Inside The Buy-side® 1Q14

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INSIDE THE BUY-SIDE®

FIRST QUARTER| ISSUE DATE: JANUARY 17, 2014

In the end, only the calendar could bring the 2013

Investment Style

bull market to a halt. Equity markets continued their run through the fourth quarter setting new records for intra-day and closing highs along the way. Markets shrugged off a U.S. government shutdown in October and the Fed’s December announcement to begin tapering and closed out 2013 in style, as both the Dow and the S&P 500 ended the final trading day of the year at record highs. For the year, the Dow surged 26.5%, its fifth straight annual gain, while the S&P 500 climbed 29.6% and the NASDAQ gained a sterling 38.3%.

In our ongoing effort to track investor sentiment and expectations, we surveyed 52 financial professionals globally and across multiple industry segments and investment styles. In total, participating institutions manage upwards of ~$500 billion in equity assets.

The biggest story of the quarter, if not the year, was the partial government shutdown that began October 1 as Congress failed to agree on a budget and pass a spending bill following weeks of bitter partisan wrangling. The partial shutdown forced about 800,000 federal workers off the job and ended on October 16, the night before the debt ceiling deadline. Yet, the markets pulled back only briefly during the battle, resuming their upward climb just a week into the shutdown.

Despite 2013’s robust gains, surveyed investors describe themselves as “cautiously optimistic” and believe market levels are sustainable. Their favorable outlook is rooted in signs of economic improvement and a more positive management tone versus last quarter. As companies prepare for earnings season, it is important to note that surveyed investors largely anticipate strong fourth quarter results.

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Core Value | 29% Core Growth | 27% GARP | 22% Growth |12% Deep Value | 6% Aggressive Growth | 2% Yield | 2%

Geography

North America | 77% Europe | 23%

Sector Generalist | 76% Consumer | 4% REIT | 4% Telecom | 4% Utilities | 4% Emerging Markets | 2% Energy | 2% Financial | 2% Multi Style | 2%

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Key Trends 

As earnings season gets underway, 86% of those surveyed expect 4Q13 results to be in line with or above consensus expectations



In almost equal numbers, the majority forecasts organic growth, EPS growth and FCF to improve this quarter –

75% expect continued cost cutting from the companies they follow

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46% describe executive’s tone as less negative quarter-over-quarter

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75% characterize their current market sentiment as “cautiously optimistic”; no one reports they are categorically bearish

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Investment professionals report favoring the IT, Industrials and Consumer Discretionary sectors and express bearish sentiment toward Utilities and Consumer Staples

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Similar to last quarter, reinvestment led investors’ preference for use of excess free cash, followed by dividends and smart M&A

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Economic growth followed by a lack of viable investment alternatives are the primary drivers of the equity rally, say those surveyed

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–

65% report the Fed’s commencement of tapering gives them confidence in an improving economy as opposed to concern

–

79% assert current market valuations are sustainable

Regarding emerging markets, Latin America generates more concern than China given it is becoming “difficult politically” especially with respect to most Atlantic-facing countries

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Equity Markets End Year with Fitting Flourish Equity investing in 2013 was like a good dream you don’t want to wake up from and 4Q13 was no different than the previous three quarters as the Dow rose 9.6%, the S&P 500 9.9% and the NASDAQ 10.7%. Moreover, in December alone the Dow advanced 3.0%, the S&P 500 rose 2.4% and the NASDAQ added 2.9%, the fourth straight monthly rally for all three indices.

4Q13 Market Performance 115 110 105 100 95 12/30/13

12/23/13

12/16/13

Contributors also suggested that when tapering was announced markets could see a slight pullback and here they seem to have missed the mark. Instead, stocks rallied following the announcement, sending benchmark indexes to

12/9/13

Last quarter, surveyed investors predicted that the Fed would announce tapering of QE by yearend and they were right, as a steadily improving economy finally led the central bank to announce on December 18 that monthly bond purchases will be trimmed to $75 billion from $85 billion beginning in January. At the same time, the Fed reaffirmed its commitment to maintaining low interest rates.

12/2/13

Annual gains were led by consumer discretionary stocks with the sector index up an amazing 40.4%, while the weakest gains belonged to defensive sectors with telecom up 6.6% and utilities up 16.5%.

