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Transcript of Financial Pacific - Volatility to Remain Elevated (third party)
UBS Investment Research
U.S. Small Cap Strategy
Small Cap Navigator — September 2011
Welcome to the Small-Cap Navigator This monthly guide provides a summary of the UBS U.S. small-cap equity market outlook, including proprietary analytics and other useful information on marketreturns, company profits, valuation, sectors, and the economy.
Volatility to Remain Elevated We continue to believe that a recession will be avoided. However, recent eventshave most likely caused some contraction in underlying business and consumeractivity that will lead to mixed economic readings over near-term. Additionally, the European sovereign debt situation remains tenuous. We expect volatility toremain elevated until incoming data begins to stabilize, and it becomes apparentthat a negative credit event will be averted.
Earnings Results Should Be Decent in the Second Half Despite anemic growth in the first half of the year, Russell 2000 companies haveposted earnings growth of 33% and an aggregate beat of almost 5% thus far in 2Qreports. We expect decent 3Q and 4Q earnings results relative to loweredexpectations. However, 2012 earnings forecasts appear stretched.
Long-Term Concerns Are Driving Company and Investor Behavior We believe that fiscal imbalances and long-term growth concerns are driving companies to keep balance sheets fortified, remain very tight on expenses, andissue overly conservative guidance. Our sense is that these same issues will likelykeep investors intently focused on companies posting the best top-line results, and those with the cheapest valuations relative to medium-term earnings prospects.
Global Equity Research
Americas
Equity Strategy
Investment Strategy
8 September 2011
www.ubs.com/investmentresearch
Chip Miller, CFA
+1-203-719 3720
Jonathan Golub, CFAStrategist
[email protected]+1-212-713 8673
This report has been prepared by UBS Securities LLC ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 58. UBS 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.
U.S. Small Cap Strategy 8 September 2011
UBS 2
UBS Strategy & Economics Teams
U.S. Equity StrategyJonathan Golub Chief Strategist [email protected] Chip Miller Small-Cap Strategist [email protected]
Manish Bangard Strategist [email protected] Tom Doerflinger Strategist [email protected] Patel Associate [email protected] Natalie Garner Strategist [email protected]
Maury Harris Chief Economist [email protected]
Drew Matus Economist [email protected]
Samuel Coffin Economist [email protected] Paul Donovan Economist [email protected]
Kevin Cummins Economist [email protected] Andrew Cates Economist [email protected]
George Magnus Senior Advisor [email protected]
Janet Pegg Analyst [email protected] Jonathan Anderson Emg Markets [email protected]
Sunil Kapadia Asset Allocation [email protected]
Mitchell Revsine Strategist [email protected]
Jeffrey Palma Chief Strategist [email protected]
Andrew Kligerman Financials [email protected] Chris Ferrarone Strategist [email protected]
N. Theodosopoulos Technology [email protected] Jerry McGuire Associate [email protected]
David Strauss Industrials [email protected]
David Palmer Consumer [email protected] Nicholas Smithie Strategist [email protected]
John Hodulik Telecom [email protected] Jennifer Delaney Strategist [email protected]
Bill Featherston Energy [email protected] Stephen Mo Strategist [email protected]
Ron Barone Energy [email protected]
Justin Lake Health Care [email protected] Stephane Deo Europe [email protected]
Amit Kara UK [email protected]
Nick Nelson Europe [email protected] Duncan Wooldridge Asia [email protected]
Karen Olney Europe [email protected] Scott Haslem Australia [email protected]
Neil Cherry UK [email protected] Tao Wang China [email protected]
George Vasic Canada [email protected]
Shoji Hirakawa Japan [email protected] George Bory Credit [email protected]
Niall MacLeod Asia x-Japan [email protected] Mansoor Mohi-Uddin Currency [email protected]
David Cassidy Australia [email protected] Michael Schumacher Rates [email protected]
John Tang China [email protected] Bhanu Baweja EM FICC [email protected]
Tomas Lajous Mexico [email protected]
David Jessop Global Head [email protected]
Berry Cox US [email protected]
U.S. Accounting
U.S. Economics Global Economics & Strategy
Larry Hatheway Chief Economist & Strategist
Global Equity Strategy
Global Emerging Markets Strategy
Regional Economics
Credit, Rates & Currency Strategy
Quantitative Strategy
U.S. Derivatives
U.S. Sector Heads
Regional Strategy
UBS Small Cap Sales & Trading
Stephen Roney TMT [email protected] Albert Aguiar Specialist [email protected]
Alphonso Diaz Health Care [email protected]
Kevin Mullane Financials/Consumer [email protected]
Richard Ryan Industrials [email protected]
Trading Sales
U.S. Small Cap Strategy 8 September 2011
UBS 3
Table of Contents
Outlook
▪ Market Outlook ……...……………………………….………………..…………….. 4-5
▪ Fiscal Imbalances ...…………………..…………….…………….…..…………….. 6-7
▪ Tactical Review .…….……………………………………….……………………… 8-9
▪ Economic Outlook .…….…………………………………….……………………… 10-13
▪ Leading Indicators .…………………………………….……………………………. 14-15 Fundamentals
▪ Consensus Earnings Growth …..…….………………………….………..……….. 16-17
▪ Earnings — Revenue ….………………...…………………………………………. 18
▪ Earnings — Operating Margins ………..………………………………………….. 19
▪ Balance Sheets & Cash Flows .……………….…………………………………... 20-21
▪ Earnings Analysis ………………..………………….………………………………. 22-25
▪ M&A ……………………………..………………………..………………….……….. 26-27
▪ Dividends & Buybacks and Cash & Working Capital ..………………………..… 28-29 Market Leadership
▪ U.S. Equity & Sector Returns ….……………..……………………………………. 30-31
▪ Sector Recommendations...…………………..……………………………………. 32-35
▪ UBS Return Drivers — Summary….……..………..………...……………………. 36-37
▪ UBS Return Drivers — Revenue Growth & PEG ……………….………..……… 38-39
▪ UBS Return Drivers — Market Cap, Op Leverage & Valuation ..………………. 40-41
▪ Small vs. Large ……………………………………………………………………… 42-43
▪ Growth vs. Value ……………………………………………………………………. 44-45
▪ Fund Positions ………………………………………………………………………. 46-47 Valuation
▪ Investment Regimes ………………………..………………………………………. 48-49
▪ Russell 2000 …………………………………………………………………………. 50-51
▪ Russell 2000 Inter-Sector Relative Valuation ……………………………………. 52-53 Appendix
▪ UBS Return Drivers .…………….………………….………………..…………….. 54-55
▪ Inter-Sector Valuation ….………………….………………..……………………… 56-57 All data as of August 31, 2011 unless otherwise noted.
Highlights
• Market Outlook — Pages 4-5
• Earnings Analysis — Pages 22-25
• Sector Recommendations — Pages 32-35
• UBS Return Drivers — Pages 36-41
• Investment Regimes — Pages 48-49
U.S. Small Cap Strategy 8 September 2011
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Market Outlook
Outlook
Small Caps Down Big In August. In August, the Russell 2000 sold off by 8.7% into weak economic readings, rising double dip concerns, an increasingly tenuous European sovereign debt situation, and S&P’s downgrade of U.S. debt. Small caps underperformed large caps by almost 300bps. Cyclical sectors, including Energy, Discretionary, and Tech, were hit the hardest.
Volatility Should Remain Elevated. We believe that recent events have caused a contraction in underlying business and consumer activity. This should lead to very mixed economic readings over the next several weeks. Additionally, the situation in Europe continues to deteriorate. We expect volatility to remain elevated until incoming data begins to stabilize.
A Credit Shock Is the Biggest Risk. In our view, the biggest risk to the economy and small-cap stock performance is the potential for a global credit shock. While we continue to believe this is a low probability event, we are closely monitoring interbank lending markets. Over the near term, U.S. small-cap performance may be driven by the situation in Europe.
Slow Growth Not Recession. We believe that recent economic readings are more consistent with slow growth, not recession. Once it becomes clear that a recession will be avoided, we expect small cap stocks to rebound, potentially sharply.
Solid Earnings Results. Despite anemic GDP growth in the first half of the year, small companies reported very solid 2Q earnings results. With roughly 90% of the universe reported, Russell 2000 companies have posted year-over-year earnings growth of 33% (20% ex-Financials), with an aggregate earnings beat of 4.9% (4.8% ex-Financials).
Earnings Probably OK in 2H; 2012 Looks Like a Stretch. Company guidance has remained very conservative, and analysts have been modestly revising down 2H11 earnings expectations. As such, we expect modest earnings beats to continue over the next two quarters. However, 2012 expectations look stretched if GDP growth remains muted.
Attractive Valuations. At 16.7x, the Russell 2000 appears cheap relative to its five- and ten-year averages of 20.3x and 21.4x, respectively. The Russell 2000 is trading at a 46% premium to the Russell 1000, toward the high end of the historical range. However, the relative valuation appears reasonable, adjusting for easy comps.
We expect volatility to remain elevated into mixed economic readings and sovereign concerns
Over the near term, U.S. small caps may be driven by the situation in Europe
We believe a recession will be avoided, and companies will continue to surpass expectations in 2H11
However, 2012 bottom-up earnings forecasts appear stretched
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Market Outlook
Leadership
A Cyclical Sector Bias. Based on our medium-term outlook, we have a cyclical bias. We’re overweight Tech, Industrials, Discretionary, and Health Care. We’re underweight Financials, and the most defensive areas, Staples, Telecom and Utilities. However, over the near-term, defensive sectors and characteristics could continue to outperform.
