Inside The Buy-side® 2Q14 by Corbin Advisors

INSIDE THE BUY-SIDE®

SECOND QUARTER | ISSUE DATE: APRIL 11, 2014

Perhaps pausing for

a breath following 2013’s sharp run up, equity markets posted a mixed performance in the first quarter, as the Dow fell 0.7% while the S&P 500 and NASDAQ posted modest gains of 1.3% and 0.5%, respectively. Still, despite the smallest quarterly advance for the S&P 500 and the NASDAQ since the fourth quarter of 2012, it was also the fifth straight quarterly rise for both. As well, the Dow and the S&P 500 posted gains for February and March.

Investment Style

In our ongoing effort to track investor sentiment and expectations, we surveyed 50 financial professionals globally and across multiple industry segments and investment styles.1 In total, participating institutions manage upwards of $729 billion in equity assets.

Geography

North America | 66%

News out of Washington was front and center in the quarter. Fed Chairwoman Janet Yellen’s first press conference in mid-March briefly sent markets tumbling. After announcing that the QE program would end this fall if the Fed continues to taper purchases in measured steps, Yellen said the first rate increase following the end of stimulus could be in “six months or that type of thing”. Fed officials also predicted their target interest rate would be 1.0% at the end of 2015 and 2.25% a year later, above previous forecasts and based on upgraded projections for the labor market. Yellen later eased investor concerns, saying the economy will need Fed stimulus for “some time”. Meanwhile, in February the House approved a one-year extension of federal borrowing authority, allowing a debt limit increase without any conditions. The vote, largely along party lines, was a shift away from the confrontational tactics House Republicans employed the past three years, culminating in last October’s 16-day government shutdown. 1

Europe | 30% Asia| 4%

Sector

Timeframe: March 20 – 25, 2014

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Key Trends 

As earnings season gets underway, 77% of those surveyed expect 1Q14 results to be in line with or below consensus expectations



While the majority forecasts organic growth, EPS growth and FCF to improve this quarter, it is a notably smaller number while the percentage of respondents expecting these metrics to worsen has risen significantly from the previous quarter



60% of participants describe executives’ tone as more cautious quarter-over-quarter



39% of those surveyed characterize their current market sentiment as “cautiously optimistic”, down significantly from the 75% who held this view last quarter



Investment professionals report favoring the IT, Healthcare and Financial sectors and express bearish sentiment toward Utilities, Energy and Consumer Staples



Dividends reemerge as the top choice for use of excess free cash followed by reinvestment and “smart” M&A



The Fed, economic growth and a lack of viable investment alternatives are the primary drivers of the equity rally, say those surveyed –

35% assert market valuations are not sustainable at current levels



Regarding the global macro outlook, concerns about China’s growth and credit are the top issues weighing on investor sentiment, followed by a stagnating U.S. economy and emerging geopolitical risks



While innovation is largely difficult to quantify, 61% of surveyed investors report that it is an important factor in their investment thesis

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Equity Markets Fluctuate with Global Macro Events U.S. stocks ended 1Q14 with minimal changes, as an early sell-off gave way to a recovery that offset the losses. The decline was relatively brief and confined to a two-week stretch in late January through early February. 1Q14 Market Performance 105 100 95 90

3/31/14

3/28/14

3/25/14

3/22/14

3/19/14

3/16/14

3/13/14

3/10/14

3/7/14

3/4/14

3/1/14

2/26/14

NASDAQ +0.5%

2/23/14

2/20/14

2/17/14

2/14/14

2/11/14

The majority of participants attribute the market’s performance to the Fed’s highly accommodative monetary policy last quarter

2/8/14

Utilities emerged as the top performing S&P 500 sector during the quarter, up 9.0%, with Healthcare also outpacing the market, finishing higher by 5.4%. Consumer Discretionary stocks, the best performer for 2013 overall, struggled in 1Q14, finishing lower by 3.2%.

2/5/14

2/2/14

1/30/14

1/27/14

1/24/14

1/21/14

1/18/14

1/15/14

1/12/14

1/9/14

1/6/14

1/3/14

12/31/13

DJIA -0.7%

S&P 500 +1.3%

Rally Drivers The Fed

56%

Economic Growth

47%

Lack of Alternatives

47%

Inflows (Fixed Income)

32%

Operational Improvements Shareholder Activism

24% 6%

“Stocks are a little too expensive but sustainable as long as the Fed remains behind the market.” Core Growth, Multi “Valuations are sustainable because there is still a large amount of money on the sidelines.” Core Growth, Multi “Multiples at these levels are typical in the current interest rate environment.” Core Growth, Generalist

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Expectations in Retreat Looking back at results for 4Q13, half of those surveyed, or 50%, indicated results were better than expected while 40% considered them to be in line. The good news came from cost containment and bottom-line growth, while revenue growth remained flat. Meanwhile, expectations for 1Q14 are significantly lower than they were for the previous quarter. The majority of respondents expect results to be in line with or worse than consensus estimates, as a “weather drag” from the worst winter in decades negatively affected businesses in the Midwest and on the East Coast, especially in the retail sector and related industries. As well, participants also see troubling signs from “adverse currency movements” and a weakening Chinese economy. What Was Your Opinion of 4Q13 Earnings Results?

