What Lies Beneath


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INVESTMENT INSIGHTS SERIES

What Lies Beneath An Objective Reading of Market Signals Reveals Opportunities in Global Equities

While global equities posted strong gains since 2008, many skeptics believe this was a reluctant bull market built on the shifting sands of easy money, and a correction is imminent. We believe differently and believe their negative perceptions are perhaps being driven by recency bias. A critical examination of pertinent market factors leads to a constructive view on global equities.

IN OUR VIEW u The

global macroeconomic backdrop looks positive, not just in the U.S., but in most regions of the world, including Europe and emerging markets.

George P. Maris, CFA Portfolio Manager Janus Global Alpha Equity Strategy

Read Inside

u

U.S. corporate profitability is sustainable.

u

u

Equity valuations are generally fair and attractive relative to other asset classes.

Global macroeconomic perspective

u

Overview of equity valuations relative to other asset classes

u

Idiosyncratic opportunities in global equity markets where safety is richly priced

u

In a market overpaying for safety, high-quality cyclicals present compelling return opportunities.

Our analysis points to a number of encouraging signs in the global economy. We believe if investors distance themselves from undue skepticism and negative headline noise, and objectively assess market signals, they will find abundant opportunities in equities.

Introduction Global equities posted strong gains since 2008, with the MSCI ACWI Index returning more than 10% annually for each of the past five years. Yet many investors believe this was a reluctant bull market built on the shifting sands of easy money. Skeptics insist the global equity rally is unsustainable and, as justification, point to several macro and fundamental signals: u

An austere, low-growth global macroeconomic backdrop

u

Peak-level corporate profit margins

u

Historically elevated equity valuations

We disagree. Upon inspection, the implications from critical top-down and bottom-up indicators are positive and supportive of global equities. Those arguing otherwise are sometimes looking at different metrics. More frequently, they are looking at similar metrics but are caught in an emotional lens of the crisis period, resulting in a misinterpretation of key signals. A critical examination of pertinent market factors leads to a more constructive view on global equities. Over the past several years, global equity markets rallied in spite of multiple headwinds, including a dysfunctional U.S. federal government, European austerity, and a stepdown in global consumption, nevermind various geopolitical crises. But while the easy monetary policies of the world’s leading central banks were vital to the recovery from the financial crisis and its aftermath, we believe improvements in corporate capital and operations that occurred during this period were critical to the recovery in equities and establish 2

a backdrop for continued healthy returns. Moreover the potential return of supportive forces makes 2014 look a bit like 2004, when investors were also skeptical of an accelerating economic rebound. We believe economic surprises will most likely be to the upside, especially as consumers regain confidence – a crucial catalyst for healthy markets. The recency bias of market skeptics – i.e., projecting recent bad experiences into the future – creates risks, but also opportunities to be exploited by diligent investors. A market overpaying for perceived safety creates segments of significant over- and under-valuation relative to company growth potential.

IN SUMMARY u The

global macro environment is not as austere as frequently portrayed, and is supportive of equities.

u Aggregate

statistics point to sustainable levels of corporate profitability.

u Equities

are attractively valued relative to other asset classes.

u

High-quality, out-of-favor cyclicals present an opportunity in a market where safety is richly priced.

u

The biggest risk to global equities may be political via the rise of anti-business populism.

The Global Macroeconomic Backdrop: Not So Bad After All For skeptics, signs of an inhospitable global macroeconomic environment are everywhere: slower U.S. growth compared to the pre-global financial crisis era; near-zero growth and deflation in the Eurozone; deceleration in emerging market (EM) growth; and the potential for accelerating inflation. These appear to be examples of recency bias where skeptics project into the future the perpetuation of past conditions. This bias seems especially severe following a crisis, as it combines with loss aversion to create a strong bias toward interpreting events more negatively than would otherwise be warranted. The deleveraging process in the private sector resulted in a step-down in global economic growth rates, but this deleveraging is unlikely to continue into perpetuity. As current increases in corporate capital expenditures as well as mergers and acquisitions (M&A) demonstrate, the deleveraging process seems to be in its last days, which should result in economies reverting to long-term averages. There are positive signs of recovery in the U.S. as corporate profits, household income and wealth are strengthening. In Europe, austerity is winding down and the European Central Bank is continuing to support aggregate demand. Japan is attacking deflation and structural inefficiencies. EM growth may have slowed, but underlying productivity gains and demographics still imply faster growth than in developed markets. The fear that these positive developments are facilitated solely by the adoption of loose monetary policies and will vanish upon the emergence of inflation spurred by such policies