Overriding Investment Themes. Given investors’ longer-term growth concerns, we see three key investment themes playing out over the next several quarters:
All Eyes on Revenue Growth. On a sector-neutral basis, companies posting the highest revenue growth were winners during both the strong run from September to March and the more recent defensive rotation that began in April. We expect this to continue.
Buy Undervalued Earnings Growth. We also expect companies with the most attractive near-term PEG ratios to continue to outperform in the current environment.
A Robust M&A Cycle. We expect a significant pickup in deal activity as macro concerns fade, and companies look to buy growth and capture outsized deal synergies.
Risks
European Sovereign Debt. We believe that the biggest risk to U.S. small-caps is a credit disruption emanating from Europe.
Economic Weakness. Further deterioration in the economic outlook poses a serious threat to small caps. Recent weak economic readings are particularly concerning given limited policy responses in the event of a recession.
Negative Feedback Loop. In our view, there is the potential for a negative feedback loop to develop, consisting of (1) weakening economic fundamentals; (2) rising sovereign concerns and bank funding stress; (3) spikes in market volatility; and (4) a further contraction in underlying economic activity.
Note: In our charts and tables, we use either the S&P 600 or the Russell 2000 to represent the small-cap universe. Refer to the footnote beneath each exhibit to determine which index is being used.
Based on our medium-term outlook, we maintain a cyclical sector bias
We expect companies posting the highest top-line growth and those with the best PEG ratios to continue to outperform
There are significant risks to our relatively optimistic outlook
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Fiscal Imbalances
Federal Budget Deficit (US$ Trillions)
0.5
1.4
1.3
1.4
1.1
0.7
0.5 0.50.6
0.6 0.60.7
0.7 0.7
08 09 10 11 12 13 14 15 16 17 18 19 20 21
Source: CBO, Haver and UBS
Federal Budget Breakdown
2011 2021
5% Interest 16%
18% Mandatory 13%
40% Entitlements 46%
14% Discretionary 9%
23% Security 17%
$3.5 Trillion
$5.9 Trillion
Source: Office of Management & Budget and UBS
The debt ceiling deal is a modest first step in addressing America’s fiscal imbalances
OMB projects that interest and entitlements will go from 45% of the budget to 62%… over 75% of tax receipts
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Fiscal Imbalances
CDS Spreads
200
400
600
800
1000
1200
1400
1600
Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11
Portugal, Ireland & ► Greece CDS Basket
Source: Bloomberg and UBS Note: European CDS basket is the 5-day moving average of Portugal, Ireland and Greece CDS through Sept. 5, 2011
10-Year Spreads
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11
Italy - Germany▼
Spain - Germany▲
Source: Bloomberg and UBS
Portuguese, Irish, and Greek CDS spreads remain wide
Increased pressure on Italy and Spain as well
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Tactical Review
Small Caps > 200-Day Moving Average
0%
20%
40%
60%
80%
100%
01/08 07/08 01/09 07/09 01/10 07/10 01/11 07/11
160
220
280
340
400
460S&P 600 ►
◄ % of Stocks > 200-Day MA
Source: Standard & Poor’s, FactSet and UBS Note: Data as of Sept. 2, 2011
Mutual Fund Flows (4-Wk Moving Avg.)
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
4/10 8/10 11/10 3/11 6/11
$B
◄ Small
◄ Large
Mid ▼
Source: Lipper and UBS
Small caps have room to run if economic data begins to stabilize
Small- and mid-cap flows have recently turned more negative
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Tactical Review
Russell 2000 Implied vs. Realized Volatility (1M)
0
10
20
30
40
50
60
70
80
90
08 09 10 11
Realized Vol ▲
Implied Vol ▼
Source: CBOE, Russell and UBS Note: Data through Sept. 2, 2011
S&P 600 Industry Group Correlation (30D)
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
05 06 07 08 09 10 11
89%92%
Source: Standard & Poor’s, FactSet and UBS
Volatility has risen sharply
Stock correlations are very high, making alpha generation difficult
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Economic Outlook
Russell 2000 vs. LEI
300
375
450
525
600
675
750
825
900
98 99 00 01 02 03 04 05 06 07 08 09 10 11
77
82
87
92
97
102
107
112
117
LEI ►
Russell◄ 2000
Source: Russell, Conference Board, Bloomberg and UBS
Small Cap Relative Performance vs. LEI
0.57
0.72
0.87
1.02
1.17
98 99 00 01 02 03 04 05 06 07 08 09 10 11
77
87
97
107
117
◄ Sm v Lg ▼
LEI ►
Source: Russell, Conference Board, Bloomberg and UBS
Small caps tend to trade in-line with the economic outlook
Small caps generally outperform when the economy is growing
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Economic Outlook
Russell 2000 v. ISM New Orders
375
506
638
769
900
03 04 05 06 07 08 09 10
20
35
50
65
80
◄ Russell 2000
New Orders ►
Source: Russell, Institute for Supply Management, Bloomberg and UBS
U.S. Economic Surprise Index
-4
-3
-2
-1
0
1
2
3
06 07 08 09 10 11
> 0 represents Positive Surprise
< 0 represents Negative Surprise
Source: Bloomberg and UBS Global Economics Team
The key is whether or not economic indicators begin to signal a substantial slowdown or recession
Is the current environment like late 2006 or early 2008?
Economic data has recently started to surprise to the upside into lowered expectations
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UBS 12
Economic Outlook
Interbank Lending Spreads
0
50
100
150
200
250
300
350
06 07 08 09 10 11
0
30
60
90
120
150
180
210
◄ TED Spread ▼
Euribor Spread ►
Source: Bloomberg and UBS Note: Data through Sept. 6, 2011
Baa Spread
150
250
350
450
550
650
06 07 08 09 10 11
Source: Moody’s, Bloomberg and UBS Note: Data through Sept. 6, 2011
Recessions are normally caused by credit contractions
European interbank spreads are showing signs of stress
The TED spread has recently risen, but remains at low levels
High quality corporate spreads have been relatively stable
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Economic Outlook
ISM Manufacturing & Non-Manufacturing
98 00 02 04 06 08 10
35
40
45
50
55
60
>50 is Expansionary
<50 is Contractionary
◄ ISM Mfg
◄ ISM Non-Mfg
50.6
54.6
Source: Institute of Supply Chain Management, FactSet and UBS Note: ISM Mfg represents Aug. 2011
Weekly Unemployment Claims
90 92 94 96 98 00 02 04 06 08 10250
300
350
400
450
500
550
600
650
4-week avg. 410k
Source: US Department of Labor, FactSet and UBS
Recent economic data is consistent with slow growth, not recession, in our view
U.S. Small Cap Strategy 8 September 2011
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Leading Indicators
Small Business Optimism Index
80
85
90
95
100
105
110
01 02 03 04 05 06 07 08 09 10 11
Source: NFIB, Bloomberg and UBS Note: Data through July 2011
Small-Cap Cyclicals vs. Non-Cyclicals
1.35
1.43
1.51
1.59
1.67
1.75
Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11
3/31: 1.70
9/6: 1.44
6/17: 1.52
Source: Standard & Poor’s, Bloomberg and UBS Notes: Cyclicals represent and equal-weighted index of Discretionary, Tech, Industrials, Financials, Energy and Materials. Non-cyclicals represent an equal-weighted index of Health Care, Staples, Telecom and Utilities. Data through Sept. 6, 2011
Confidence is the key going forward
A reemergence of cyclical leadership would be a positive signal — we’re not there yet
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UBS 15
Leading Indicators
10-Year Treasury Yield
1.9
2.2
2.5
2.8
3.1
3.4
3.7
4.0
1/10 4/10 7/10 10/10 1/11 4/11 7/11
4/11: 3.58
9/6: 1.97
6/24: 2.86
Source: Bloomberg and UBS Note: Data through Sept. 6, 2011
CRB US Spot Raw Industrials
450
500
550
600
650
1/10 4/10 7/10 10/10 1/11 4/11 7/11
4/12: 638
9/2: 571
Source: CRB, Reuters, Bloomberg and UBS Note: Data through Sept. 2, 2011
We attribute a majority of the move down in the 10-year yield to falling growth expectations
Industrial commodities may be stabilizing
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UBS 16
Consensus Earnings Growth
Consensus Earnings Growth — Index Level 2011 Earnings Growth 2012 Earnings Growth
R2000 S&P 600 R2000 S&P 600Cyclicals
C. Discretionary 7.4 % 20.0 % 45.6 % 28.7 %Industrials 30.7 28.5 36.4 24.5Technology 11.2 11.2 25.0 17.4Energy 100+ 26.8 100+ 52.5Materials 48.8 23.5 27.0 25.7
Non-Cyclicals
C. Staples -3.3 9.2 72.7 22.7Health Care 100+ 3.2 100+ 19.9Telecom Svcs 71.6 -5.3 100+ 32.9Utilities -0.1 3.5 8.4 7.3
Index ex-Fin 40.6 15.6 45.0 23.4
Financials 100+ 35.4 46.5 34.4
Index 62.1 18.2 45.3 25.2 Source: Russell, Standard & Poor’s, Thomson Financial, Compustat, FactSet and UBS Note: Analysis based on constituents as of August 31, 2011. Analysis excludes FBP
Consensus Earnings Growth — Median Company 2011 Earnings Growth 2012 Earnings Growth
R2000 S&P 600 R2000 S&P 600Cyclicals
C. Discretionary 15.6 % 15.4 % 21.7 % 18.6 %Industrials 30.1 22.0 25.6 21.6Technology 16.9 15.8 21.2 17.3Energy 52.9 42.9 70.5 56.1Materials 19.4 16.5 21.5 19.5
Non-Cyclicals
C. Staples 14.1 10.1 17.3 15.8Health Care 10.7 10.7 18.9 15.8Telecom Svcs 0.4 -2.6 44.4 59.9Utilities 3.0 3.0 6.2 6.7
Index ex-Fin 17.8 14.6 22.6 18.3
Financials 23.3 17.8 20.6 22.0
Index 18.7 15.4 22.1 19.0 Source: Russell, Standard & Poor’s, Thomson Financial, Compustat, FactSet and UBS Note: Analysis based on constituents as of August 31, 2011. Analysis excludes FBP
Largely due to easy comps, Russell 2000 earnings growth is expected to be 62% in 2011 and 45% in 2012
Growth rates appear more reasonable looking at median estimates
Easy comps are distorting overall earnings growth estimates
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UBS 17
Consensus Earnings Growth
S&P 600 Bottom-Up Consensus
10%
15%
20%
25%
30%
35%
01/10 04/10 07/10 10/10 01/11 04/11 07/11
2011 ▼
2012 ▼
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
S&P 600 Forward PE vs. EPS
17
20
23
26
29
Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11
13.0
14.5
16.0
17.5
19.0
◄ Fwd EPS ▼
Fwd P/E ►
$28
14.1x
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
Analysts have been revising down 2011 earnings expectations
However, 2012 expectations have remained largely unchanged
Buy-side expectations have fallen much faster than sell-side forecasts
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Earnings — Revenue
Revenue Growth vs. Nominal GDP Growth
-24%
-17%
-10%
-3%
4%
11%
18%
25%
00 01 02 03 04 05 06 07 08 09 10 11
-5%
-3%
-1%
1%
3%
5%
7%
9%
◄ Revenue
GDP ►
Y/Y Y/Y
Source: Standard & Poor’s, BEA, Compustat, FactSet and UBS Note: Analysis excludes Financials
Revenue Surprises — Small vs. Large
0.4
2.3
0.5
-0.1
0.4
2.6
-2.0
0.2
2.01.7 1.8
1.3
3.0 2.92.7
1.41.0
-0.9
2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11E
Large Caps
Small Caps
Source: Standard & Poor’s, Compustat, Thomson Financial and UBS Note: Analysis excludes Financials and certain other companies with missing data.
