Zeng Jan 0505

Equity Research North America

US Quant Strategy

QuantFocus

How Global Is Your Industry?

January 2005

Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

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Summary

US and European returns increasingly integrated • US and European markets jointly dominate MSCI World returns, and have increasingly tended to move in parallel • Global asset allocators will need to look beyond the US and Europe, in order to achieve meaningful diversification • Little connection between US / European returns and Japanese returns

Cross-region integration varies significantly by sector • Most sectors in US and Europe behave as if they were fully integrated – Exceptions are some parts of Consumer Staples, Healthcare, and Real Estate • Scope for US / European pair trades in Autos, Materials, and Energy Source: Morgan Stanley Quantitative Research As of 11/30/2004. Research findings were originally published in “How Global Is Your Industry?” (6/28/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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Insights from Market Participants and Academics Please see analyst certification and other important disclosures starting on page 28.

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What Do Market Participants Believe?

No real agreement on whether country or sector is more important • Buyside and sellside market participants generally believe there is significant variation at sectoral level in extent of cross-regional linkage • In general, market participants mostly seem to believe that: – Energy and Materials are closely linked globally, because their inputs and outputs are actively traded – Technology is also closely linked globally, because US firms indicate prospects for entire world – Real Estate and Consumer Staples are not linked cross-regionally, because they are more affected by local economic trends • Research teams generally organized by sector, rather than geography – But few analysts have expertise in more than one region Source: Morgan Stanley Quantitative Research As of 11/30/2004. Research findings were originally published in “How Global Is Your Industry?” (6/28/2004).

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Review of Past Academic Research

Academic research has focused on explanatory power of country factors vs. sector / industry factors • Lessard (1974) found that country risk explained variance far better than industry risk – Implication: investors should diversify by geography • Increasing interest from early 1990s in analyzing the explanatory power of countries versus industries – Grinold et al (1989) found that some industries are far more “global” than others, in the sense that industry factors outweigh country ones – Roll (1992) found that cross-national variations in industrial composition (as reflected in national indices) influenced results – Heston and Rouwenhorst (1994) suggested that industry factors had very low explanatory power, and that country factors were far more important than industry factors Source: Morgan Stanley Quantitative Research As of 11/30/2004. Research findings were originally published in “How Global Is Your Industry?” (6/28/2004). Full citations at end of paper.

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Review of Recent Academic Research

More recent research has sought to extend earlier work • Majority of work has followed Heston and Rouwenhorst (1994) methodology – Griffin and Karolyi (1998) found that country effects are generally more significant, but that industry factors seem to be relatively more important when firms produce tradable goods – Baca et al (2000) compared the explanatory power of country and sector effects, and found that country effects were generally larger, but sector effects mattered for Technology, Resources, and Utilities – Cavaglia et al (2000) analyzed change over time, and found that industry factors had outweighed country factors from 1998 onwards • Cai and Warnock (2004) use confidential data reported by custodians to Federal Reserve to analyze foreign holdings of US stocks – Find that foreign investors typically have greater exposure to larger firms with greater international presence Source: Morgan Stanley Quantitative Research As of 11/30/2004. Research findings were originally published in “How Global Is Your Industry?” (6/28/2004). Full citations at end of paper.

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Why Would This Matter for Investors?

Major implications for portfolio formation and structure of research efforts • Investors are likely to have questions like: – Is it reasonable to treat a German bank and a Canadian bank as being “substitutes,” in any meaningful sense?

– Is it necessary or desirable to incorporate “regional” considerations into a portfolio, e.g. be underweight Europe or overweight Japan?

• Answers to the question of “sector vs. industry” would also have implications for research (on both sellside and buyside): – If country effects are more significant, then research should presumably be organized by geographical specialization – If sector effects matter more, then a better model would be to create global sector groups – If country and sector effects are both significant, then a “matrix” model may be optimal Source: Morgan Stanley Quantitative Research As of 11/30/2004. Research findings were originally published in “How Global Is Your Industry?” (6/28/2004).

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What Can We Learn from Correlations?

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Correlations between Regions

Data come from MSCI 1000 All Countries • 23 developed and 27 emerging markets, with consistent coverage back to 1988 – Organized in terms of Global Industry Classification Standard (jointly developed by MSCI and S&P) which identifies 10 sectors, 24 industry groups, and 62 industries • We look at total return, not only at price indices – Assumption that dividends are reinvested • We focus on local-currency outcomes for each region – Implication is that investors are fully hedged against currency movements – Avoids our results being contaminated by FX effects • We look at monthly data

Source: Morgan Stanley Quantitative Research As of 11/30/2004. Research findings were originally published in “How Global Is Your Industry?” (6/28/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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Correlation of Regional Returns World

World USA Europe

100

USA

Europe

Japan

World ex USA

Pacific ex JP

86

83

66

90

64

100

62

30

57

53

100

48

86

58

100

81

39

100

63

Japan World ex USA Pacific ex JP

100

Source: Morgan Stanley Quantitative Research As of 11/30/2004. Research findings were originally published in “How Global Is Your Industry?� (6/28/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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What Can Rolling Regressions Tell Us? Please see analyst certification and other important disclosures starting on page 28.