ignores structural changes made the past few years by sovereigns, corporates and individuals. It also overstates inflation risks by not adequately accounting for the current historically low levels of monetary velocity. With a balanced assessment of growth drivers, the picture appears supportive of healthy global equity performance.

United States: Delevered & Ready for Growth? 1. The U.S. Economy is on a Firmer Footing Advocates of the popular “new normal” concept argue for the inevitability of slower growth in the world’s developed economies. This argument, as shown in Exhibit 1, points to a step-down in U.S. GDP growth from 3.0% per year (1998 – 2007) to 2.1% (September 2009 – March 2014). However, consider the following simple equality: Spending = Income + Borrowing The recent decline in U.S. economic growth is a function of the deleveraging process where consumers and businesses are spending less. Prior to 2008, the private sector of the U.S. economy supplemented its spending with borrowing, artificially boosting growth rates; subsequent to 2008, the private sector decreased borrowing in response to the financial crisis. This deleveraging (i.e., increased saving) decreased spending, which contributed to the deceleration in domestic growth. All else being equal, a delevered, fiscally-sound private sector places the U.S. economy on a firmer footing for healthier growth in the future and lessens the probability of another credit-induced shock to the broader economy and financial markets. That, we believe, is constructive for equities.

EXHIBIT 1: U.S. GDP GROWTH RATE 8% Average

6% 4%

3.0%

2%

2.1%

0% -2% -4% -6% -8% 3/14

3/13

3/12

3/11

3/10

3/09

3/08

3/07

3/06

3/05

3/04

3/03

3/02

3/01

3/00

3/99

3/98

-10%

Source: U.S. Bureau of Economic Analysis. As of 3/31/14.

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In the financial sector, there is clear evidence of a similar deleveraging process with declining returns on equities (ROE) but rising returns on assets (ROA). For equity investors, rising ROEs are generally desirable, but not necessarily when the increase in ROE is due solely to increasing financial leverage. We illustrate the relationship between ROE, leverage and ROA:

EXHIBIT 2: U.S. MONEY STOCK (M2) VS. VELOCITY OF MONEY 3.0

$10,000

2.5

ROE = ROA * Leverage

$8,000

2.0

In the mid-2000s, many financials relying on high leverage delivered ROEs in excess of 20% while generating ROAs well below 1%. Contrast that with the current environment where financials are often delivering ROAs in excess of 1% but with more reasonable ROEs in the low- to mid-teens. We would argue the latter is indicative of a healthier business justifying higher multiples, not lower as is currently the case. Improvements in ROE are now more directly tied to improvements in operations rather than stretched balance sheets.

$6,000

1.5

$4,000

1.0

$2,000

0.5

0

0.0

This structural shift broadly applies to companies with substantial cyclicality in their businesses. Capital markets, rating agencies and regulators are punishing businesses with high cyclicality carrying highly geared balance sheets. The result is a market-imposed improvement in operations and capital strength, which should merit better market valuations. 2. No Sign of Rampant Inflation Inflation hawks often cite continued loose monetary policy (i.e., the Federal Reserve’s (Fed) growing balance sheet or size of the money stock (M21)) as evidence of imminent runaway inflation. This argument seems overly simplistic. Inflation requires the confluence of a large money stock and high velocity of money.2 The Fed was able to pump historically large sums of money into the economy during and subsequent to the Great Recession without generating much inflation because of a decline in the velocity of money since 2007. As shown in Exhibit 2, the velocity of money materially decelerated as low confidence resulted in lower levels of consumer spending and corporate capital expenditure. The result is monetary velocity is currently at historically low levels. As long as the velocity of money remains stuck in first gear, inflationary pressures should remain subdued. It seems reasonable to expect a gradual increase in both monetary velocity and inflation as profits and wages rise, and confidence improves. It is worth noting a moderate level of inflation is good for equities by facilitating revenue growth and increasing their attractiveness relative to other