Small-cap revenue growth and nominal GDP are highly correlated
Top-line beats have been surprisingly strong over the past three quarters
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Earnings — Operating Margins
Operating Margin vs. Capacity Utilization
4%
5%
6%
7%
8%
9%
10%
00 01 02 03 04 05 06 07 08 09 10 11
65
70
75
80
85
◄ Small-Cap Margins
Cap. Util. ►
8.9%
7.1%
4.8%
Source: Standard & Poor’s, Federal Reserve, Compustat, FactSet and UBS Note: Margins have been adjusted to reflect a trailing 4-quarter basis. Capacity Utilization shows quarterly averages
Current & Peak Operating Margins
58 8
57 7
9
52
89 9
12
9
5
1815 14
24
9 9 810 9
12 13
65
10
15
1113
12
8
21
26
17
2
6
13
Ene
rgy
Mat
eria
ls
Cap
Goo
ds
Com
m S
vcs
Tra
nspo
rts
Aut
os
Dur
able
s
Con
s S
vcs
Med
ia
Ret
ail
Foo
d R
etai
l
Foo
d B
ev
HH
Pro
d
HC
Svc
s
Pha
rma
Sof
twar
e
Har
dwar
e
Sem
is
Tel
ecom
Util
ities
Peak
2Q11
Peak 4Q01 1Q07 1Q98 4Q98 3Q07 3Q99 1Q06 4Q02 3Q04 3Q02 2Q06 3Q10 1Q07 2Q04 1Q03 2Q05 3Q00 4Q00 3Q04 3Q98
Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Margins reflect a trailing 4-quarter basis. Peak quarter is listed below chart
Small-cap margins tend to mirror capacity utilization
We see margin expansion opportunities across the small-cap universe
U.S. Small Cap Strategy 8 September 2011
UBS 20
Balance Sheets
Net Debt vs. Interest Coverage
10%
15%
20%
25%
30%
35%
40%
99 00 01 02 03 04 05 06 07 08 09 103.0x
4.0x
5.0x
6.0x
7.0x
8.0x
Interest Cov ►
Net Debt Ratio
deleveraging
6.3x
16.5%
Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials
Capex & R&D
7.0%
7.5%
8.0%
8.5%
9.0%
9.5%
01 02 03 04 05 06 07 08 09 10 113.0%
3.5%
4.0%
4.5%
5.0%
5.5%
R&D / Sales◄ (Rolling 12M)
Capex / Sales ► (Rolling 12M)
7.7%
3.6%
Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials
Small-cap balance sheets remain solid
U.S. Small Cap Strategy 8 September 2011
UBS 21
Cash Flows
Free Cash Flow ($Bn) – Sources 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11
Net Income 1.3 3.5 2.6 3.9 4.0 4.6 4.4 4.5 4.6
Depreciation 4.4 4.4 4.4 4.3 4.2 4.3 4.4 4.5 4.1
Working Capital 2.9 0.6 1.0 (1.2) (2.2) (2.9) (0.9) (3.4) (1.6)
Other Op Items 3.4 2.7 3.8 1.6 2.4 2.5 3.1 1.1 1.5
CF From Ops 12.1 11.1 11.8 8.6 8.4 8.4 11.0 6.6 8.5
- Capex (net) 4.0 3.8 4.0 3.3 4.1 4.4 4.7 4.7 4.4
Free Cash Flow 8.1 7.3 7.8 5.3 4.3 4.1 6.4 1.9 4.1 Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Universe excludes Financials
Companies focused on cash generation during the downturn
Working capital being replenished, but plenty of cash left over
Free Cash Flow ($Bn) – Uses 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11
Free Cash Flow 8.1 7.3 7.8 5.3 4.3 4.1 6.4 1.9 4.1
- Dividends 0.6 0.7 0.6 0.8 0.7 0.7 1.7 0.8 0.7
- Buybacks, net (0.8) (1.6) (0.6) (0.6) 0.6 0.6 (0.3) (0.7) 0.7
- Acquisitions, net 1.1 0.9 2.4 2.4 2.5 3.6 7.3 3.0 3.8
Debt Iss/(Repay) (4.4) (3.2) (2.5) (2.0) 0.1 2.7 4.8 0.7 2.2
L/T Investments (0.3) (0.7) (0.7) (0.4) (0.5) 0.3 (0.9) (0.3) (0.2)
Other Investing 0.4 0.2 (0.0) 0.6 0.5 (0.0) 0.4 (0.3) 0.3
Other Financing (0.1) (0.3) 1.4 0.0 (1.1) 0.2 (1.1) 0.4 (0.3)
Chg-Cash & ST Inv 2.7 3.3 3.6 1.0 (0.4) 2.3 0.9 (0.7) 0.9 Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Universe excludes Financials
M&A activity has picked up. We expect this to continue
Dividends and buybacks should gradually increase as well
U.S. Small Cap Strategy 8 September 2011
UBS 22
Earnings Analysis
Russell 2000 — Earnings Summary — 2Q11E Revenue Earnings
Growth Surprise Growth SurpriseRptd Total YoY (%) Pct (%) Beat Miss YoY (%) Pct (%) Beat Miss
Cyclicals ex-Finls 959 1068 15.7 2.6 558 297 29.4 4.9 572 347
Cons. Discretionary 238 269 6.3 1.2 122 82 23.0 10.5 140 90
Autos 18 18 20.4 5.3 11 5 51.7 10.9 8 10
Dur. & Apparel 49 56 0.9 1.6 33 15 <-100 <-100 31 17
Cons. Services 66 74 4.7 0.9 33 21 23.5 7.5 40 23
Media 31 38 6.8 4.2 13 12 >100 20.2 15 14
Retailing 74 83 5.7 -0.4 32 29 9.9 23.3 46 26
Industrials 250 278 15.6 2.0 154 75 23.1 7.3 152 85
Capital Goods 142 161 17.1 2.3 85 50 33.8 3.2 74 59
Services 70 79 12.4 1.9 44 17 36.7 9.1 48 20
Transportation 38 38 16.1 1.5 25 8 -1.2 15.0 30 6
Technology 313 334 14.1 1.4 190 84 16.2 6.0 202 98
Software 140 150 16.4 1.0 88 33 23.0 6.9 96 38
Hardware 104 115 13.1 1.8 64 33 14.6 3.0 60 41
Semiconductors 69 69 12.1 1.0 38 18 11.0 8.2 46 19
Energy 95 115 48.4 9.6 57 35 >100 -4.5 47 44
Materials 63 72 19.7 2.3 35 21 27.3 -5.2 31 30
Non-Cyclicals 352 397 9.9 1.7 189 127 -29.6 3.9 193 141
Cons. Staples 43 62 10.9 2.4 28 9 -29.7 -9.0 25 17
Food & Stpls Retail 9 15 9.5 1.9 7 1 75.8 >100 7 2
Food Bev. & Tob. 22 33 12.9 3.1 14 6 -59.7 -44.4 10 11
Hhld Products 12 14 12.1 2.1 7 2 16.1 9.6 8 4
Health Care 256 278 8.6 1.1 131 100 -29.9 83.2 139 102
Equip. & Services 131 137 9.0 0.4 66 50 21.2 6.0 72 47
Pharma/Biotech 125 141 6.1 6.7 65 50 -84.5 11.5 67 55
Telecom 21 23 12.1 0.4 9 8 <-100 <-100 9 10
Utilities 32 34 10.2 2.4 21 10 -21.1 -9.7 20 12
Russell 2000 ex-Finls 1311 1465 14.3 2.4 747 424 20.3 4.8 765 488
Financials 352 385 -28.2 0.7 201 118 82.9 5.1 206 130
Banks 164 177 5.6 2.5 91 53 >100 22.9 111 49
Diversified Finls 59 68 -68.6 -3.0 34 22 46.8 -7.2 34 22
Insurance 38 43 2.2 1.3 23 13 -53.8 -8.8 18 20
Real Estate 91 97 14.9 1.0 53 30 40.1 4.9 43 39
Russell 2000 1663 1850 8.6 2.2 948 542 33.3 4.9 971 618 Source: Russell, Compustat, Thomson Financial, FactSet and UBS Note: Analysis excludes companies with no analyst coverage or that are missing data in applicable databases. Results contain some UBS estimates
U.S. Small Cap Strategy 8 September 2011
UBS 23
Earnings Analysis
S&P 600 — Earnings Summary — 2Q11E Revenue Earnings
Growth Surprise Growth SurpriseRptd Total YoY (%) Pct (%) Beat Miss YoY (%) Pct (%) Beat Miss
Cyclicals ex-Finls 360 382 17.4 2.8 205 105 16.8 3.9 224 121
Cons. Discretionary 100 107 6.9 2.4 55 28 7.1 10.5 64 32
Autos 5 5 2.8 0.3 2 2 -6.2 3.3 2 3
Dur. & Apparel 27 29 6.7 3.7 20 5 -5.2 10.8 18 8
Cons. Services 27 30 4.0 0.9 13 6 5.6 2.3 17 10
Media 3 3 19.0 16.3 2 1 >100 >100 2 1
Retailing 38 40 6.9 0.9 18 14 3.6 15.7 25 10
Industrials 83 90 13.2 1.4 47 25 16.5 4.6 50 27
Capital Goods 53 58 10.1 1.7 30 16 11.0 1.7 27 21