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Regression Methodology

How integrated is the performance of one industry group in a region compared with its counterpart in another region?

• For example, to what extent is there similarity between the returns from the European auto sector vs. the returns from the US auto sector?

• To address this question, we use the following equation: Return i,j = α + β1 (world return) + β2 (world sector return – world return) – Where i = region, j = sector – And we estimate β1 and β2 using 2SLS with monthly data on a two-year rolling basis • As explained previously, we look at total return rather than price returns, and we consider only local-currency outcomes

Source: Morgan Stanley Quantitative Research As of 11/30/2004. Research findings were originally published in “How Global Is Your Industry?” (6/28/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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Beta and R-squared for US

1 0.9

Beta of US R square

0.8 0.7 0.6 0.5 0.4

US market explaining a steadily increasing proportion of world returns (on 2-year trailing basis)

0.3 0.2 0.1 0 Jan-76

Jan-80

Jan-84

Jan-88

Jan-92

Jan-96

Jan-00

Jan-04

Source: Morgan Stanley Quantitative Research As of 11/30/2004. Research findings were originally published in “How Global Is Your Industry?� (6/28/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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More Globalized Industries (for US)

Information Technology Industrials Technology Hardware & Equipment Health Care Consumer Discretionary Consumer Staples Financials Pharmaceuticals & Biotechnology USA Europe Japan

Capital Goods Materials Energy Diversified Financials

Food Beverage & Tobacco Software & Services Banks 0

0.1

0.2

0.3 0.4 0.5 0.6 0.7 0.8 R-squared of Globalization equation

Source: Morgan Stanley Quantitative Research.

As of 5/31/2004. All returns are calculated in local currency terms only. See “How Global Is Your Industry?� (6/22/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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0.9

1

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Less Globalized Industries (for US) Media

Telecommunications Services Utilities Insurance Retailing Commercial Services & Supplies Household & Personal Products Consumer Durables & Apparel Automobiles & Components Transportation Hotels Restaurants & Leisure USA Europe Japan

Food & Staples Retailing Health Care Equipment & Services Real Estate 0

0.1

0.2

0.3 0.4 0.5 0.6 0.7 0.8 R-squared of Globalization equation

Source: Morgan Stanley Quantitative Research.

As of 5/31/2004. All returns are calculated in local currency terms only. See “How Global Is Your Industry?� (6/22/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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1

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Levels of Globalization: US vs. Europe Tightly Integrated Cross-Regionally

1 European Sector More Global than US

R-squared for European sectors

0.9 0.8

Consumer Durables & Apparel Autos & Parts Hotels, Restaurants, Leisure Transportation

0.7 0.6 0.5

Financials Materials Banks Industrials Energy Telecoms Capital Goods Insurance Diversified Financials Tech Pharm & Biotech Utilities Healthcare Utilities Commercial Services Food Beverage Software & Retailing & Tobacco Services Media

Food & Staples Retailing Household & Personal

0.4

Health Care Equipment

0.3 0.2

Real Estate

0.1

European Sector Less Global than US

0 0

0.1

0.2

0.3 0.4 0.5 0.6 0.7 0.8 R-squared of globalization equation for US sectors

Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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Levels of Globalization: West vs. Japan

1 R-squared for Japanese sectors

0.9

Tightly Integrated Cross-Regionally Industrials

Japanese Sector More Global than West

0.8

Consumer Discretionary Diversified Financials Capital Goods Tech Hardware Tech Financials

Consumer Durables & Apparel

0.7

Commercial Services Autos & Parts Transportation Media Hotels, Restaurants, Leisure

0.6 0.5

Materials Banks Consumer Staples

Software Insurance

Real Estate

0.4

Food & Staples Retailing Household & Personal

0.3 0.2

Health Care Equipment

Retailing

Telecoms Food Beverage & Tobacco Energy

Pharm & Biotech

Healthcare

Utilities

Japanese Sector Less Global than West

0.1 0 0

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 Average R-squared of globalization equation for US and European sectors

Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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How Global Is Your Industry?