1/82 1/84 1/86 1/88 1/90 1/92 1/94 1/96 1/98 1/00 1/02 1/04 1/06 1/08 1/10 1/12 1/14

$12,000

M2 Money Stock (billions)

Velocity

Source: Federal Reserve Bank of St. Louis. As of 1/1/14.

asset classes given a greater ability to pass along the effects of inflation. 3. Continued Improvement in Labor Markets There are supportive trends in both income and wealth, which should buoy consumer confidence. The Job Openings and Labor Turnover Summary (JOLTS) trend is moving upward – a sign people feel more secure about employment and their ability to find jobs. As shown in Exhibit 3, not only is hiring up, the number of people leaving their jobs is also rising. People do not normally quit their current jobs if they believe the broad employment picture looks bleak. The fact more people are willing to quit (i.e., higher labor turnover) is an indication both job openings and confidence are improving. On an absolute basis, job openings and labor turnover are below pre-crisis levels; notwithstanding, it is the sustained positive change, not the absolute level that contributes to improvements in consumer confidence.

Europe: Winding Down Austerity & Committed to Increasing Demand The European recovery is still a work-in-progress, but there are signs of traction toward a sustained recovery. It appears the most significant issue facing Europe is deflation induced by structural inefficiencies, resulting in stagnating income, high unemployment, and austerity in both the private and public sectors (Exhibit 4).

Source: Federal Reserve Board. M2 includes a broader set of financial assets held principally by households. M2 consists of M1 plus: (1) savings deposits (which include money market deposit accounts, or MMDAs); (2) small-denomination time deposits (time deposits in amounts of less than $100,000); and (3) balances in retail money market mutual funds (MMMFs). Seasonally adjusted M2 is computed by summing savings deposits, small-denomination time deposits, and retail MMMFs, each seasonally adjusted separately, and adding this result to seasonally adjusted M1 (mainly currency in circulation, checking accounts and traveler’s cheques). 2 Price level of transactions in an economy is generalized in Irving Fisher’s transaction equation: M * V = P * T, where M = Money Stock, V = Velocity of Money in Circulation, P = Price Level, and T = Total Volume of Transactions in an economy in a period. 1

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EXHIBIT 3: U.S. JOB OPENINGS AND LABOR TURNOVER

EXHIBIT 4: DEFLATION PRESSURES HIT THE EUROZONE

6,000

Inflation Swaps – U.S. vs. Eurozone 3.0%

5,000

4,000 2.2%

3,000

1.8%

2,000

1.4%

Hires

Quits

Eurozone 5yr Inflation Swap

7/14

1/14

7/13

1/13

7/12

1/12

7/11

1/11

1.0% 7/10

3/14

3/13

3/12

3/11

3/10

3/09

3/08

3/07

3/06

3/05

3/04

3/03

3/02

3/01

1,000

1/10

In Thousands

2.6%

U.S. 5yr Inflation Swap

Source: U.S. Department of Labor: Bureau of Labor Statistics. As of 3/1/14.

Source: International Strategy & Investment Group LLC. “Portfolio Strategy: Early Thought.” As of 4/25/14.

Eurozone countries were unable to access policy tools often used to alleviate the pressures of unsustainable debt. In times of financial crisis, when countries are struggling to meet debt obligations, they may default or devalue their currency as a means of reducing their debt burden and improving their export competitiveness. For example, when Argentina defaulted and devalued its currency in 2002, the average Argentine wage in U.S. dollar terms fell by approximately 70% within a year.

growth. Sensing the effects of these improvements, investors pushed the Greek bourse up 53% in 2013 – the best performing equity market in both developed and emerging markets.

