Ms 2012-forecast

January 2, 2012

US Equity Strategy The 2012 Playbook

We are establishing a 2012 year-end price target of 1167, representing 7% downside from today’s price. The consensus top-down view has coalesced, with limited variation, around 1350, making our forecast 13% more conservative than the “muddle through” scenario implied by consensus.

While 2011 was about multiple contraction, and further contraction is likely, we think 2012 and 2013 are likely more about earnings than the multiple. We are posting a 2013 EPS estimate for the S&P500 of $103.1, 15% below the consensus bottom-up view of $121.1. We have modestly lowered our 2012 earnings forecast, from $103 to $100. We are most below the bottom-up 2012 forecasts in materials, financials, and technology. In 2013, most sectors appear to have estimates more than 10% too high (Exhibit 10). Of note, BAC is forecasted by analysts to drive 14% of the entire S&P500 EPS growth for 2012 vs. 2011 (Exhibit 7).

Our more cautious view on earnings stems from three key factors. 1) We see global GDP decelerating over the next few months in nearly every major geography (Exhibit 15). 2) Recent company results have been weak (Exhibit 11), with companies like TXN, INTC, MU, ORCL, CRM, RHT, DRI, COST, FDX, and WAG reducing their outlook. This likely portends weak January results or April guidance. 3) The dollar has materially strengthened against the euro over the last few months (Exhibit 12) and our analysis shows this is highly correlated to earnings downside, with select staples, technology, and materials likely impacted. Furthermore, inventory levels remain crucial, as several industries now have inventory-to-sales ratios well above five-year averages (Exhibit 14).

With record high cash balances, we see capital use and its consequences as key (Exhibit 18), with dividend yield likely a continued successful factor. CVX, JPM, TGT, BEN, CBS, WU, SPLS, and ABC are our top ideas for sustainable yield (Exhibit 20).

Our three overweight sectors are utilities, health care, and consumer staples. We are recommending underweights in consumer discretionary and energy stocks (Exhibit 1). We make two major sector changes to start 2012. We have downgraded energy from market-weight to underweight, and upgraded industrials from underweight to market-weight (see details, pages 9 through 11).

Exhibit 1 Our Current Sector Recommendations Retain a Defensive Bent

Morgan Stanley Sector Recommendations As of January 2012

(5%)

(4%)

(3%)

(2%)

(1%)

0%

1%

2%

3%

4%

5%

Util

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Fina

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Dis

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Ener

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Overweights - Utilities, Health Care, StaplesMarket-Weights - Technology, Industrials, Telecoms, Financials, MaterialsUnderweights - Discretionary, Energy

Source: Morgan Stanley Research

This week, we are removing BHI and WAG from the portfolio and adding UTX, TFM, and TGT. For details on our portfolio, its characteristics and performance see Exhibit 24-Exhibit 27. To search for stock ideas or decompose individual names to assess what is driving our quantitative outlook, go to www.morganstanley.com/equitystrategy.

Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.

M O R G A N S T A N L E Y R E S E A R C H N O R T H A M E R I C A

Morgan Stanley & Co. LLC Adam S. Parker, Ph.D

[email protected] +1 212 761 1755

Brian T. Hayes, Ph.D [email protected]

Antonio Ortega [email protected]

Adam J. Gould, CFA [email protected]

Phillip Neuhart [email protected]

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M O R G A N S T A N L E Y R E S E A R C H

January 2, 2012 US Equity Strategy

Brief Review of 2011 In retrospect, the resiliency of the US equity market in the face of macro volatility was surprising in 2011. The SPX ending the year essentially unchanged and the Dow ending up 6% in 2011 were better outcomes than we anticipated, with the former slightly above our year-end target of 1238 established on January 3rd of 2011. However, the multiple contracted as we expected, given that SPX earnings appear to have grown roughly 17% in 2011. Multiple contraction remains our core thesis about the US equity market (please see: January 3rd, 2011: Initiating Coverage – The 2011 Playbook, January 10th, 2011: Expanding on Our Contraction Thesis and July 5th, 2011: Could the Multiple Go to 10x?). This view is consistent with Morgan Stanley chief US Economist Vincent Reinhart’s “After the Fall” paper, which focused on low growth rates post financial crises (C. Reinhart and V. Reinhart, "After the Fall," FRB Kansas City, Jackson Hole Symposium, August 2010).

Underlying the total market performance were some interesting major themes. Quality outperformed junk by nearly 12%, and growth outperformed value by almost 10%, both of which we anticipated (see January 18th, 2011: The Quality / Junk Debate and May 23rd, 2011: Do You Have Style?). Further, mega caps began outperforming in May and outperformed small caps by almost 540 basis points in 2011, something we previewed on March 21st, 2011 (Will Mega and Large Caps Remain an Inferior Asset Class?). We offered specific mega cap stock ideas on May 9th, 2011: A Five-Year View of the $100 Billion Market Cap. Club).

Sector betting was skewed toward the defensive, with utilities, health care, and staples the top 3 performing sectors in 2011 (all of which we overweight). We did not recommend financials, materials, or industrials all year, the three worst performing sectors in 2011 in the GICS ten. Our MOST Strategic Portfolio, a combination of fundamental and quantitative disciplines, outperformed the market by 190 basis points in 2011. For those unfamiliar with the portfolio, please see the back part of this note, which lists current stock picks as well as those deleted during the year. The portfolio had 60% turnover in 2011 and has an average market capitalization of over $50 billion, in order to enable avid followers to mirror the portfolio composition.

It truly ended up being a flat year. Within the top 500 market capitalization stocks, 246 ended the year down, and 254 up.

Winners and losers: Petrohawk Energy (acquired), El Paso (acquired), ISRG, ALXN, and MA were the best five performing

S&P stocks in 2011. FSLR, CREE, ANR, ROVI, and NFLX were the five worst performing stocks.

Adjusting for market capitalization (to better show the biggest contributors to a portfolio manager’s performance) changes the list. AAPL, XOM, IBM, PM, PFE, CVX, MCD, WMT, V, and INTC were the biggest 10 contributors, adjusting for size, in 2011. The biggest stocks to avoid included BAC, C, GS, HPQ, and JPM. Making a bet on integrated oil and select technology within mega caps, and avoiding financials, were keys to success.

Our 2012 S&P500 Forecast The switch of the calendar is more psychological than anything else and doesn’t necessarily mean huge rotations will occur by style, substance, or size. As such, we think some of the major themes we saw in 2011 are still in place today. We prefer mega caps to the broader market, growth over value, and quality to junk.

Our year-end 2012 price target for the S&P500 is 1167, a price implying 7% downside from today’s price by year-end (Exhibit 2). The consensus top-down view for 2012 is 1350, making our outlook 13% more cautious than the consensus top-down call. While top-down expectations are clearly less sanguine for 2012 than they were for 2011 at this time a year ago, there is little variation among the top-down forecasts, implying that a “muddle-through” scenario for the economy and earnings is the consensus. We think the risk-reward is skewed to the negative. Our bear case for the S&P500 is 944, and our bull case 1450. Accounting for the probabilities we see as likely, our expectation for the S&P500 by year-end 2012 is 1167.

Exhibit 2 Our Year-End 2012 Price Target Is 1167, 7% Down from Current Levels and 13% Below the Consensus Expectation of 1350 for End-2012

Morgan Stanley S&P 500 Price Target Methodology

Probability Scenario Upside /EPS Landscape of Scenario 2011E 2012E 2013E Multiple Target (Downside)

Bull Case 15% 99.2 107.1 117.0 12.9x 1450 15.3%Growth 17% 8% 9%

Base Case 50% 97.4 100.0 103.1 12.0x 1237 (1.6%)Growth 15% 3% 3%

Bear Case 35% 97.6 83.6 76.1 12.4x 944 (24.9%)Growth 15% (14%) (9%)

Probability Weighted S&P 500 Price Target 1167 (7.2%) Source: Factset, Morgan Stanley Research

We are launching our 2013 EPS estimate of $103.1, 15% below the bottom-up consensus forecast of $121.1.