11/25/13

S&P 500 + 9.9%

In line with such enthusiastic sentiment, the socalled “fear index”, the CBOE Volatility Index or VIX, fell 23.9% year-over-year, which is the biggest annual drop since 2009.

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11/18/13

11/11/13

11/4/13

10/28/13

10/21/13

10/14/13

10/7/13

9/30/13

DJIA + 9.6%

NASDAQ + 10.7%

Rally Drivers

Economic Growth

63%

Lack of Alternatives The Fed

55% 47%

Inflows (Fixed Income)

39%

Operational Improvements

37%

Opinion of Fed's Announcement to Reduce Bond Purchases

Gives me Confidence | 65% Neutral | 24% Still Concerned | 11%

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then-all-time highs on December 18. Fast-forward to our current survey, now two-thirds of investors assert that tapering is a confidence-booster that demonstrates the economy is gaining potency and “reflects improving market strength”.

“The genie is out of the bottle and the uncertainty has lifted.” – Growth, Generalist “The Fed has put too much money into the system already. Tapering is coming too late in the long run, although it will boost short-term returns.” – GARP, Real Estate “The Fed’s announcement represents only a very marginal change in policy.”

– GARP, Generalist

4Q13 Earnings Outlook Bright Expectations for the fourth quarter are brighter than they were for the third quarter, with a large majority of contributors expecting results to meet or exceed estimates.

Cost controls, continued efficiencies and “consensus numbers being driven down” by management should allow most companies to beat estimates even “without strong revenue growth” suggest investors.

Further, 75% of surveyed respondents expect the companies they cover will remain acutely focused on cost cutting. Not only is it “what good managers do” they note, but cost cutting is an “everyday way of life” and “necessary to grow EPS in this climate”.

“Continued efficiencies and pressure on labor costs are keeping margins healthy, even without strong revenue growth.” – Core Value, Generalist

What Was Your Opinion of 3Q13 Earnings Results Relative to Consensus?

Better Than | 44% In Line | 33% Worse Than | 23%

What Are Your Expectations for 4Q13 Earnings Results Relative to Consensus?

Better Than | 50% In Line | 36% Worse Than | 14%

“I expect the economy to continue its slow improvement with employment growth but I think that the 2013 market increase has discounted much of the 2014 improvement.” – Core Growth, Generalist “I am not sure if there will be continued margin growth as margins are at extremely high levels but corporate cost cutting is a business constant.” – Core Growth, Generalist

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Management Tone Turns a Shade Brighter Surveyed investors report that executives with whom they interact are far less negative than in the previous quarter. The number of respondents reporting a “more negative” tone plummeted to 6% from 25% last quarter while those who report a “less negative” tone rose to 46% from 31%.

Management Tone -- Prior Quarter

Management Tone -- Current Quarter

Unchanged (Cautious) | 44%

Unchanged (Cautious) | 48%

Less Negative | 31%

Less Negative | 46%

More Negative | 25%

More Negative | 6%

“The message is the same, as always: ‘The environment is difficult but we are bullish.’” – Deep Value, Generalist “Mostly we are hearing cautious optimism and comments about improvement in operating environments.” – GARP, Generalist “Management teams are less negative on the outlook but are being cautious to avoid exciting analysts too much.” – Growth, Generalist

Market Sentiment: Rising Optimism As the fourth quarter wrapped up, the number of investors describing themselves as “cautiously optimistic” seemed to rise in line with the markets, to 75% from last quarter’s 39%. Steady economic growth, “fitter” corporate earnings and balance sheets and a continued rotation out of bonds more than offset the perceived sluggish pace of growth and a belief that a repeat of 2013’s performance is unlikely. Meanwhile, no one describes themselves as outright bearish while the number characterizing their view as neutral to bearish is down by more than 50%.

Investor Sentiment -- Prior Quarter

Bullish | 20% Cautiously Optimistic | 39%

Investor Sentiment -- Current Quarter

Bullish | 10% Cautiously Optimistic | 75%

Neutral | 20% Neutral to Bearish | 17% Bearish | 4%

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Neutral | 8% Neutral to Bearish | 8%

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“Interest rates are extremely low making equities relatively attractive and U.S. cyclical sectors, specifically housing and autos, are improving. That suggests rising markets.” – Core Growth, Generalist “Stocks have outpaced the economy this year and we expect the economy to continue improving. We expect stocks to cool off a bit; perhaps still an up year but more modest.” – Core Value, Telecom/Technology “While valuations are a bit stretched and have been discounting economic improvements, consensus earnings remain too high and will be revised down as the year progresses. As well, after a robust market return in 2013, history suggests we can expect positive returns in 2014 but to a much smaller degree.” – Core Growth, Generalist Are Markets Sustainable at Current Levels?

