Inside The Buy-side® 2Q13

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INSIDE THE BUY-SIDE®

SECOND QUARTER| ISSUE DATE: APRIL 11, 2013

Amid

continued monetary stimulus, the perception of an improving U.S. economy and a modestly positive corporate earnings landscape, as well as rotation out of bonds, the equity markets saw a significant rally during 1Q13 to close at new highs. For the quarter, the Dow gained 11%, the S&P 500 added 10% and the NASDAQ added 8%.

Meanwhile, the Russell 2000 Index, a barometer for small-caps, rose 12%. Markets have further expanded into 2Q13, with both the S&P and Dow reaching all-time highs.

In our ongoing quest to remain at the forefront of current trends in investor sentiment, we recently conducted interviews with 28 global financial professionals across multiple industry segments and investment styles. Participating institutions aggregately manage upwards of $1.1 trillion in equity assets.

By Sector

4, 13%

3, 11% 2, 7% 2, 7% 2, 7%

10, 36%

2, 7% 1, 4% each

By Investment Style 5, 18%

Core Value

6, 21%

Growth 5, 18%

Despite continued geopolitical gridlock and uncertainty, investor tone has steadily improved with the vast majority of surveyed investors describing their sentiment as bullish. Still, they remain leery about whether the recent market surge will receive continued support with nearly 60% asserting, “It is probably not sustainable”.

As first quarter earnings season gets underway, investors report they are expecting an in line quarter.

As one investor comments on management cues, “No one seemed to give blowout guidance with massive upside”.

Consistent with last quarter’s findings, indications are that investors will be focused on earnings growth potential, cash flow generation, capital allocation strategy and, given the significant runup, valuation.

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Generalist Multi Healthcare Energy Materials Retail Technology Financial Industrials REIT

Core Growth Deep Value GARP

7, 25%

4, 14%

Hedge Fund

1, 4%

By Country

10, 36%

U.S. Europe

16, 57%

Canada 2, 7%

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Key Trends 

The majority of investors point to the Federal Reserve as the primary catalyst of the current rally citing extreme liquidity driven by “money printing”

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58% of surveyed investors believe the market rally is not sustainable

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In the case of a potential market correction, the majority assigns a level of 5% to 10%

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Investors forecast that 1Q13 earnings will be in line to slightly ahead of consensus following year-end results that were primarily viewed as “better than expected”

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Management tone is generally characterized as “less negative”, driving consensus estimates higher quarter over quarter –

According to our ongoing research on executive tone, this marks the first time it is perceived as improving since 1Q12 earnings

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Investors largely project that organic growth, free cash flow and EPS will improve, indicating another notable positive change in investor sentiment

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The financial community remains mixed regarding the European financial crisis –

Not surprisingly, Europe is identified as the only global region with flat to negative growth

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Post the Cyprus announcement, over 40% of participants consider the European crisis as “in its early stages”

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Despite the ongoing Eurozone issues, the U.S. government once again ranks as the top concern for investors, with focus shifting from the fiscal cliff to the budget deficit and longer-term policy

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Continuing the positive progression from prior quarters, the vast majority characterizes their outlook as bullish; only 4% maintain a bearish stance

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In our ongoing research on investor preferences for uses of excess free cash, a penchant for dividends remains the top priority

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Finally, contributing investors note that controllable, company-specific factors which can positively influence their investment decisions include: execution track record, transparency and disclosure, as well as access to management through non-deal roadshows

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Let The Good Times Roll; Markets Rally The market rally continued through 1Q13 as geopolitical issues and headwinds were dwarfed by Fed actions, favorable U.S. economic data and bond market rotation. Within the S&P 500, the healthcare sector was the largest gainer, returning over 15%, followed by utilities and consumer discretionary, which both realized 12% gains.

1Q13 Market Performance 112 108 104 100 96 3/28/2013

3/25/2013

3/20/2013

3/15/2013

3/12/2013

3/7/2013

3/4/2013

2/27/2013

DOJ 14,578.5

2/22/2013

2/19/2013

2/13/2013

2/8/2013

2/5/2013

1/31/2013

1/28/2013

1/23/2013

1/17/2013

1/14/2013

1/9/2013

1/4/2013

12/31/2012

NAS 3,267.5

S&P 1569.2

When polled about the principal drivers of the current market rally, 58% of investors point to the Federal Reserve, citing the impact of added liquidity driven by “minting money”.

Furthermore, U.S. economic fundamentals, bolstered by better than expected key indicators, such as housing starts, manufacturing data and consumer confidence continue to improve, with 77% reporting this should work to offset government policy challenges. As one investor1 states, “The government policy headwinds have been so bad that the only direction for them to go is up”.

