UBS Investment Research US Equity Strategy Market Navigator — September 2011 Welcome To The Market Navigator This monthly guide provides a summary of the UBS US equity market outlook, as well as proprietary analytics and other useful information about market returns, corporate profits, valuation, sectors, the economy, and credit. Slow Growth But No Recession After dropping 13%, the market ended down 5% in August. We believe the economy will experience slow growth — not a recession. As such we expect stocks to advance through the end of the year. That said, we expect markets to remain quite volatile with European debt issues our main concern. While consumer and business survey data indicate a lack of confidence in the economy, more direct measures of activity such as retail sales and durable goods orders remain healthy. 14 Of The Past 9 Since the end of World War II, there have been 14 instances where the S&P 500 fell by more than 17%. Only nine of these were accompanied by recessions. Importantly, when recession was avoided, equities advanced an average of 15% during the first four months after reaching a trough and 28% over one year. Price Target Of 1,350 Represents 15% Upside We are trimming our 2011 and 2012 S&P 500 EPS estimates to $95.00 and $101.00 from $99.35 and $108.00 to reflect UBS’s recently lowered global growth outlook. Consistent with these changes, we are paring our year-end 2011 S&P 500 price target to 1,350 from 1,425. Global Equity Research Americas Equity Strategy Investment Strategy 6 September 2011 www.ubs.com/investmentresearch Jonathan Golub, CFA Strategist [email protected]+1-212-713 8673 Manish Bangard, CFA Strategist [email protected]+1-212-713 3036 Daniel Murphy Strategist [email protected]+1-212-713 3186 Vishal Patel Associate Strategist [email protected]+1-212-713 4027 Thomas M. Doerflinger, Ph.D. Strategist [email protected]+1-212-713 2540 Natalie Garner, CFA Strategist [email protected]+1-212-713 4915 This report has been prepared by UBS Securities LLC ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 60. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
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UBS Investment Research
US Equity Strategy
Market Navigator — September 2011
Welcome To The Market Navigator This monthly guide provides a summary of the UBS US equity market outlook, aswell as proprietary analytics and other useful information about market returns,corporate profits, valuation, sectors, the economy, and credit.
Slow Growth But No Recession After dropping 13%, the market ended down 5% in August. We believe theeconomy will experience slow growth — not a recession. As such we expectstocks to advance through the end of the year. That said, we expect markets toremain quite volatile with European debt issues our main concern. Whileconsumer and business survey data indicate a lack of confidence in the economy, more direct measures of activity such as retail sales and durable goods ordersremain healthy.
14 Of The Past 9 Since the end of World War II, there have been 14 instances where the S&P 500fell by more than 17%. Only nine of these were accompanied by recessions. Importantly, when recession was avoided, equities advanced an average of 15%during the first four months after reaching a trough and 28% over one year.
Price Target Of 1,350 Represents 15% Upside We are trimming our 2011 and 2012 S&P 500 EPS estimates to $95.00 and$101.00 from $99.35 and $108.00 to reflect UBS’s recently lowered global growthoutlook. Consistent with these changes, we are paring our year-end 2011 S&P 500 price target to 1,350 from 1,425.
This report has been prepared by UBS Securities LLC ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 60. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
US Equity Strategy 6 September 2011
UBS 2
UBS Strategy & Economics Teams
U.S. Equity StrategyJonathan Golub Chief Strategist [email protected]
Constructive on Stocks. We believe signs point to slow growth — not a recession — and expect stocks to drift higher as worst-case outcomes are avoided and risk appetite improves. While recent survey data indicate a lack of confidence in the economy, more direct measures of activity such as retail sales and durable goods orders are stronger.
14 of the Past 9. By our count, the S&P 500 predicted 14 of the past nine recessions which suggests the market is not a particularly good early indicator of economic downturns. Of the five non-recessionary periods, the market was up an average of 15% during the first four months after the trough and 28% over one year.
Economic Soft Patch Extended. 2Q GDP was revised down from 1.3% to 1.0% and 1Q grew just 0.4%. We believe that debt and budgetary issues in Europe and the U.S. will weigh on 2H11 growth. Chief U.S. Economist Maury Harris recently lowered 3Q11 GDP to 1.5% from 2.5%..
Valuation. At 10.9x forward EPS, stock multiples are well below long term averages. Attractive valuations, improving M&A activity, and large share repurchases should help drive stock prices higher.
Trimming S&P 500 EPS. We are trimming our 2011 and 2012 S&P 500 EPS estimates to $95.00 and $101.00 from $99.35 and $108.00, respectively. This change reflects our economists’ view that the global economy will be weaker, though non-recessionary. More specifically, UBS recently lowered its forecast for 2012 global GDP growth to 3.3% from 3.8%.