By contrast, countries like Portugal, Ireland, Spain and Greece could not lower wages through currency devaluation given their membership in the European Currency Union. Structural inefficiencies, including inflexible labor laws, restrictions on businesses’ flexibility, and other such measures, limited the ability of the European corporate sector to adjust to the difficulties of the financial crisis and recession. These inefficiencies resulted in a slow economic recovery in the broader Eurozone, in stark contrast to the UK where painful adjustments were more quickly embraced. But even in Europe, we see green shoots of improvement. Austerity programs resulting in harsh cuts to government spending and increases in taxes have mostly run their course. Ireland successfully exited the IMF/EU bailout in December 2013 and Portugal expects to do the same this year. Greece and Spain are experiencing strong improvements in unit labor costs after implementing painful reforms, resulting in greater competitiveness and a healthier foundation for future

Importantly, the European Central Bank (ECB) is signaling its intention to do whatever is needed to spur demand and alleviate deflationary pressures (Exhibit 4). On June 5, 2014, the ECB lowered the rate on the main refinancing operations of the Eurosystem by 10 basis points to 0.15% , and lowered the rate on its deposit facility by 10 basis points to -0.10% . This is the first time where a major central bank charged a negative interest rate on the deposits maintained by the banks in its system. By charging banks for holding excess reserves at the central bank, the ECB is incentivizing the lending of excess reserves which should help spur economic activity. Despite pockets of anemic growth in countries such as France and Italy, there are reasons to be positively disposed toward opportunities in Europe.

Japan: A Healthier Corporate Sector, Despite Stalled Political Reform Corporate Japan has come a long way in improving its focus on governance and shareholder return. A little over a decade ago, I asked the CEO of one of Japan’s largest companies what the financial goals were for his company. He replied that he hoped to generate 10 trillion yen (approximately $100 billion) in sales by 2010. When asked

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about profit margins and returns, he laughed and said those were fancy Western concepts that were not relevant in Japan.

Emerging Markets: Demographics and Deleveraging Supportive of Long-Term Growth

Today, Japanese management teams are dramatically more focused on margins and returns on capital, as a continued weak economy and strong currency necessitated a more sophisticated approach. In addition, corporate activism and restructuring are on the rise with companies like SoftBank acquiring competitors and Sony jettisoning unprofitable businesses.

Perhaps nowhere are views more negative than with respect to emerging markets. Emerging economies are still viewed through the lens of the recent crisis, disregarding the strength of underlying structural fundamentals. [Hiroshi Yoh, our emerging market equity portfolio manager, recently penned an investment insight piece on emerging market equities titled Emerging Market Equities, Down But Not Out, April 2014.]

From a macroeconomic perspective, reversing persistent deflationary pressure is of utmost importance and is critical to future growth. Deflation is a powerful deterrent to economic growth by incentivizing consumers and businesses to delay purchases of goods and services because of continued future anticipated price declines. Japanese policymakers are aware of this and seem committed to eliminating deflation. While Japan is undertaking several measures to stimulate economic activity, perhaps none is more important than the efforts of the Bank of Japan to expand the monetary base. In April 2013, the Bank of Japan announced: “It will double the monetary base and the amounts of JGBs …”3 As long as monetary velocity does not decline too greatly, the general price levels of goods and services should begin to rise as a consequence of loose monetary policy. In addition, this policy should weaken the Yen against both the dollar and euro, making export-oriented companies such as Toyota more competitive. Indeed, soon after the introduction of monetary easing, the Yen depreciated versus the U.S. dollar from the high 70s to the low 100s. Such Yen weakness should promote domestic growth by making Japanese corporates more competitive relative to global peers. Positive changes notwithstanding, we are guarded about Japan’s future prospects due to recent difficulties implementing structural reforms. Japan’s old political guard is resisting structural reforms that include lowering the corporate tax rate, making the agricultural sector more efficient, and reducing labor rigidity. Without such reforms, it is unlikely Japan will achieve a self-sustaining economic recovery. We were optimistic in 2013 regarding Japan’s potential to reinvigorate its economic model given the boldness of its policies. The resurgent political obstinacy, however, remains a major stumbling block. Over the past two decades, Japan disappointed expectations of sustained recovery time and again, militating caution regarding the prospects for real change.