Continuing, nearly 80% of respondents assert current market valuations are sustainable, though some caution “only if earnings come through” and that they may not be sustainable over the longterm. Interest rates will ultimately rise enough to pressure equities and multiple contraction is “sure to take hold eventually”, they assert.

Yes | 57% Yes with Caveats | 22% Depends | 7% Not Likely | 7% No | 7%

“Valuations are sustainable. The market is reasonably valued on a historical basis plus we have an improving macro outlook, solid balance sheets and investors are under allocated.” – GARP, Generalist “Valuations are in line with historical averages. Multiple expansion is behind us and EPS growth must take the lead.” – GARP, Consumer “It is not sustainable in the long-term. Valuations are way above trend. QE will eventually stop and interest rates will eventually rise. This will deflate asset prices and there will be other sources of yield.” – Growth, Generalist

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Sector Trends and Investment Themes Surveyed investment professionals indicate that cyclicals, dividend-yielding stocks and secular growth are the most attractive investment themes. Further, IT, Industrials and Consumer Discretionary are sectors earning the most bullish sentiment given their perceived growth.

Conversely, participants maintain they are avoiding low quality/high beta, defensive and smallcap stocks, adding that they are bearish on Utilities and Consumer Staples. Despite attractive dividend payouts, slowing growth and sensitivity to rising interest rates, as well as “rogue regulation” faced by utilities weighs on sentiment.

Investment Themes -- Most Attractive 47%

45%

Investment Themes -- Least Attractive 39%

41%

32% 20%

Cyclical

Dividend Yield

Secular Growth

Low Quality/ High Beta

Defensive

Small-cap

Sector Snapshot 4%

2% 18%

20%

30% 22%

65%

IT IT

18%

61%

49%

47%

26% 41%

Consumer Industrials Financials Discretionary Healthcare Industrials Consumer Financials Healthcare Discretionary

41% Energy Energy

29% Materials Materials

18% Consumer Telecom Telecom

64%

34% 20% Consumer Staples

6% Utilities Staples Utilities

“We are moving from a bricks and mortar society to an electronic/connectivity society.” – Deep Value, Real Estate “Rising employment will benefit discretionary stocks. Better global growth will benefit industrial stocks.” – GARP, Generalist “Consumer staples and utilities have been overbought because of dividends only.”

– Core Growth, Generalist

“Slower growing and interest rate sensitive sectors may underperform.” – GARP, Generalist

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When thinking about investment opportunities, surveyed buy-siders confirm that the most important qualitative factors considered relate to management and include: 

Management quality and talent

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Execution track record

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Operational capabilities

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Bench strength

Checking in on Performance Metrics In our quarterly check on performance metrics, the overwhelming majority of contributors, 90% or more for each metric, expect EPS, FCF and Organic growth to improve or stay the same in the fourth quarter.

Organic Growth

EPS Growth

FCF Growth

70%

70%

70%

60%

60%

60%

50%

50%

50%

40%

40%

40%

30%

30%

30%

20%

20%

20%

10%

10%

10%

0%

0% 2Q13

3Q13

4Q13 Improving

0% 2Q13

3Q13

Staying the Same

4Q13

2Q13

3Q13

4Q13

Worsening

Desire for Reinvestment Remains Strong, Fades for Buybacks For the second straight quarter, surveyed investors rank reinvestment as their preferred use of excess free cash, significantly ahead of other options.

Dividends continue to be the favored method of returning cash to shareholders, well ahead of buybacks whose popularity waned during 2013 as valuations soared. Companies continue to raise their dividend payouts and according to S&P Dow Jones Indices, dividend net increases, which measures increases less decreases, rose $12.7 billion during the fourth quarter for U.S. domestic common stock versus an $11.9 billion gain in 3Q13 and an $8.4 billion increase in the fourth quarter of 2012.