What Are Your Expectations for 1Q14 Earnings Results Relative to Consensus?

Better Than | 50%

Better Than | 23%

In Line | 40%

In Line | 32%

Worse Than |10%

Below | 45%

“As usual, as 2013 progressed, earlier earnings estimates moved lower and then results seemed in line or beat by a small bit. Revenues were flat in most cases as expected.” Core Growth, Multi “I expect results to come in worse than expectations. The market is near a top, China is in trouble and stimulus does not work.” Core Value, Generalist “I expect stronger demand with a pick-up in the economy but there are cost pressures and adverse currency movements to take into consideration.” Core Value, Generalist

“Companies have lowered the bar citing weather and are likely poised to surprise on the upside.” Core Value, Generalist

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Management Tone Notably More Cautious Surveyed investors report that executives with whom they interact are far more cautious than in the previous quarter. The number of respondents reporting an unchanged but “cautious” tone rose to 60% from 48% last quarter while those who report a “less negative” tone fell to 13% from 46%. Investors attribute their increased caution to a variety of factors, including the weather and skepticism regarding the potential to expand margins and grow the top-line. Management Tone -- Prior Quarter

Unchanged (Cautious) | 48%

Management Tone -- Current Quarter

Unchanged (Bullish) | 17% Unchanged (Cautious) | 60%

Less Negative | 46% Less Negative | 13% More Negative | 6%

More Negative | 11%

“There is a choppy demand environment with a lack of top-line growth and you see many companies blaming the weather for weak results.” GARP, Multi “They are worried but, as always, optimistic that the year will unfold in a constructive manner. Weather is obscuring visibility.” Core Value, Industrials “It depends on sectors but it seems there is a general pick-up in business activity and CapEx, which are leading to more bullish views.” Core Value, Generalist “Broadly, managements have been cautious on margin expansion. They are focused on returning cash to shareholders via repurchases and/or dividends.” Core Growth, Multi

Market Sentiment Fades… As equity markets lost some of their mojo in 1Q14, investor sentiment turned more sober, with 39% of surveyed respondents describing themselves as “cautiously optimistic” compared to 75% last quarter. Further, the percentage of contributors describing their outlook as neutral or neutral to bearish is significantly higher while those reporting an outright bearish view rose to 6% from 0%. Participants cite “slightly overvalued” stocks relative to earnings and a dearth of real economic growth, the tapering of the Fed’s QE policy, slowing growth in China and general global macro uncertainty for their relative pessimism toward equity markets.

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Investor Sentiment -- Prior Quarter

Bullish | 10% Cautiously Optimistic | 75% Neutral | 8%

Investor Sentiment -- Current Quarter

Bullish | 10% Cautiously Optimistic | 39% Neutral | 24% Neutral to Bearish | 20%

Neutral to Bearish | 8%

Bearish| 6%

“I am cautiously optimistic. I feel that the current markets are slightly overvalued based on trailing 12 months EPS and even on forward EPS based on historical valuations, so a correction or sideways consolidation in the next few months seems likely. I expect that the second half of the year will be positive and the market will close positive for the year.” Core Growth, Multi “I am neutral. The market is still likely to consolidate near-term before gaining strength in the second half. The geopolitical situation provides an opportunity to move to the sidelines after a strong 2013. Better growth in the U.S. and Europe will drive second half strength.” Core Value, Generalist “Looking into the future, I don’t see drivers for employment, which is the ultimate driver of an improving economy.” Core Value, Multi “I am neutral to bearish because of inflation, a weak consumer, potential for reduced QE and a slow housing recovery. Meanwhile, valuations are elevated.” GARP, Multi

…And Valuations are Questionable In regard to the sustainability of current market valuations, contributor opinion is mixed.

Are Markets Sustainable at Current Levels?