Along these lines, a solid corporate landscape and continuing albeit slower emerging market growth are also serving to bolster opinion.

Indeed, investors seeking higher returns have rotated out of fixed income products en masse to flood the equity markets.

Nonetheless, 58% of investors question the “long-term sustainability” of the market while a smaller group, who are expecting a market correction, predict a pullback in the range of 5% to 10%. Potential pressures include lofty valuation, rising interest rates, deceleration in corporate profitability and geopolitical risk. Regarding the potential for an interest rate hike, 43% suggest it will not occur “anytime soon”.

1

Growth, Generalist

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Rally Drivers

58%

Sustainability

32% 21%

The Fed

Improving Fundamentals

Housing Recovery

16%

Risk/ Reward

11%

No 58%

Yes 42%

Irrational Exuberance

“The Fed is driving the rally. The amount of money they are putting into the market at 0% interest simply drives the price up of all other financial assets. Driving up the price drives the returns down so that in effect it competes with zero cost money. It is not sustainable.” – GARP, Healthcare/Industrials/Telecom “There is a lot of bullishness; 80% of people are bullish. That feeds on itself. You have this mania to a certain extent. What is fundamentally feeding it is global liquidity and the central banks printing money. In the U.S., the housing market is definitely strong and recovering, that helps other sectors. The energy renaissance in the U.S. is also a positive. The petrochemical market is very strong. Housing is sustainable for the time being and energy is sustainable. The liquidity and the printing of money is not sustainable. At some point, they will withdraw that. The market will not continue to go higher on a straight line the whole year. It will have a pullback.” – Deep Value, Industrials “It is largely Fed driven and is sustainable. The Fed has poured enough fuel on the fire to get the market going and now it is starting to have some positive impact on housing and it has some positive benefit for the traditional trickle down.”

– Core Growth, Generalist I

4Q12 Earnings Topped Expectations -- 1Q13 Results Should Be “In Line” After soft results posted in 3Q12, conservative guidance provided by management drove yearend 2012 results above expectations. In total, 47% of investors assert that 4Q12 earnings results were “better than expected” citing margin expansion and revenue performance.

“We follow companies largely in the consumer space and they were in line on the top-line but positively surprised on the bottom-line with operating leverage.”

– Core Value, Consumer

“Everyone’s expectations were so bad for 4Q going in that by the time earnings were reported, it was not the end of the world.” – Core Growth, Generalist I “A positive trend is that the margins have remained elevated.” – Growth, Healthcare www.corbinperception.com

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Looking ahead to 1Q13 expectations, the same number, or 48%, anticipate an in line quarter noting that while management tone has become “less negative”, executives still remain cautious.

Only 26%, comprising mainly financials, healthcare and consumer analysts, predict a “modest beat”.

The balance, made up of mainly energy investors, remains cautious.

1Q13 Expectations Muted 26%

In Line 48% Above 26%

In general, investors report an acute focus on: 

Continued margin expansion

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Top-line growth

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North America growth rate

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Expense control

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Tax policy

Our research also uncovered that a greater portion of participants are currently looking for dividend yield and continue to place a significant amount of importance on effective capital allocation strategies.

“We will be focused on whether we continue to see margin expansion increasing. As a whole, we expect our companies to keep growing but we believe consensus has moved closer to reality now, so we would expect less beats but not necessarily disappointments.” – Core Value, Consumer “My expectations are modest based on several headwinds, certainly Europe in general and the uncertainty over U.S. public policy and the consequences of tax increases. I am modest based on what companies are saying because they are in the best position to know what lies ahead at least in a short-term sense. Several of them are commenting on issues in their business.” – Deep Value, Generalist I “I expect more of the same. For the rest of the year I am more constructive but I do not have high expectations for 1Q. You have the payroll tax that blew everyone up.

I expect a lot of companies to disappoint because I am not sure people have fully reflected that in their estimates yet.” – Core Growth, Generalist I

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The Iceberg Begins To Thaw…Management Tone Is Seen As “Less Negative” While management tone remains cautiously optimistic, the majority of investors perceive the message as being less negative than in previous quarters. This is a marked change from 4Q12 where 73% of investors reported hearing a “more negative” communiqué. Notably, 1Q13 serves as the first time since 1Q12 in which surveyed investors view management sentiment as improving.

Of the 28% who perceive a “more negative” executive tone, the majority is located outside the U.S. and cites an asset price bubble in Asia, energy slowdown in Canada and government policy in Europe.