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We made some minor changes to our 2011 and 2012 EPS estimates, modestly raising 2011 from $96 to $97.4, in-line with the consensus forecast. For 2012, we are lowering our estimate from $103 to $100. Less labor productivity and a stronger US dollar are among the key drivers for plateauing profits in our base case. Our 2013 EPS forecast of $103.1 is well below the $121.1 forecasted by bottom-up analysts (Exhibit 3).

Exhibit 3 We Are 15% Below Consensus on 2013 Earnings

$98

$107

$121

$97$100

$103

2011E 2012E 2013E

ConsensusMS Estimates

Morgan Stanley and Consensus S&P 500 Earnings EstimatesAs of December 2011

Source: Factset, Morgan Stanley Research

Three Key Themes for 2012 1) We forecast continued market multiple contraction.

This represents a continuation of our main theme in 2011. We know that low and volatile growth is bad for multiples and

showed that several times in our work in 2011. Is it possible to forecast year-ahead changes in US earnings and/or multiples, using only information available today? We tested a range of macro and financial variables for their effectiveness at predicting changes to the market multiple. Since our price target objective requires an estimate for next 12 months (NTM) earnings one year from now (i.e., at the end of 2012, what is our view of 2013 S&P500 earnings), together with an earnings multiple for that date, we need to analyze those quantities one year out.

As predictor variables (Exhibit 4) we considered a number of logical macro variables. These include:

• change in the level and slope of the yield curve • change in credit spreads • change in dividend yields • percent change in crude oil prices • percent change in the dollar vs. a trade-weighted

basket of currencies • the equity market return • the relative performance of value stocks versus

growth stocks • the relative performance of large-cap stocks vs.

small-cap stocks • the lagged performance of the change in earnings or

multiple.

In each case, the change or return was computed over the prior year (to be used in a forecast of coming year change in earnings or multiple). The models were tested over a 123-quarter period starting in 1980.

We found that forecasting the multiple a year out is fruitless using these major macro factors, with the exception of the prior year’s large vs. small cap performance.

Exhibit 4 We Attempted to Model the SPX Earnings and Multiples a Year Out from Macro Factors – Few Obvious Macro Factors Held Any Statistical Significance

Forecast Models1980 Through November 2011

Factors Tested (Check Indicates Significance)

Model

Slope of Yield Curve

Level of Yield Curve

Growth-Value Return

Large-Small Return

Baa-Aaa Spread

Dividend Yield

Top 500 Return

Dollar Index Crude Oil

Lagged Dependent

VariableNTM Earnings GrowthNTM P/E Growth


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So why do we think there will be further multiple contraction?

While valuation for the overall US stock market may look attractive versus recent history, if one examines a longer history, the top 500 stocks in the US have traded significantly below current levels for extended periods of time, particularly when interest rates were much higher. So, while on the surface, the valuation of the S&P500 may appear cheap, we think there are some important underlying explanations and that the market is less attractively valued than the conventional wisdom might otherwise dictate. Analysts earnings estimates have been posted in a central place since 1976. Relative to this complete history, the US equity market is trading slightly lower (cheaper) than its median (Exhibit 5), at the 39th percentile versus its long-term history and particularly cheap compared to the last ten years.

Exhibit 5 The Market Is in the 39th Percentile vs. History on Price-to-Forward Earnings

Top 500: Price to Forward Earnings1976 Through December 2011

0x

5x

10x

15x

20x

25x

30x

35x

76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

Median = 13.6

25th Percentile = 10.0

75th Percentile = 15.6


However, our judgment is that over the medium term, EPS growth is likely to be at-or-below its long-term average of 7%, owing to a muted economic backdrop and volatility induced by above-normal government intervention and regulation, demographics, European sovereign debt woes, and Chinese inflation, to name a few of the macro issues. We believe that by the middle-to-end of 2012, the view of forward one-year growth will be markedly lower than today’s consensus view. As such, the market multiple is more likely to contract than expand over the medium to long term – unless we see a recovery where 2012 EPS growth is higher than 2011 EPS growth. At present, we assign only a 15% probability to this bull case.

Because the consensus view is that the multiple will remain stable or gradually expand as earnings grow, we see our

multiple-contraction thesis as contrarian, despite the fact we had the same call last year and it worked throughout 2011.

Moreover, having received dozens of investors’ questions over the last couple of weeks, we are confident that the consensus view is that a “muddle through” scenario for EPS growth is “likely” and that modest multiple expansion will be a byproduct.

The major pushback we received in 2011 on our multiple contraction thesis took two forms:

1. Relative to bonds and other asset classes equities look cheap and therefore will see inflows, driving multiples higher. Our response is that there is no empirical evidence to show that inflows drive multiple expansion, the same as there is no evidence that outflows drive multiple contraction. As an example, in 2009, the equity market nearly doubled while there were substantial outflows.

2. There is a popular thesis that when rates are low the multiple is usually high. We have frequently acknowledged over the last year that this argument resonates with us. Holding certain high yielding equities, where the dividend is safe (i.e., at least twice covered) and earnings that ought to grow over the next decade does seem like a sensible approach relative to holding the 10-year US government bond yielding less than 2%. As such, we have recommended stocks like MCD and PM in our portfolio all year. However, we don’t subscribe to the thesis that low rates mean a high multiple. In fact, we believe it is quite the opposite. When interest rates are high, it is reasonable to expect that the equity risk premium rises, as a fixed equity risk premium would give less proportional compensation for investing in equities. What’s subject to some debate is whether a higher or lower equity risk premium is required when rates are low. In fact, part of the Fed’s strategy (i.e., Operation Twist) is to lower the 10-year yield to make risk assets like equities look more attractive. But our view is that the relationship between rates and the equity risk premium is actually a smile (non-linear), as opposed to a line (see the theoretical drawing in Exhibit 6). When rates are close to zero, we think you need a higher equity risk premium because the reason rates are near zero is that everything is out of kilter. Today, that means high deficit / debt, intense political polarization, massive fiscal stimulus that needs to be unwound, high unemployment, and a

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pretty severe hangover from the housing crisis, among other issues. Hence, lowering the 10-year yield doesn’t necessarily make equities more attractive, as extremely low rates and risk-aversion, not risk-seeking, are synonymous.

Exhibit 6 In Our View the Relationship between the 10-Year and Equity Risk Premium Is a Smile, not a Line

Theoretical DrawingEquity Risk Premium vs Treasury Yields

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%Equity Risk Premium

10-Y

r. Tr

easu

ry Y

ield

Fed's Target?

Theoretical Smile

Source: Morgan Stanley Research

2) We believe the 2012 and 2013 analyst estimates are too high.

We analyzed the 2012 consensus EPS estimates and have several observations. (If anyone wants the spreadsheet details, please don’t hesitate to contact us.) According to the consensus 2012 bottom-up estimates, 14% of the entire 2012 S&P500 EPS growth is slated to come from Bank of America and over 25% of the EPS growth from the largest six financials.

Only 51 of the 500 companies are forecasted to have declining earnings in 2012 vs. 2011. Furthermore, analysts are currently forecasting that only 15 companies in the S&P500 will have lower earnings in 2013 than in 2012. For context, 103 companies are forecasted to have lower earnings in 2011 than 2010.