Year-end S&P 500 Price Target to 1,350. Consistent with these changes, we are lowering our 2011 year-end price target for the S&P 500 to 1,350 from 1,425. This forecast represents a 15% upside from current levels.
We anticipate a relief rally as the economy avoids recession and risk appetite improves
The market has a less-than-impressive track record in predicting recessions
Debt issues in U.S. and Europe are prolonging the economic soft patch
Valuation is well below long term averages
15% upside to our new 2011 year-end S&P 500 target of 1350
US Equity Strategy 6 September 2011
UBS 5
Market Outlook
Market Leadership
Sector Positioning. Since mid-February, defensives have led the market, however, this leadership has reversed course over the past couple of weeks. Looking to the remainder of 2011, we favor economically sensitive names. More specifically, we expect Tech, Industrials and Financials to do especially well in an up market. We are underweight Staples, Telecom and Utilities.
Small Caps. During the current soft patch, smaller companies have underperformed their larger peers. We expect small-caps to regain their leadership role as they benefit from margins that are much further from peak levels. M&A trends are also a positive.
Large Caps. S&P 500 margins are close to cyclical peaks. As a result, companies exhibiting strong top-line success should remain clear winners in this universe.
Risks
European Sovereign Debt: We believe the greatest risk to U.S. stocks is the potential for a credit disruption emanating from Europe.
Global Growth. Fallout from the debt debate has extended the economic soft patch in the U.S. Separately, monetary tightening across emerging economies has led to heightened growth concerns in a number of markets.
Fiscal Policy. While the fight over raising the debt ceiling is over, the appointment of a super committee to find ways to reduce debt should extend the policy debate.
Monetary Policy. The Fed is constrained by the lower bound on interest rates and the effectiveness of alternative tools, such as quantitative easing, is unclear.
Inflation. Despite the economic slowdown, the most recent headline inflation data came in ahead of expectations, suggesting that inflationary pressures could be less transitory than the Fed, and many investors, believe.
We favor cyclicals including Tech, Industrials and Financials
Average 5.3 qtrs -20.1 Source: S&P, Thomson Financial, FactSet and UBS Note: 2008-09 EPS of $93.41 and $60.14 adds back $8.85 and $9.30, respectively, to account for extraordinary write-offs taken by the Financials sector.
The market has predicted 14 of the past 9 recessions
In the 5 instances where a 17% market decline was not followed by a recession, stocks rebounded 15% in four months and 28% in one year
The market has predicted 14 of the past 9 recessions
Source: Moody’s, Standard & Poor’s, Thomson Financial, FactSet and UBS
Equities experience prolonged booms or periods of anemic returns
These “investment regimes” hold the key to stock prices
The forward consensus P/E is 10.9x. The bond market is implying 18.2x
US Equity Strategy 6 September 2011
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Valuation
S&P 500 E/P vs. 10 Yr Treasuries (Great Moderation/The Fed Model)
82 84 86 88 90 92 94 96 984
6
8
10
12
14
16◄ Earnings Yield
10-year Yield ▲
Source: Federal Reserve, Standard & Poor’s, Thomson Financial, FactSet and UBS
S&P 500 E/P vs. 10 Yr Treasuries
00 02 04 06 08 102
4
6
8
10
Earnings Yield ►
10-year Yield ▲
Source: Federal Reserve, Standard & Poor’s, Thomson Financial, FactSet and UBS
During the “Great Moderation”, the “Fed Model” explained returns
However, since 2000, this relationship has broken down
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Valuation
S&P 500 E/P vs. Inflation (Disco Regime)
72 74 76 78 804
6
8
10
12
14
16
Inflation ►
Earnings Yield ▼
Source: Standard & Poor’s, Dept. of Labor, Thomson Financial, FactSet and UBS Note: Earnings Yield based on trailing earnings; CPI (+2%) is lagged by 3 months
The Disco Regime (1981 – Present)
85 90 95 00 05 10
3
6
9
12
15
▲ Inflation
Earnings Yield ►
Source: Standard & Poor’s, Dept. of Labor, Thomson Financial, FactSet and UBS Note: Earnings Yield based on trailing earnings; CPI (+2%) is lagged by 3 months
In the 1970s “Disco Regime”, inflation was the primary driver of stock values
Falling inflation since the late ’70s has made CPI less important to valuations
US Equity Strategy 6 September 2011