Investors report that management discussions have centered on: 

Sales and other metrics

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Consumer spending

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U.S. and European government policy

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End market exposure and positioning Previous Quarter

Current Quarter Unchanged 33%

More Negative 73%

Unchanged 18% More Uncertain 9%

More Negative 28%

Depends 6% Less Negative 33%

“Companies are still positive. Forward guidance has become more conservative. It is not necessarily slower growth but they are very certain in announcing what they know is going to happen rather than what they think.” – Core Value, Consumer “It depends on what region you are looking at. There is a degree of caution in parts of the world. Asset prices have had very strong growth in some of the Asian markets, which left managements slightly cautious in terms of bubble risk.”

– Core Growth, REIT

“They were slightly more positive this quarter than in the fourth quarter. A lot of them said that in the end markets they serve, the customers they are talking to are placing more orders and talking about things getting better in their markets. It seems as though the second and third quarters of last year had a tremendous www.corbinperception.com

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slowdown in all of the end markets but then things started to get a little better. That is what these management teams have communicated. They are still not great but relative to the second and third quarters they got better.”

– GARP, Healthcare/Industrials/Telecom

Call On Performance Metrics: Continued Improvement In our quarterly channel check on performance metrics, investor expectations continue to trend favorably, with a notable decline in the number of investors predicting performance will worsen.

Organic Growth

EPS Growth

FCF Growth

60%

50%

50%

50%

40%

40%

30%

30%

20%

20%

10%

10%

40% 30% 20% 10% 0%

0% 3Q12

4Q12

1Q13

0% 3Q12

Improving

4Q12 Staying the Same

1Q13

3Q12

4Q12

1Q13

Worsening

Furthermore, in examining growth expectations, investors expect elevated expansion in North America, as well as, perhaps surprisingly, Asia and Latin America, while 50% forecast continued declines in Europe.

Paradise Lost; Cyprus Catapults Europe Back Into The Headlines The Eurozone was once again thrust into the headlines with the March 16 news of major Cyprus banks closing and the government considering a levy system on Cypriot deposits. While the market initially pulled back on the announcement, as more information was disseminated the rally resumed. In total, the S&P closed the quarter 1.5% higher off the Cyprus trough.

While renewed fears have done little to thwart investor exuberance, they have altered investors’ thoughts on the European recovery. Interviews conducted spanned the announcement of the Cyprus event, with roughly 45% conducted after the announcement. As expected, responses varied widely depending on interview timing. Post the Cyprus announcement, 42% of investors consider the European crisis to be in the “early stages” compared to only 6% prior to the announcement.

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Still, when asked about the incident specifically, surveyed investors asserted they were not overly concerned. Summing up general sentiment, one investor2 asserts, “The concept is more dangerous than the event itself”.

The greatest impact of the announcement was the uncertainty it created regarding the timing of when the Eurozone will revert to its historic growth rates. The level of respondents indicating they were “unsure” of the timing increased to 50%, up from 22% for those interviewed prior.

Timing Of Eurozone Recovery 50% 33% 22%

20%

22%

22% 10%

10% 0%

Unsure

3-5 Years

10+ Years Prior to Cyprus

1-2 Years

10% 0%

5-10 Years

0%

Never

Post Cyprus

“Europe will never revert to its historical growth rates. Maybe when the baby boomers start dying. I am quite serious about that because there are some very large demographic overhang dependencies.

Ipso facto, if your workforce participation is going down, that will help unemployment over the long-term. You have a massive workforce surplus at the moment whilst the rich, more skilled ones are retiring. It is not a great outlook with regard to wage inflation and consumption in those markets.” – Core Value, Consumer “I am not sure what the endgame is for Europe. They have already bent some of the rules with the Eurozone with repurchasing debt from distressed sovereigns. It will be difficult to see austerity playing out into a positive long-term economic outcome.

I see it as a risky experiment that could lead to a vicious cycle downward or a continuous negative feedback loop in the economy.” – Growth, Industrials/Energy “It took them a long time to create this mess so it will probably take them a while to get out. There are more structural problems than cyclical ones. The grand experiment with the welfare state is hitting the wall and they have to figure out how to make themselves more competitive by becoming less of a public sector and more of a private sector. Obviously, transitioning countries or regions that way can be fraught with a bunch of hurdles on the tracks.” – Deep Value, Generalist I

2

Growth, Industrials/Energy

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Despite U.S. Economic Expansion, Government Remains Top Concern Even with the sequestration deadline in the rearview mirror, investors continue to identify Washington policy as their top concern. Doubt has now shifted to the broader political agenda and the long-term implications of quantitative easing, with a general view being a “concern about money printing because that never ends well”. Continuing, investors point to an inflated deficit and the handling of the budget as additional concerns.