Exhibit 7 Analysts Forecast that Bank of America Will Drive 14% of the Entire S&P500’s EPS Growth in 2012

Company 2011E 2012E

$ Growth (2012 Vs

2011)

% Growth Contribution To S&P 500

(2012)S&P 500 Index 883,520 970,617 87,097Bank of America Corp. (2,478) 9,777 12,255 14.1%

Apple Inc. 28,858 33,514 4,657 5.3%

Goldman Sachs Group Inc. 2,361 6,293 3,932 4.5%

General Electric Co. 14,349 16,373 2,023 2.3%

Wells Fargo & Co. 14,840 16,744 1,904 2.2%

Google Inc. Cl A 9,340 11,029 1,689 1.9%Schlumberger Ltd. 4,914 6,589 1,675 1.9%International Business Machines Corp. 15,794 17,469 1,675 1.9%

Allstate Corp. 391 1,856 1,465 1.7%

Caterpillar Inc. 4,518 5,918 1,401 1.6%

JPMorgan Chase & Co. 17,103 18,428 1,325 1.5%

Total Top 6 Financials (including GE) 26.3% Source: Factset, Morgan Stanley Research

At the sector level, analysts are forecasting that financials will account for over 35% of total S&P500 EPS growth in 2012 (Exhibit 8). As investors look to 2013 EPS, they may notice that the energy sector earnings are expected to rebound, with bottom-up forecasts currently embedding 18.6% earnings growth, such that the energy sector will account for 20% of total S&P500 earnings in 2013 if these numbers prove to be accurate.

Exhibit 8 Financials Are Forecasted to Account for over 35% of 2012 EPS Growth…

2012 vs. 2011 and 2013 vs. 2012 EPS Growth Contribution to S&P 500 by Sector

(5%)0%5%

10%15%20%25%30%35%40%45%

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2012 vs. 20112013 vs. 2012


In 2011, by contrast, earnings for the S&P500 were driven primarily by the technology and energy sectors, with financials accounting for a paltry 3.3% of the total S&P500 earnings growth (Exhibit 9).

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Exhibit 9 …But Accounted for 3% of the Growth in 2011

EPS Contribution to S&P 500

Sector 2011E vs 2010 2010Energy 34% 12%Information Technology 20% 19%Industrials 13% 9%Consumer Discretionary 10% 9%Health Care 7% 14%Materials 6% 3%Consumer Staples 6% 10%Financials 3.5% 16%Utilities 0% 4%Telecommunication Services 0% 3%

2011 EPS Growth vs 2010 vs. Total EPS in 2010

Financials 3.3% Source: Factset, Morgan Stanley Research

At the sector level (Exhibit 10) we are most below consensus in 2012 for materials, financials, and technology. For 2013, our top-down estimates are 10% or more lower than the bottom-up outlook in industrials, energy, materials, consumer discretionary, telecoms and financials. Exhibit 10 For 2012, We Are Most Below the Bottom-Up Forecasts in Materials, Financials, and Technology- We Are More than 10% Below Consensus for Most Sectors in 2013

S&P 500 Earnings Per Share Summary TableAs of July 2011

2011E 2012E 2013E 2011E 2012E 2013ES&P 500 97.5 107.2 121.1 15% 10% 13%

Consumer Discretionary 8.9 9.8 11.6 12% 11% 18%MS Consumer Discretionary 8.9 9.3 10.0 12% 4% 8%

Consumer Staples 9.2 10.0 10.9 6% 8% 9%MS Consumer Staples 9.2 9.4 9.6 6% 2% 2%

Energy 14.9 15.3 18.1 41% 2% 19%MS Energy 14.9 14.9 15.5 41% 0% 4%

Financials 14.3 18.0 20.3 10% 25% 13%MS Financials 14.3 15.8 16.4 9% 10% 4%

Health Care 12.6 13.1 14.1 5% 3% 8%MS Health Care 12.6 12.7 12.9 5% 1% 2%

Industrials 9.7 11.0 12.4 22% 13% 13%MS Industrials 9.7 10.4 10.0 21% 7% (4%)

Information Technology 18.7 20.6 23.1 14% 10% 12%MS IT 18.7 19.0 20.0 14% 2% 5%

Materials 3.4 3.9 4.4 33% 14% 14%MS Materials 3.4 3.0 3.0 32% (12%) 0%

Telecom Services 2.2 2.4 2.8 3% 7% 19%MS Telecoms 2.2 2.2 2.4 3% 0% 9%

Utilities 3.5 3.3 3.4 3% (5%) 4%MS Utilities 3.5 3.3 3.3 4% (6%) 0%

Consensus 97.5 107.2 121.1MS Estimates 97.4 100.0 103.1 Source: Factset, Morgan Stanley Research

Recent corporate results and guidance have been soft.

The number of companies issuing negative guidance during the fourth quarter has increased, and this perhaps has flown a little under the radar screen over the last few weeks in our judgment. In terms of breadth, we have seen the highest ratio of negative to positive guidance in several quarters (Exhibit 11). Companies like TXN, INTC, MU, ORCL, CRM, RHT, DRI, COST, FDX, WAG, among others, have guided down or discussed slowdowns over the past several weeks. We think this may portend weak guidance or soft results during the January earnings season and the corresponding guidance for April.

Exhibit 11 More Companies Have Issued Negative Guidance Recently than Any Time in Over a Year

Ratio of Negative-to-Positive At T-1S&P 500 Guidance Relative to Consensus Expectations

0.0

0.5

1.0

1.5

2.0

2.5

4Q10 1Q11 2Q11 3Q11 4Q11

T=0 is end of Quarter


Currency will continue to be an important issue, with tailwinds turning into headwinds.

For some reason whenever I think of currency, I think of IBM’s July 2011 earnings report. They reported 12% revenue growth, with 7% coming from currency. The dollar weakened by 9% from January 2011 through early May 2011. IBM was the third best stock in the S&P500 last year by market capitalization contribution. What’s our point? It has to be related. The dollar has strengthened materially against the euro since, particularly since late October (Exhibit 12).

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Exhibit 12 The Dollar Has Meaningfully Strengthened Against the Euro Recently

US Dollar/Euro Spot

1.25

1.30

1.35

1.40

1.45

1.50

Jan-11 Apr-11 Jul-11 Oct-11


We measured the sensitivity of overall US equity earnings to currency moves using a highly quantitative approach. Our conclusion is that each 1% appreciation in the US dollar corresponds to an expected 0.97% decline in aggregate earnings. Historically, swings in earnings have been more dramatic than swings in currency, so currency overall is not a dominant factor in overall earnings growth, but it does matter at the margin. Morgan Stanley’s Currency Strategist Hans Redeker is forecasting a further weakening of the euro to US$1.20 by the end of 2012. For most sectors in the US, a strengthening dollar is negative for earnings growth, with a positive but statistically insignificant impact on consumer discretionary, financials, and telecom earnings being counter to the negative impact on the other seven GICS sectors. Materials, technology, and staples are typically most negatively impacted by currency moves, and we would avoid high beta bets in these sectors heading into earnings season.

Overall, we think the risk-reward is skewed to the negative on corporate profitability, although our base case is for continued, though quite modest, growth. The starting point is of course relevant, and we now have record profit margins and record expectations for margins over the next year (Exhibit 13).

Exhibit 13 Companies Are Making Record Profits – This Could Continue but We Think Risk-Reward Is Skewed to the Negative

Top 500 Net MarginThrough 2013E

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12


We are not saying that everything is cyclical and mean-reverts in our margin outlook. There are real reasons why the margins are higher today, including better productivity. However, we don’t see incremental margin expansion as accelerating. We made a big point of this in 2011, and expectations for 2012 profit margins have begun to moderate. Nonetheless, labor productivity, currency, and factory utilization will be keys for further profit margin expansion. In addition, we are closely monitoring corporate inventory levels, which have begun to grow and may limit margin progress in 2012. In fact, there are several industries where current inventory-to-sales levels are well above average levels seen over the past five years (Exhibit 14), including machinery and metals and mining.

