Inside The Buy-side® 1Q12

®

INSIDE THE BUY-SIDE®

YTD Performance Snapshot

FIRST QUARTER| ISSUE DATE: JANUARY 23, 2012

Dow: +5.5% NASDAQ: -1.8% S&P 500: Flat

The

US stock market closed the year essentially flat despite extreme volatility driven broadly by a myriad of events and factors: the European debt crisis, political stagnation, government debt, global catastrophes, geopolitical uprisings, commodity inflation, high unemployment and a weak consumer. Despite that, investors remain encouraged by strong corporate balance sheets and attractive valuations.

By Sector 10%

10%

5% 5% 5% 5% 5% 3%

45%

As the Year of the Dragon commences, a year which symbolizes change, investors report they plan on employing an even keener focus on global conditions and the political landscape while looking for companies able to grow in a slow-growth environment.

In our ongoing effort to stay at the forefront of investor sentiment, we recently conducted interviews with 40 global financial professionals across multiple industry segments and investment styles.

Participating institutions aggregately manage upwards of $1.1 trillion in equity assets.

By Investment Style

15%

15% 7%

17% 5% each 3% each

25%

Key Trends 

Investor outlook on the US’ prospects has been slightly bolstered following surprisingly strong third quarter results but the deepening European crisis and volatile capital markets continue to temper enthusiasm –

GARP Core Growth Core Value Growth Deep Value Hedge Fund Aggr. Gr. Fixed Income Value Income Value

By Region 2% 40% 50%

Buy-side sentiment can best be described as cautiously optimistic as investors weigh the risk of volatile markets against the potential reward of current low valuations

www.corbinperception.com

7%

Generalists Multi Healthcare Financials Emer. Mkts.

Basic Materials Consumer Industrials Technology Energy

US Canada Europe Asia

8%

1

®



Channel checks indicate that managements’ tone is more cautious heading into this earnings season as compared to last quarter; investors encourage management to remain focused on effective execution, as well as prudent capital allocation



The “dysfunctional” political landscape is indeed impacting investment decisions and continues to serve as an area of concern, especially for health care-focused analysts



In the current uncertain environment investors are gravitating towards strong, well-managed companies; capital allocation track record is of growing importance



In light of stagnating growth, investor focus has shifted from top-line acceleration to margin improvement; to be clear, sales generation remains a differentiator in today’s competitive environment



Investor focus on emerging markets exposure gains momentum again, with China, India and Brazil topping the list; investor feedback also indicates that Indonesia is attracting a higher level of interest, particularly as these markets are now slowing somewhat



According to the 72% of contributors who describe their investment horizon as long-term, or three to five years, market volatility has made “life more difficult” but has not impacted investment decisions –



The remainder has adapted to the current environment by implementing active risk management strategies, maintaining a certain level of cash and/or trading more frequently

Buybacks are now seen as the best use of cash, surging past dividends and acquisitions this quarter

Third Quarter Results Come In Mostly As Expected While the geopolitical landscape is fraught with strife, corporate performances have generally been seen as “exceptionally strong”. Consistent with last quarter’s research, most surveyed investors, or 62%, were generally encouraged by third quarter results, which were “on average, better than expected” amid “fundamentals that continue to be very robust” and profits that are “remarkably solid”.

Investor Sentiment Bullish 36%

Cautiously Optimistic 36%

Bearish 28%

In terms of surprises, select industrial-focused analysts were positively surprised by earnings results asserting that “margins are holding up reasonably well” though they note that order trends are “uninspiring”. Meanwhile, analysts covering financials were pleasantly surprised by strong loan growth despite a stagnating economy.

www.corbinperception.com

2

®

“One surprise is that some companies seemed to be more comfortable regarding bottoming. They felt that end-demand is stabilizing, this is more of an inventory correction and we should be back to growth in late December or early Q1.”

