Financial Pacific - Volatility to Remain Elevated (third party)

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  • 1.  Global Equity Research Americas UBS Investment Research Equity Strategy U.S. Small Cap Strategy Investment Strategy Small Cap Navigator — September 2011 8 September 2011  Welcome to the Small-Cap Navigator www.ubs.com/investmentresearch This monthly guide provides a summary of the UBS U.S. small-cap equity market outlook, including proprietary analytics and other useful information on market returns, company profits, valuation, sectors, and the economy. Chip Miller, CFA  Volatility to Remain Elevated Strategist We continue to believe that a recession will be avoided. However, recent events chip.miller@ubs.com +1-203-719 3720 have most likely caused some contraction in underlying business and consumer activity that will lead to mixed economic readings over near-term. Additionally, Jonathan Golub, CFA the European sovereign debt situation remains tenuous. We expect volatility to Strategist remain elevated until incoming data begins to stabilize, and it becomes apparent jonathan.golub@ubs.com +1-212-713 8673 that 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 have posted earnings growth of 33% and an aggregate beat of almost 5% thus far in 2Q reports. We expect decent 3Q and 4Q earnings results relative to lowered expectations. 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, and issue overly conservative guidance. Our sense is that these same issues will likely keep investors intently focused on companies posting the best top-line results, and those with the cheapest valuations relative to medium-term earnings prospects. 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.
  • 2. U.S. Small Cap Strategy 8 September 2011UBS Strategy & Economics Teams U.S. Equity StrategyJonathan Golub Chief Strategist jonathan.golub@ubs.com Chip Miller Small-Cap Strategist chip.miller@ubs.comManish Bangard Strategist manish.bangard@ubs.com Tom Doerflinger Strategist tom.doerflinger@ubs.comVishal Patel Associate vishal-a.patel@ubs.com Natalie Garner Strategist natalie.garner@ubs.comU.S. Economics Global Economics & StrategyMaury Harris Chief Economist maury.harris@ubs.com Chief Economist Larry Hatheway larry.hatheway@ubs.comDrew Matus Economist drew.matus@ubs.com & StrategistSamuel Coffin Economist samuel.coffin@ubs.com Paul Donovan Economist paul.donovan@ubs.comKevin Cummins Economist kevin.cummins@ubs.com Andrew Cates Economist andrew.cates@ubs.comU.S. Accounting George Magnus Senior Advisor george.magnus@ubs.comJanet Pegg Analyst janet.pegg@ubs.com Jonathan Anderson Emg Markets jonathan.anderson@ubs.comU.S. Derivatives Sunil Kapadia Asset Allocation sunil.kapadia@ubs.comMitchell Revsine Strategist mitchell.revsine@ubs.com Global Equity StrategyU.S. Sector Heads Jeffrey Palma Chief Strategist jeffrey.palma@ubs.comAndrew Kligerman Financials andrew.kligerman@ubs.com Chris Ferrarone Strategist christopher.ferrarone@ubs.comN. Theodosopoulos Technology nikos.theodosopoulos@ubs.com Jerry McGuire Associate jerry.mcguire@ubs.comDavid Strauss Industrials david.strauss@ubs.com Global Emerging Markets StrategyDavid Palmer Consumer david-s.palmer@ubs.com Nicholas Smithie Strategist nicholas.smithie@ubs.comJohn Hodulik Telecom john.hodulik@ubs.com Jennifer Delaney Strategist jennifer.delaney@ubs.comBill Featherston Energy william.featherston@ubs.com Stephen Mo Strategist stephen.mo@ubs.comRon Barone Energy ronald.barone@ubs.com Regional EconomicsJustin Lake Health Care justin.lake@ubs.com Stephane Deo Europe stephane.deo@ubs.comRegional Strategy Amit Kara UK amit.kara@ubs.comNick Nelson Europe nick.nelson@ubs.com Duncan Wooldridge Asia duncan.wooldridge@ubs.comKaren Olney Europe karen.olney@ubs.com Scott Haslem Australia scott.haslem@ubssecurities.comNeil Cherry UK neil.cherry@ubs.com Tao Wang China wang.tao@ubssecurities.comGeorge Vasic Canada george.vasic@ubs.com Credit, Rates & Currency StrategyShoji Hirakawa Japan shoji.hirakawa@ubs.com George Bory Credit george.bory@ubs.comNiall MacLeod Asia x-Japan niall.macleod@ubs.com Mansoor Mohi-Uddin Currency mansoor.mohi-uddin@ubs.comDavid Cassidy Australia david.cassidy@ubs.com Michael Schumacher Rates michael.schumacher@ubs.comJohn Tang China john.tang@ubs.com Bhanu Baweja EM FICC bhanu.baweja@ubs.comTomas Lajous Mexico tomas.lajous@ubs.com Quantitative Strategy David Jessop Global Head david.jessop@ubs.com Berry Cox US berry.cox@ubs.comUBS Small Cap Sales & TradingTrading SalesStephen Roney TMT stephen.roney@ubs.com Albert Aguiar Specialist albert.aguiar@ubs.comAlphonso Diaz Health Care alphonso.diaz@ubs.comKevin Mullane Financials/Consumer kevin.mullane@ubs.comRichard Ryan Industrials richard.ryan@ubs.com UBS 2