Despite slowing growth and recent market dislocations, emerging markets present interesting opportunities. This is especially true in China, where the recent growth slowing is an outcome of healthy deleveraging taking place in the social financing sector (i.e., bank loans, corporate bonds, trust loans and other lending facilities), as well as an economic rebalancing toward consumptionoriented activities. As shown previously, deleveraging leads to a slowdown in spending which results in slower economic growth. While deleveraging can slow an economy in the short term, it can often place an economy on a firmer footing by lowering the future probability of credit-induced shocks, and preparing it for less-volatile future growth. Given an estimated $4.0 trillion in foreign exchange reserves held by the People’s Bank of China (PBOC), combined with the deleveraging taking place in the financial sector, neither a hard landing nor financial crisis seems likely. As major Chinese banks are majority-owned by the government, and given the backstop of PBOC liquidity, it is difficult to envision a scenario where these banks would face liquidity or solvency issues. On an earnings yield basis, EM equities are more intriguing than their developed market counterparts (Exhibit 5). Compared to the average over the past 20 years, EM equities possess a forward earnings yield of

EXHIBIT 5: P/E RATIOS April 2014 P/E

E/P

P/E Fwd

E/P Fwd

MSCI EM IMI

13.0

7.7%

10.1

9.9%

MSCI World ex U.S. IMI

17.2

5.8%

14.1

7.1%

S&P 500

17.3

5.8%

16.0

6.2%

Source: MSCI, Bloomberg. 12-month period. As of 4/30/14.

Bank of Japan press release, April 4, 2013.

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“EM equities are now trading at significantly deeper discounts than during the 2008 financial crisis ... And while ROE of EM equities may slide further, current market prices imply unrealistically low forward ROEs. In our view, the market is effectively pricing in a drop of ROE of 7% to 8%. This represents a large decline from the current level of about 12%, and we do not believe it is a very likely outcome.”4 Slowing growth notwithstanding, the underlying demographics of developing economies imply better overall growth prospects compared to developed markets. For equity investors, China appears attractive with real GDP growing approximately 7% with a forward P/E ratio of 8.75 versus developed economies growing 1% to 2% with a forward P/E ratio of 14.1. That said, developing economies are not monolithic. While we are generally constructive on China’s path, we are a bit more concerned about Brazil. It is concerning when a country with attractive demographic opportunities only generated real GDP growth of 1.0% in 2012 and 2.3% 6 in 2013. The issue for Brazil is confronting the harmful prospects of stagflation. After fighting a successful battle to control inflation in the 1990s, the last few years witnessed the rise of inflationary pressures due to adoption of demand-oriented economic policies. As a developing country, Brazil possesses elements of structural inefficiency resulting in elevated inflationary pressures compared to more economically developed nations. Rather than tackle these structural inefficiencies, the country adopted policies that were politically popular, but led to weaker growth and higher inflation. This combination of weak growth and high inflation creates a difficult environment for successful investing.

U.S. Corporate Profitability: Aggregate Statistics Indicate Sustainable Performance Many point to the level of aggregate corporate profits as evidence a fall in U.S. equities is imminent. They argue margins are bound to decline from the current peak levels (Exhibit 6). However, given the persistence of historically high margins since 2001, perhaps the question is not when margins will decline but what are the sources behind the shift in margins and whether these are sustainable. It seems a key factor buttressing the sustainability of U.S. profit margins is the lack of cyclical pressure from wage

EXHIBIT 6: U.S. AGGREGATE WAGES VS. AGGREGATE CORPORATE PROFITS 15%

14.5%

60% 52.7%

12%

50%

9%

40%

6%

30%

3%

20%

0%

10%

1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013

10% which is a level more indicative of crisis than stability. Hiroshi Yoh, my counterpart for the Janus Emerging Markets Equity strategy, commented:

