Market Outlook: Raise Cash, or Put It to Work?

1. Market Outlook: Raise Cash, or Put It to Work? • Pat Dorsey, CFA • Director of Equity Research, Morningstar

2. Morningstar Equity Research One of the largest independent equity research groups in the world. Broad coverage: 90 analysts covering 1800 companies across the globe Consistent, disciplined research approach focused on intrinsic values and economic moats. 2

3. Our Approach We evaluate stocks as small pieces of a business. We do primary research by reading filings & trade journals, visiting companies, talking to competitors & customers, and attending industry conferences. We have a long-term perspective. Our recommendations are driven by valuation, but we are not “value investors” in the most traditional sense. We believe that competitive advantages–“economic moats”–add intrinsic value, and we rigorously assess the competitive position of the companies we cover. We believe that the ability of a business to generate returns on invested capital (ROIC) above cost of capital is the primary test of shareholder value creation. 3

4. Morningstar Approach to Equity ResearchWe evaluate stocks as pieces of a business

5. Big Picture: The Bad Stuff • Unemployment will likely take some time to come down • Many of the jobs created during the last expansion are not coming back soon. Construction, finance, real estate, etc. • High U-6 rates (includes people who are involuntarily part-time) mean that employers can increase hours rather than hiring when demand recovers. • Consumer spending is still ugly • Demand for credit has declined considerably – it may stay down for a while. The politicians squawking about the supply of credit are barking up the wrong tree. • Deleveraging will take a long time. • Credit markets are terra incognita • The Fed has never before intervened on this scale in the bond and mortgage markets. What happens as the much-ballyhooed “exit strategy” goes forth is anyone’s guess.

6. Big Picture: More Bad Stuff • Washington’s balance sheet is in bad shape • Gov’t finances were stretched before crisis, and things are much worse now. • There is zero political will to deal with mandatory spending. Unless we raise taxes, cut defense spending, cut Medicare spending, or cut social security benefits, we’ll be living with a lot of debt for a long time. • Don’t shoot me – that’s the math. 75% of spending is defense + entitlements. • Valuation is no longer compelling in most markets • Tough to make a “cheap” argument for most assets.Relatively attractive in spots, maybe, but not cheap. • Our median price/fair value for 1800-stock coverage universe is 1.07. • Our rolled-up FV for the S&P 500 is ~1250.

7. Defense + Entitlements Are The Big Kahunas

8. Not Expensive…But Not Cheap, Either

9. Not Expensive…But Not Cheap, Either

10. Round Trip

11. Big Picture: The Good Stuff • Truly massive global stimulus – liquidity is still flooding the system • Intervention is working. The question is what happens when it stops. • Credit markets have thawed. • Spreads are down across the board, most to normal (pre-Lehman) levels. • Housing market seems to be thawing • Sales volumes up, prices stabilizing. • A big positive for consumers and for banks. • Manufacturing is coming back nicely • Manufacturing jobs are only 15% of the employment base, but they tend to be relatively well-paying, so the knock-on effect is large. • Earnings could surprise on the upside. • The US economy ≠the S&P 500’s earnings stream.

12. Big Picture: More Good Stuff • Maybe valuations aren’t all that bad • Heck, 12x for JNJ is a steal! • Many high-quality mega-cap stocks are pretty reasonably priced. • Massive cost-cutting may mean that high margins are sustainable • “We’ve done three years of restructuring in the past year.” • MMM revenues down 14%, op margins went from 22.8% to 21.7%. (4Q09) • UNP revenues down 25%, op margins went from 25% to 26%. (4Q09) • U.S. productivity growth was excellent in 2009. • Retail investors are very skeptical of the rally. • Equity flows have been barely positive, and bond flows are off the charts • Typically, retail fund flows are a great contrarian indicator

13. Sherman, set the WABAC machine to 1999!

14. WABAC Investing • In 1999-2000, money was pouring into equity funds, and out of bond funds. Why? The 90s were better for stocks than for bonds. • Fast-forward 10 years. From 1999-2009, the S&P 500 was basically flat, while Treasuries have returned 6.5% annually. Result? Now everyone is buying bonds! +$15bn 1-Yr +$400bn 1-Yr