Exhibit 14 We Are Monitoring Corporate Inventory Levels, Which Are Rising in Machinery and Metals and Mining, Among Other Sectors

Top 1500 Inventory-to-Sales by Industry1974 - Q3 2011

Industry Current

Percentile vs. 5-Year

Median Example TickersAerospace & Defense 19.3% 100.0% UTX, BA, HON, PCP, GD, LMTMachinery 15.9% 100.0% CAT, DE, ITW, CMI, ETN,Leisure Equipment & Products 18.1% 100.0% MATFood & Staples Retailing 8.7% 94.7% WMT, CVS, COST, WAG, SYYContainers & Packaging 13.2% 89.4% BLL, CCKConstruction & Engineering 7.5% 84.2% FLR, JECHousehold Durables 12.9% 84.2% GRMNMetals & Mining 15.4% 78.9% FCX, NEM, SCCO, NUE, AAAuto Components 7.9% 78.9% JCI, BWAGas Utilities 6.9% 78.9% OKEIndustrial Conglomerates 10.9% 73.6% GE, MMM, DHR, TYCAutomobiles 41.0% 73.6% F, GM, HOG Source: Morgan Stanley Research

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The Bear Case Is a Meaningful Slowdown in Earnings

While not a dramatic decline, our Global Economics Team is currently forecasting decelerating GDP for the next couple of quarters in nearly every major global economy. Moreover, their base case includes a recession with deceleration in Europe (Exhibit 15). Not only is this likely to impact corporate profits, it is also likely to change sentiment around corporate spending from managements, as well as the multiple investors are willing to pay for the reported earnings.

Exhibit 15 The GDP of Most Major Regions Will Likely Decelerate Over the Next Few Months

Morgan Stanley GDP Growth Estimates

(2%)

(1%)

0%

1%

2%

3%

4%

G10 US Euro Area

Q4 2011Q1 2012


In particular, the slowdown in the emerging markets and China will be important. Data points in China have clearly been weak over the last couple of months. Economic surprise indices are markedly worse than in the early fall, and property, rail car, and corporate spending data points, among others, have also stalled. While fears of a hard landing have already episodically weighed on multiples, the reality of lower growth will likely impact reported earnings in 2012.

3) Capital Use and Its Consequences Will Matter

Cash balances are at record highs and continue to expand. We argued early last year that the market was paying an increasingly lower multiple for cash on the balance sheets of companies, in part due to uncertainly about future uses. Apple is probably the best current example. With over $1.4 trillion in net cash on the balance sheets of the largest 1500 US companies (Exhibit 16), deployment of this capital will continue to be a major theme for US equity investors.

Exhibit 16 US Companies Have More than $1.4 Trillion in Net Cash on Their Balance Sheets Today

Cash Balances Top 1,500 Stocks (Ex-Financials, $T)

Through Q3 2011

$0.0

$0.2

$0.4

$0.6

$0.8

$1.0

$1.2

$1.4

$1.6

$1.8

68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10


Much of that cash (about 80%) is concentrated in four sectors: technology, industrials, health care, and consumer discretionary, and these will likely be places where some small-to-mid cap exposure is prudent for capitalizing on M&A (Exhibit 17).

Exhibit 17 80% of that Cash Is Concentrated in Four Sectors – Technology, Industrials, Health Care and Discretionary

Share of Cash Balances by Sector (Ex-Financials)As of Q3 2011

5%7%

9%

15% 16%19%

30%

0%

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15%

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35%

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Of late, the market has rewarded dividend yielders the most (Exhibit 18), though companies buying back stock were also handsomely rewarded in 2011, in fact more than over the previous several years (not shown here). Acquirers were punished, particularly those who did all-stock deals. High capital spenders lagged the market.

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Exhibit 18 Investors Rewarded Dividend Yield the Most in 2011 – M&A Was Punished, Particularly All-Stock Deals

Efficacy of Capital Uses by Time Period: One-Year ReturnTop vs. Bottom Tertile (T1-T3), 2011

Capital Spending (6.2%)

R&D Expenditures (5.9%)

M&A 1.9%Cash Only (0.4%)Stock Only (6.4%)Blend 2.1%

Reduce Leverage

Change in Debt-to-Assets (3.4%)

Total Yield 16.8%Dividend Yield 17.0%Share Buybacks 12.6%

T1 defined as high capx, high R&D, high shareholder yield, low change in total debtFor M&A the figures represent median performance of acquires vs. the market

Return to Shareholders

External Growth

Internal Growth


We believe dividends will continue to work as a factor in predicting subsequent stock return. Investors have asked us whether the strong efficacy of this factor since May of 2011 means that it will stop working early in 2012. We don’t think so. Taking a longer-term perspective, dividends have accounted for over 40% of S&P500 return over the past century (Exhibit 19).

Exhibit 19 Dividends Have Accounted for Over 40% of SPX Returns over the Last Century

S&P 500 Total Return: Price and Dividend Contribution

Total Price Income As a Share of Total ReturnReturn Appreciation Return Price App. Div. Income

1930's 0.1% (5.3%) 5.7% na na1940's 8.9% 3.0% 5.7% 33.6% 64.5%1950's 18.9% 13.6% 4.7% 72.0% 24.7%1960's 7.7% 4.4% 3.1% 57.2% 41.0%1970's 5.8% 1.6% 4.1% 27.8% 71.1%1980's 17.2% 12.6% 4.1% 73.2% 23.8%1990's 18.0% 15.3% 2.3% 85.1% 12.9%2000's (0.9%) (2.7%) 1.8% na na

2010 15.1% 12.8% 2.0% 84.9% 13.4%2003-2010 6.7% 4.6% 2.0% 68.5% 30.1%1930-2010 9.3% 5.2% 3.9% 55.6% 42.2% Source: Morgan Stanley Research

Stocks that currently offer dividend yields above 2.5% that are twice covered, have forecasted long-term EPS growth above 5%, are Overweight rated by our analysts and screen well, i.e.,

in the top two quintiles of our MOST (3-month) and BEST (two-year) quantitative models, are shown in Exhibit 20.

Exhibit 20 Stock Ideas with EPS Growth and Sustainable Dividend Yields Include CVX, JPM, TGT, and ABC, Among Others

Sustainable Dividend Stock Ideas

MarketTicker Company Name Sector Cap ($ B) BEST MOST

CVX Chevron Corp. Energy 211.9 Q1 Q1JPM JPMorgan Chase & Co. Financials 126.3 Q1 Q1TGT Target Corp. Consumer Discretionary 34.4 Q2 Q1BEN Franklin Resources Inc. Financials 20.9 Q2 Q1CBS CBS Corp (Cl B) Consumer Discretionary 17.8 Q2 Q2WU Western Union Co. Information Technology 11.3 Q2 Q1SPLS Staples Inc. Consumer Discretionary 9.7 Q1 Q1ABC AmerisourceBergen Corp. Health Care 9.7 Q1 Q1

Stocks with Market Cap of $5 Billion or GreaterDividend Yield > 2.5% or Buyback Yield > 2%.Payout Ratio < 55%.Top two quintiles of BEST and MOST. Source: Factset, Morgan Stanley Research. Stock prices: CVX: $106.40, JPM: $33.25, TGT: $51.22, BEN: $96.06, CBS: $27.14, WU: $18.26, SPLS: $13.89, ABC: $37.19

Sector Recommendations

Our three overweight sectors are utilities, health care, and consumer staples. We are recommending underweights in consumer discretionary and energy stocks (Exhibit 21).