No | 35%

More than one-third, or 35%, contend Yes | 18% valuations cannot hold up, believing prices are already “too extended” and that interest Yes with Caveats | 35% rates will rise while also pointing to the lack of corporate growth. The same Depends | 12% number of respondents maintains valuations are sustainable “for another year or so” provided the Fed refrains from “aggressive monetary tightening”. Meanwhile, just 18% say unequivocally that market prices are sustainable, as valuations are rebounding from “very depressed values” and current multiples are “typical” for the current interest rate environment. www.corbinperception.com

“The market is fully valued or slightly overvalued at this point. I expect future EPS growth as well as top-line growth to drive the market higher in the second half.” Core Growth, Multi

“Profit margins are at all-time highs and multiples are elevated. Meanwhile, topline organic growth is non-existent. As the Fed reduces liquidity, assets will be repriced and stocks will likely fall.” GARP, Multi “Valuations are sustainable as long as interest rates remain low. As such, equity valuations can remain here or go higher.” Core Growth, Technology

Investment Themes and Sector Trends Surveyed investment professionals indicate that secular growth, mid-cap, and dividend-paying stocks are the most attractive investment themes while IT, Healthcare and Financials are the sectors earning the most bullish sentiment given their favorable valuations and growth prospects. Conversely, participants maintain they are avoiding low quality/high beta, early cycle and defensive themes, similar to last quarter, and are bearish on Utilities, Energy, Consumer Staples and Telecom. The energy space is perceived as a potential underperformer, particularly if the Chinese slowdown persists leading to a decline in global demand. Further, despite attractive dividend payouts, utilities are perceived to be fully valued and thus less attractive in a period of rising real interest rates, while regulatory policy remains a concern in the space. “We have had a bias over the last few years toward stocks that pay a decent yield. That is something that we look for.” Core Value, Multi

Investment Themes -- Most Attractive

35%

Secular Growth

31%

29%

Mid-cap

Dividend Yield

Investment Themes -- Least Attractive 55%

Low Quality/ High Beta

25%

23%

Early Cycle

Defensive

“We are avoiding interest rate sensitive stocks with above historical valuations.” Core Value, Generalist

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Sector Snapshot 6% 15%

15% 15%

21%

68% 50%

30%

50% 37%

Financials

36%

32%

Healthcare Industrials Consumer Discretionary Bullish

21%

58% 33%

33%

Telecom

Consumer Staples

15%

Energy

Materials

3% Utilities

Bearish

“We are bullish on IT because of the valuations.” Growth, Generalist “Financials will continue to recover as rates rise. Valuations are also less expensive in financial stocks and banks in particular.” GARP, Multi “Utility valuations are too high given anemic growth rates. Their dividend yields are higher than the market but 3% yields elsewhere could provide comfort if we get a 10%+ correction in prices.” Core Growth, Technology When evaluating companies, surveyed investors confirm that the most important financial characteristics considered are: 

91% | Organic Growth



87% | Consistent Cash Flow Generation



85% | EPS Growth Potential



85% | Top-line Growth



85% | Balance Sheet Strength



83% | ROIC



80% | Margin Expansion “The best stocks over the long-term are the compounders, which generate lots of free cash flow, have ROIC well in excess of WACC and can grow organically.” Core Value, Industrials

“Evidence of pricing power and sustainable growth are key.” Core Value, Generalist

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“I believe sustainable earnings growth will drive stock performance and it does not need to be organic.” Core Value, Generalist

Performance Metrics Channel Check In our quarterly channel check on performance metrics, the majority of contributors are less optimistic about companies’ ability to deliver continued upside in Organic Growth, EPS and FCF than they were last quarter. While slightly more investors expect an improvement in Organic Growth and FCF, it is a much smaller percentage this quarter than last. Moreover, views that these three measures will worsen is significantly higher quarter-over-quarter. Organic Growth

EPS Growth

FCF Growth

70%

60%

50%

40%

30%

20%

10%

0% 3Q13

4Q13

1Q14

Improving

0% 3Q13

4Q13

Staying the Same

1Q14

3Q13

4Q13

1Q14

Worsening

Dividends Take Center Stage After Two Quarters of Playing Second Fiddle Surveyed investors rank dividends as their preferred use of excess free cash, up from the prior quarter, while the desire for reinvestment has waned after two straight quarters of holding the top spot. For the second consecutive quarter, share buybacks ranked lowest in terms of top priority cashdeployment preferences as valuations continue to look rich. Despite fading popularity amongst the buy side, buybacks by S&P 500 companies in 4Q13 reached $129 billion, exceeding the 3Q13 total of $128 billion, according to preliminary estimates by S&P Dow Jones Indices.