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Valuation
NTM P/E – Cyclicals vs. Non-Cyclicals
10
11
12
13
14
15
16
Mar-09 Aug-09 Jan-10 Jun-10 Nov-10 Apr-11
◄ Cyclicals
◄ Non-Cyclicals
10.9x
12.6x
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS Note: Cyclicals are comprised of Energy, Materials, Industrials, Consumer Discretionary, Financials and Technology while Non-Cyclicals include Consumer Staples, Health Care, Telecom and Utilities
Change in NTM P/E Forward P/E % Chg — Apr 29 to Now
Apr 29 Now Change Price NTM EPS
Cyclicals
Industrials 15.2 11.8 -3.4 -17.0 7.0
Materials 13.8 11.1 -2.7 -13.1 8.1
Energy 12.1 9.6 -2.5 -16.5 4.9
Financials 11.8 9.6 -2.2 -17.5 1.6
Technology 13.2 11.3 -1.9 -9.4 5.9
Discretionary 15.5 13.7 -1.8 -8.5 3.8
Non-Cyclicals
Health Care 12.2 11.1 -1.1 -6.2 3.5
Telecom 16.8 15.5 -1.3 -7.7 0.1
Staples 14.5 13.8 -0.7 -2.4 2.7
Utilities 13.3 13.5 0.2 1.6 0.3 Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
Cyclical stocks appear attractively valued vs. more defensive names
The recent shift in multiples is the result of both price and EPS changes
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Inter-Sector Relative Valuations
Relative Valuation – Overvalued/Undervalued
-2.1
-1.0-0.7 -0.7 -0.7
0.3
1.31.5
2.3
2.8
MAT TECH FIN IND EN DISCR HC STPLS TCOM UTIL
P/E
Mu
ltip
le P
oin
ts
Overvalued
Undervalued
Cyclicals Non-Cyclicals
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS Note: Analysis performed on a 36-month rolling basis
Energy vs. Materials
-3.7
-2.7
-1.7
-0.7
0.3
1.3
2.3
3.3
97 99 01 03 05 07 09
P/E
Mu
ltip
le P
oin
ts
-4.2
-3.0
-1.7
-0.4
0.8
2.1
3.4
4.6
◄ Energy
Materials ►
Overvalued
Undervalued
Source: First Call, Standard & Poor’s, FactSet and UBS Note: Analysis performed on a 36-month rolling basis
On a relative basis, Utilities & Telecoms look the most overvalued; Materials & Tech the cheapest
Materials appear cheap versus Energy
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Inter-Sector Relative Valuations
Industrials vs. Technology
-2.4
-1.4
-0.4
0.6
1.6
2.6
97 99 01 03 05 07 09
P/E
Mu
ltip
le P
oin
ts
-2.3
-1.4
-0.5
0.4
1.3
2.2
◄ IndustrialsTechnology ►
Overvalued
Undervalued
Source: First Call, Standard & Poor’s, FactSet and UBS Note: Analysis performed on a 36-month rolling basis
Consumer Discretionary vs. Financials
-1.2
-0.2
0.8
1.8
97 99 01 03 05 07 09
P/E
Mu
ltip
le P
oin
ts
-2.0
-0.6
0.8
2.1
◄ Discretionary
Financials ►
Overvalued
Undervalued
Source: First Call, Standard & Poor’s, FactSet and UBS Note: Analysis performed on a 36-month rolling basis
Industrials valuations have come down sharply
Tech trades in line with the broad market
See Appendix for inter-sector valuation methodology
Discretionary is the most overvalued of the cyclical sectors
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Inter-Sector Relative Valuations
Telecommunication Services vs. Utilities
-2.9
-1.9
-0.9
0.1
1.1
2.1
3.1
97 99 01 03 05 07 09
P/E
Mu
ltip
le P
oin
ts
-3.6
-2.3
-1.1
0.2
1.4
2.7
3.9
◄ Telecom
Utilities ►
Overvalued
Undervalued
Source: First Call, Standard & Poor’s, FactSet and UBS Note: Analysis performed on a 36-month rolling basis
Health Care vs. Consumer Staples
-3.0
-2.0
-1.0
0.0
1.0
2.0
97 99 01 03 05 07 09
P/E
Mu
ltip
le P
oin
ts
-2.5
-1.5
-0.6
0.4
1.4
2.4
◄ Health Care Staples ►
Overvalued
Undervalued
Source: First Call, Standard & Poor’s, FactSet and UBS Note: Analysis performed on a 36-month rolling basis
Telecom and Utilities look extremely expensive
While expensive, Health Care and Staples are much more attractively valued than Utilities or Telecom
US Equity Strategy 6 September 2011
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Market Leadership
UBS Market Leadership Framework
Valuation
Earnings Fundamentals
Op Leverage
Non-Cyclicals
Cyclicals
I. Early Phase II. Middle Phase III. Late Phase
Volatility Quality
Source: UBS
S&P 500 vs. Cyclical Outperformance
475
675
875
1075
1275
1475
1675
02 03 04 05 06 07 08 09 10
80
90
100
110
120
130
140Middle LateEarly Current
▲ S&P 500
Cycl. vs.Non-Cycl. ►
Source: Standard & Poor’s, Haver, FactSet and UBS Note: Cyclical Outperformance indexed to 100 as of Jan, 1990
Different investment characteristics are rewarded at each stage of the investment cycle
Cyclicals typically outperform in the early stage and during periods of economic strength
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Market Leadership — Return Drivers
Price Volatility & Operating Leverage
-4%
-2%
0%
2%
4%
Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11