Corporate Profits

Wages

Source: U.S. Bureau of Economic Analysis. As of 12/31/13.

growth. While overall employment improved, millions of longterm unemployed and underemployed remain, as evidenced by declines in labor force participation. The implication is there is room for companies to drive production growth without wage pressure, resulting in businesses better capturing the increase in profits as the economy grows. Moreover, even if wage pressures arise, the resultant increase in per capita disposable income should lead to increased consumption, which in turn should result in higher growth for the economy, allowing for profit margin sustainability as better corporate sales growth should generate increased operating leverage. Companies also appear to be on a healthier footing today, making today’s profit margins sustainable, contrary to popular wisdom. The step-up in margins since the early 2000s appears to be a function of improved operational efficiency and a secular departure from an earlier growthat-all-costs mentality. As shown in Exhibit 7, subsequent to 2008, companies improved margins despite rising raw material costs and weak economic growth. The strength in corporate margins despite generally higher raw material costs confirms an improved corporate discipline that should sustain profits over a cycle. Moreover, the fact the corporate sector grew profitability without the help of a strong economy is prima facie evidence of improved operational efficiency. Rather than profit margins being at peak, if the economy recovers and revenue growth improves, margin levels should accelerate as a consequence of

Yoh, Hiroshi. “Emerging Market Equities, Down But Not Out.” Investment Insights Series, April 2014. Source: MSCI China Index as of 5/30/14. 6 Source: IMF. World Economic Outlook. April 2014. 4 5

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EXHIBIT 7: BREAKDOWN OF COSTS AND PROFITS FOR S&P 500 EX-FINANCIALS AND UTILITIES 40%

67%

66%

18%

17%

Share of Sales

30%

20% 5% 10%

5% 4%

5% 5%

9%

Selling, General and Administrative Expense Interest and Taxes Depreciation and Other Operating Income

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

0%

Cost of Goods Sold

Source: Goldman Sachs Portfolio Strategy Research. “Writing in the margins: Analyzing peak profitability.” 3/17/14. As of 3/12/14.

companies being better able to leverage their costs over a higher revenue base. Finally, companies are increasingly pressured by shareholders to focus on profitability, return on invested capital, free cash flow growth and shareholder returns. In a manner that feels more focused than in the past, underperforming companies are quickly becoming acquisition targets by more efficient competitors and ineffective managements are being replaced by impatient boards of directors. Incredibly, corporate margins are presumed to be at a peak level despite fairly tepid economic growth. There is plenty of support for expecting continued strong profit growth.

Equity Valuations: Generally Fair, but Compelling when Compared to Other Assets Given the rise in equity markets over the past year, there is a notion the rise in share prices, combined with potentially peak profit margins, resulted in equities being overvalued. The reasoning generally argues normalized earnings should be lower than current earnings. Using the U.S. as an example, the S&P 500 Index appears expensive as the trailing P/E of 17 is higher than the historical average of 15, and the earnings basis for the trailing P/E multiple is too high compared to the normalized earnings base given a notion of unsustainable margins. Despite these concerns, on a cross-asset comparison, equities appear compelling. As shown in Exhibit 8, compared to U.S. Treasurys, U.S. equities seem exceptionally attractive. It seems significantly more preferable to hold equities yielding 6.2% to 9.9% on a forward-looking basis with a growing stream of earnings, instead of holding 10-Year Treasurys yielding 2.7% – or in other words, having an equivalent P/E multiple of 37 with no growth whatsoever. Likewise, liquid equities with higher growth prospects seem more compelling than illiquid real estate with underlying hurdle rates of 6.7%7 and whose long-term real growth rate is in the low single digits. High yield bonds, at a 5.5% effective yield before taking into consideration losses associated with defaults, seem richly priced when compared to equities. From a global perspective, there are ample opportunities outside the U.S. that are at least as attractive as U.S. stocks. As stated previously, given recent market dislocations, we view emerging markets as quite intriguing.