– GARP, Technology

“We knew Europe was slowing and we saw some of that. The biggest surprise to me was how inconsistent the message was. We look at oil and ore companies. Some people saw weaknesses in certain areas and some saw weaknesses in others. It was not clear that it was inventory. It was not a consistent message of ‘Yes, we are falling off of a cliff’ or ‘Yes, things are getting better with a mix.’” – GARP, Basic Materials

“Credit is the only thing that even comes close to a surprise. It continues to get better a lot faster than people were expecting and reserve draws are bigger. Much beyond that, it is still a tough environment for these companies.” – Core Value, Financials II

“Overall, energy is very strong, the industrial distributors are very strong and the airlines are doing very well.” – Deep Value, Industrials/Energy

A Slightly More Cautious Tone From Executives…

As reported in last quarter’s Inside The Buy-side®, executive outlooks were not as doom and gloom as the media portrayed and generally characterized by surveyed investors as cautiously optimistic.

This time around, investor takeaways from meetings with management are mixed.

Specifically, they assert the tone of discussions with executives ranges from cautious given concerns around Europe to cautiously optimistic amid uncertainty in Washington to outright positive.

Executive Tone Cautiously Optimistic 31% Cautious 38%

Positive/ Confident 31%

“In general, people are cautious. The general opinion is that Europe is going to be bad and the US will probably do okay. No one wants to be caught long inventory so everyone is taking a cautious tone.” – GARP, Basic Materials “Guarded is the word. Most companies are carrying more cash on their balance sheets than they would like to. With all of the uncertainties with respect to tax rates, health care costs plus the increased level of government involvement with new rules and regulations, companies are becoming very guarded in their spending plans.

When they do spend money and if they have an international presence, more of the spending is being directed overseas where some of those factors are not as uncertain as they are in this country.” – GARP, Generalist

www.corbinperception.com

3

®

“Management sentiment has generally been very positive. This is overstating it a bit but the general message is, ‘We do not know what is wrong with you people on Wall Street but things on our side of the business are fine. You are focused too much on Europe, we are not seeing any material slowdown, order books look fine, it is not great but things are good.’ It is realistic that their perception of our perception is correct, that the market is overly focused on the global macro, almost to the exclusion of all else at times.” – Core Growth, Generalist “Their tone is cautiously optimistic. Things are pretty good but they are worried about the political environment. They lack the ability to plan out the future because they are uncertain about what policies are being put in place in Washington.” – Deep Value, Industrials/Energy

“Going forward, companies are forecasting more cautious guidance and below what the Street expects. Management is definitely guiding expectations downwards for 2012.” – Growth, Consumer Discretionary

…Has Investors Trying To Read The Tea Leaves As 2012 gets underway, surveyed buy-siders report they will be even more focused on global macroeconomic conditions and the implications on end market demand and thus company performances going forward.

Specifically, 39% point to margin improvement as an area of interest while topline acceleration remains in the spotlight. To be clear, contributors will be focused on management’s agility and their ability “to grow in a slow-growth environment” and deliver on guidance.

Key Areas of Focus Global Macro

44%

Margins

39%

Top-line Growth

33%

Management Agility

28%

Guidance

28%

Bottom-line Growth

17%

Meanwhile, bottom-line improvements have moved down the scale of importance as surveyed investors indicate most companies have rationalized their cost structures to take into account the new norm.

“The economy is showing some signs of strengthening, although it is not that significant or across the board. Nevertheless, conditions on average are better than they were a year ago and will probably be slightly better than the third quarter.”

– GARP, Generalist

“The challenge for a lot of companies will be the ability to grow when the economy is only growing at 1% or 2%. Margins have been pretty robust over the cycle and some people fear that those margins could revert to more of a mean level so there might be a little bit of risk there.” – Deep Value, Industrials/Energy www.corbinperception.com

4

®

“I will be focused on trends. I cannot do much about the macro nor can I predict it, so I will be focused on who is preparing for different outcomes and who is managing their business given what we know. Obviously, everyone will be tracking trends, how this shakes out and whether we are left to deal with a mess. The two main things are how businesses are managed given the environment and what the environment is based on what people are saying.” – GARP, Basic Materials

Positive Signs In US Fuel Optimism Only To Be Tamped Down By Europe’s Plague Not surprisingly, Europe and the “spillover effect” on the US economy is front of mind with 68% of surveyed buy-side professionals citing this as their leading concern. Continuing, the macro effects on the consumer, both here and in Europe, continue to weigh on investor sentiment while US government “dysfunction” and the upcoming election round out the list of concerns.