◄ Price Vol
◄ Op Levg
3-Month Moving Avg
Source: Standard & Poor’s, Compustat, Thomson Financial, Worldscope, FactSet and UBS
ROE
-4%
-3%
-2%
-1%
0%
1%
2%
3%
Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11
ROE ►
3-Month Moving Avg
Source: Standard & Poor’s, Compustat, Thomson Financial, Worldscope, FactSet and UBS
Similar to 2010’s mid-year slowdown, early-cycle characteristics have rolled over
At the same time, defensive traits are adding value We expect these trends to reverse
US Equity Strategy 6 September 2011
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Market Leadership — Return Drivers
Op Lev Return Index vs. Op Margins
94
98
102
106
110
00 02 04 06 08 10
9%
10%
11%
12%
13%
14%
15%
◄ Op. Leverage Return Driver Index
S&P 500 (ex- Finl.)Operating Margins ►
Source: Standard & Poor’s, Compustat, Thomson Financial, Worldscope, FactSet and UBS
Volatility Return Driver in Up S&P 500 Months
-5
0
5
10
15
20
1 7 13 19 25 31 37 43 49 55 61 67 73
Performance in Up SPX Months Avg: 1.9% Max: 17.5% Min:-2.7% Months Outperforming: 56 of 77
Source: Standard & Poor’s, Compustat, Thomson Financial, Worldscope, FactSet and UBS
Operating Leverage is highly correlated with margin upside
More volatile stocks should benefit the most from a market rebound
See Appendix for calculation methodology on UBS Return Drivers
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Market Leadership — Return Drivers
Foreign Sales Return Index
100
105
110
115
120
125
130
135
90 92 94 96 98 00 02 04 06 08 10
1.2% avg alpha per year
Source: Standard & Poor’s, Compustat, Thomson Financial, Worldscope, FactSet and UBS
Foreign Sales – Industry Group Breakdown Foreign Sales Foreign Sales
S&P 500 495 500 13.2 417 75 2.9 322 103 Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
Stocks beat 2Q expectations by 5%
74% of companies have beaten on the bottom-line
65% of companies (ex-financials) have delivered positive revenue surprises
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Earnings Analysis
S&P 500 Earnings Surprise
7.0
11.5
9.9
8.98.0
5.25.9 6.2
5.1
2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11E
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS Note: Universe excludes Financials
S&P 500 Revenue Surprise
0.4
2.3
0.5 0.4
1.4
1.0
2.6
-0.9 -0.1
2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11E
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS Note: Universe excludes Financials
EPS has beaten expectations in each of the past 9 quarters
Revenues are coming in much stronger than expected
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Earnings Analysis
Earnings Surprise – Cyclicals vs. Non-cyclicals
10
1514
12
9
6
7 76
4
8
3
56
43
5
3
2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11E
Cyclicals
Non-Cyclicals
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS Note: Universe excludes Financials
2011 EPS Revisions since 06/30/11 1.0
0.3 0.1-1.0 -10.2-0.4-0.4
Tech Non-Cycls
Indls Matr ConsDisc
Energy Finls
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
Earnings surprises have been stronger for Cyclicals vs. Non-cyclicals
Earnings revisions have been negative for Financials and the commodity sectors
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UBS 30
Earnings Analysis
2Q11 Price Response to Surprises
Beat Miss Beat Miss
Be
at
0.86 -0.24 0.55
Be
at
0.79 -0.60 0.30
Mis
s
-2.84 -4.64 -3.89M
iss
-1.46 -2.54 -2.04
0.27 -2.24 0.20 -1.29
1Q112Q11
Revenue Surprise
EP
S S
urp
ris
e
Revenue Surprise
EP
S S
urp
ris
e
Source: S&P, Compustat, Thomson Financial, FactSet and UBS. Note: Price action for above table is calculated for all companies reported 2Q results from 1 day before to 1 day after report date. For history shown in table below, price action is calculated from 1 day before to 2 days after report date
Historical Price Response to Surprises Price Action (%)
Beat EPS Beat EPS Miss EPS Miss EPSQuarter Beat Sales Miss Sales Beat Sales Miss Sales
R. 1000 Value 15.5 19.7 (36.8) (0.2) 22.2 7.1 16.5
R. 1000 Growth 16.7 37.2 (38.4) 11.8 9.1 5.3 6.3
R. Mid-Cap 25.5 40.5 (41.5) 5.6 15.3 12.7 20.2
R. Mid-Cap Value 24.8 34.2 (38.4) (1.4) 20.2 12.6 23.7
R. Mid-Cap Growth 26.4 46.3 (44.3) 11.4 10.7 12.1 15.5
R. 2000 26.9 27.2 (33.8) (1.6) 18.4 4.6 18.3
R. 2000 Value 24.5 20.6 (28.9) (9.8) 23.5 4.7 22.2
R. 2000 Growth 29.1 34.5 (38.5) 7.0 13.3 4.2 14.3 Source: Dow Jones, NASDAQ, Standard & Poor’s, Russell, FactSet and UBS Note: All returns include dividends except the Dow and NASDAQ.