Services 22 24 11.7 0.8 12 6 35.6 7.9 15 6
Transportation 8 8 35.3 1.4 5 3 23.8 19.8 8 0
Technology 125 130 17.4 1.2 72 37 11.8 1.5 79 43
Software 45 46 19.2 0.0 27 11 -1.3 -0.1 31 14
Hardware 49 53 17.5 1.7 28 18 23.8 1.6 28 20
Semiconductors 31 31 14.2 0.8 17 8 12.4 2.8 20 9
Energy 19 21 61.2 10.1 13 5 70.1 5.7 12 6
Materials 33 34 17.7 1.6 18 10 17.8 -3.0 19 13
Non-Cyclicals 104 114 15.4 2.3 52 35 -11.2 -7.0 51 43
Cons. Staples 19 23 18.3 4.1 9 3 -24.0 -6.8 8 8
Food & Stpls Retail 3 5 19.6 7.2 2 0 50.1 28.3 2 1
Food Bev. & Tob. 11 13 19.7 2.7 7 1 -44.3 -21.0 5 4
Hhld Products 5 5 8.6 -0.7 0 2 -14.6 -5.6 1 3
Health Care 65 70 14.9 0.5 33 25 -7.7 -9.0 35 24
Equip. & Services 51 53 15.7 0.5 25 20 6.0 2.2 27 18
Pharma/Biotech 14 17 7.9 0.9 8 5 -82.3 -80.1 8 6
Telecom 7 7 10.7 1.0 2 3 -39.8 -20.3 1 5
Utilities 13 14 13.2 7.2 8 4 10.7 6.9 7 6
S&P 600 ex-Finls 464 496 17.0 2.7 257 140 9.9 1.5 275 164
Financials 100 102 8.2 1.1 56 26 33.1 3.2 52 40
Banks 41 41 3.6 1.4 22 11 >100 29.5 28 10
Diversified Finls 13 13 15.2 -0.4 6 6 24.0 -1.5 8 4
Insurance 16 17 8.8 1.8 10 3 -36.6 3.6 6 10
Real Estate 30 31 7.2 0.9 18 6 4.2 -10.4 10 16
S&P 600 564 598 16.3 2.6 313 166 14.2 1.9 327 204 Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS Note: Analysis excludes companies with no analyst coverage or that are missing data in applicable databases. Results contain some UBS estimates
U.S. Small Cap Strategy 8 September 2011
UBS 24
Earnings Analysis
Earnings Surprises — Small vs. Large
7
12
109
8
56 6
5
13
19
14
8
12
9
79
2
2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11E
Large Caps
Small Caps
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS Note: Analysis excludes Financials and certain other companies with missing data
Earnings Surprises — Cyclicals vs. Non-Cyclicals
18
21
19
7
15
8 8 8
45
12
3
9
5
14
6
10
-7
2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11E
Cyclicals
Non-Cyclicals
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS Note: Analysis excludes Financials and certain other companies with missing data
Large-cap beats have been higher in 2Q reports
Cyclical sectors posted much better results relative to expectations
U.S. Small Cap Strategy 8 September 2011
UBS 25
Earnings Analysis
2Q11E Price Response – S&P 600 vs. S&P 500
Beats Misses Beats Misses
Bea
ts
4.20 -0.47 2.73
Bea
ts
0.86 -0.24 0.55
Mis
ses
-4.20 -6.25 -5.50
Mis
ses
-2.84 -4.64 -3.89
2.18 -4.11 0.27 -2.24
Small Cap Large Cap
Revenue Surprise Revenue Surprise
E
PS
Su
rpri
se
E
PS
Su
rpri
se
Source: Standard & Poor’s, Thomson Financial, FactSet and UBS
1Q11 Price Response – S&P 600 vs. S&P 500
Beats Misses Beats Misses
Bea
ts
3.21 -0.87 2.11
Bea
ts
0.79 -0.60 0.30
Mis
ses
-2.96 -4.10 -3.49
Mis
ses
-1.46 -2.54 -2.04
1.73 -2.87 0.20 -1.29
E
PS
Su
rpri
se
Small Cap Large Cap
Revenue Surprise Revenue Surprise
E
PS
Su
rpri
se
Source: Standard & Poor’s, Thomson Financial, FactSet and UBS
4Q10 Price Response – S&P 600 vs. S&P 500
Beats Misses Beats Misses
Bea
ts
4.27 0.96 3.10
Bea
ts
1.49 -0.49 0.75
Mis
ses
-2.47 -3.30 -2.86
Mis
ses
-2.31 -2.48 -2.35
2.43 -1.18 0.81 -2.06
Small Cap Large Cap
Revenue Surprise Revenue Surprise
E
PS
Su
rpri
se
E
PS
Su
rpri
se
Source: Standard & Poor’s, Thomson Financial, FactSet and UBS
U.S. Small Cap Strategy 8 September 2011
UBS 26
M&A
Number of Deals – $250M to $2.5B
88108
190229
283
463444
549
637
329288291
414449
557550
289
232
390410
92 95 98 01 04 07 10
Source: Mergerstat, FactSet and UBS Note: 2011 estimated based on deals through July
Number of Deals – $250M and $2.5B
10
151512
15
2220
282926
22
2627
35
40
32
50
28
36
4042
3435
28
37
2830
24
32
41
02/09 05/09 08/09 11/09 02/10 05/10 08/10 11/10 02/11 05/11
Source: Mergerstat, FactSet and UBS Note: Data through July 2011
Deal activity picks up post recessions
We believe macro concerns have been holding back transaction volumes
U.S. Small Cap Strategy 8 September 2011
UBS 27
M&A
Deals by Sector – 2010 and 2011 YTD 114 112
79
71 70 68
55
39
29
10
Fin Tech Discr H Care Ind En Mat Stpls Util Telcm
Source: Mergerstat, FactSet and UBS Note: Data through July 2011
Large vs. Small Operating Margins
4%
5%
6%
7%
8%
9%
10%
99 00 01 02 03 04 05 06 07 08 09 10
9%
10%
11%
12%
13%
14%
15%
◄ Small Caps ▲
Large Caps ►
Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials
Financials and Tech have seen the biggest pickup in deal activity
The difference between small- and large-cap margins is close to an all-time high
We believe that CEOs put more credence in cost synergies than potential revenue opportunities
U.S. Small Cap Strategy 8 September 2011
UBS 28
Dividends & Buybacks
Payout Ratio
-25%
0%
25%
50%
75%
100%
125%
94 96 98 00 02 04 06 08 10
◄ Dividends + Buybacks
Dividends ▲
11%
43%
Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials and Utilities
Payout Ratios by Sector
4637
64
31 3040 38
127
9369 69
47
131
87
164
201
401
278
600 x-Fin &Util
Ind Discr Mat En Tech H Care Stpls Telcm
Peak
2Q11
PkQtr 4Q08 1Q08 3Q08 4Q00 4Q10 2Q02 3Q07 2Q06 3Q05
Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials and Utilities
Room to return cash across sectors
Total payout is way below prior peaks
U.S. Small Cap Strategy 8 September 2011
UBS 29
Cash & Working Capital
Cash & Inventories (% Total Assets)
6%
9%
12%
15%
18%
00 01 02 03 04 05 06 07 08 09 10 11
Cash ►
◄ Inventories
12.2%
13.5%
Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials
Working Capital (% of Sales)
6%
7%
8%
9%
10%
99 00 01 02 03 04 05 06 07 08 09 10
7.1%
Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials
Working capital management has been stellar over the past few years
Cash balances remain high
U.S. Small Cap Strategy 8 September 2011
UBS 30
U.S. Equity Returns
U.S. Equity Indices Index Aug-11 QTD YTD 1 Yr 3 Yr 5 Yr 7 Yr 10 Yr