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Preferred Uses of Cash Prior Quarter 5% 32%

17%

34%

38% 63%

29%

9%

29%

37%

58%

48%

39%

M&A

32%

24% 43%

60% 33%

22%

Share Debt Repurchase Reduction 1st Choice

19%

31%

20%

45%

Reinvestment Dividend Growth

Current Quarter

Reinvestment Dividend Growth 2nd Choice

33% M&A

35% 45% 20%

56% 22% 22%

Share Debt Repurchase Reduction

Low Priority

Europe Downside Subsiding While Confidence in LatAm Growth Wanes Investors continue to turn a cautious eye to international and economic news, though no single global or macro issue dominated headlines or gave U.S. equity investors pause, as the sovereign debt crisis has in the past.

In part because “expectations are low everywhere”, participants in large measure describe themselves as only “mildly concerned” when discussing Europe. In the 28-nation European Union, for example, the November jobless rate was unchanged at 10.9%, while third-quarter growth was just 0.2% compared with 0.3% in the second quarter. Yet, this marked the first time in two years the EU posted sequential growth.

Participant concerns are highest around emerging market economies. In Latin America, a perceived “leftward drift” in policy is causing apprehension especially with respect to most countries on the Atlantic side. While Mexico is a bright spot in investors’ eyes based on expected benefits from President Pena Nieto’s policies as well as spillover effect from a strengthening U.S., several executives we polled are still skeptical.

Meanwhile, investors remain uncertain about China’s ability to manage growth.

“Our concerns center on dysfunction in emerging market economies.” – GARP, Generalist

“We are concerned about government actions that would tend to curtail growth.”

– GARP, Energy

“China has to calm down and we expect too much. Europe is still dire and politicos will still fudge through without addressing real issues.” – Growth Generalist “It is not obvious to us how well China will be able to manage its transition.”

– GARP, Generalist

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Top Investor Concerns Prior Quarter

Current Quarter

Geopolitical Events Changes in Fed Policy and Reaction China/Emerging Market Slowdown Health of U.S. Consumer Global GDP Growth

Health of LatAm Economies Lack of China Recovery European Stagnation (e.g., deflation risks) U.S. Gov’t (e.g., leadership, regulation, policy) Rising Interest Rates/Inflation

IR Best Practice: Corporate Governance With proxy season commencing, we polled investors on their views about corporate governance. Participants universally report that they pay attention to corporate governance issues with nearly 40% indicating it has come into closer focus amid a rise in shareholder activism. While some comment that the topic is often “media driven” one notes, “Our attention on issues of corporate governance is increasing as a means of differentiation between companies.”

Given the Rise in Shareholder Activism, are You Paying More Attention to Corp. Gov.?

No; Always Paid Attention | 61% Yes | 39%

Which Corp. Gov. Issues are Hot Buttons for You? 74% 50%

Executive Compensation

Political Spending/ Lobbying

49%

Board Declassification

43%

Environmental

36%

Separation of CEO and Chairman Role

The following are selected corporate governance best practices: 

Conduct a company assessment to identify areas of vulnerability to corporate governance issues (e.g., company performance, board structure, management compensation, shareholder value delivery)

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Take a triangulated approach encompassing internal beliefs, peer comparisons and investor sentiment

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Know your shareholder base: –

Who has voting authority (in some cases, it is the beneficial owner versus the firm filing the 13F)

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How do they vote (e.g., in-house department, ISS, Glass Lewis or combination)

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How involved is the portfolio manager/security analyst in the voting process

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Which firms have activist tendencies

PROVEN METHODOLOGY, PROVEN RESULTS Corbin Perception is an investor research and IR advisory firm assisting public companies with driving long-term shareholder value. Our value-added services include: 

Perception Studies

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Investor Targeting

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Investor Days

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Investor Presentations

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IR Diagnostic Reviews

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We leverage our broad company and industry experience, ongoing research on the buy side and knowledge of investor engagement best practices to achieve results.

We are passionate about what we do and develop relationships that are collaborative and long lasting.

Our client proposition is based on: 1) insightful, research-driven counsel; 2) a talented and experienced team; 3) an in-depth understanding of best practices and the ability to apply that knowledge to unlock value; and 4) an unparalleled commitment to client service and satisfaction.

Visit our website or contact us to learn more: www.corbinperception.com info@corbinperception.com (860) 321-7309

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