Conclusions

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Conclusions

General results are consistent with what one would expect • Sectors which are expected to move together do indeed seem to be more closely linked cross-regionally – Technology, Industrials, Materials, Consumer Discretionary and Financials all seem to move together quite tightly – Real Estate, Healthcare Equipment, and Retailing seem to behave in a more region-specific fashion – US and European sectors seem quite similar, but Japanese sectors appear to behave rather differently • Investors who focus mainly on US and Europe should be wary – Diversification benefits seem to be restricted to only a few sectors • May be reasonable for investors to focus more actively on Japan – Greater opportunities for portfolio diversification by looking there Source: Morgan Stanley Quantitative Research As of 11/30/2004. Research findings were originally published in “How Global Is Your Industry?” (6/28/2004).

Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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How Global Is Your Industry?

Bibliography

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Bibliography

Baca, Sean P.; Brian L. Garbe; Richard A. Weiss. 2000. “The rise of sector effects in major equity markets.” Financial Analysts Journal, volume 56 number 5, pages 34-40.

Cai, Fang; Francis E. Warnock. 2004. “International diversification at home and abroad.” Federal Reserve Board working paper IFDP#793.

Cavaglia, Stefano; Christopher Brightman; Michael Aked. 2000. “The increasing importance of industry factors.”

Financial Analysts Journal, volume 56 number 5, pages 41-54.

Griffin, John M.; G. Andrew Karolyi. 1998. “Another look at the role of the industrial structure of markets for international diversification strategies.” Journal of Financial Economics, volume 50, pages 351-373.

Grinold, Richard; Andrew Rudd; Dan Stefek. 1989. “Global factors: fact or fiction?” Journal of Portfolio Management, volume 16, Fall, pages 79-88.

Heston, Stephen L.; K. Geert Rouwenhorst. 1994. “Does industrial structure explain the benefits of international diversification?” Journal of Financial Economics, volume 36, pages 3-27.

Lessard, Donald R. 1974. “World, country, and industrial relationships in equity returns.” Journal of Finance, volume 29 number 2, pages 379-398.

Roll, Richard. 1992. “Industrial structure and the comparative behavior of international stock market indices.” Journal of Finance, volume 47 number 1, pages 3-41.

Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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How Global Is Your Industry?

Appendices

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More Globalized Industries (for Europe)

USA Europe Japan

Materials Banks Energy

Consumer Discretionary Industrials Capital Goods Telecommunications Services Information Technology Diversified Financials Insurance Consumer Durables & Apparel Consumer Staples Technology Hardware & Equipment Health Care 0

0.1

0.2

0.3 0.4 0.5 0.6 0.7 0.8 R-squared of Globalization equation

Source: Morgan Stanley Quantitative Research.

As of 5/31/2004. All returns are calculated in local currency terms only. See “How Global Is Your Industry?� (6/22/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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Less Globalized Industries (for Europe)

Pharmaceuticals & Biotechnology Utilities Automobiles & Components Commercial Services & Supplies Food Beverage & Tobacco Hotels Restaurants & Leisure Transportation Software & Services Retailing Media Food & Staples Retailing USA Europe Japan

Household & Personal Products Health Care Equipment & Services Real Estate 0

0.1

0.2

0.3 0.4 0.5 0.6 0.7 0.8 R-squared of Globalization equation

Source: Morgan Stanley Quantitative Research.

As of 5/31/2004. All returns are calculated in local currency terms only. See “How Global Is Your Industry?� (6/22/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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More Globalized Industries (for Japan) Industrials

Consumer Discretionary Capital Goods Diversified Financials Information Technology Financials Technology Hardware & Equipment Consumer Durables & Apparel Materials Commercial Services & Supplies Banks Automobiles & Components USA Europe Japan

Transportation Consumer Staples 0

0.1

0.2

0.3 0.4 0.5 0.6 0.7 0.8 R-squared of Globalization equation

Source: Morgan Stanley Quantitative Research.

As of 5/31/2004. All returns are calculated in local currency terms only. See “How Global Is Your Industry?� (6/22/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

25

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0.9

1

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Less Globalized Industries (for Japan) Media

Software & Services Hotels Restaurants & Leisure Insurance Telecommunications Services Real Estate Retailing Food & Staples Retailing Food Beverage & Tobacco Energy Health Care Household & Personal Products Pharmaceuticals & Biotechnology Health Care Equipment & Services USA Europe Japan

Utilities 0

0.1

0.2

0.3 0.4 0.5 0.6 0.7 0.8 R-squared of Globalization equation

Source: Morgan Stanley Quantitative Research.

