Financial Pacific - Positioning for weakness in the periphery (third party)

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  • 1. ab Global Equity Research Americas UBS Investment Research Equity Strategy US Equity Strategy Investment Strategy Positioning for Weakness in the Periphery 12 September 2011 European Weakness ≠ Euro Weakness www.ubs.com/investmentresearch Despite the efforts of policymakers, the debt crisis in the European periphery remains front page news. Many U.S. investors have tried to insulate themselves against these deteriorating economic conditions by positioning for a decline in the Euro versus the dollar. However, our work indicates that other factors — Jonathan Golub, CFA Strategist especially monetary policy — make the link between European and Euro weakness jonathan.golub@ubs.com less direct. As such, we believe investors should focus on a more direct measure of +1-212-713 8673 economic stress — CDS. Manish Bangard, CFA Positioning for Weakness in the European Periphery Strategist manish.bangard@ubs.com This note provides a US Equity - European Periphery Weakness List, which is +1-212-713 3036 designed to outperform during periods of rising stress in Peripheral Europe as measured by sovereign CDS. This List is designed to outperform when the cost of Daniel Murphy credit protection against a default in the European Periphery is rising, regardless of Strategist daniel-d.murphy@ubs.com the direction of the USD. +1-212-713 3186 Basket Available on Bloomberg. Ticker: UBUSEWKN Vishal Patel UBS has created a basket based on this analysis, available on Bloomberg via ticker Associate Strategist UBUSEWKN. vishal-a.patel@ubs.com +1-212-713 4027 Thomas M. Doerflinger, Ph.D. Strategist tom.doerflinger@ubs.com +1-212-713 2540 Natalie Garner, CFA Strategist natalie.garner@ubs.com +1-212-713 4915 Exhibit 1: US Equity - European Periphery Weakness List Mattel Inc. (MAT) CareFusion Corp. (CFN) OReilly Automotive (ORLY) Cephalon Inc. (CEPH) Altria Group Inc. (MO) DaVita Inc. (DVA) Colgate-Palmolive Co. (CL) Gilead Sciences Inc. (GILD) General Mills Inc. (GIS) Medco Health Solutions (MHS) Hormel Foods (HRL) UnitedHealth Group Inc. (UNH) Kroger Co. (KR) Norfolk Southern Corp. (NSC) Lorillard Inc. (LO) Raytheon Co. (RTN) Reynolds American (RAI) Stericycle Inc. (SRCL) Wal-Mart Stores (WMT) SAIC Inc. (SAI) Peoples United Finl (PBCT) MetroPCS Communications (PCS) Abbott Laboratories (ABT) Consolidated Edison (ED) Becton Dickinson & Co. (BDX) Duke Energy Corp. (DUK) C.R. Bard Inc. (BCR) Pinnacle West Capital (PNW) Cardinal Health Inc. (CAH) Wisconsin Energy (WEC) Source: Bloomberg, S&P, FactSet and UBS This report has been prepared by UBS Securities LLC ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 6. 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.
  • 2. US Equity Strategy 12 September 2011Positioning for Weakness in the PeripheryFor the past several months, the European sovereign debt crisis has been a focusof the U.S. financial markets. Even with the passage of a Greek bailout packageearlier this summer, the markets remain on edge with respect to a potentialdefault. This is particularly evident in the price of credit protection for countriesin the European periphery, which has risen dramatically since April and remainsat elevated levels. Exhibit 2: European Periphery CDS 1150 European periphery CDS has surged since April and remains at elevated 950 levels 750 550 350 ◄ Portugal, Ireland, Italy, Spain, & Greece CDS Basket 150 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11Source: Bloomberg and UBSNote: European CDS basket is the 5-day moving average of Portugal, Ireland, Italy, Spain and Greece CDSDespite the volatile nature of this crisis, the dollar-euro exchange rate hasremained relatively stable — a sharp contrast to the steep declines experiencedin late 2008 and early 2010. This has left many U.S. equity investorsanticipating a fall in the Euro and wondering how to best position themselves tobenefit from a stronger dollar. Exhibit 3: USD/EUR 1.7 The USD/Euro relationship is a function 1.6 of sovereign debt concerns, monetary policy differentials and other issues 1.5 1.4 1.3 1.2 1.1 07 08 09 10 11Source: Wall Street Journal, Bloomberg, FactSet and UBSHowever, we believe that investors are asking the wrong question. Morespecifically, as we will explain further, weakness in the European Peripherydoes not necessarily strengthen the greenback. UBS 2