We are making two major sector changes to start 2012. We have downgraded energy from market-weight to underweight, and upgraded industrials from underweight to market-weight. This moves industrials to our 5th ranked sector versus a prior rank of 9th (out of ten). We clearly prefer industrials to energy at this juncture. To embody this in our portfolio, we removed Baker Hughes and added United Technologies. We have also added Target to the portfolio for its dividend yield and the potential of its Canada operations (per our analyst Mark Wiltamuth’s thesis). We removed WAG and added TFM, which modestly increased our exposure to the consumer discretionary sector, viewing the growth profile of TFM as superior to WAG.

10



Exhibit 21 We Are Overweight Health Care, Utilities and Staples, and Underweight Energy and Consumer Discretionary

Morgan Stanley Sector Recommendations As of January 2012

(5%)

(4%)

(3%)

(2%)

(1%)

0%

1%

2%

3%

4%

5%

Util

ities

Hea

lth C

are

Stap

les

Tech

nolo

gy

Indu

stria

ls

Tele

com

s

Fina

ncia

ls

Mat

eria

ls

Dis

cret

iona

ry

Ene

rgy

Overweights - Utilities, Health Care, StaplesMarket-Weights - Technology, Industrials, Telecoms, Financials, MaterialsUnderweights - Discretionary, Energy


Why our sector changes?

Industrials: We have upgraded industrials from underweight to market-weight today. The industrials sector was the third worst performing sector (behind only materials and financials) in the S&P500 last year. Doubts about sustained growth and negative earnings revisions occurred in the middle of the year, driving down valuations that had previously been less compelling than other parts of the market. We feel relatively more balanced about the outlook today, primarily because the analyst expectations for 2012 profit margins have meaningfully moderated since last spring (Exhibit 22). In May, analysts were expecting industrial companies to get 35 cents of profit from every dollar of revenue growth. Now, the expectations are for a more reasonable 13 cents. Reductions to the outlook are true across the board, not just for GE, which is the largest security in the sector.

Exhibit 22 Incremental Margin Expectations for Industrials Have Moderated Meaningfully Since Last May

Industrials: 2012 Incremental Margins

10%

15%

20%

25%

30%

35%

40%

Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11


Moreover, the multi-industry conglomerates and defense industries, which represent a large percent of earnings and market capitalization of the sector, look more attractively valued than the sector as a whole, as multiples have contracted over the last several quarters (Exhibit 23).

Exhibit 23 The Valuation of Conglomerates and Aerospace and Defense Has Become More Attractive

Relative Price-to-Forward EarningsIndustrial Conglomerates and Aerospace & Defense Industries vs.

Industrials Sector (excludes GE)2008 Through 2011

0.8x

0.9x

1.0x

1.1x

1.2x

1.3x

1.4x

08 09 10 11


We don’t advocate chasing higher beta machinery today, but could see adding to quality conglomerates. Industrials that are high or moderate quality and also screen in the top two quintiles of both MOST and BEST models include UTX, PH, EMR, TYC, FLR, TW, FCN, and WTS. And CLH, URI, GWR, HUBG, TAL, and TGH are companies that screen poorly on

11



MOST and BEST and are low quality or junk according to our quality model.

Energy: We downgraded energy to underweight from market-weight today.

We started 2011 with energy as our largest overweight, and in mid-April downgraded it to market-weight. We briefly oscillated back to overweight over the summer, but became market-weight the sector again since August. Netting it out, the sector allocation had almost no impact on our portfolio last year. Why are we cautious now?

Estimates for 2013 look too high: The bottom-up energy sector expectations for 2013 of 18.6% EPS growth seem excessive, and downward revisions are likely without a material rise in oil prices.

Global economy is decelerating: We see strong demand as unlikely, as the global economy is slated to decelerate in nearly every region of the world over the next few months. Moreover, if we are wrong, and the global economy improves more materially than we expect, we think select industrials, technology, and financials might represent more attractive beta than energy. The reason is because nearly every year for the last several, a global geopolitical issue has surfaced that has negatively impacted energy stocks.

Supply fears are possible: This matters, because supply constraints are the other major reason that oil rises. But our prior work has shown that the energy sector underperforms when supply fears drive oil higher. Why? Because these are typically coincident with geopolitical risks, like Libya in 2011, and potentially Iran or Russia in 2012 or 2013.

Normally, the “chicken energy” trade is effective in a “risk off” regime. Given the huge size of the biggest three energy companies today (CVX, COP, and XOM are more than $700 billion market capitalization) it is typically the case that owning these high yielding, lower growth integrated oil companies will be prudent. In fact, that was the case in 2011. However, we believe a rotation out of XOM and some of the large capitalization integrated oil names is possible in the first part of 2012. We don’t think incremental dollars will flow into a stock like XOM given its massive outperformance last year. As a portfolio strategy we see using a stock like XOM as a source of funds in divergent scenarios in 2012 – if you are bearish you reduce energy and buy MSFT or other quality names that have not performed as well. If you are bullish, you sell energy and buy beta energy which is relatively cheap.

Our Portfolio

We publish our portfolio each week. The strategy we use for stock selection is to combine the fundamental analyst recommendations with our quantitative models. We have been able to show that when both fundamental and quantitative disciplines are used in combination, a synergy results that historically had produced excess return. In 2011, our portfolio outperformed the S&P500 by 190 basis points (Exhibit 24). We view the portfolio as “Core” more than “Growth or Value” as our analyst recommendations and quantitative frameworks are ostensibly style neutral.

Exhibit 24 The MOST Strategic Portfolio Outperformed the S&P 500 (Total Return) in 2011 by 190 Basis Points

1.8%

3.7%

1.9%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

S&P Portfolio Relative Performance

MOST Strategic Portfolio Performance December 31, 2010 to December 30, 2011

Source: Morgan Stanley Research. Past performance is no guarantee of future returns. Performance includes dividends but excludes transaction costs.

The portfolio is comprised of stocks that currently average nearly $56 billion in market capitalization, and we turned the portfolio over less than 60% in 2011. Our goal is to provide a portfolio where clients can follow our additions and deletions, and closely mirror our results if they so choose, given our low turnover and focus on large capitalization names. Our portfolio is cheaper on price-to-operating cash flow and EV-to-cash flow than the broader market (Exhibit 25), and trades in-line with the broader market on other classic valuation metrics. Our portfolio has a higher free cash flow yield, higher cash balances, lower capital spending, less accruals, and lower gross margins than the benchmark. The sales stability is higher and the beta is markedly lower. We think this is the correct positioning for a risk-neutral to risk-averse environment as we head into 2012.

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Exhibit 25 Our Portfolio Is Cheaper, Larger Capitalization, and Lower Beta than the Benchmark

The MOST Strategic Portfolio vs S&P 500 as of End-December, 2011

Factor Portfolio BenchmarkPortfolio vs Benchmark

Price-to-Book 2.0x 2.0x 1.0xPrice-to-Fwd. Earnings 11.4x 11.9x 1.0xPrice-to-Sales 0.8x 1.2x 0.7xPrice-to-Oper. Cash flow 8.1x 8.5x 0.9xEV-to_EBIT 9.1x 10.1x 0.9xEV-Free Cash Flow 17.3x 23.1x 0.7xDividend Yield 2.4% 2.4% (0.1%)Total Yield 4.7% 4.8% 0.0%Free Cash Flow Yield 5.7% 4.3% 1.4%Total Cash-to-Market Capitalization 12.7% 11.4% 1.1xCapex-to-Sales 5.8% 8.5% 0.7xAccruals 3.8% 9.4% 0.4xIncremental Margin 8.2% 12.5% (4.3%)Asset Turnover 118.0% 89.7% 1.3xGross Margin 37.9% 41.6% (3.7%)Changes in Shares Outstanding 0.2% 0.1% 0.1%9-Month Price Momentum 3.1% 0.7% 2.4%3-Month Smoothed Earnings Revisions 1.0% 0.4% 0.6%Up-to-Down Revisions (8.2%) (7.0%) (1.2%)Sales Stability 12.0% 18.7% (6.8%)Beta 0.89 1.02 0.9x

Size Market Cap 55,991 23,991 2.3x

Valuation

Capital Use and

Profitability

Growth and Investor

Sentiment


In 2011, our sector bets in utilities and health care and our avoidance of industrials aided portfolio performance (Exhibit 26). Stock selection in discretionary, materials, health care, and staples provided the remainder of the outperformance.