US Equity Strategy 6 September 2011
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Global Equity Returns
Global Equity Indices Country Curr. Aug-11 QTD YTD 1 Yr 3 Yr 5 Yr 7 Yr 10 Yr
Source: Standard & Poor’s, MSCI, FactSet and UBS Note: All returns include dividends.
US Equity Strategy 6 September 2011
UBS 35
Correlations of Stocks and Economic Indicators
Correlations with Major Economic Indicators Indl ISM UBS Econ Nonfarm S&P 500
Prod. ISM Non-Mfg Surp Payrolls Index
Industrial Production 1.00
ISM 0.11 1.00
ISM Non-Mfg 0.02 0.27 1.00
UBS Econ Surprise 0.18 0.25 0.16 1.00
Nonfarm Payrolls 0.52 -0.06 0.03 0.21 1.00
S&P 500 Index 0.08 0.25 0.28 0.47 0.20 1.00 Source: ISM, Federal Reserve, US Dept of Labor, OECD, FactSet and UBS
S&P 500 vs. Economic Surprise Index & ISM Non-Mfg
-30%
-20%
-10%
0%
10%
20%
30%
99 00 01 02 03 04 05 06 07 08 09 10 11
-30%
-20%
-10%
0%
10%
20%
30%
◄ S&P 500
US Econ ▲ Surprise &Non-Mfg ISM
Source: Standard & Poor’s, FactSet and UBS. Note: Rolling 3-month changes
UBS’s proprietary Economic Surprise Index and the ISM Non-Mfg have the highest correlations with stocks of any of the economic indicators
US Equity Strategy 6 September 2011
UBS 36
Sector Recommendations Overweight
Technology
Tech appears attractive for a host of reasons. With a multiple of 11.3x the group trades inline with the market — highly unusual for the sector. Additionally, 2Q earnings beats were the largest of any group and Tech has become the most defensive cyclical sector with 29% of its total assets in cash. This excess capital is driving rapid growth in dividends and buybacks.
Industrials
Industrials have swung from expensive to cheap as prices have dropped 13% since the end of June while forward NTM earnings estimates have continued to rise. Many Capital Goods companies are benefiting from strong spending on agriculture and mining equipment, and Transports, particularly Rails, have solid pricing power. We believe this sector has the most margin upside from current levels due to the group’s later-stage nature.
Financials
Financials underperformed in August due, in part, to investor concerns about the impact of falling asset prices on balance sheets. However, there are a number of tailwinds that should support the group’s performance, including (1) improving loss trends; (2) a turn in C&I and consumer loan volumes; (3) a more favorable backdrop for investment banking activity; (4) increased regulatory clarity; and (5) attractive valuations.
Market Weight
Health Care
Health Care remains our favorite non-cyclical sector due to its solid earnings trends and strong balance sheets. With cash equal to 17% of assets, this group has large reserves that should help drive EPS gains through M&A activity and buybacks. However, we are concerned about high valuations, uncertainty surrounding ‘ObamaCare’, and patent expirations.
Consumer Discretionary
Compared to other economically sensitive areas of the market, Discretionary is expensive and has less potential for dividend and buyback growth due to a high total payout ratio. The group’s relative earnings strength tends to fade as the cycle advances from its early stage.
Tech looks cheap and we expect strong buyback activity
Despite year-to-date underperformance, Financials stand to benefit from a variety of tailwinds
Health Care remains our favorite non-cyclical
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Sector Recommendations Market Weight (continued)
Energy
Falling 10%, Energy was the worst performing sector in August. Since its peak in April, the price of WTI has fallen 22%, and so far in 3Q the average price of oil is 11% below the 2Q level. This decline has curtailed estimate revisions. During 2Q reporting season, Energy companies surpassed top-line expectations by 6% but beat on the bottom-line by just 2% due to margin pressures.
Materials
We expect Materials’ performance to remain closely tied to the outlook for commodity prices, which could continue to be volatile given significant global macro risks. However, the group is currently the cheapest sector based on our valuation work.