  • 3. US Equity Strategy 12 September 2011As a result, rather than focusing on currency, investors may find greater successby looking directly on the underlying issue — stress in the European system.Along those lines, we offer a list designed to outperform on European weakness,as measured by sovereign CDS, regardless of currency moves.European Weakness ≠ Euro WeaknessAs shown below, since February 2009 — the start of the current recovery, therehave been 19 months during which Peripheral CDS rose. Surprisingly, despitedeteriorating conditions in Europe during these periods, the Euro strengthenedrelative to the dollar nearly the same number of months as it weakened — 9versus 10. Exhibit 4: USD/Euro and CDS Since February 2009 European CDS Up Down Confounding factors — like Fed policy — can cause the dollar to fall despite Up 10 3 13 rising stress in the European periphery USD/EUR Down 9 8 17 19 11Source: S&P, Wall Street Journal, Bloomberg, FactSet and UBSNote: European CDS basket is the 5-day moving average of Portugal, Ireland, Italy, Spain and Greece CDSWhat would explain this odd result? The answer is that a host of things impactcurrency. More to the point, the Fed’s easy money policy negatively impactedthe dollar but positively impacted US stocks during much of this period. Asshown below, the S&P 500 advanced during periods of dollar weakness, despitethe strains in the European system. Exhibit 5: USD/Euro and CDS Since February 2009 S&P 500 Returns European CDS In months when European CDS rose Up Down and the dollar fell, stocks gained 1.6% on average Up -1.97 5.10 -0.77 USD/EUR Down 1.59 5.52 -0.98 0.65 -3.54Source: S&P, Wall Street Journal, Bloomberg, FactSet and UBSNote: European CDS basket is the 5-day moving average of Portugal, Ireland, Italy, Spain and Greece CDSAs a result, we believe a focus solely on CDS rather than currency would likelyprovide a better result. UBS 3
  • 4. US Equity Strategy 12 September 2011Focusing on StressUBS has created the US Equity – European Periphery Weakness List, whichis designed to outperform during periods of rising stress in Europe as measuredby sovereign CDS. This List is designed to outperform when the cost of creditprotection against a default in the European Periphery is rising, regardless of thedirection of the dollar.In a nutshell, this List is made up of stocks whose performance we believe ismost closely aligned with CDS. (See “Construction Methodology” on page 5 ofthis note).ConstituentsThe current holdings of the List are shown below. Exhibit 6: US Equity - European Periphery Weakness List Ticker Com pany Nam e Sector MAT Mattel Inc. Consumer Discretionary Our list contains stocks most closely ORLY OReilly Automotive Inc. Consumer Discretionary aligned with European Periphery CDS MO Altria Group Inc. Consumer Staples CL Colgate-Palmolive Co. Consumer Staples GIS General Mills Inc. Consumer Staples HRL Hormel Foods Corp. Consumer Staples KR Kroger Co. Consumer Staples LO Lorillard Inc. Consumer Staples RAI Reynolds American Inc. Consumer Staples WMT Wal-Mart Stores Inc. Consumer Staples PBCT Peoples United Financial Inc. Financials ABT Abbott Laboratories Health Care BDX Becton Dickinson & Co. Health Care BCR C.R. Bard Inc. Health Care CAH Cardinal Health Inc. Health Care CFN CareFusion Corp. Health Care CEPH Cephalon Inc. Health Care DVA DaVita Inc. Health Care GILD Gilead Sciences Inc. Health Care MHS Medco Health Solutions Inc. Health Care UNH UnitedHealth Group Inc. Health Care NSC Norfolk Southern Corp. Industrials RTN Raytheon Co. Industrials SRCL Stericycle Inc. Industrials SAI SAIC Inc. Technology PCS MetroPCS Communications Inc. Telecom ED Consolidated Edison Inc. Utilities DUK Duke Energy Corp. Utilities PNW Pinnacle West Capital Corp. Utilities WEC Wisconsin Energy Corp. UtilitiesSource: UBS UBS 4
  • 5. US Equity Strategy 12 September 2011Back Test ResultsAs mentioned earlier, the purpose of this investment strategy is to outperformduring periods of rising stress in the European periphery, regardless of thedirection of the currency.There are two key conclusions of the back test: This strategy outperformed in 12 of 19 months when CDS rose, or 63% of the time. It added 65 bps on average when CDS rose – 60 bps, when the USD appreciated and 70 bps when the Euro appreciated.Construction Methodology A. Benchmark & Universe. The stocks are selected from the S&P 500 index. The benchmark is the S&P 500 equal weighted B. Screen For Potential Candidates 1. Identify Periods of European Weakness/Strength. We define periods of European weakness as those in which European CDS rises. We define periods of European strength as those in which European CDS falls. 2. Stocks Must Outperform in Periods of European Weakness. We restrict the universe of potential holdings to those stocks which have outperformed the market in a clear majority of periods of European weakness. 3. Stocks Must Underperform in Periods of European Strength. Further, we restrict the universe of potential holdings to those stocks which have underperformed the market in a clear majority of periods of European strength. This is done to ensure a degree of sensitivity to conditions in Europe and eliminate extraneous results. C. Select Holdings Based on Best Fit. We then select the 30 stocks most correlated to rising CDS. UBS 5