R. 2000 (8.7) (12.0) (6.5) 22.2 0.8 1.5 5.5 5.8R. 2000 Value (8.8) (11.8) (8.5) 16.9 (0.6) (0.6) 4.3 6.5R. 2000 Growth (8.6) (12.1) (4.6) 27.5 2.1 3.6 6.6 4.9R. Mid-Cap (6.9) (10.3) (3.0) 21.3 2.9 3.0 7.0 7.2R. Mid-Cap Value (6.9) (10.2) (4.2) 17.5 2.0 1.4 6.4 7.5R. Mid-Cap Growth (6.8) (10.3) (1.7) 25.6 3.8 4.3 7.4 5.9R. 1000 (5.8) (7.8) (1.9) 19.1 0.8 1.1 4.0 3.2R. 1000 Value (6.2) (9.4) (4.0) 14.4 (1.4) (1.6) 3.0 3.4R. 1000 Growth (5.3) (6.2) 0.2 24.0 3.1 3.7 4.9 2.7S&P 600 (7.7) (10.6) (3.9) 24.4 2.1 2.7 6.4 7.0S&P 400 (7.1) (10.4) (2.7) 22.9 4.0 4.6 7.6 7.3S&P 500 (5.4) (7.4) (1.8) 18.5 0.5 0.8 3.5 2.7Dow (4.4) (6.5) 0.3 16.0 0.2 0.4 1.9 1.6Nasdaq (6.4) (7.0) (2.8) 22.0 2.9 3.4 5.0 3.6
Index Value 2010 2009 2008 2007 2006 2005 2004R. 2000 727 26.9 27.2 (33.8) (1.6) 18.4 4.6 18.3R. 2000 Value 956 24.5 20.6 (28.9) (9.8) 23.5 4.7 22.2R. 2000 Growth 419 29.1 34.5 (38.5) 7.0 13.3 4.2 14.3R. Mid-Cap 25.5 40.5 (41.5) 5.6 15.3 12.7 20.2R. Mid-Cap Value 24.8 34.2 (38.4) (1.4) 20.2 12.6 23.7R. Mid-Cap Growth 26.4 46.3 (44.3) 11.4 10.7 12.1 15.5R. 1000 16.1 28.4 (37.6) 5.8 15.5 6.3 11.4R. 1000 Value 15.5 19.7 (36.8) (0.2) 22.2 7.1 16.5R. 1000 Growth 16.7 37.2 (38.4) 11.8 9.1 5.3 6.3S&P 600 26.3 25.6 (31.1) (0.3) 15.1 7.7 22.6S&P 400 26.6 37.4 (36.2) 8.0 10.3 12.6 16.5S&P 500 1,219 15.1 26.5 (37.0) 5.5 15.8 4.9 10.9Dow 11,614 11.0 18.8 (33.8) 6.4 16.3 (0.6) 3.1Nasdaq 2,579 16.9 43.9 (40.5) 9.8 9.5 1.4 8.6
Source: Russell, Standard & Poor’s, Dow Jones, NASDAQ, FactSet and UBS Note: All returns include dividends except the Dow and NASDAQ
U.S. Small Cap Strategy 8 September 2011
UBS 31
Sector Returns
Russell 2000 Sectors Index Aug-11 QTD YTD 1 Yr 3 Yr 5 Yr 7 Yr
Financials (6.9) (8.8) (8.1) 11.7 (3.8) (6.2) (0.9)
Technology (9.3) (16.6) (10.0) 23.4 6.2 4.1 6.7
Industrials (8.6) (12.5) (9.5) 22.6 (3.9) 2.0 7.3
Consumer Discret. (10.1) (12.8) (8.4) 23.4 5.0 0.0 2.1
Healthcare (8.9) (12.1) (0.6) 25.2 2.0 4.0 6.3
Energy (16.9) (14.4) (5.0) 41.1 (10.2) 0.8 11.8
Materials (9.0) (12.3) (7.5) 27.2 6.1 12.9 15.6
Utilities 2.2 0.5 9.5 21.8 8.1 5.8 8.4
Consumer Staples (3.2) (6.2) 4.4 23.9 9.2 7.9 9.9
Telecom Svcs. (8.2) (16.3) (1.1) 23.8 (3.3) (4.2) 3.5
Russell 2000 (8.7) (12.0) (6.5) 22.2 0.8 1.5 5.5
Index Weights 2010 2009 2008 2007 2006 2005
Financials 21.7 20.7 (1.4) (23.4) (19.6) 19.4 2.0
Technology 16.9 34.4 59.9 (43.8) 3.6 13.6 (1.9)
Industrials 15.5 29.7 13.9 (29.9) 6.2 22.0 9.4
Consumer Discret. 13.3 32.1 60.8 (47.6) (15.0) 14.6 (2.0)
Healthcare 12.5 17.2 22.6 (29.3) 13.6 8.6 5.5
Energy 7.0 33.3 41.0 (50.3) 14.3 16.5 47.3
Materials 4.9 34.0 60.9 (39.1) 26.3 41.5 4.5
Utilities 3.7 17.5 7.9 (11.0) (0.1) 26.4 0.7
Consumer Staples 3.6 19.7 23.7 (18.8) 4.2 29.1 (0.3)
Telecom Svcs. 1.0 11.6 24.1 (49.7) 3.5 40.7 2.0
Russell 2000 100.0 26.9 27.2 (33.8) (1.6) 18.4 4.6 Source: Russell, FactSet and UBS Note: All returns include dividends
U.S. Small Cap Strategy 8 September 2011
UBS 32
Sector Recommendations
Overweight
Consumer Discretionary
We expect employment trends to gradually improve over the remainder of 2011, and expectations for the sector are low. Earnings results have been solid and valuations appear reasonable. We are most bullish on Media and companies exposed to higher-end consumer spending.
Industrials
Industrials is expected to deliver solid earnings growth over the next two years, supported by a modest economic reacceleration, as well as margin expansion. Analysts have underestimated operating leverage in recent quarters, a trend that should continue. In particular, we like Capital Goods companies exposed to later-cycle end markets.
Technology
In our view, Technology has become the most defensive cyclical sector. Notably, Tech carries roughly 25% of its assets in cash, which can be used to fund M&A activity, buybacks and dividend increases. While 2Q earnings results have been somewhat disappointing, we expect a reacceleration in 2H11.
Health Care
While 2Q results have been mixed, Health Care earnings trends have been strong over the past three quarters. Within the sector, we believe that larger companies will increasingly look to acquire small-cap names to achieve growth objectives. We note that the group does face longer-term profitability concerns given increased government intervention.
Market Weight
Energy
We believe that commodity prices and the Energy sector will benefit from an improving demand outlook. However, recent earnings results have been somewhat disappointing. Moreover, we expect energy prices to remain volatile over the next several quarters.
We’re most favorable toward Media and names exposed to high-end consumer spending
In our view, Tech has become the most defensive cyclical sector
We expect continued commodity price volatility
U.S. Small Cap Strategy 8 September 2011
UBS 33
Sector Recommendations
Market Weight (continued)
Materials
We expect Materials’ performance to remain closely tied to the outlook for the global economy and commodity prices, which could be volatile. We note that Materials’ undervaluation gap relative to the Energy has recently closed.
Underweight
Financials
We believe that many smaller banks remain undercapitalized, particularly relative to their larger peers, and that REITs will most likely underperform if interest rates rise. Moreover, new regulations could pose challenges to longer-term returns on capital and earnings growth. However, we note that the sector appears attractively valued on a normalized basis.
Consumer Staples
Consumer Staples could benefit from a defensive trade over the near term. Additionally, we continue to believe that the sector has strong secular growth prospects. However, we expect the sector to underperform as the 2H economic outlook gradually improves. Additionally, Staples appears somewhat expensive on a normalized basis.
Telecom
Telecom companies delivered disappointing earnings results in 2Q reports. Additionally, the group will most likely underperform if economic fundamentals reassert themselves and interest rates rise. Additionally, we believe that the group faces challenging competitive pressures over the long term.
Utilities
The Utilities sector is expected to post the lowest earnings growth of any sector over the next two years. Moreover, the sector faces a challenging pricing environment and may feel an outsized impact from increased regulations. However, the sector could outperform significantly if longer-term government bond yields continue to decline.