  • 3. U.S. Small Cap Strategy 8 September 2011Table of ContentsOutlook ▪ Market Outlook ……...……………………………….………………..…………….. 4-5 Highlights ▪ Fiscal Imbalances ...…………………..…………….…………….…..…………….. 6-7 ▪ Tactical Review .…….……………………………………….……………………… 8-9 ▪ Economic Outlook .…….…………………………………….……………………… 10-13 • Market Outlook — ▪ Leading Indicators .…………………………………….……………………………. 14-15 Pages 4-5Fundamentals ▪ Consensus Earnings Growth …..…….………………………….………..……….. 16-17 ▪ Earnings — Revenue ….………………...…………………………………………. 18 • Earnings Analysis — ▪ Earnings — Operating Margins ………..………………………………………….. 19 Pages 22-25 ▪ Balance Sheets & Cash Flows .……………….…………………………………... 20-21 ▪ Earnings Analysis ………………..………………….………………………………. 22-25 ▪ M&A ……………………………..………………………..………………….……….. 26-27 ▪ Dividends & Buybacks and Cash & Working Capital ..………………………..… 28-29 • Sector Recommendations — Pages 32-35Market Leadership ▪ U.S. Equity & Sector Returns ….……………..……………………………………. 30-31 ▪ Sector Recommendations...…………………..……………………………………. 32-35 ▪ UBS Return Drivers — Summary….……..………..………...……………………. 36-37 • UBS Return Drivers — ▪ UBS Return Drivers — Revenue Growth & PEG ……………….………..……… 38-39 Pages 36-41 ▪ UBS Return Drivers — Market Cap, Op Leverage & Valuation ..………………. 40-41 ▪ Small vs. Large ……………………………………………………………………… 42-43 ▪ Growth vs. Value ……………………………………………………………………. 44-45 ▪ Fund Positions ………………………………………………………………………. 46-47 • Investment Regimes — Pages 48-49Valuation ▪ Investment Regimes ………………………..………………………………………. 48-49 ▪ Russell 2000 …………………………………………………………………………. 50-51 ▪ Russell 2000 Inter-Sector Relative Valuation ……………………………………. 52-53Appendix ▪ UBS Return Drivers .…………….………………….………………..…………….. 54-55 ▪ Inter-Sector Valuation ….………………….………………..……………………… 56-57All data as of August 31, 2011 unless otherwise noted. UBS 3
  • 4. U.S. Small Cap Strategy 8 September 2011Market OutlookOutlook Small Caps Down Big In August. In August, the Russell 2000 We expect volatility to remain sold off by 8.7% into weak economic readings, rising double dip elevated into mixed economic concerns, an increasingly tenuous European sovereign debt readings and sovereign situation, and S&P’s downgrade of U.S. debt. Small caps concerns 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 Over the near term, U.S. small risk to the economy and small-cap stock performance is the caps may be driven by the potential for a global credit shock. While we continue to situation in Europe 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 We believe a recession will be first half of the year, small companies reported very solid 2Q avoided, and companies will earnings results. With roughly 90% of the universe reported, continue to surpass Russell 2000 companies have posted year-over-year earnings expectations in 2H11 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. However, 2012 bottom-up Company guidance has remained very conservative, and earnings forecasts appear analysts have been modestly revising down 2H11 earnings stretched 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. UBS 4
  • 5. U.S. Small Cap Strategy 8 September 2011Market OutlookLeadership A Cyclical Sector Bias. Based on our medium-term outlook, Based on our medium-term we have a cyclical bias. We’re overweight Tech, Industrials, outlook, we maintain a cyclical Discretionary, and Health Care. We’re underweight Financials, sector bias 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, We expect companies posting companies posting the highest revenue growth were winners the highest top-line growth and during both the strong run from September to March and the those with the best PEG ratios more recent defensive rotation that began in April. We to continue to outperform 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 There are significant risks to U.S. small-caps is a credit disruption emanating from Europe. our relatively optimistic Economic Weakness. Further deterioration in the economic outlook 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. UBS 5
