 THE INVESTMENT CURVE
- 9. How does the investment curve (I) in Exhibit 6 change as the level of national income changes? •The investment curve does not change. It remains at $75 billion at every level of national income.
- 10. Four factors determine the size of the economy’s autonomous investment. 1. Technology Level 2. Interest Rate 3. Expectations of Future Economic Growth 4. Rate of Capacity Utilization
- 11. 1.Technology level •The introduction of new technologies is one of the mainsprings of investment. Technological leaps produce extensive networks of investment spending.
- 12. 2.Interest rate •Producers undertake investment when they believe the rate of return generated by the investment will exceed the interest rate, that is, the cost of borrowing investment funds.
- 13. 2.Interest rate •There is an inverse relationship between the rate of interest and the quantity of investment spending.
- 14. EXHIBIT 7 THE EFFECT OF CHANGES IN THE RATE OF INTEREST ON THE LEVEL OF INVESTMENT
- 15. Why is the demand curve for investment in panel a of Exhibit 7 downward sloping? •The demand curve for investment is downward sloping because as the rate of interest decreases, the level of investment in the economy increases.
- 16. 3.Expectations of future economic growth •Investment spending reflects how producers view the future. Future expectations are shaped by past performance.
- 17. 4. Rate of capacity utilization •Producers seldom choose to operate at 100 percent capacity. Operating at less than 100 percent capacity gives them the ability to expand production on demand.
- 18. •How much flexibility producers end up choosing influences the economy’s level of production. For producers who choose to operate close to full capacity, a moderate increase in sales may shift them quickly into investment spending. 4. Rate of capacity utilization
- 19. The level of investment spending in the U.S. economy is volatile. Sometimes the factors that effect investment spending pull in opposite directions. Other times, they work in unison and lead to impressive economic growth.
- 20. EXHIBIT 8 THE VOLATILITY OF INVESTMENT Unlike consumption, which is fairly stable over time, investment is subject to erratic fluctuations even through very short periods of time. The economic and technological factors that influence investment can sometimes create the conditions for rapid expansion of investment and, just as quickly, reverse to cause investment to fall just as rapidly, as we see in the annual rate of change in real investment spending over the years 1960 to 1995. Source: Economic Report of the President 2006 (Washington, D.C.: United States Government Printing Office, 2006), p. 285.
- 21. How does the rate of investment spending in Exhibit 8 compare to the rate of consumption spending? •While the rate of consumption spending is fairly stable over time, the rate of investment spending is volatile.