Portfolio changes: This week, we are removing BHI and WAG from the portfolio and adding UTX, TFM, and TGT.

UTX is rated Overweight by Heidi Wood and screens in the top quintile of our MOST and BEST models. It is a high quality industrial that fits our dividend mandate.

TFM is in the top quintile of our MOST model and middle quintile of BEST. It is rated Overweight by Mark Wiltamuth and is we view it as a classic growth stock gaining share. TGT is in the top quintile of MOST and the second quintile of BEST and Mark also rates it Overweight. Both these names replace WAG, which Mark recently downgraded to Underweight.

We removed BHI. It is in the fourth quintile of MOST. While it appears cheap and is in the top quintile of BEST, we think the timing for beta energy likely will be better later in the year.

The full portfolio is shown in Exhibit 27. For those interested in our quantitative output, please go to www.morganstanley.com/equitystrategy and use the alpha screener product for output from our 3-month model (MOST) and our 24-month model (BEST). A video tutorial is available there, or we or your Morgan Stanley salesperson can give you a brief demonstration.

Exhibit 26 Sector Bets in Utilities and Health Care and Avoidance of Industrials Helped Drive 2011 Outperformance

MOST Strategic Portfolio Performance Attribution December 31, 2010 to December 30, 2011

Relative Sector Sector Relative Sector Sector Relative Sector StockSector Weight Weight Return Return Weight Return Return Allocation Selection TotalOverweight 10.5% 37.0% 19.4% 5.5% 26.5% 13.9% 12.1% 0.9% 1.3% 2.2%

Utilities 4.3% 8.0% 20.9% 1.0% 3.7% 19.9% 18.1% 0.5% 0.1% 0.6%Health Care 3.5% 15.0% 18.8% 6.5% 11.5% 12.3% 10.5% 0.4% 0.8% 1.3%Consumer Staples 2.7% 14.0% 19.3% 5.6% 11.3% 13.7% 11.9% (0.0%) 0.4% 0.3%

Market-Weights (4.1%) 48.0% (3.8%) (0.8%) 52.1% (3.0%) (4.8%) (0.1%) (0.5%) (0.5%)Materials (1.5%) 2.0% 18.7% 28.9% 3.5% (10.1%) (11.9%) (0.0%) 0.8% 0.8%Financials (1.5%) 12.0% (15.0%) 2.7% 13.5% (17.7%) (19.5%) (0.0%) 0.3% 0.3%Information Technology 0.4% 20.0% (0.3%) (2.7%) 19.6% 2.4% 0.6% (0.0%) (0.5%) (0.5%)Telecommunication Services (1.0%) 2.0% (13.4%) (19.0%) 3.0% 5.5% 3.7% (0.0%) (0.4%) (0.4%)Energy (0.4%) 12.0% (0.7%) (5.2%) 12.4% 4.5% 2.7% 0.0% (0.7%) (0.7%)

Underweights (6.4%) 15.0% 4.3% 1.6% 21.4% 2.7% 0.9% (0.0%) 0.2% 0.2%Industrials (2.7%) 8.0% (7.2%) (6.5%) 10.7% (0.7%) (2.5%) 0.2% (0.5%) (0.4%)Consumer Discretionary (3.7%) 7.0% 17.4% 11.4% 10.7% 6.1% 4.3% (0.2%) 0.8% 0.6%

Total 0.0% 100.0% 3.7% 100.0% 1.8% 0.8% 1.1% 1.9%

S&P 500Portfolio


http://www.morganstanley.com/equitystrategy

13



Exhibit 27 The MOST Strategic Portfolio With Fundamental Analyst Recommendations and MOST Alpha Rankings

Weight Price Inclusion MOST MS AnalystTicker Company S&P 500 Portfolio Latest Inclusion Date Quintile Rating

Consumer Discretionary 10.7% 9.0%Hotels Restaurants & Leisure YUM Yum! Brands Inc. 2.00% 59.01 49.05 12/31/2010 Q1 OverweightMedia CBS CBS Corp (Cl B) 2.00% 27.14 19.05 12/31/2010 Q2 OverweightSpecialty Retail ANN Ann Inc. 1.00% 24.78 24.43 12/2/2011 Q1 OverweightHotels Restaurants & Leisure MCD McDonald's Corp. 2.00% 100.33 76.76 1/1/2011 Q1 Equal-WeightMultiline Retail TGT Target Corp. 2.00% 51.22 51.22 12/30/2011 Q1 Overweight

Consumer Staples 11.6% 14.0%Food & Staples Retailing COST Costco Wholesale Corp. 3.00% 83.32 72.21 12/31/2010 Q1 OverweightFood Products KFT Kraft Foods Inc. 2.00% 37.36 31.51 12/31/2010 Q5 NCHousehold Products PG Procter & Gamble Co. 2.00% 66.71 61.90 4/8/2011 Q5 OverweightTobacco PM Philip Morris International Inc. 2.00% 78.48 58.53 12/31/2010 Q1 OverweightTobacco LO Lorillard Inc. 2.00% 114.00 111.51 5/13/2011 Q2 Equal-WeightFood & Staples Retailing TFM Fresh Market Inc. 1.00% 39.90 39.90 12/30/2011 Q1 OverweightHousehold Products CL Colgate-Palmolive Co. 2.00% 92.39 88.92 9/23/2011 Q1 Overweight

Energy 12.2% 8.0%Integrated Oil & Gas OXY Occidental Petroleum Corp. 1.00% 93.70 98.10 12/31/2010 Q1 Equal-WeightOil & Gas Storage & Transportation EP El Paso Corp. 0.01% 26.57 13.76 12/31/2010 Q5 ++Integrated Oil & Gas CVX Chevron Corp. 3.00% 106.40 91.25 12/31/2010 Q1 OverweightOil & Gas Equipment & Services SLB Schlumberger Ltd. 1.00% 68.31 83.50 12/31/2010 Q5 OverweightIntegrated Oil & Gas XOM Exxon Mobil Corp. 2.00% 84.76 85.22 7/22/2011 Q2 Equal-WeightOil & Gas Equipment & Services HAL Halliburton Co. 0.99% 34.51 39.13 10/28/2011 Q4 Overweight

Financials 13.5% 12.0%Insurance ACE ACE Ltd. 1.00% 70.12 64.31 6/17/2011 Q4 OverweightCommercial Banks PNC PNC Financial Services Group Inc. 3.00% 57.67 60.83 1/21/2011 Q4 OverweightInsurance RNR RenaissanceRe Holdings Ltd. 2.00% 74.37 71.25 7/8/2011 Q4 OverweightInsurance CB Chubb Corp. 1.00% 69.22 57.89 9/23/2011 Q3 OverweightInsurance TRV Travelers Cos. Inc. 2.00% 59.18 59.80 4/15/2011 Q3 OverweightDiversified Financial Services JPM JPMorgan Chase & Co. 2.00% 33.25 42.42 12/31/2010 Q2 OverweightInsurance AXS AXIS Capital Holdings Ltd. 1.00% 31.96 25.43 9/23/2011 Q5 Equal-Weight