Top Investor Concerns

2Q12

3Q12

European Crisis U.S. Political Paralysis Pause In U.S. Momentum Margin Pressures China Slowdown

China Slowdown European Crisis Fiscal Cliff U.S. Equity Valuations Violent Unrest

4Q12

Current

Fiscal Cliff (Partially Resolved) Washington Policy, Brinkmanship European Crisis Challenging Macro/Muted Growth Global Political Unrest

Washington Policy; QE European Crisis U.S. Equity Valuations Revenue Growth, Margin Expansion Global Political Unrest

Valuations, driven by an “overheated” market, trouble 30% of the surveyed investors, while declining revenues and shrinking margins are the primary fears of 25% of participants who cite corporate performance as a concern.

While geopolitical risk remains a concern, investors indicate that emerging markets have hit a “stability point”. In total, over 70% of interviewed investors indicate that a slowdown in the emerging markets, including China, would have no impact on their investment posture.

“My big concern is the political situation in Italy and if political deadlock were to happen in Spain. We are running off the imbalance for the oil and gas supply demand curve. This is from the effect of fracking. A large geopolitical move in the Middle East could cause oil to come back up to or surpass $100, which would be a damper on growth, especially in the U.S.” – Core Value, Consumer “My top concern is the high level of government involvement in the economy in terms of QE, government policy and policy announcements every time the equity market weakens. That does not make it feel like a very rational market to invest in.”

– Core Growth, REIT

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“There is a range of debate around the margin structure of companies being at or near post-WWII peaks. The margin or profit structure certainly cannot take a whole lot of disappointment in terms of the big macro factors. The global economy has to at least muddle along; it cannot go into a recession. The combination of those two things is certainly important for overall market drivers.” – Deep Value, Generalist I “My top concern is that the government does not stay out of the way from here forward and that Europe takes another leg down which then ripples through China.”

– Core Growth, Generalist I

Bulls on Parade Not surprisingly, investor sentiment continues to improve. The number of investors who identified their sentiment as bullish increased to 40%, up from 13% in the prior quarter.

However, there were no clear sector trends with the majority of bullish responses coming from generalists. Notably, only 4% of respondents characterize themselves as bearish, down from 20% in the prior quarter.

Trend In Investor Sentiment: Bullish Previous Quarter Bearish 20% Cautiously Optimistic 60%

Bullish 13% Neutral 7%

Current Quarter Bearish 4%

Bullish 42%

Cautiously Optimistic 25% Neutral 29%

“We see resurging growth in North America. We are happy with the quality of the growth in Asia. The equity risk premium in Europe is actually too much. The equity risk premium is probably about 7% to 8% and historically was about 3.5%. Part of this is from the government bonds being so low. As the equity risk premium moves down, stocks will become less correlated and the duration of growth will become increasingly valued. People like income at the moment and this is why people in bonds are safe. They have definite income. This is why dividend stocks, consumer staples and healthcare have been the best performers, especially over the last couple of quarters, because you know income is coming. People are not really buying growth beyond the year. As that comes, there will be a rebound in the growth sector.

The next step will be long-term growth, which is one of the reasons we are bullish.

Also, equities have lower valuations, especially given the core profit and earnings growth. There needs to be rotation out of assets that are not generating any real return. Government and even corporate bonds look very expensive now. You can

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buy a growing company’s shares and get a high dividend versus buying a bond.”

– Core Value, Consumer

“I have some grounds for optimism but I am slightly wary of it. Everyone is piling into the market because they have to at this point. It does not feel like there is that much conviction.” – Core Growth, REIT “The valuations are not that cheap, margins are high and the economic outlook is better than it was before. It is hard to be very bearish or very bullish.”

– Deep Value, Healthcare

Sector Snapshot Bearish

Capital Goods

Bullish

Telecom Utilities

Technology Energy Materials

Healthcare Financials Industrials Consumer Disc.

“We are most definitely bullish on luxury retail. We see very strong earnings quality. Going forward we expect top-line growth for this year of about 10% or 11% and an operating ratio of almost 2x. We expect bottom-line growth somewhere between 18% to 20%. We are still below pre-crisis levels of valuation.”

– Core Value, Consumer

“I am bullish on healthcare and I am mixed on financials. I find many attractive names that have been sold off for cheap as a result of the crisis unfolding. There are also names that I am strongly negative on so my sentiment is mixed.”