Many Banks will have to reinvest profits into their balance sheets rather than loan growth
Staples look expensive and cyclical sectors should have more earnings leverage
U.S. Small Cap Strategy 8 September 2011
UBS 34
Sector Recommendations
Consumer: Retailers vs. Food Retailers
0.25
0.35
0.45
0.55
0.65
0.75
0.85
0.95
00 01 02 03 04 05 06 07 08 09 10 11
81
86
91
96
101
106
111
116
LEI ►
◄ Retail vs. Food Retail
Source: Standard & Poor’s, FactSet, and UBS
Industrials: Capital Goods vs. Comm. Services
0.95
1.05
1.15
1.25
1.35
1.45
1.55
1.65
00 01 02 03 04 05 06 07 08 09 10 11
81
86
91
96
101
106
111
116
LEI ►
◄ Cap Goods vs. Comm Svcs
Source: Standard & Poor’s, FactSet, and UBS
If a recession in avoided, Retailers could see significant outperformance
Currently, we favor Capital Goods companies with later-cycle end market exposure
U.S. Small Cap Strategy 8 September 2011
UBS 35
Sector Recommendations
Technology: Semis vs. Hardware
1.0
1.2
1.4
1.6
1.8
2.0
2.2
2.4
00 01 02 03 04 05 06 07 08 09 10 11
81
86
91
96
101
106
111
116
LEI ►
◄ Semis vs. Hardware
Source: Standard & Poor’s, FactSet, and UBS
Financials: Loan Loss Reserves (% Assets)
0
1
2
3
4
5
84 86 88 90 92 94 96 98 00 02 04 06 08 10
◄ Banks with avg assets >$15B
Banks with avg assets <$1B ▲
Source: Federal Reserve, FRED database and UBS
We expect Semis to outperform if the economic outlook improves
Smaller banks are still building loan loss reserves
U.S. Small Cap Strategy 8 September 2011
UBS 36
UBS Return Drivers
UBS Market Leadership Framework
Valuation
Earnings Fundamentals
Op Leverage
Non-Cyclicals
Cyclicals
I. Early Phase II. Middle Phase III. Late Phase
Volatility Quality
Source: UBS
Russell 2000 Cyclicals vs. Non-Cyclicals
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
03 04 05 06 07 08 09 10 11
89
93
97
101
105
109
113
117
LEI ►
▲◄ Cyclicals v Non-Cyclicals
Source: Russell, Conference Board, Bloomberg and UBS
Different investment characteristics are rewarded at each stage of the investment cycle
Cyclicals and Non-Cyclicals tend to trade in-line during the middle of the cycle
U.S. Small Cap Strategy 8 September 2011
UBS 37
UBS Return Drivers
UBS Small Cap Return Drivers
3.8
-3.3-3.7 -1.3-2.8 0.21.4 1.5
Vol Op Lev Sm Cap PEG Ern Surp RevGrwth
Div Yld ROE
Apr 11 - Aug 11: Reemerging Concerns
Offense DefenseMiddle
2.51.8
1.2
4.7
2.5
4.3
-1.4-0.1
Op Lev Vol Sm Cap PEG Ern Surp RevGrwth
Div Yld ROE
Sept 10 - March 11: Entering the Middle Innings
Offense DefenseMiddle
3.8
-3.3-4.7 -1.9-1.42.1 1.9
3.0
Vol Sm Cap Op Lev PEG Earn Surp Div Yld Rev Gwth ROE
May 10 - Aug 10: Credit Concerns
Offense DefenseMiddle
-17.3-13.7-8.4-5.4
17.2
3.4
27.0 26.7
Vol Sm Cap Op Lev PEG Earn Surp Div Yld Rev Gwth ROE
Mar 09 - Apr 10: Junk Rally
Offense DefenseMiddle
Source: Standard & Poor’s, Compustat, Thomson Financial, Worldscope, FactSet and UBS
Initially, the recent defensive rotation was about slowing growth; now it’s primarily about credit concerns
Revenue Growth was a big winner during the market’s strong run from September to March
Credit concerns drove a defensive rotation last summer
The “junk” trade was on during the initial phases of the market rally
See Appendix for UBS Return Driver calculation methodology
U.S. Small Cap Strategy 8 September 2011
UBS 38
UBS Return Drivers — Revenue Growth
Revenue Growth Return Driver
90
95
100
105
110
115
120
01 02 03 04 05 06 07 08 09 10 11
75
84
93
102
111
120
LEI ►
◄ Rev Growth ▼
March '09
Oct '02
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
Revenue Growth — Sector Performance
16.8
8.76.9 5.8 5.4 5.2
2.4 1.90.8
30.9
-2.4
STPL EN MAT FIN SP600 DISC HC UTIL TECH IND TLCM
Relative Outperformance
Relative Underperformance
Sep 10 - Aug 11
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
Companies producing the highest revenue growth have performed surprisingly well in recent months
Revenue Growth has been working broadly
U.S. Small Cap Strategy 8 September 2011
UBS 39
UBS Return Drivers — PEG
PE to Growth (NTM) Return Driver
89
94
99
104
109
01 02 03 04 05 06 07 08 09 10 11
75
84
93
102
111
120
▲LEI ►
◄ PEG ▼
March '09
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
PE to Growth (NTM) — Sector Performance
9.08.3
7.3
3.32.8
2.1 1.7
0.7-2.8 -3.2
9.3
STPL EN MAT FIN SP600 DISC HC UTIL TECH IND TLCM
Relative Outperformance
Relative Underperformance
Sep 10 - Aug 11
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
PEG generally works in the middle innings of the cycle
PEG is working broadly as well
See Appendix for UBS Return Driver calculation methodology
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UBS Return Drivers — Cap & Op Leverage
Small Market Cap Return Driver
95
100
105
110
115
120
125
130
135
01 02 03 04 05 06 07 08 09 10 11
75
84
93
102
111
120
▼ LEI ►
◄ Small Market Cap
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
Operating Leverage Return Driver
95
100
105
110
115
120
01 02 03 04 05 06 07 08 09 10 11
75
84
93
102
111
120
▼ LEI ►
◄ Op Leverage
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
Cap is not a primary driver of returns in the middle innings of the cycle
Operating Leverage should continue to add value in cyclical sectors if recession is avoided
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UBS Return Drivers — Valuation
Earnings Yield Return Driver
100
110
120
130
140
150
160
170
00 01 02 03 04 05 06 07 08 09 10
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
Dividend Yield Return Driver
95
100
105
110
115
120
00 01 02 03 04 05 06 07 08 09 10
Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS
Buying cheaper stocks tends to add value over time
Dividend Yield is a cyclical characteristic
See Appendix for UBS Return Driver calculation methodology
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Small vs. Large
Relative Performance – Russell 2000 vs. 1000
50
70
90
110
130
150
170
78 81 84 87 90 93 96 99 02 05 08
Source: Russell and UBS Note: Recessionary periods highlighted
Sector Weights R2000 R1000 Difference
Cyclicals 57.6 % 56.6 % 1.0 %
C. Discretionary 13.3 11.6 1.7
Industrials 15.5 10.7 4.8
Technology 16.9 18.2 -1.3
Materials 4.9 4.3 0.6
Energy 7.0 11.7 -4.8
Non-Cyclicals 20.8 28.7 -7.9
C. Staples 3.6 10.2 -6.6
Health Care 12.5 11.7 0.7
Telecom 1.0 3.0 -2.0
Utilities 3.7 3.8 -0.1
Index ex-Fin 78.3 85.2 -6.9
Financials 21.7 14.8 6.9
Index 100.0 100.0 0.0 Source: Russell, FactSet and UBS
We expect small caps to outpace large companies over the medium term
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Small vs. Large
Relative P/E
0.7
0.9
1.1
1.3
1.5
1.7
1.9
00 01 02 03 04 05 06 07 08 09 10 11
Small CapsCheap
Small CapsExpensive
Source: Russell, Thomson Financial and UBS
Small vs. Large Cons. Earnings Estimates 2011 Earnings Growth 2012 Earnings Growth
R2000 R1000 R2000 R1000Cyclicals
C. Discretionary 7.4 % 17.7 % 45.6 % 14.6 %Industrials 30.7 18.2 36.4 19.3Technology 11.2 15.5 25.0 11.6Energy 100+ 36.0 100+ 12.8Materials 48.8 43.9 27.0 14.8
Non-Cyclicals
C. Staples -3.3 8.4 72.7 9.4Health Care 100+ 7.0 100+ 7.6Telecom Svcs 71.6 10.9 100+ 22.1Utilities -0.1 1.7 8.4 1.0
Index ex-Fin 40.6 17.5 45.0 12.1
Financials 100+ 14.0 46.5 33.7
Index 62.1 16.9 45.3 15.4 Source: Russell, Thomson Financial, FactSet and UBS Note: Analysis excludes FBP
Small caps’ relative valuation is near the high end of the historical range
We believe small caps’ premium is justified given higher expected earnings growth
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Growth vs. Value
Relative Performance
10
30
50
70
90
110
130
150
78 81 84 87 90 93 96 99 02 05 08
Source: Russell and UBS
Sector Weights Growth Value Difference
Cyclicals 66.8 % 48.2 % 18.6 %
C. Discretionary 14.8 11.7 3.2
Industrials 16.0 15.0 1.1
Technology 22.7 11.0 11.8
Energy 8.8 5.2 3.6
Materials 4.4 5.4 -1.0
Non-Cyclicals 20.9 13.5 7.4
C. Staples 4.2 2.9 1.3
Health Care 19.6 5.3 14.2
Telecom 1.2 0.8 0.5
Utilities 0.1 7.3 -7.3
Index ex-Fin 92.0 64.6 27.4
Financials 8.0 35.4 -27.4
Index 100.0 100.0 0.0 Source: Russell, FactSet and UBS
We expect Growth to outperform Value
Technology is over 20% of Growth
Financials is over 35% of Value
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Growth vs. Value
Relative P/E
0.5
1.0
1.5
2.0
2.5
3.0
3.5
90 92 94 96 98 00 02 04 06 08 10
Growth Cheap
Growth Expensive
Source: Russell, Thomson Financial and UBS
Growth vs. Value Cons. Earnings Estimates 2011 Earnings Growth 2012 Earnings GrowthGrowth Value Growth Value