Underweight
Consumer Staples
Consumer Staples has outperformed during the current soft patch. However, we expect the sector to struggle versus the broader market as investors rotate toward more cyclical names. From a longer-term perspective, Staples’ secular growth prospects remain solid and much of the group should benefit from significant overseas exposure. High total (dividends and buybacks) payout ratios could constrain the return of capital to shareholders in the future.
Telecom
Telecom is expensive and valuations could be at risk if the economy avoids recession as we expect. Additionally, short term earnings and revenue trends, as measured by surprises and revisions, are weak and longer term the group faces a challenging competitive environment.
Utilities
Up 2%, Utilities was the best performing sector in August. However, it is the most expensive group and analysts expect it to post the lowest earnings growth of any sector over the next two years. Merchant utilities face a challenging pricing environment and environmental costs could have an outsized impact on the industry. Additionally, due to high re-investment needs, the sector has been a net issuer of equity.
Upward estimate revisions have stalled in the Energy sector
We expect Staples to struggle as investors rotate to more cyclical names
Earnings growth and re-investment needs are headwinds for Utilities
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Balance Sheet Strength
Cash as a % of Total Assets
2%
4%
6%
8%
10%
12%
14%
16%
99 00 01 02 03 04 05 06 07 08 09 10 11
▲ Large Cap (S&P 500)
11.0%
Small Cap▼ (S&P 600)
13.5%
Post Recession Build-up
Cash Draw-down
Source: S&P, Compustat, FactSet and UBS Note: Universe excludes Financials. Data as of 2Q11
Net Debt to Equity
35%
45%
55%
65%
75%
85%
95%
99 00 01 02 03 04 05 06 07 08 09 10 11
Source: S&P, Compustat, FactSet and UBS Note: Universe excludes Financials. Data as of 2Q11
Cash balances remain extremely high levels
Balance sheets continue to strengthen
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M&A and Capex
Number of Deals Above $1 Billion
176165
101120
268
244
195
157
9896
143
255
233
180
151
9087
67
110907050301999795Ann.
Source: MergerStat, FactSet and UBS Note: 2011 is estimated based on a run rate of 117 deals as of August 30, 2011
Capex and R&D
5.3%
6.0%
6.8%
7.5%
8.3%
00 01 02 03 04 05 06 07 08 09 10 11
7.0%
7.5%
8.0%
8.5%
9.0%
R&D / Sales(Rolling 12M) ►
◄ Capex/Sales (Rolling 12M) ►
cost cutting
6.3%
7.1%
Source: Standard & Poor’s, CompuStat, FactSet and UBS. Note: Universe excludes Financials. Data as of 2Q11
Deal activity has increased meaningfully off a low base and should continue to rise
Capex spending has picked up while R&D spending remains subdued
Energy and Tech account for the a large part of this rise
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Cash Repatriation
Total Payout Ratio
10
30
50
70
90
110
00 01 02 03 04 05 06 07 08 09 10 11
◄ Dividends+ Buybacks
▲ Dividends 27.7
61.2
45.6
91.6
Source: S&P, Compustat, FactSet and UBS Note: Universe excludes Financials. Data as of 2Q11
Total Payout Potential 2011 Current 10-yr Avg Difference Cash
Earnings Payout Payout b/w Avg and % ofGrowth (%) Ratio (%) Ratio (%) Current Assets
Source: Federal Reserve, Department of Labor, FactSet and UBS
The Fed is now focused on unconventional measures to provide stimulus
Real rates are now substantially negative
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Treasuries
10-Year Treasury Yields
65 70 75 80 85 90 95 00 05 102
4
6
8
10
12
14
16
2.22
Source: Federal Reserve, Bloomberg, FactSet and UBS
Municipal Bond Spreads
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
97 99 01 03 05 07 09 11
Yield (%)10-year US Treasury 2.2
GO BondsNational Avg 2.6 NY 2.9IL 4.1CA 3.6
Source: Federal Reserve, Wall Street Journal, Haver and UBS
Treasury yields remain subdued on growth concerns
Typically, municipal bonds carry lower yields due to their tax-exempt status
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Bond Spreads
Mortgage Spread
90 92 94 96 98 00 02 04 06 08 10
1.0
1.5
2.0
1.31
Avg 1.49
Source: Freddie Mac, Bloomberg, FactSet and UBS
Corporate (Baa) Spread
90 92 94 96 98 00 02 04 06 08 101
2
3
4
5
6
Avg: 2.3
3.12
Source: Moody’s, Bloomberg, FactSet and UBS
Mortgage spreads remain narrow
Corporate spreads have widened recently as a result of falling treasury yields
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Appendix: S&P 500 Valuation Our S&P 500 valuation framework is based upon a traditional discounted cash flow methodology, illustrated in the exhibit below. What differentiates our approach is how we apply it in practice.