On that note, 78% of contributors describe their sentiment towards the US political landscape as negative with 73% confirming that it impacts their investment decisions to some extent. As a financials-dedicated analyst asserts, “We are being very cautious regarding anything that has to do with Washington these days”.

2011 Investor Concerns 1Q11

2Q11

Cost Pressures Global Government Debt Levels Slowing Growth Weak Consumer Global Turmoil

Global Economic Slowdown Government Policy Cost Pressures Weak Consumer Weaker Than Expected Results Oil Prices

3Q11

Current

Global Economic Slowdown, Demand Decelerating Revenue Growth US Government Policy Commodity Inflation Market Volatility

European Crisis Spill-over Effect on US Macro Impact on Consumer US Government Policy, Elections Health Care Costs

As earnings season gets underway, investors remain uncertain about 4Q and full year results and exhibit a more tempered level of enthusiasm compared to last quarter. While optimism about prospects in the US has improved, Europe remains a wild card and fears of a deep recession are prevalent. Indeed, investors are eager to hear management provide 2012 outlooks and “whether they are seeing any impact from recent global macroeconomic concerns.”

“In terms of markets, the US offers an attractive mix of quality management, high free cash flow generation and defensive growth.” – GARP, Generalist www.corbinperception.com

5

®

“A recession would be my biggest concern from an economic perspective. Stocks in Europe are heavily discounted because a recession is pretty much imminent, if it has not started already. The US has been a bit of an island recently with fairly strong economic data despite weakening emerging markets and a weakening Europe. The question is can the US diverge from what the world is stating or will it just be correlated with it? That is an unknown question at this point. It concerns me when growth slows, the economy slows, unemployment worsens and those metrics start going down.” – Deep Value, Industrials/Energy “Has anybody answered this and not said Europe straightaway? That is number one followed by the need to recapitalize the banks. They are slowly becoming more focused but we are never quite sure what will happen there. Most of the concern in France is that downgrading would basically close the auction for the ESFS to be securitized, which looks highly likely.” – Growth, Consumer Discretionary

In Slow-growth Environment, Focus On Emerging Markets Reemerges Amid slow to stagnating growth in most developed markets, investors are seeking investment in companies with significant exposure to emerging markets. China remains “the biggest bull of all” with 52% of investors citing it as the most promising of the BRICs. Indeed, economic slowdown and policy tightening in the past year have helped to ease inflationary pressures while property prices have finally started to correct.

China’s underdeveloped consumer cannot be ignored, contributors maintain.

Most Promising Emerging Markets China

52%

India

48%

Brazil

38%

Indonesia Africa Russia

24% 14% 10%

Continuing, investor sentiment on India has staged a resurgence with 48% of study contributors reporting “high hopes” for growth coming out of this country.

Despite a high interest rate environment, 38% of buy-siders are “particularly optimistic” on Brazil and indicate it remains a core investment focus. Other LatAm countries of minor interest include Mexico, which some maintain “is better than the macro picture suggests”, Chile and Argentina.

Interestingly, and for the first time since Corbin Perception has been tracking investor opinion on emerging markets,1 Indonesia has emerged as a nation that should boast significant long-term growth potential, according to 24% of participants.

Meanwhile, sentiment is mixed on Russia with 14% of participants indicating they are “staying clear” given it is an autocracy where “no real rule of law exists”.

1

Research has been ongoing since 2007

www.corbinperception.com

6

®

“Europe’s debt problems will continue to hang over developed world markets but fiscal spending and favorable monetary conditions should support the investment climate in emerging Southeast Asia.” – GARP, Generalist “Long-term everyone is bullish on China but clearly there are short-term issues.

China is having issues but are you going to bet against it long-term? I do not know.

Does anyone really know enough to make a negative call on China?” – Core Value, Industrials

“China is a big wildcard. It is growing but I am nervous about the property market there. That could potentially be a very big problem in the future. They are going through a property bubble and that has driven a lot of commodity pricing because a lot of cement and aggregates go into building those buildings. In an absolute down, you will see commodity prices fall and that, I would argue, is one of the biggest risks out there. China could be very good but it runs the risk of government-led initiatives that can distort free market capitalism. Unlike China, Brazil is a democracy and has better political controls. Brazil has slowed but it is definitely one of my favorite investment focuses. As interest rates go down that should propel credit. People are not highly levered there so, overall, you have an under levered consumer that has a lot of power to spend as we go forward.” – Deep Value, Industrials/Energy

Capturing Investor Mindshare: Does Your Company Exhibit These Traits?