Cyclicals
C. Discretionary 22.0 % 1.2 % 23.5 % 68.9 %Industrials 42.6 22.8 29.8 43.9Technology 18.3 3.7 23.0 24.1Energy 100+ 100+ 100+ 100+Materials 74.5 32.4 22.8 27.3
Non-Cyclicals
C. Staples 70.5 -32.6 32.0 100+Health Care 85.7 3.0 100+ 95.0Telecom Svcs 72.7 44.5 100+ 100+Utilities 22.2 -0.9 18.6 8.4
Index ex-Fin 84.5 12.9 39.0 49.1
Financials 18.0 100+ 39.3 50.3
Index 75.5 44.9 39.0 49.5 Source: Russell, Thomson Financial, FactSet and UBS Note: Analysis excludes FBP
On a relative basis, Growth and Value P/Es are within historical norms
Earnings growth differentials are largely explained by easy comps
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Fund Positions
Select Small-Cap Core Funds — Relative Sector Positions
4.13.7 3.4
1.1 0.9-6.9-1.9-1.6-1.3-0.9-0.7
En Mat Ind Other Stpls Telcm HCare Util Discr Tech Fin
Source: Lionshares, Russell, FactSet and UBS Note: Analysis is based on 2Q11 holdings data for six large small-cap core funds. 2Q11 holdings data for one of the funds is as of May 31, 2011
Select Small-Cap Core Funds — Top 10 OWs and UWs
Rel Weight Return (%)Ticker Company Name 2Q11 August YTDOverweightsASNA Ascena Retail Group Inc. 40 -12.1 7.6MANT ManTech International Corp. (Cl A) 31 -8.1 -9.3NUS Nu Skin Enterprises Inc. (Cl A) 29 12.7 39.8CATO Cato Corp. (Cl A) 26 -8.8 -7.4BKE Buckle Inc. 26 -11.1 4.3IGTE iGATE Corp. 26 -25.1 -43.0JDAS JDA Software Group Inc. 23 -5.5 -5.7CLC CLARCOR Inc. 22 5.6 8.5KCG Knight Capital Group Inc. (Cl A) 22 14.1 -6.4MMS Maximus Inc. 22 -4.2 12.8UnderweightsHS HealthSpring Inc. -25 -4.9 47.2NETL NetLogic Microsystems Inc. -22 -13.1 -4.4BRY Berry Petroleum Co. Cl A -22 -14.5 12.2ROSE Rosetta Resources Inc. -22 -11.2 22.1PMTC Parametric Technology Corp. -22 -13.4 -20.1DAN Dana Holding Corp. -21 -23.5 -25.9TEN Tenneco Inc. -21 -17.9 -20.3SIVB SVB Financial Group -20 -24.5 -13.1BMR BioMed Realty Trust Inc. -20 -6.8 -1.9MFA MFA Financial Inc. -20 0.0 -8.2
Source: Lionshares, Russell, FactSet and UBS Note: Analysis is based on 2Q11 holdings data for six large small-cap core funds. 2Q11 holdings data for one of the funds is as of May 31, 2011
Many Core managers are overweight commodity sensitive areas and underweight Financials
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Fund Positions
Select Small-Cap Growth Funds — Relative Sector Weights
6.3
1.60.8 0.5 0.2 0.0 -3.6-2.8-1.6-1.30.0
Discr Fin En Util Other Telcm Mat Stpls Ind Hcare Tech
Source: Lionshares, Russell, FactSet and UBS Note: Analysis is based on 2Q11 holdings data for six large small-cap growth funds
Select Small-Cap Value Funds — Relative Sector Weights
7.5
4.6
2.7 2.60.9 0.8 0.4 -15.8-2.3-1.5-0.2
En Tech Ind Mat Hcare Stpls Other Discr Telcm Util Fin
Source: Lionshares, Russell, FactSet and UBS Note: Analysis is based on 2Q11 holdings data for six large small-cap value funds. 2Q11 holdings data for one of the funds is as of May 31, 2011
Many Growth managers are underweight Tech
Many Value managers are underweight Financials
U.S. Small Cap Strategy 8 September 2011
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Investment Regimes
Dow Jones Industrials — Super Cycle Log Scale
all or
nothing
10 20 30 40 50 60 70 80 90 00 104050
100
200300400500
1,000
2,0003,0004,0005,000
10,000
Source: Dow Jones, FactSet and UBS
S&P 500 E/P vs. Inflation (Disco Regime)
72 74 76 78 804
6
8
10
12
14
16
Inflation ►
Earnings Yield ▼
Source: Standard & Poor’s, Dept. of Labor, Thomson Financial, FactSet and UBS Note: Earnings Yield based on trailing earnings; CPI (+2%) is lagged by 3 months
In the 1970s “Disco Regime,” inflation was the primary driver of stock values
Equities experience prolonged booms or periods of anemic returns
These “investment regimes” hold the key to stock prices
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Investment Regimes
S&P 500 E/P vs. 10 Yr Yield (Great Moderation)
82 84 86 88 90 92 94 96 984
6
8
10
12
14
16◄ Earnings Yield
10-year Yield ▲
Source: Federal Reserve, Standard & Poor’s, Thomson Financial, FactSet and UBS
S&P 500 E/P vs. Baa Yields (Millennium Regime)
5
6
7
8
9
10
04 05 06 07 08 09 10 11
Earnings Yield ►
▲ Baa Yield
P/E Anchored to Baa Bond Yields
Slower Growth
Recession Fears
g )er(i
pr
gk
pr
E
P 11
1
0
−++=
−=
rprf
Source: Moody’s, Standard & Poor’s, Thomson Financial, FactSet and UBS
During the “Great Moderation” the Fed Model explained returns
Stocks look attractively valued relative to bond equivalents
We believe long-term growth concerns will restrain multiple expansion
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Russell 2000 Valuation
Russell 2000 — Forward P/E
8
12
16
20
24
28
32
36
40
00 01 02 03 04 05 06 07 08 09 10 11
Undervalued
Overvalued
Source: Russell, Thomson Financial and UBS
Russell 2000 vs. Russell 1000 — Forward P/E
0.7
0.9
1.1
1.3
1.5
1.7
1.9
00 01 02 03 04 05 06 07 08 09 10 11
Small CapsCheap
Small CapsExpensive
Source: Russell, Thomson Financial and UBS
Small caps are trading below historical averages on an absolute basis
Small caps look expensive on a relative basis
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Russell 2000 Valuation
Russell 2000 – Price-to-Book
1.0
1.5
2.0
2.5
3.0
00 01 02 03 04 05 06 07 08 09 10 11
Undervalued
Overvalued
Source: Russell, Compustat, FactSet and UBS
Russell 2000 vs. Russell 1000 – Price-to-Book
0.4
0.5
0.6
0.7
0.8
0.9
1.0
00 01 02 03 04 05 06 07 08 09 10 11
Small CapsCheap
Small CapsExpensive
Source: Russell, Compustat, FactSet and UBS
The Russell 2000 appears reasonably valued on a price-to-book basis
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Inter-Sector Relative Valuation
Industrials vs. Technology
-20
-15
-10
-5
0
5
10
15
20
94 96 98 00 02 04 06 08 10
P/E
Mu
ltip
le P
oin
ts
-20
-15
-10
-5
0
5
10
15
20
◄ Industrials
Technology ►
Overvalued
Undervalued
Source: Thomson Financial, Russell, FactSet and UBS
Consumer Discretionary vs. Financials
-20
-15
-10
-5
0
5
10
94 96 98 00 02 04 06 08 10
P/E
Mu
ltip
le P
oin
ts
-20
-15
-10
-5
0
5
10
◄ Discretionary
Financials ►
Overvalued
Undervalued
Source: Thomson Financial, Russell, FactSet and UBS
Industrials and Technology appear reasonably valued
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Inter-Sector Relative Valuation
Energy vs. Materials
-25
-20
-15
-10
-5
0
5
10
15
20
94 96 98 00 02 04 06 08 10
P/E
Mu
ltip
le P
oin
ts
-25
-20
-15
-10
-5
0
5
10
15
20
◄ Energy
Materials ►
Overvalued
Undervalued
Source: Thomson Financial, Russell, FactSet and UBS
Health Care vs. Staples
-25
-20
-15
-10
-5
0
5
10
15
94 96 98 00 02 04 06 08 10
P/E
Mu
ltip
le P
oin
ts
-25
-20
-15
-10
-5
0
5
10
15
◄ Health Care
Staples ►
Overvalued
Undervalued
Source: Thomson Financial, Russell, FactSet and UBS
The divergence between Energy and Materials valuations has recently closed
Consumer Staples appears modestly overvalued
See Appendix for inter-sector relative valuation methodology
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Appendix: UBS Return Drivers We define market leadership by specific stock characteristics, such as Size (small vs. large), Valuation (expensive vs. cheap), Growth, Momentum, and Volatility. We track fifteen such characteristics, which we have dubbed “UBS Return Drivers.”
UBS Return Drivers
Size (Capitalization) Price Volatility Revenue Surprise
Operating Leverage Financial Leverage Earnings Surprise
Fwd Earn Yld (E/P) Dividend Yield PEG Ratio
Earnings Growth Return on Equity Total Payout
Book Value Yld (B/P) Foreign Sales Revenue Growth
Source: UBS
Computation Each Return Driver is calculated as a hypothetical long/short portfolio built around a single quantitative decision variable. Our calculations assume monthly rebalancing and no transaction or borrowing costs. For each Return Driver, the computation process has four steps:
(1) Break Stocks into Industry Groups. While our Return Drivers are reported at the sector and index level, our process starts by breaking the S&P 600 into its 24 GICS industry groups.
S&P 600 GICS Sectors and Industry Groups
Source: Standard and Poor’s and UBS
(2) Rank Based on Return Drivers. Within each industry group, stocks are ranked from top to bottom by the Return Driver in question (e.g., highest to lowest price volatility). The list is then broken into three groups: top-third, middle-third, and bottom-third. Our calculations assume that the top-third of stocks are bought and the bottom-third of stocks are sold.