Gordon Growth Model
g ERP)RRF(I
PR
gk
PR
E
P 11
1
0
−++=
−=
P0 = current price
E1 = next year’s EPS
PR = payout ratio
k = discount rate or cost of capital
I = inflation rate
RRF = real risk free rate
ERP = equity risk premium
g = long-term growth rate
Source: UBS
Importantly, while our P/E formula remains constant over time, our work suggests that equity markets experience extended stretches over which only one or two key variables dominate overall stock market valuations. We call these prolonged periods “investment regimes” and believe that they hold the key to understanding stock prices.
Investment Regimes
Period Key Factor Valuation Metric Valuation Formula
Notably, over the past couple of years, the market has been discounting slower long-term growth rate. The current relationship between the S&P 500’s 12.4x P/E, the Baa’s 6.0% bond yield, and growth expectations is shown below.
2009 – Present Regime PE
18.9%
8.9% =
Market implied EPS growth slowing by 3.4%
=
=
1Baa Yield - (Δ Growth)
11.3
5.5% - (-3.4%)Baa Yield Δ Growth
Source: UBS
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Appendix: Inter-Sector Valuation The goal of our inter-sector valuation work is to gauge whether each S&P 500 sector is undervalued or overvalued relative to the overall market. Our analysis is based upon the historical valuation relationships between sectors. Importantly, we normalize sector valuations for three dynamics that could potentially provide spurious results, if not accounted for correctly:
Some sectors tend to be more expensive than others on a systematic basis (e.g., Tech consistently trades at a higher P/E than Financials).
The valuation dispersion between sectors is wide in some environments (e.g., the late-90s) and tight in others (e.g., 2008-09). In other words, a multiple point today is not necessarily the same as a multiple point yesterday.
Sector dynamics change over time. For example, Health Care carried a premium multiple throughout the 90’s, but has traded at a discount over the past decade.
Our inter-sector valuation work suggests that relative sector valuations are mean-reverting over medium-term time frames. As such, we view our inter-sector valuation rankings as a good starting point in determining sector recommendations. However, we note that sectors can stay cheap or expensive for multi-year time periods.
Ranking Overview In order to properly normalize inter-sector valuations over time, our analysis focuses on how many standard deviations away each sector’s P/E is from the market’s P/E. (For our fellow math geeks, this is known as cross-sectional standard deviation analysis.) We then put this calculation into a historical context on a sector-by-sector basis.
Step-by-Step Calculations (1) Aggregate P/Es and Standard Deviations. First, we calculate a forward P/E for the S&P 500 and all
ten of its sectors, using consensus EPS estimates over the next twelve months. We also calculate the weighted average standard deviation of the market’s forward P/E.
(2) Calculate Z-Scores. Next, we calculate a Z-Score for each sector. This expresses each sector’s P/E as a number of standard deviations away from the market’s P/E. This is calculated by subtracting the market’s P/E from each sector’s P/E and dividing the result by the weighted average standard deviation of the market’s forward P/E.
(3) Put Current Valuations in Historical Context. A Net Z-Score is then calculated for each sector by comparing current Z-Scores to average Z-Scores over the prior 36 months. We perform our analysis on a rolling 36-month basis to account for secular changes in sector dynamics (e.g., new governmental regulations).
(4) Rank Sectors from Most to Least Expensive. We then rank all ten sectors based upon their Net Z-Scores (i.e., how expensive or cheap each sector’s current Z-Score is in comparison to its historical average). Sectors with negative scores are cheap on a relative basis. Sectors with positive scores are expensive.
(5) Convert Net Z-Scores into Current P/E Multiple Points. To make the visual interpretation of our analysis easier to understand, we covert each sector’s historical Net Z-Scores into current P/E multiple points (cheap or expensive). This is done by multiplying the historical Net Z-Scores by the current weighted average standard deviation of the market’s forward P/E.
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Appendix: UBS Return Drivers We define market leadership by specific stock characteristics, such as Size (large vs. small), Valuation (expensive vs. cheap), Growth, Momentum, and Volatility. We track twelve such characteristics, which we have dubbed “UBS Return Drivers.”
UBS Return Drivers
Size (Capitalization) Foreign Sales
Valuation (Forward P/E) Volatility
Earnings Growth Financial Leverage
Price Momentum Operating Leverage
Earnings Revisions Dividend Yield
Short Interest Return on Equity Source: UBS
Computation Each Return Driver is calculated as a hypothetical long/short portfolio built around a single quantitative decision variable. Our calculations assume monthly rebalancing and no transaction or borrowing costs. For each Return Driver, the computation process has four steps:
(6) Break Stocks into Industry Groups. While our Return Drivers are reported at the sector and index level, our process starts by breaking the S&P 500 into its 24 GICS industry groups.