– Growth, Financials/Healthcare/Technology

“I am neutral on technology because the spending environment is still uncertain and the stocks are closer to the top end of the valuation ranges. Given those two contrasts, it is hard to be super excited.” – GARP, Technology

Total Return Mentality; Dividends Reign Supreme For the fifth consecutive quarter, dividends remain the top investor preference for uses of excess free cash though averages have normalized close to 50% after a spike to 71% in 3Q12.

Furthermore, given the recent market rally, it is not surprising that the level of participants preferring share repurchases declined quarter over quarter, falling to 47% from 50% in 4Q12.

When asked their thoughts about companies repatriating trapped foreign cash back to the U.S., 58% of polled investors indicate that the money should be invested overseas rather than subjected to the tax penalty. www.corbinperception.com

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Free Cash Flow Preferences - Quarterly Trend 71% 52%

57%

53%

50% 47% 21% 29%

43% 21% 24%

42% 32%

42%

29% 29% 26% 6% 0% 0%

Dividends

Buybacks 2Q12

3Q12

Reinvestment 4Q12

Current

M&A

Debt Reduction

Rolling 12 Month Avg.

“If a company can grow then I prefer reinvestment and acquisitions but if it cannot grow then give it back to me. We as a firm like companies to give us the money back but I think there are companies that do very well acquiring and can add a lot of value that way.” – Deep Value, Industrials “We prefer companies to reinvest in the business assuming they can get returns that are consistent with the current business or higher. If not, we are agnostic as to whether they do a share buyback or dividend.” – Core Value, Energy “It depends on their opportunities but most of them have poor track records so they should return capital to shareholders in terms of buybacks and dividends.”

– Core Value, Materials II

Outside of Fundamentals, Investors Turn to Companies’ Communication Efforts In our ongoing effort to assist companies in effectively positioning their investment thesis to the financial community, contributors point to the following qualitative factors as critical to their investment decision: 

71% | Execution, including effective capital allocation

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71% | Access to management with a preference towards non-deal roadshows

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65% | Transparency and disclosure

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43% | Strong company and industry knowledge, ability to identify and talk to trends

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8% | Corporate governance

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“Have a clear presentation with lots of information, include the financial accounts and provide transparency. I would like it if companies went on more roadshows in Europe so we could meet management. That is not always easy for some American companies because we are based in Europe and we do not go to America a whole lot.” – Core Value, Consumer “Just have a clear message. As far as proactive efforts, regular communication, updates and actively reaching out is always good.” – Core Value, Industrials/Technology/Telecom

“Provide as much detail as possible on underappreciated components of the business, certain investments that a company owns. Anything that gives you comfort or line of sight to higher earnings will ultimately enhance your multiple on the stock.

– Growth, Industrials/Energy

IR Best Practice: Employ A Proactive Targeting Strategy Our research continues to underscore the importance that high quality, long-term investors place on exposure to executives, who report preferring non-deal roadshows and investor days to industry conferences when it comes to meeting with management.

Given their limited bandwidth and the fierce competition for investment dollars, it is imperative that management and IR employ a proactive approach towards engaging current and potential holders.

Best practices include: 

Leverage proprietary targeting software or databases to identify high fit underweight and prospective investors



Conduct an in-depth analysis of current shareholder base and develop outreach strategy



–

Underweight investors have already passed the first hurdle of fundamental compatibility

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Be cognizant of investment style

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Conduct research and remove quant, passive and other lower quality firms

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Screen hedge funds, remember not all hedge funds are created equal

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Prioritize and develop a proactive outreach strategy

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Track activities and further refine your efforts

When utilizing the sell side, cross-reference the marketing schedule to ensure the majority of suggested firms match the company’s best interests

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Collaborate with brokers in determining the final schedule (i.e., push back on firms that are not aligned with your goals and provide additional meeting suggestions)

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Strive for 10 to 12 non-deal roadshows annually; employ a divide and conquer approach with executives where two people are always present (e.g., C-suite executive and IR manager)

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Do not neglect Europe; if appropriate for your company, conduct at least one overseas trip per year

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Follow-up after meetings to ensure all questions have been answered and to maintain mindshare

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Develop a scorecard to measure your effectiveness quarterly and annually (e.g., changes in mix/style, contact with Top 10/25/50, target conversion rate, etc.)

Proven Methodology, Proven Results Corbin Perception is an IR research and advisory firm assisting public companies with driving long-term shareholder value.

We recognize the positive impact best-inclass 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

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Investor Targeting

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Investor Presentation Development

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Investor Day Strategy and Execution



Strategy Development, Communication



IR Diagnostic Reviews, IR Strategy

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