With contributors describing the current investment environment as a stock picker’s market, differentiating your company remains critical to capturing and maintaining investor mindshare.

Indeed, solid execution during these turbulent times remains a sought-after attribute by 43% of investors.

Continuing, 36% reiterate that effective communication is key. Specifically, they highlight the ability to access and speak with management as well as the importance of communicating the long-term strategy and pathway to achieving stated goals. As always, honesty and candor are highly appreciated and respected management traits.

Meanwhile, astute capital allocation is perceived as an investment differentiator by 21% of the study group who note that in order to build credibility, it is important to signal deployment plans and then execute on communicated targets.

To a lesser extent, investors note another factor is “being open minded about growing in emerging markets”.

“Companies can differentiate themselves in my eyes by having good people that know how to run a business and by communicating and delivering on what they say they are going to do.” – Deep Value, Industrials/Energy

www.corbinperception.com

7

®

“It is important to have good communication with their shareholders and a clear vision of what they are trying to achieve, especially if they are involved in the international market to any degree. You need to be clear, honest and have an effective means of communicating with the Street.” – GARP, Generalist “Companies are best able to differentiate themselves by allocating capital efficiently to higher-returning investments than their competitors; that is the bottom line. If you can show us that you are able to do that in a way that is consistent with our process than we love owning you. If you cannot, we will take a pass.” – Core Growth, Generalist

Management Remains The Key Ingredient To Investment Stories Management quality remains the leading “intangible” factor in investment decisions, according to 88% of surveyed financial professionals. Along these lines, strategic vision, consistent execution and effective communication are key factors in differentiating a company from other investments. Specifically, contributors highlight best-in-class management teams as those who: 

“Look to make longer-term decisions that put them in good standing over the next several years in multiple different kinds of environments”



“Have plans in terms of growth opportunities to offset some of the negative impacts”



Maintain continuity and are thus “clear about succession”



Are honest, “admit when errors are made” and take responsibility, then develop a plan to “correct errors”; credibility is key



Are “good stewards of capital” and “focused on delivering shareholder value” “In general, giving credible guidance, not shooting for the stars and hitting that guidance are important. Execute and do what you say you are going to do. I would rather see a company execute a good program or business vision than really shoot for something spectacular and disappoint. Managing Street expectations is very important. Do not spend money just to spend money. Grow the top-line. If acquisitions are done, which they always are, do them responsibly. Do not overspend on acquisitions and waste capital.” – Core Growth, Health Care/Consumer Staples

“The credibility and competence of management and the competence of IR are important. I put a lot of faith in meeting management teams, seeing if their story makes sense, seeing if I agree with and believe in them.” – Deep Value, Industrials/Energy

“Management teams, in general, are important. communication.” – GARP, Technology

www.corbinperception.com

Specifically, strategy and

8

®

Continuing, 41% of investors reveal they are seeking to invest in high quality companies, which they view as those that boast: 

Strong balance sheets, robust cash flow generation and proven capital allocation strategies



“Low debt levels, have high and sustainable profit margins, are well suited to fend off competition and pay dividends”



Competitive differentiators, including high barriers to entry



Attractive end markets “We are focusing on quality companies with experienced management and proven business models. In the tough conditions we foresee, the strong are likely to get stronger.” – Core Growth, Generalist “When I say the quality of the business, I am referring to whether it is a good business, whether there is a moat around this business, whether there are barriers to entry and what the competitive dynamics are.” – GARP, Basic Materials

According to interviewed investors, management teams should be focused on the following to drive shareholder value: 

Prudent capital allocation and acute focus on returns



Long-term strategy communication and executing “what you say you are going to do”



Providing credible and conservative guidance



Margin preservation

Meanwhile, as reported in last quarter’s Inside The Buy-side®, operational agility remains a competitive advantage and a “component in determining how well a company is managed”.