As of 5/31/2004. All returns are calculated in local currency terms only. See “How Global Is Your Industry?� (6/22/2004) Qi Zeng (212) 761 3537 qi.zeng@morganstanley.com

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US Quant Strategy: Recent Publications

Factor Allocation Strategy Methodology (11/2003)

Systemic Influences on Sector Returns (7/2004)

Hedging Strategy Risk (12/2003)

Can REIT Stocks Hedge Your Inflation Risk (7/2004)

Digging Deeper in the Sectors (1/2004)

Avoid Heroics  Quant Synopsis (8/2004)

Low Beta/High Idiosyncratic Risk (1/2004)

Sector Rotation to Safety (8/2004)

High Beta/Low Idiosyncratic Risk (2/2004)

Looking Again at Momentum (8/2004)

Market Beta, Sector Beta, and Stock Picking (3/2004)

How Quants Can Help Fundamental Analysts (9/2004)

Will Interest Rate Increases Hurt Stocks (4/2004) Risk Revisited (4/2004) Settle for Alpha, or Stop Hugging Your Beta (4/2004)

Questioning the Significance of Analyst Revisions (10/2004) A Weaker Dollar Should Not Hurt Market Performance (10/2004) Oil Prices and Equity Returns (10/2004)

Alpha Searching Within Sectors (5/2004)

Momentum Reversal: Beyond Large Caps (11/2004)

Good News, Lousy Tapes (5/2004)

Factor Effectiveness Monthly (12/2004)

How Global is Your Industry (6/2004) Moving Beyond Sideways (7/2004)

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Important Disclosures

Analyst Certification The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Qi Zeng.

Important US Regulatory Disclosures on Subject Companies The information and opinions in this report were prepared by Morgan Stanley & Co. Incorporated and its affiliates (“Morgan Stanley�).

Morgan Stanley policy prohibits research analysts, strategists and research associates from investing in securities in their sub industry as defined by the Global Industry Classification Standard ("GICS," which was developed by and is the exclusive property of MSCI and S&P).

The research analysts, strategists, or research associates principally responsible for the preparation of this research report have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues.

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Ratings Distribution and Definitions Disclaimers Stock Ratings Different securities firms use a variety of rating terms as well as different rating systems to describe their recommendations. For example, Morgan Stanley uses a relative rating system including terms such as Overweight, Equal-weight or Underweight (see definitions below). A rating system using terms such as buy, hold and sell is not equivalent to our rating system. Investors should carefully read the definitions of all ratings used in each research report. In addition, since the research report contains more complete information concerning the analyst’s views, investors should carefully read the entire research report and not infer its contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor’s decision to buy or sell a stock should depend on individual circumstances (such as the investor’s existing holdings) and other considerations.

Global Stock Ratings Distribution (as of November 30, 2004) Coverage Universe Stock Rating Category

Count

Investment Banking Clients (IBC) % of Total

Count

% of Total IBC

% of Rating Category

Overweight/Buy 635 34% 260 39% 41% Equal-weight/Hold 875 46% 304 46% 35% Underweight/Sell 375 20% 101 15% 27% Total 1,885 665 Data include common stock and ADRs currently assigned ratings. For disclosure purposes (in accordance with NASD and NYSE requirements), we note that Overweight, our most positive stock rating, most closely corresponds to a buy recommendation; Equal-weight and Underweight most closely correspond to neutral and sell recommendations, respectively. However, Overweight, Equal-weight, and Underweight are not the equivalent of buy, neutral, and sell but represent recommended relative weightings (see definitions below). An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received investment banking compensation in the last 12 months.

Analyst Stock Ratings

Overweight (O). The stock’s total return is expected to exceed the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Equal-weight (E). The stock’s total return is expected to be in line with the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Underweight (U). The stock’s total return is expected to be below the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

More volatile (V). We estimate that this stock has more than a 25% chance of a price move (up or down) of more than 25% in a month, based on a quantitative assessment of historical data, or in the analyst’s view, it is likely to become materially more volatile over the next 1-12 months compared with the past three years. Stocks with less than one year of trading history are automatically rated as more volatile (unless otherwise noted). We note that securities that we do not currently consider "more volatile" can still perform in that manner.

Unless otherwise specified, the time frame for price targets included in this report is 12 to 18 months. Ratings prior to March 18, 2002: SB=Strong Buy; OP=Outperform; N=Neutral; UP=Underperform. For definitions, please go to www.morganstanley.com/companycharts.

Analyst Industry Views

Attractive (A). The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark named on the cover of this report.

In-Line (I). The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark named on the cover of this report.

Cautious (C). The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark named on the cover of this report.

Stock price charts and rating histories for companies discussed in this report are also available at www.morganstanley.com/companycharts. You may also request this information by writing to Morgan Stanley at 1585 Broadway, 14th Floor (Attention: Research Disclosures), New York, NY, 10036 USA.

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