15. Investors are skeptical of the rally March 2000 S&P=1500 April 2006 S&P=1300 October 2002 S&P=820 March 2009 S&P=700

16. Valuations are a lot better than ten years ago December 1999 December 2009

17. Wild Cards • Inflation / Deflation • Last January, 10-year TIPS were forecasting 0.5% inflation – now over 2%. Over the same time span, 5-year TIPS have gone from deflation to about 2%. • We’ve expanded the money supply and the Fed’s assets big-time…the source of all those scary charts you see. • Long-term disinflationary tailwinds – productivity growth, increased labor supply from China/India – may be waning. • BUT…the velocity of money hasn’t increased much. Most of the money that’s been printed is sitting in bank accounts. In some ways, the Fed hasn’t really “printed money” – it has “created deposits.” • Also, the output gap is quite large in the U.S. – in terms of labor and manufacturing – so perhaps we can grow for a little while before pushing up against any capacity limits.

18. Wild Cards • Valuation • Three sources of returns from equities: Dividends, earnings growth, and changes in valuations (earnings multiples.) Dividends are ~2%. • We’re somewhat above the mean long-run multiple now, so future returns depend on multiple expansion or earnings growth. • Peak earnings for S&P were $92. If the next peak is lower due to de-leveraging and muted growth…well, put a 15 multiple on $80 and you get 1200. • BUT if the next peak is just 9% higher than the last one, and the S&P 500 earns $100, then the market is worth 1500 before any multiple expansion. • So, substantial upside from here (S&P ~1200) requires that either the next peak in earnings be higher than the 2006-2007 peak, or that multiples expand. • My best guess? It will be a tug of war between a weak U.S. consumer (negative), and higher global growth + the sustainability of higher margins (positives.) Stay tuned!

19. Wild Cards • China • All OK for now – after all, when Beijing says jump, Chinese bankers ask, “how high?” • But never in the history of mankind has credit expanded at the pace it did in China in 2009 without some eventual fallout. It’s not humanly possibly to expand your loan book at >50% year-over-year and maintain prudent lending standards. • Longer-term, demography will be a headwind: • Dependency ratio will increase very rapidly for a relatively low-income country that lacks a social safety net. Currently 11 over-65s per 100 working adults -- this ratio will be 38 in 2050. (Equals Japan today, or U.S. in 2050.) • One-child policy + female infanticide = tens of millions of young men who cannot marry or start a family. A potential source of social unrest. • When does the bubble burst? Can Beijing sweep things under the rug like the last time it bailed out the banks? What are the external repercussions? How do the demographics play out? Tough questions to answer.

20. So Now What? • Avoid long-dated Treasuries. Unattractive returns from a borrower with a weakening balance sheet. Jim Grant has called them “return-free risk” – I agree. • Be careful of high-yield as a group – went from a fat pitch to a bubble in < year. Also, HY bond funds have seen massive inflows -- a good contrarian indicator. • Emerging markets no longer look cheap. Some look downright bubbly. Long-term fundamentals are good, but you’re paying a high price for a cheery consensus. • Blue chips (wide moats) with strong balance sheets are very attractive. Go for yield. • Large stocks, on balance, are cheaper than small stocks. • Health Care, Financials look cheap, Tech seems pricey.

21. A Few Ideas • Health Care: Thermo Fisher TMO, Novartis NVS, Stryker SYK • Financial Services: J.P. Morgan Chase JPM, Wells Fargo WFC, BofA BAC, Discover DFS, Capital One COF • Consumer: Apollo Group APOL, Lowe’s LOW, Molson Coors TAP • Energy: Spectra SE, Range RRC, ExxonMobil XOM • Utilities: National Grid NGG, Westar WR, Exelon XC • Tech: KLA-Tencor KLAC, Applied Materials AMAT, France Telecom FTE

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