EXHIBIT 8: ASSET CLASS CROSS SECTIONAL COMPARISON

Cash

U.S. 10-YR Treasury

Real Estate Cap Rate

High Yield

U.S. Equity

World ex U.S. Equity

Emerging Market Equity

Current Nominal Yield

0.0%

2.7%

6.7%

5.5%

6.2%

7.1%

9.9%

Breakeven Inflation: 10-YR TIPS

2.2%

2.2%

2.2%

2.2%

2.2%

2.2%

2.2%

Current Real Yield

-2.2%

0.5%

4.5%

3.3%

4.0%

4.9%

7.7%

Source: 10-Year Constant Maturity Treasury and Breakeven Inflation on 10-YR TIPS: U.S. Department of Treasury as of 4/30/14. Real Estate: 3/31/14 Capitalization Rates - U.S. Core Properties over $2.5 million, PREA Compensium of Statistics, as of 5/5/14. High Yield: BofA Merrill Lynch US High Yield Master II Index as of 4/30/14. US, World ex. U.S. and EM equities: MSCI as of 4/30/14. As a rule of thumb, institutional investors, on average, demand a 3.0% illiquidity premium. Therefore, the cap rate for private real estate, adjusted for illiquidity premium, is much lower at 3.7% and makes liquid equities look relatively attractive. 7

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All developed economies are in danger from such antibusiness populism – whether as an outgrowth over the financial crisis or as a backlash to austerity programs. Investors, in turn, could require higher equity risk premiums as compensation for taking on anti-business populism risks, driving down future economic growth and equity returns.

Where is The Opportunity? In High-Quality, Out-of-Favor Cyclicals We believe the best way to compound wealth over time is by investing in companies whose current stock prices do not accurately reflect the potential growth of free cash flows. We are region, country, style, and size agnostic. We believe the price one pays today matters. Finally, risk must be managed at both the individual stock and overall portfolio level. Currently, due to persistent recency bias and risk aversion following the financial crisis, the market appears to be

24 22 20 18 16 14 12

S&P 500 Staples Next 12 Months P/E

LT Median

25th Pctile

2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

10 1994

The irony is Petrobras is a world-class company with the potential to grow faster than most major exploration and production companies. While companies like ExxonMobil, Total and Chevron struggle to maintain production growth, Petrobras could deliver 7% to 9% annual production growth over the next decade. This world-class company is trading at a P/E multiple of 8, nearly a 40% discount to ExxonMobil’s P/E multiple of 14. From an operational perspective, Petrobras is a world leader and could offer investors attractive returns, but the company is saddled with potentially billions in losses as a result of the governmentimposed subsidy.

EXHIBIT 9: EQUITY VALUATION FOR U.S. CONSUMER STAPLES

1992

Petrobras, one of the world’s largest oil companies, is a case study for the dangers of anti-business populism. The current administration in Brazil, in an effort to improve well-being and reduce inflation, sought to do so by delivering belowmarket-price refined fuel to consumers. To deliver on the promise of cheaper petroleum, the administration required Petrobras to subsidize domestic petroleum consumption at a loss. The company’s subsidization resulted in significant deterioration in profits and balance sheet strength, resulting in cuts to its bond ratings, a diminished ability to invest in growth, and a significantly lower share price.

The foregoing partly explains why the P/E multiple on the S&P 500 Index remains above the long-term average.

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While stagnant growth, high inflation, and geopolitics always represent material risks for equity investors, one of today’s biggest risk factors is the emergence of anti-business populism. While populism is a regular feature of democratic societies, today’s populism post the global financial crisis seems increasingly hostile to businesses with increased regulation and prosecutorial activism obvious signs of this change. This latter type of populism can harm the broader economy and shareholders.

overpaying for near-term certainty and earnings stability. Nowhere is this more pronounced than in the U.S. Consumer Staples sector, where, as shown in Exhibit 9, the forward looking P/E multiple stands at 18.