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Preferred Uses of Cash Prior Quarter 9%

19%

31% 48%

24% 43%

60% 33% Reinvestment Dividend Growth

33% M&A

Current Quarter 17%

35%

56%

45%

34%

22%

20%

22%

Share Repurchase

Debt Reduction

1st Choice

49%

19% 49% 32%

Dividend Reinvestment Growth 2nd Choice

34%

30%

29%

34%

41%

48%

32%

30%

24%

M&A

Debt Share Reduction Repurchase

Low Priority

You Asked, We Polled: Repatriation Nearly half of all respondents, or 49%, favor repatriation of foreign cash while 47% also agree but concede that support for the policy depends on the tax rate imposed. Further, of participants in favor of repatriation, 54% state that a tax rate of 10% to 20% would lead them to change their opinion. Additionally, 18% said their opinions would change at a tax rate of 30%, while 14% of investors had no opinion. Only 9% favor repatriation regardless of the rate. “If they have NPV positive investment opportunities abroad, then no need to repatriate.” Core Growth, Generalist “It depends on the situation but in general, I don’t like excess cash holdings, no matter where they are domiciled.” Core Growth, Technology “It depends. If there is an important need for it domestically and/or leverage is a concern, then companies should.” Core Value, Industrial

China, Status of U.S. Recovery and Geopolitical Risks Top Concerns Investors were hit with an onslaught of disturbing economic and geopolitical news from abroad with China emerging as a leading concern this quarter. Sparking credit fears, China experienced its first-ever domestic bond default, raising questions about the potential for “contagion” in the region and around the globe and prompting concerns about the health of the nation’s shadowbanking sector. The combination of government credit risk and an economic slowdown resulted in the Yuan falling by roughly 2.6% against the U.S. Dollar during 1Q14 as investors continue to pay close attention to the world’s soon-to-be largest economy. While the weather received the lion’s share of the blame for weaker-than-expected non-farm payroll numbers out of the U.S., investors remain skeptical of the health of the domestic

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economy. Thus, concerns related to labor force participation, as well as rising debts and deficits remain top of mind. Continuing, as the Federal Reserve continued to taper its QE program by $10 billion a month, questions remain regarding how policy will be carried out and the pace at which rates will rise. Although the markets have generally responded positively to the Fed’s actions, investors warn that rates rising too quickly have the potential to derail the ongoing recovery. Russia’s invasion of Crimea caught global markets off guard, resulting in heightened volatility and broad based uncertainty surrounding the economic impact of potential sanctions levied by the West. While rhetoric has dissipated somewhat from the initial infiltration of Ukraine, investors will undoubtedly remain attentive to the Russian situation. European Central Bank chairman Mario Draghi and IMF head Christine Lagarde remain steadfast in their commitment to prevent the E.U. from falling into a deflationary spiral. Despite the fact that Euro-zone inflation in March hit its lowest level since November 2009, Draghi has avoided lowering the central bank’s benchmark interest rate from 0.25%. “Organic growth in the U.S. and China will be lower than expected. China’s credit situation is very dangerous and valuations in the U.S. are very overvalued in normalized terms.” GARP, Industrials “Labor force participation rate is too low, a divisive climate of blaming others promoted by the Administration and excessive debt levels in all areas of government are highly troublesome.” Core Growth, Generalist “Top concerns include the Fed falling behind the curve, Europe lapsing into recession and emerging markets pulling the developed world into slowdown.” Core Growth, Generalist

“I am concerned about U.S. political posturing domestically. International concerns include geopolitical risk and Japanese slowdown.” Core Value, Industrials Top Investor Concerns

Prior Quarter

Current Quarter

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

China Slowdown, Credit Crunch Status of U.S. Recovery Geopolitical Risk Fed Uncertainty (e.g., QE, rising rates, inflation) E.U. Growth, Fiscal Concerns

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IR Best Practice: Positioning Innovation as a Competitive Differentiator According to the majority of surveyed buy side investors, or 61%, innovation is Important to Very Important to their investment thesis, yet they note it is often “difficult to judge”.

How Important is a Company’s Ability to Innovate to Your Investment Thesis? Very Important| 21% Important| 40%

Corbin Perception delved deeper and asked what measures are most important when assessing innovation and, not surprisingly, found that investors are most focused on evidence of market share wins and resultant growth.

Somewhat Important| 35% Not Important| 4%

In messaging, corporations should seek to tell and reinforce their innovation story by tying technology, products, engineering and R&D spend to organic growth. As organic growth rises investors will likely increasingly recognize innovation as a driver and investment differentiator. As well, companies should develop metrics that measure success and progress. Innovation Measurements Ability to Take Market Share

100%

Ability to Raise Prices

100%

Organic Growth

97%

% of New Product Sales

95%

Technology (proprietary)

92%

Pipeline

92%

Products (quality, value-add)

89%

Engineering Capabilities

89%

Ability to Lower Costs "Disruptive"

85% 83%

Investment in R&D

79%

Technology (leading edge)

79%

R&D as a % of Sales

78%

IP Protection

78%

# of New Products

76%

“Innovation equates to value creation that delivers economic profits.” Core Growth, Multi

“Innovation with new and improved products is what ultimately drives revenues.” Core Value, Multi

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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: 

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

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

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

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