Health Care 11.8% 15.0%Health Care Providers & Services ABC AmerisourceBergen Corp. 2.00% 37.19 34.12 12/31/2010 Q1 OverweightPharmaceuticals BMY Bristol-Myers Squibb Co. 3.00% 35.24 29.12 7/8/2011 Q5 OverweightHealth Care Providers & Services MCK McKesson Corp. 2.00% 77.91 77.74 2/4/2011 Q1 OverweightHealth Care Providers & Services CAH Cardinal Health Inc. 1.00% 40.61 38.31 12/31/2010 Q2 OverweightHealth Care Equipment & Supplies COV Covidien PLC 2.00% 45.01 52.50 6/17/2011 Q4 OverweightPharmaceuticals PFE Pfizer Inc. 3.00% 21.64 18.15 9/16/2011 Q2 OverweightHealth Care Providers & Services UNH UnitedHealth Group Inc. 2.00% 50.68 36.11 12/31/2010 Q5 Overweight

Industrials 10.7% 10.0%Construction & Engineering URS URS Corp. 2.00% 35.13 41.61 12/31/2010 Q1 NCAerospace & Defense NOC Northrop Grumman Corp. 2.00% 58.49 54.82 9/16/2011 Q3 Equal-WeightAerospace & Defense COL Rockwell Collins Inc. 1.00% 55.37 58.26 12/31/2010 Q3 OverweightAerospace & Defense GD General Dynamics Corp. 2.00% 66.41 60.60 9/16/2011 Q3 OverweightRoad & Rail UNP Union Pacific Corp. 1.00% 105.94 92.66 12/31/2010 Q4 OverweightAerospace & Defense UTX United Technologies Corp. 2.00% 73.09 78.85 12/30/2010 Q2 Overweight

Information Technology 19.0% 20.0%Software MSFT Microsoft Corp. 5.00% 25.96 27.91 12/31/2010 Q2 OverweightIT Services ACN Accenture PLC 3.00% 53.23 48.49 12/31/2010 Q1 OverweightSoftware ORCL Oracle Corp. 3.00% 25.65 31.19 6/17/2011 Q2 OverweightComputers & Peripherals EMC EMC Corp. 2.00% 21.54 22.90 12/31/2010 Q4 OverweightSoftware INTU Intuit Inc. 2.00% 52.59 49.30 12/31/2010 Q1 Equal-WeightCommunications Equipment MSI Motorola Solutions Inc. 2.00% 46.29 45.08 7/8/2011 Q3 Equal-WeightIT Services WU Western Union Co. 3.00% 18.26 21.66 2/18/2011 Q1 Overweight

Materials 3.5% 2.0%Chemicals LYB LyondellBasell Industries N.V. Cl A 2.00% 32.49 34.50 10/28/2011 Q2 Overweight

Telecommunication Services 3.2% 2.0%Diversified Telecommunication Services CTL CenturyLink Inc. 2.00% 37.20 46.17 12/31/2010 Q2 Overweight

Utilities 3.9% 8.0%Electric Utilities ETR Entergy Corp. 3.00% 73.04 65.60 9/16/2011 Q1 NCElectric Utilities AEP American Electric Power Co. Inc. 3.00% 41.31 35.98 12/31/2010 Q2 NCMulti-Utilities AEE Ameren Corp. 2.00% 33.14 30.42 9/16/2011 Q2 NC

100.0% 100.0% Source: Morgan Stanley Research. Past performance is no guarantee of future results. Price performance does not take transaction costs into account. For companies included in the portfolio, all important disclosures including personal holdings disclosures and Morgan Stanley disclosures appear on the Morgan Stanley public website at www.morganstanley.com/researchdisclosures. ++Rating for this company has been removed from consideration in this report because, under applicable law and/or Morgan Stanley policy, Morgan Stanley may be precluded from issuing such information with respect to this company at this time. NC = Not covered.