  • 6. US Equity Strategy 12 September 2011 Analyst CertificationEach research analyst primarily responsible for the content of this researchreport, in whole or in part, certifies that with respect to each security or issuerthat the analyst covered in this report: (1) all of the views expressed accuratelyreflect his or her personal views about those securities or issuers and wereprepared in an independent manner, including with respect to UBS, and (2) nopart of his or her compensation was, is, or will be, directly or indirectly, relatedto the specific recommendations or views expressed by that research analyst inthe research report. UBS 6
  • 7. US Equity Strategy 12 September 2011Required DisclosuresThis report has been prepared by UBS Securities LLC, an affiliate of UBS AG. UBS AG, its subsidiaries, branches andaffiliates 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 isnot 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 RegulatoryCommission.UBS Investment Research: Global Equity Rating Allocations 1 2 UBS 12-Month Rating Rating Category Coverage IB Services Buy Buy 54% 39% Neutral Hold/Neutral 39% 35% Sell Sell 7% 14% 3 4 UBS Short-Term Rating Rating Category Coverage IB Services 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 withinthe 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 providedwithin 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: Stock price expected to rise within three months from the time the rating was assigned Buy because of a specific catalyst or event. Sell: Stock price expected to fall within three months from the time the rating was assigned Sell because of a specific catalyst or event. UBS 7
  • 8. US Equity Strategy 12 September 2011KEY DEFINITIONS Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not aforecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stocks price target and/or rating aresubject 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 anychange in the fundamental view or investment case.Equity Price Targets have an investment horizon of 12 months.EXCEPTIONS AND SPECIAL CASESUK 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 ReviewCommittee (IRC). Factors considered by the IRC include the stocks volatility and the credit spread of the respective companysdebt. 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 notregistered/qualified as research analysts with the NASD and NYSE and therefore are not subject to the restrictions contained inthe NASD and NYSE rules on communications with a subject company, public appearances, and trading securities held by aresearch analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any,follows.UBS Securities LLC: Jonathan Golub, CFA; Manish Bangard, CFA; Daniel Murphy; Vishal Patel; Thomas M. Doerflinger,Ph.D.; Natalie Garner, CFA. UBS 8
  • 9. US Equity Strategy 12 September 2011Company Disclosures Company Name Reuters 12-mo rating Short-term rating Price Price date 4, 6a, 6c, 7, 8, 16 Abbott Laboratories ABT.N Buy N/A US$50.43 09 Sep 2011 16, 18b, 22 Altria Group MO.N Buy N/A US$26.37 09 Sep 2011 2, 4, 6a, 6b, 6c, 7, 16 Bard (CR) Inc. BCR.N Not Rated N/A US$89.62 09 Sep 2011 16 Becton Dickinson & Co. BDX.N Not Rated N/A US$76.02 09 Sep 2011 2, 4, 6a, 6c, 7, 16, Cardinal Health, Inc. 18a, 22 CAH.N Buy N/A US$40.18 09 Sep 2011 4, 6a, 16 CareFusion Corporation CFN.N Buy N/A US$23.63 09 Sep 2011 13, 16 Cephalon CEPH.O Neutral N/A US$80.61 09 Sep 2011 16 Colgate-Palmolive CL.N Neutral N/A US$88.96 09 Sep 2011 4, 5, 6a, 6b, 7, 16 Consolidated Edison ED.N Neutral N/A US$55.12 09 Sep 2011 16 Davita Inc. DVA.N Buy N/A US$71.36 09 Sep 2011 2, 4, 5, 6a, 16 Duke Energy DUK.N Neutral N/A US$18.55 09 Sep 2011 6b, 7, 16, 22 General Mills Inc. GIS.N Neutral N/A US$37.53 09 Sep 2011 16 Gilead Sciences GILD.O Buy N/A US$37.82 09 Sep 2011 16 Hormel Foods Corp. HRL.N Not Rated N/A US$26.77 09 Sep 2011 16 Lorillard LO.N Buy N/A US$107.54 09 Sep 2011 16 Mattel Inc. MAT.O Buy N/A US$26.13 09 Sep 2011 4, 6a, 