With that said, 91% of contributors indicate that “almost every company out there will tell you it is doing lean” but very few are able to “portray the discipline and clearly demonstrate tangible results”. Companies cited for this characteristic include:        

3M (MMM) Coach (COH) Donaldson (DCI) Graco (GGG) Medtronic (MDT) Royal Dutch Shell (RDS.A/B) Snap-on (SNA) Stanley Black & Decker (SWK)

www.corbinperception.com

9

®

Margins! Margins! We Want Margins!

Research on quantitative factors reveals that the majority of surveyed investment professionals, or 78%, view margins as the most important metric on which they are focused, followed by revenue, earnings and free cash flow, respectively. Returns, including ROA, ROE and ROIC are growing in importance according to this quarter’s findings.

Key Performance Metrics of Interest 78% 50% 48% 43%

3Q11 4Q11 1Q12

57% 44% 39%

44%

44% 35%

26% 10%13%

10%

0% Margins

28%

Top-line Growth

Earnings Momentum

Balance Sheet

0% 0%

FCF Generation

Return Metrics

“In general, corporate America is developing fortressed balance sheets, which is important with uncertainties becoming as large and unpredictable as they are. On the other hand, it is important to use that strength from time to time in a prudent way.” – Growth, Generalist “Operating margin improvement is the most important to us. We do not only focus on operating margin expansion; clearly, we want to see that turn into cash flow generation. Where CapEx is significantly ahead of depreciation and amortization and you do not see adequate returns coming from that investment, we are not going to own that stock.” – Core Growth, Generalist “Sales growth is very important. More emphasis is going to the top-line, the ability to grow volumes and the ability to take pricing to drive the top-line.” – Core Growth, Health Care/Consumer Staples

Share Buybacks Pull Into The Lead Corbin Perception’s ongoing poll on investor preferences for uses of excess free cash reveals that share repurchases trumped dividends this quarter for the first time since 4Q10.

Of note, S&P 500 constituents paid $240.6 billion in dividends in 2011, up from $205 billion in 2010. The 2011 payout was the www.corbinperception.com

FCF Preferences - Quarterly Update Buybacks

52%

Dividends

38%

Acquisitions

38%

Reinvestment

28%

10

®

largest since 2008 when firms had not yet been impacted to the full extent by the financial crisis and paid a record $247.8 billion in dividends. Dividends are on track to set a record of more than $252 billion in 2012, according to data released by S&P, which is based on the current dividend rates of 394 companies.2 Contrary to 2010 findings when investors preferred companies allocate capital towards acquisitions, 2011 research3 reveals a penchant for returning cash to shareholders in the form of dividends and buybacks. While interest in acquisitions has fallen from peak levels in 2010 and reverted back to norm levels, investors still value accretive, synergistic deals, especially in fragmented markets.

Offensive FCF Uses − Investor Preferences 69% 66% 58%

66% 47% Buybacks

36%

41% 42% 32% 32%

20%

Dividends

30%

37%

43% 31% 25%

48% 47% 35%33%

Acquisitions Reinvestment 2007

2008

2009

2010

2011

“Given what has happened in the markets the last few years, specifically the relative lack of return and significant increase in cash flows on balance sheets, most companies would be well served by share repurchases.” – Core Growth, Generalist “I favor buybacks and dividends; however, I would favor a multi-pronged approach in a very fragmented industry where you can buy companies very inexpensively, integrate them and create a lot of synergy.” – Deep Value, Industrials/Energy “To the extent that they have opportunities, we want to see them invest their cash.

To the extent that those opportunities are not present, we like to see cash returned to shareholders. We would favor dividends over stock buybacks but either one would be okay.” – GARP, Generalist

2 3

Source: “Dividends Rise in Sign of Recovery.” New York Times January 10, 2012 n = 298

www.corbinperception.com

11

®

Proven Methodology, Proven Results Corbin Perception is an IR research and advisory firm assisting public companies with unlocking their full market potential. We recognize the positive impact best-in-class investor relations has on valuation and partner with our clients to develop strategies that positively influence investor perception.

Our comprehensive approach to research-driven counsel enables our clients to capture investor mindshare and differentiate their company as an investment.

We have deep functional and industry expertise as well as a strong and consistent execution track record of value creation.

Our core Advisory Services include:     

Perception Studies Investor Presentation Development Strategy Communication Analyst Day Strategy and Execution IR Diagnostic Reviews, Strategy Development

www.corbinperception.com

12