14



History of Portfolio Changes

Ticker Company Date Added Date Removed Price When Added

Price When Removed or Latest

Price Total ReturnS&P 500 Total

ReturnRelative

PerformanceABT Abbott Laboratories 12/31/2010 2/4/2011 47.91 46.12 -2.8% 4.2% -7.1%ACE ACE Ltd. 6/17/2011 64.31 70.12 10.1% -1.1% 11.2%ACN Accenture PLC 12/31/2010 48.49 53.23 12.1% 0.0% 12.1%AFL AFLAC Inc. 12/31/2010 6/17/2011 56.43 45.02 -19.2% 1.1% -20.3%ALB Albemarle Corp. 12/31/2010 10/28/2011 55.78 55.13 -0.3% 2.2% -2.5%AGN Allergan Inc. 12/31/2010 6/17/2011 68.67 80.84 17.9% 1.1% 16.8%AEE Ameren Corp. 9/16/2011 30.42 33.14 10.3% 3.4% 6.8%AEP American Electric Power Co. Inc. 12/31/2010 35.98 41.31 20.0% 0.0% 20.0%AXP American Express Co. 12/31/2010 1/21/2011 42.92 46.00 7.6% 2.0% 5.6%ABC AmerisourceBergen Corp. 12/31/2010 34.12 37.19 10.3% 0.0% 10.3%AMR AMR Corp. 7/8/2011 9/16/2011 5.50 3.54 -35.6% -9.5% -26.1%ANN Ann Inc. 12/2/2011 24.43 24.78 1.4% 1.1% 0.4%ACI Arch Coal Inc. 12/31/2010 9/23/2011 35.06 15.26 -55.6% -9.6% -45.9%AVP Avon Products Inc. 12/31/2010 2/4/2011 29.06 29.25 0.7% 4.2% -3.6%AXS AXIS Capital Holdings Ltd. 9/23/2011 25.43 31.96 27.5% 10.7% 16.9%BHI Baker Hughes Inc. 12/31/2010 12/30/2011 57.17 48.64 -13.9% 0.0% -13.9%BAC Bank of America Corp. 12/31/2010 7/8/2011 13.34 10.70 -19.6% 6.9% -26.5%BK Bank of New York Mellon Corp. 12/31/2010 9/23/2011 30.20 18.52 -37.5% -9.6% -27.9%BMY Bristol-Myers Squibb Co. 7/8/2011 29.12 35.24 22.1% -6.4% 28.6%CAM Cameron International Corp. 12/31/2010 1/28/2011 50.73 52.48 3.4% 1.5% 2.0%CAH Cardinal Health Inc. 12/31/2010 38.31 40.61 8.2% 0.0% 8.2%CBS CBS Corp (Cl B) 12/31/2010 19.05 27.14 44.3% 0.0% 44.3%CTL CenturyLink Inc. 12/31/2010 46.17 37.20 -13.1% 0.0% -13.1%CF CF Industries Holdings Inc. 7/8/2011 10/4/2011 149.01 124.10 -16.4% -16.4% -0.1%CVX Chevron Corp. 12/31/2010 91.25 106.40 20.0% 0.0% 20.0%CB Chubb Corp. 9/23/2011 57.89 69.22 20.2% 10.7% 9.6%COH Coach Inc. 12/31/2010 12/2/2011 55.31 62.20 13.9% -1.1% 15.0%CL Colgate-Palmolive Co. 9/23/2011 88.92 92.39 4.6% 10.7% -6.1%CMA Comerica Inc. 12/31/2010 9/23/2011 42.24 22.49 -46.0% -9.6% -36.4%COST Costco Wholesale Corp. 12/31/2010 72.21 83.32 16.7% 0.0% 16.7%COV Covidien PLC 6/17/2011 52.50 45.01 -13.5% -1.1% -12.4%DHR Danaher Corp. 12/31/2010 9/16/2011 47.17 45.94 -2.5% -3.3% 0.8%DAL Delta Air Lines Inc. 12/31/2010 7/8/2011 12.60 9.35 -25.8% 6.9% -32.6%DVN Devon Energy Corp. 12/31/2010 4/15/2011 78.51 87.82 12.1% 4.9% 7.1%DIS Walt Disney Co. 1/28/2011 10/4/2011 38.85 29.86 -23.1% -11.9% -11.2%EP El Paso Corp. 12/31/2010 13.76 26.57 93.4% 0.0% 93.4%EMC EMC Corp. 12/31/2010 22.90 21.54 -5.9% 0.0% -5.9%ETR Entergy Corp. 9/16/2011 65.60 73.04 12.6% 3.4% 9.2%ESRX Express Scripts Inc. 12/31/2010 2/4/2011 54.05 57.13 5.7% 4.2% 1.5%F Ford Motor Co. 12/31/2010 3/11/2011 16.79 14.36 -14.5% 3.7% -18.2%GD General Dynamics Corp. 9/16/2011 60.60 66.41 10.4% 3.4% 6.9%GE General Electric Co. 4/15/2011 7/8/2011 20.04 18.99 -4.5% 1.8% -6.3%GOOG Google Inc. Cl A 12/31/2010 9/16/2011 593.97 546.68 -8.0% -3.3% -4.7%GSIC GSI Commerce Inc. 12/31/2010 7/22/2011 23.23 NA NA 6.9% NAHAL Halliburton Co. 10/28/2011 39.13 NA NA -2.1% NAHPQ Hewlett-Packard Co. 12/31/2010 6/17/2011 42.10 35.00 -16.4% 1.1% -17.5%INTC Intel Corp. 12/31/2010 2/18/2011 21.03 22.14 6.1% 6.8% -0.6%IBM International Business Machines Corp. 12/31/2010 7/8/2011 146.76 176.49 21.2% 6.9% 14.4%INTU Intuit Inc. 12/31/2010 49.30 52.59 7.0% 0.0% 7.0%JPM JPMorgan Chase & Co. 12/31/2010 42.42 33.25 -19.7% 0.0% -19.7%KFT Kraft Foods Inc. 12/31/2010 31.51 37.36 22.2% 0.0% 22.2%LRCX Lam Research Corp. 2/18/2011 7/22/2011 56.10 44.26 -21.1% 0.1% -21.3%LO Lorillard Inc. 5/13/2011 111.51 114.00 5.7% -6.0% 11.7%LYB LyondellBasell Industries N.V. Cl A 10/28/2011 34.50 32.49 7.9% -2.1% 10.1%MCD McDonald's Corp. 9/23/2011 87.37 100.33 15.6% 10.7% 5.0%MCK McKesson Corp. 2/4/2011 77.74 77.91 1.2% -4.1% 5.3%MHS Medco Health Solutions Inc. 12/31/2010 7/8/2011 61.27 55.26 -9.8% 6.9% -16.7%MSFT Microsoft Corp. 12/31/2010 27.91 25.96 -4.6% 0.0% -4.5%MSI Motorola Solutions Inc. 7/8/2011 45.08 46.29 3.7% -6.4% 10.1%NBR Nabors Industries Ltd. 12/31/2010 4/8/2011 23.46 31.56 34.5% 5.6% 28.9%NTRS Northern Trust Corp. 12/31/2010 4/15/2011 55.41 51.78 -6.0% 4.9% -11.0%NOC Northrop Grumman Corp. 9/16/2011 54.82 58.49 7.6% 3.4% 4.2%NVE NV Energy Inc. 12/31/2010 9/16/2011 14.05 14.74 7.5% -3.3% 10.8%OXY Occidental Petroleum Corp. 12/31/2010 98.10 93.70 -2.6% 0.0% -2.6%ORCL Oracle Corp. 6/17/2011 31.19 25.65 -17.4% -1.1% -16.3%PFE Pfizer Inc. 12/31/2010 2/4/2011 17.51 19.30 11.4% 4.2% 7.1%PFE Pfizer Inc. 9/16/2011 18.15 21.64 20.3% 3.4% 16.9%PM Philip Morris International Inc. 12/31/2010 58.53 78.48 38.9% 0.0% 38.9%PNC PNC Financial Services Group Inc. 1/21/2011 60.83 57.67 -3.5% -2.0% -1.5%PNW Pinnacle West Capital Corp. 3/11/2011 9/16/2011 43.56 44.21 3.9% -6.8% 10.7%PG Procter & Gamble Co. 4/8/2011 61.90 66.71 10.3% -5.3% 15.6%QCOM QUALCOMM Inc. 12/31/2010 4/15/2011 49.49 53.14 7.8% 4.9% 2.8%RNR RenaissanceRe Holdings Ltd. 12/31/2010 4/15/2011 63.69 69.08 8.9% 4.9% 3.9%RNR RenaissanceRe Holdings Ltd. 7/8/2011 71.25 74.37 5.1% -6.4% 11.5%COL Rockwell Collins Inc. 12/31/2010 58.26 55.37 -3.3% 0.0% -3.3%SLB Schlumberger Ltd. 12/31/2010 83.50 68.31 -17.0% 0.0% -17.0%SYK Stryker Corp. 2/4/2011 7/22/2011 58.51 56.88 -2.2% 2.6% -4.8%TFM Fresh Market Inc. 12/30/2011 39.90 39.90 0.0% 0.0% 0.0%TGT Target Corp. 12/30/2011 51.22 51.22 0.0% 0.0% 0.0%TYC Tyco International Ltd. 12/31/2010 4/15/2011 41.44 51.70 25.3% 4.9% 20.4%TRV Travelers Cos. Inc. 4/15/2011 59.80 59.18 1.0% -4.7% 5.7%UNP Union Pacific Corp. 12/31/2010 92.66 105.94 16.4% 0.0% 16.4%UNH UnitedHealth Group Inc. 12/31/2010 36.11 50.68 42.0% 0.0% 42.0%URS URS Corp. 12/31/2010 41.61 35.13 -15.6% 0.0% -15.6%UTX United Technologies Corp. 12/30/2011 73.09 73.09 0.0% 0.0% 0.0%WAG Walgreen Co. 7/8/2011 12/30/2011 44.07 33.06 -24.0% -6.4% -17.5%WPI Watson Pharmaceuticals Inc. 12/31/2010 7/8/2011 51.65 69.85 35.2% 6.9% 28.4%WLP WellPoint Inc. 2/4/2011 9/16/2011 65.07 67.70 5.2% -7.2% 12.4%WU Western Union Co. 2/18/2011 21.66 18.26 -14.3% -6.4% -7.9%XOM Exxon Mobil Corp. 7/22/2011 85.22 84.76 0.6% -6.5% 7.1%YUM Yum! Brands Inc. 12/31/2010 49.05 59.01 22.4% 0.0% 22.4% Source: Morgan Stanley Research

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Coverage Universe Investment Banking Clients (IBC)

Stock Rating Category Count % of Total Count

% of Total IBC

% of Rating Category

Overweight/Buy 1119 39% 460 44% 41%Equal-weight/Hold 1231 43% 439 42% 36%Not-Rated/Hold 104 4% 23 2% 22%Underweight/Sell 427 15% 117 11% 27%Total 2,881 1039 Data include common stock and ADRs currently assigned ratings. 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 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. Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to 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. Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months. 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, as indicated below. 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, as indicated below. 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