Price-Earnings (P/E) Ratio

For Global Equities, the Biggest Risks Seemingly are Political

75th Pctile

Source: International Strategy & Investment Group LLC, Equity Research Group. As of 7/14/14.

The market’s preference for near-term certainty and earnings stability is not endemic just to U.S. markets. As demonstrated in Exhibit 10, EM low volatility stocks are trading at a nearly 50% premium to EM high volatility stocks. Low volatility equity portfolios tend to be a bastion of consumer staples and utilities. Clearly, investors’ willingness to pay a premium for near-term certainty and earnings stability extends to emerging markets as well. To us, there are compelling return opportunities globally among quality cyclical companies. There are substantial well-managed, cyclically-oriented companies with the potential to deliver strong earnings and cash flow growth over the next twelve to eighteen months, where valuations remain at a discount to stocks offering earnings stability, but less growth over an economic cycle. Such opportunities are especially pervasive in capital markets-oriented financials, industrials, and consumer discretionary companies. Opportunities exist in global financials as deleveraging and improved operational efficiency lead to healthy returns on assets and more resilient balance sheets. We favor insurers with exposure to Asian consumers and multi-national 9

Conclusion: Objective Analysis Reveals a Favorable Backdrop for Global Equities

EXHIBIT 10: SAFETY IS RICHLY PRICED MSCI Emerging Markets Index

It is difficult to criticize a U.S. economy that grew in 17 of the past 19 quarters, despite prevailing uncertainty and fiscal headwinds. Returns on the S&P 500 Index averaged nearly 10% since 1927, a period including the Great Depression, World War II, the Vietnam and Korean wars, a global oil crisis, a Latin American debt crisis, a Russian default, the technology-media-telecomm bubble, the September 11 terrorist attacks, the Global Financial Crisis, and so forth.

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3

2

Median P/B of High Volatility Stocks

6/14

6/11

6/08

6/05

6/02

6/99

11/90

0

6/96

1

6/93

Price-to-Book (P/B) Ratio

4

Median P/B of Low Volatility Stocks

Source: Bank of America, Merrill Lynch. As of 6/30/14.

financial institutions with global reach and exposure to capital markets. Likewise, we favor industrials and consumer discretionary companies poised to benefit from recovering consumer demand and improvements in their underlying operations. Finally, when markets overpay for safety and stability, investors may want to consider a contrarian approach and invest in undervalued and underappreciated companies. Consider the following comparison: Hindustan Unilever is a great Indian consumer staples company trading at nearly 35 times next year’s earnings, equivalent to an earnings yield of 2.9%. In contrast, Hyundai Motor trades at 6 times next year’s earnings, equivalent to a 17% earnings yield with the potential for double-digit annual earnings growth over the next three years. Even though Hyundai Motor’s future earnings stream may be more cyclical than Hindustan Unilever’s, we prefer the former given the low price required to receive Hyundai’s strong future cash flows.

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Even though a work in progress, Europe looks promising. With austerity programs coming to an end, countries such as Ireland and Portugal exiting the IMF/EU bailout programs, and sovereign default risk receding, continental Europe may be in a position to generate a self-sustaining recovery. Given the difficulty of implementing structural reforms, Japan remains a question. However the Japanese corporate sector is as healthy as it has been in years. If the political leaders in Japan are able to push through the necessary reforms, we believe Japan may generate excellent returns. Due to material underperformance over the past few years, attractive valuations and structural growth advantages, we see compelling opportunities in emerging market equities. Contrary to negative headlines, on balance, the environment appears hospitable to investing in equities. Given our view on corporate profit levels and the relative value of equities, we believe the outlook for equities remains especially favorable when compared to other asset classes. Behavioral biases are generating negative views of equity markets, when a dispassionate assessment of facts leads to greater optimism regarding the current global economic cycle and equities. It is time for investors to distance themselves from undue skepticism and objectively assess market signals, rather than being disoriented by headline noise blinding them from the opportunities being presented.

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