6b, Medco Health Solutions Inc. 6c, 7, 16 MHS.N Buy N/A US$51.31 09 Sep 2011 16 Metro PCS Communications, Inc PCS.N Buy N/A US$10.46 09 Sep 2011 4, 6a, 6b, 6c, 7, Norfolk Southern Corp. 16, 18c, 22 NSC.N Neutral N/A US$64.83 09 Sep 2011 16 OReilly Automotive, Inc. ORLY.O Buy N/A US$67.29 09 Sep 2011 16 Peoples United Financial Inc. PBCT.O Not Rated N/A US$11.65 09 Sep 2011 2, 3, 4, 6a, 16 Pinnacle West Capital Co. PNW.N Neutral N/A US$41.90 09 Sep 2011 2, 4, 6a, 6c, 7, 16, 22 Raytheon Co. RTN.N Neutral N/A US$40.64 09 Sep 2011 16 Reynolds American RAI.N Buy N/A US$36.56 09 Sep 2011 2, 4, 6a, 16 SAIC Inc. SAI.N Not Rated N/A US$12.76 09 Sep 2011 4, 6a, 6b, 6c, 7, 16 Stericycle, Inc. SRCL.O Not Rated N/A US$80.18 09 Sep 2011 16, 22 The Kroger Company KR.N Not Rated N/A US$22.02 09 Sep 2011 2, 4, 5, 6a, 6b, 6c, 7, UnitedHealth Group 16 UNH.N Buy N/A US$45.52 09 Sep 2011 2, 4, 5, 6a, 6b, 6c, 7, 16 Wal-Mart Stores WMT.N Not Rated N/A US$51.36 09 Sep 2011 4, 6a, 16 Wisconsin Energy Corp. WEC.N Buy N/A US$30.46 09 Sep 2011Source: UBS. All prices as of local market close.Ratings in this table are the most current published ratings prior to this report. They may be more recent than the stock pricingdate2. UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of this company/entity or one of its affiliates within the past 12 months.3. UBS Securities LLC is acting as advisor to Pinnacle West Capital on its announced agreement to acquire a 48% undivided ownership interest in Units 4 and 5 at the Four Corners Power Plant from Southern California Edison4. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking services from this company/entity.5. UBS AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services from this company/entity within the next three months.6a. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and investment banking services are being, or have been, provided.6b. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-investment banking securities-related services are being, or have been, provided.6c. This company/entity is, or within the past 12 months has been, a client of UBS Securities LLC, and non-securities services are being, or have been, provided. UBS 9
  • 10. US Equity Strategy 12 September 20117. Within the past 12 months, UBS Securities LLC has received compensation for products and services other than investment banking services from this company/entity.8. The equity analyst covering this company, a member of his or her team, or one of their household members has a long common stock position in this company.13. UBS AG, its affiliates or subsidiaries beneficially owned 1% or more of a class of this company`s common equity securities as of last month`s end (or the prior month`s end if this report is dated less than 10 days after the most recent month`s end).16. UBS Securities LLC makes a market in the securities and/or ADRs of this company.18a. A U.S. based global equity strategist, a member of his team, or one of their household members has a long common stock position in Cardinal Health, Inc.18b. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in Altria Group.18c. The U.S. equity strategist, a member of his team, or one of their household members has a long common stock position in Norfolk Southern Corp.22. UBS AG, its affiliates or subsidiaries held other significant financial interests in this company/entity as of last month`s end (or the prior month`s end if this report is dated less than 10 working days after the most recent month`s end).Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report.For a complete set of disclosure statements associated with the companies discussed in this report, including information onvaluation and risk, please contact UBS Securities LLC, 1285 Avenue of Americas, New York, NY 10019, USA, Attention:Publishing Administration. UBS 10
  • 11. US Equity Strategy 12 September 2011Global DisclaimerThis 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. In certain countries, UBS AG isreferred to as UBS SA.This report is for distribution only under such circumstances as may be permitted by applicable law. Nothing in this report constitutes a representation that any investment strategy orrecommendation contained herein is suitable or appropriate to a recipient’s individual circumstances or otherwise constitutes a personal recommendation. It is published solely for informationpurposes, it does not constitute an advertisement and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments in any jurisdiction. 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