S&P 500 GICS Sectors and Industry Groups
Source: Standard and Poor’s and UBS
(7) Rank Based on Return Drivers. Within each industry group, stocks are ranked from top to bottom by the Return Driver in question (e.g., largest to smallest market capitalization). The list is then broken into three groups: top-third, middle-third, and bottom-third. Our calculations assume that the top-third of stocks are bought and the bottom-third of stocks are sold.
Ranking and Return Calculation Methodology
Top 1/3Buy (Top 1/3).Stock returns equal-weighted within industry group
Middle 1/3
Bottom 1/3Sell (Bottom 1/3).Stock returns equal-weighted within industry group
Source: UBS
Sectors Industry Groups
Energy Energy
Materials Materials
Industrials Capital Goods; Commercial & Professional Services; Transportation
(8) Calculate Returns. Monthly returns are then calculated by subtracting the returns of the bottom-third (sells) from the top-third (buys). The result is then divided by two to put the outperformance in a long-only context. This analysis is done on an equal-weighted basis within each Industry Group.
Return Driver Calculation — Hypothetical Example Foreign Sales Calcualtion — Industry Group Example
(9) Aggregate Results. At the sector level, Returns Drivers are calculated as a weighted average of industry group returns based on S&P 500 index weights. S&P 500 index results are a weighted average of sector results. We also index monthly returns as a time series for further analysis.
GICS Sectors and Industry Groups — S&P 500
S&P 500
Sector Sector
Industry Group Industry Group
Cap-weighted result of Sector Average
Cap-weighted result of Industry Group Average
S&P 500
Sector Sector
Industry Group Industry Group
S&P 500
Sector Sector
Industry Group Industry Group
Cap-weighted result of Sector Average
Cap-weighted result of Industry Group Average
Source: Standard and Poor’s and UBS
(10) Analytics. There are several ways that UBS Return Drivers can be used in investment decision making. We have listed a few below:
Identify Winning Investment Characteristics. UBS Return Drivers identify which specific equity characteristics have outperformed and underperformed during a specific time period. This data is available at the industry group, sector, and index level. Additionally, investors can get a sense for the magnitude of outperformance or underperformance of Return Drivers relative to one another.
Track Historical Trends. In our analysis, we track the performance of each one of our Return Drivers over time. This allows us to identify the types of market environments in which each Return Driver tends to outperform or underperform.
Avoid Crowded Trades. Our work also helps identify over-loved and under-loved investment themes. For each UBS Return Driver, we track the valuation spread between the top-third of companies and the bottom-third of companies over time. As such, we can help identify points when particular portfolio tilts or trades appear to be “crowded” or “priced in.” Alternatively, we can also identify points when upside opportunities appear outsized.
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Analyst Certification
Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers and were prepared in an independent manner, including with respect to UBS, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report.
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Required Disclosures
This report has been prepared by UBS Securities LLC, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS.
For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. Additional information will be made available upon request. UBS Securities Co. Limited is licensed to conduct securities investment consultancy businesses by the China Securities Regulatory Commission.
UBS Investment Research: Global Equity Rating Allocations
Buy Buy less than 1% 33%Sell Sell less than 1% 25%
1:Percentage of companies under coverage globally within the 12-month rating category. 2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. 3:Percentage of companies under coverage globally within the Short-Term rating category. 4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months. Source: UBS. Rating allocations are as of 30 June 2011. UBS Investment Research: Global Equity Rating Definitions
UBS 12-Month Rating Definition
Buy FSR is > 6% above the MRA. Neutral FSR is between -6% and 6% of the MRA. Sell FSR is > 6% below the MRA.
UBS Short-Term Rating Definition
Buy Buy: Stock price expected to rise within three months from the time the rating was assigned because of a specific catalyst or event.
Sell Sell: Stock price expected to fall within three months from the time the rating was assigned because of a specific catalyst or event.
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KEY DEFINITIONS
Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or rating are subject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near-term (up to three months) performance of the stock and do not reflect any change in the fundamental view or investment case. Equity Price Targets have an investment horizon of 12 months.
EXCEPTIONS AND SPECIAL CASES
UK and European Investment Fund ratings and definitions are: Buy: Positive on factors such as structure, management, performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell: Negative on factors such as structure, management, performance record, discount. Core Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment Review Committee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respective company's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece.
Research analysts contributing to this report who are employed by any non-US affiliate of UBS Securities LLC are not registered/qualified as research analysts with the NASD and NYSE and therefore are not subject to the restrictions contained in the NASD and NYSE rules on communications with a subject company, public appearances, and trading securities held by a research analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any, follows.
UBS Securities LLC: Jonathan Golub, CFA; Manish Bangard, CFA; Daniel Murphy; Vishal Patel; Thomas M. Doerflinger, Ph.D.; Natalie Garner, CFA.
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Company Disclosures
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this company/entity or one of its affiliates within the past 12 months.
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