Ranking and Return Calculation Methodology
Top 1/3Buy (Top 1/3).Stock returns equal-weighted within industry group
Middle 1/3
Bottom 1/3Sell (Bottom 1/3).Stock returns equal-weighted within industry group
Source: UBS
Sectors Industry Groups
Energy Energy
Materials Materials
Industrials Capital Goods; Commercial & Professional Services; Transportation
Consumer Cyclicals Autos; Consumer Durables & Apparel; Consumer Services; Media; Retailing
Consumer Staples Food & Staples Retailing; Food Beverage & Tobacco; Household & Personal Products
Health Care Health Care Equipment & Services; Pharmaceuticals, Biotech & Life Sciences
Financials Banks; Diversified Financials; Insurance; Real Estate
Technology Software & Services; Hardware & Equipment; Semiconductors & Equipment
Telecom Telecommunication Services
Utilities Utilities
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(3) Calculate Returns. Monthly returns are then calculated by subtracting the returns of the bottom-third (sells) from the top-third (buys). The result is then divided by two to put the outperformance in a long-only context. This analysis is done on an equal-weighted basis within each Industry Group.
Return Driver Calculation — Hypothetical Example Foreign Sales Calcualtion — Industry Group Example
Long: Highest Foreign Sales Stocks (Top 1/3) 9.8%Short: Lowest Foreign Sales Stocks (Bottom 1/3) 4.6%Difference 5.2%Divide by 2 ÷ 2Factor Result 2.6%
Source: UBS
(4) Aggregate Results. At the sector level, Returns Drivers are calculated as a weighted average of industry group returns based on S&P 600 index weights. S&P 600 index results are a weighted average of sector results. We also index monthly returns as a time series for further analysis.
GICS Sectors and Industry Groups — S&P 600
S&P 600
Sector Sector
Industry Group Industry Group
Cap-weighted result of Sector Average
Cap-weighted result of Industry Group Average
S&P 600
Sector Sector
Industry Group Industry Group
S&P 600
Sector Sector
Industry Group Industry Group
Cap-weighted result of Sector Average
Cap-weighted result of Industry Group Average
Source: Standard and Poor’s and UBS
(5) Analytics. There are several ways that UBS Return Drivers can be used in investment decision making. We have listed a few below:
Identify Winning Investment Characteristics. UBS Return Drivers identify which specific equity characteristics have outperformed and underperformed during a specific time period. This data is available at the industry group, sector, and index level. Additionally, investors can get a sense for the magnitude of outperformance or underperformance of Return Drivers relative to one another.
Track Historical Trends. In our analysis, we track the performance of each one of our Return Drivers over time. This allows us to identify the types of market environments in which each Return Driver tends to outperform or underperform.
Avoid Crowded Trades. Our work also helps identify over-loved and under-loved investment themes. For each UBS Return Driver, we track the valuation spread between the top-third of companies and the bottom-third of companies over time. As such, we can help identify points when particular portfolio tilts or trades appear to be “crowded” or “priced in.” Alternatively, we can also identify points when upside opportunities appear outsized.
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Appendix: Inter-Sector Valuation The goal of our inter-sector valuation work is to gauge whether each Russell 2000 GICS sector is undervalued or overvalued relative to the overall market. Our analysis is based upon the historical valuation relationships between sectors. Importantly, we normalize sector valuations for three dynamics that could potentially provide spurious results, if not accounted for correctly:
Some sectors tend to be more expensive than others on a systematic basis (e.g., Tech consistently trades at a higher P/E than Financials).
The valuation dispersion between sectors is wide in some environments (e.g., the early-00s) and tight in others (e.g., 2010). In other words, a multiple point today is not necessarily the same as a multiple point yesterday.
Sector dynamics change over time. For example, Tech traded at a premium multiple in the late-90s and early-00s, but trades relatively inline with the market today.
Our inter-sector valuation work suggests that relative sector valuations are mean-reverting over medium-term time frames. As such, we view our inter-sector valuation rankings as a good starting point in determining sector recommendations. However, we note that sectors can stay cheap or expensive for multi-year time periods.
Ranking Overview In order to properly normalize inter-sector valuations over time, our analysis focuses on how many standard deviations away each sector’s P/E is from the market’s P/E. (For our fellow math geeks, this is known as cross-sectional standard deviation analysis.) We then put this calculation into a historical context on a sector-by-sector basis.
In the table below, we provide an overview of the calculations behind our inter-sector valuation rankings. On the following page, we walk though our calculations on a step-by-step basis.
Inter-Sector Valuation Ranking Overview — Hypothetical Example
(A) (B) (C=A-B) (D) (E=C/D) (F) (G=E-F) (H)Sector Market Premium Market Z Score Avg Z Net Z
Sector Fwd P/E Fwd P/E (Current) Std Dev (1) Current (Trail 36M) Current RankMaterials 13.54x 13.2x 0.3 1.4 0.2 1.1 -0.86 1Technology 13.13x 13.2x -0.1 1.4 -0.1 0.7 -0.80 2Financials 11.71x 13.2x -1.5 1.4 -1.1 -0.6 -0.47 3Energy 12.09x 13.2x -1.1 1.4 -0.8 -0.6 -0.15 4Health Care 12.19x 13.2x -1.0 1.4 -0.7 -0.9 0.15 5Cons. Staples 14.71x 13.2x 1.5 1.4 1.0 0.7 0.34 6Utilities 13.35x 13.2x 0.1 1.4 0.1 -0.4 0.47 7Cons. Discretionary 15.20x 13.2x 2.0 1.4 1.4 0.9 0.51 8Industrials 15.23x 13.2x 2.0 1.4 1.4 0.7 0.72 9Telecom 14.63x 13.2x 1.4 1.4 1.0 -0.1 1.13 10
(1) Represents the standard deviation of the Russell 2000’s Forward P/E Source: First Call, Russell and UBS
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Step-by-Step Calculations (1) Aggregate P/Es and Standard Deviations (columns A, B and D). First, we calculate a forward P/E
for the market and all ten of its sectors, using consensus EPS estimates over the next twelve months. We also calculate the weighted average standard deviation of the market’s forward P/E.
(2) Calculate Z-Scores (column C). Next, we calculate a Z-Score for each sector. This expresses each sector’s P/E as a number of standard deviations away from the market’s P/E. This is calculated by subtracting the market’s P/E from each sector’s P/E and dividing the result by the weighted average standard deviation of the market’s forward P/E.
Z-Score Calculation
Market P/E
MarketSector
)P/E(P/EScore-Sector Z
σ−=
Source: UBS
(3) Put Current Valuations in Historical Context (columns E, F and G). A Net Z-Score is then calculated for each sector by comparing current Z-Scores to average Z-Scores over the prior 36 months. We perform our analysis on a rolling 36-month basis to account for secular changes in sector dynamics (e.g., new governmental regulations).
Net Z-Score — Valuation in Historical Terms
AverageMonth -36CurrentScore- Z Score- ZScore-Net Z minus=
Source: UBS
(4) Rank Sectors from Most to Least Expensive (column H). We then rank all ten sectors based upon their Net Z-Scores (i.e., how expensive or cheap each sector’s current Z-Score is in comparison to its historical average). Sectors with negative scores are cheap on a relative basis. Sectors with positive scores are expensive.
(5) Convert Net Z-Scores into Current P/E Multiple Points. To make the visual interpretation of our analysis easier to understand, we covert each sector’s historical Net Z-Scores into current P/E multiple points (cheap or expensive). This is done by multiplying the historical Net Z-Scores by the current weighted average standard deviation of the market’s forward P/E.
Health Care — Multiple Points Cheap / Expensive
-3
-2
-1
0
1
2
97 99 01 03 05 07 09
P/E
Mu
ltip
le P
oin
ts
Overvalued
Undervalued
Source: Standard & Poor’s, Thomson Financial, FactSet and UBS
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Analyst Certification
Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers and were prepared in an independent manner, including with respect to UBS, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report.
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Required Disclosures
This report has been prepared by UBS Securities LLC, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS.
For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. Additional information will be made available upon request. UBS Securities Co. Limited is licensed to conduct securities investment consultancy businesses by the China Securities Regulatory Commission.
UBS Investment Research: Global Equity Rating Allocations
UBS 12-Month Rating Rating Category Coverage1 IB Services2
Buy Buy 54% 39%Neutral Hold/Neutral 39% 35%Sell Sell 7% 14%
UBS Short-Term Rating Rating Category Coverage3 IB Services4
Buy Buy less than 1% 33%Sell Sell less than 1% 25%
1:Percentage of companies under coverage globally within the 12-month rating category. 2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. 3:Percentage of companies under coverage globally within the Short-Term rating category. 4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months. Source: UBS. Rating allocations are as of 30 June 2011. UBS Investment Research: Global Equity Rating Definitions
UBS 12-Month Rating Definition
Buy FSR is > 6% above the MRA. Neutral FSR is between -6% and 6% of the MRA. Sell FSR is > 6% below the MRA.
UBS Short-Term Rating Definition
Buy Buy: Stock price expected to rise within three months from the time the rating was assigned because of a specific catalyst or event.
Sell Sell: Stock price expected to fall within three months from the time the rating was assigned because of a specific catalyst or event.
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KEY DEFINITIONS
Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or rating are subject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near-term (up to three months) performance of the stock and do not reflect any change in the fundamental view or investment case. Equity Price Targets have an investment horizon of 12 months.
EXCEPTIONS AND SPECIAL CASES
UK and European Investment Fund ratings and definitions are: Buy: Positive on factors such as structure, management, performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell: Negative on factors such as structure, management, performance record, discount. Core Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment Review Committee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respective company's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece.
Research analysts contributing to this report who are employed by any non-US affiliate of UBS Securities LLC are not registered/qualified as research analysts with the NASD and NYSE and therefore are not subject to the restrictions contained in the NASD and NYSE rules on communications with a subject company, public appearances, and trading securities held by a research analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any, follows.
UBS Securities LLC: Chip Miller, CFA; Jonathan Golub, CFA. Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report.
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