  • 6. U.S. Small Cap Strategy 8 September 2011Fiscal ImbalancesFederal Budget Deficit (US$ Trillions) 1.4 1.4 1.3 The debt ceiling deal is a modest first step in 1.1 addressing America’s fiscal imbalances 0.7 0.7 0.7 0.6 0.7 0.6 0.6 0.5 0.5 0.5 08 09 10 11 12 13 14 15 16 17 18 19 20 21Source: CBO, Haver and UBSFederal Budget Breakdown $5.9 Trillion OMB projects that interest 5% Interest 16% and entitlements will go from 45% of the budget to 62%… 18% Mandatory 13% over 75% of tax receipts $3.5 Trillion 40% Entitlements 46% 14% Discretionary 9% 23% Security 17% 2011 2021Source: Office of Management & Budget and UBS UBS 6
  • 7. U.S. Small Cap Strategy 8 September 2011Fiscal ImbalancesCDS Spreads 1600 Portugal, Ireland & ► Portuguese, Irish, and Greek 1400 Greece CDS Basket CDS spreads remain wide 1200 1000 800 600 400 200 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 and Greece CDS through Sept. 5, 201110-Year Spreads 4.0 3.5 Increased pressure on Italy and Spain as well 3.0 Italy - Germany▼ 2.5 2.0 1.5 1.0 Spain - Germany▲ 0.5 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11Source: Bloomberg and UBS UBS 7
  • 8. U.S. Small Cap Strategy 8 September 2011Tactical ReviewSmall Caps > 200-Day Moving Average 100% 460 S&P 600 ► Small caps have room to run 80% 400 if economic data begins to stabilize 60% 340 40% 280 20% 220 ◄ % of Stocks > 200-Day MA 0% 160 01/08 07/08 01/09 07/09 01/10 07/10 01/11 07/11Source: Standard & Poor’s, FactSet and UBS Note: Data as of Sept. 2, 2011Mutual Fund Flows (4-Wk Moving Avg.) 2.0 $B ◄ Small Small- and mid-cap flows 1.0 have recently turned more Mid ▼ negative 0.0 -1.0 -2.0 ◄ Large -3.0 -4.0 4/10 8/10 11/10 3/11 6/11Source: Lipper and UBS UBS 8
  • 9. U.S. Small Cap Strategy 8 September 2011Tactical ReviewRussell 2000 Implied vs. Realized Volatility (1M) 90 80 Volatility has risen sharply 70 60 50 Implied Vol ▼ 40 30 20 10 Realized Vol ▲ 0 08 09 10 11Source: CBOE, Russell and UBS Note: Data through Sept. 2, 2011S&P 600 Industry Group Correlation (30D) 1.0 92% 89% 0.9 Stock correlations are very high, making alpha 0.8 generation difficult 0.7 0.6 0.5 0.4 0.3 05 06 07 08 09 10 11Source: Standard & Poor’s, FactSet and UBS UBS 9
  • 10. U.S. Small Cap Strategy 8 September 2011Economic OutlookRussell 2000 vs. LEI 900 117 825 LEI ► 112 Small caps tend to trade in- line with the economic 750 107 outlook 675 102 600 Russell 97 ◄ 2000 525 92 450 87 375 82 300 77 98 99 00 01 02 03 04 05 06 07 08 09 10 11Source: Russell, Conference Board, Bloomberg and UBSSmall Cap Relative Performance vs. LEI 1.17 117 Small caps generally ◄ Sm v Lg ▼ outperform when the 1.02 107 economy is growing LEI ► 0.87 97 0.72 87 0.57 77 98 99 00 01 02 03 04 05 06 07 08 09 10 11Source: Russell, Conference Board, Bloomberg and UBS UBS 10
  • 11. U.S. Small Cap Strategy 8 September 2011Economic OutlookRussell 2000 v. ISM New Orders 900 80 The key is whether or not ◄ Russell 2000 economic indicators begin to 769 65 signal a substantial slowdown or recession 638 50 Is the current environment like late 2006 or early 2008? New Orders ► 506 35 375 20 03 04 05 06 07 08 09 10Source: Russell, Institute for Supply Management, Bloomberg and UBSU.S. Economic Surprise Index 3 > 0 represents Positive Surprise Economic data has recently 2 started to surprise to the upside into lowered 1 expectations 0 -1 -2 -3 < 0 represents Negative Surprise -4 06 07 08 09 10 11Source: Bloomberg and UBS Global Economics Team UBS 11
  • 12. U.S. Small Cap Strategy 8 September 2011Economic OutlookInterbank Lending Spreads 350 210 300 180 Recessions are normally caused by credit 250 150 contractions ◄ TED Spread ▼ 200 120 European interbank spreads 150 90 are showing signs of stress Euribor Spread ► 100 60 The TED spread has recently 50 30 risen, but remains at low levels 0 0 06 07 08 09 10 11Source: Bloomberg and UBS Note: Data through Sept. 6, 2011Baa Spread 650 High quality corporate spreads have been relatively 550 stable 450 350 250 150 06 07 08 09 10 11Source: Moody’s, Bloomberg and UBS Note: Data through Sept. 6, 2011 UBS 12
  • 13. U.S. Small Cap Strategy 8 September 2011Economic OutlookISM Manufacturing & Non-Manufacturing >50 is Expansionary 54.6 ◄ ISM Non-Mfg 60 Recent economic data is consistent with slow growth, 55 not recession, in our view 50 50.6 45 ◄ ISM Mfg 40 35 <50 is Contractionary 98 00 02 04 06 08 10Source: Institute of Supply Chain Management, FactSet and UBS Note: ISM Mfg represents Aug. 2011Weekly Unemployment Claims 650 600 550 500 450 400 4-week 350 avg. 410k 300 250 90 92 94 96 98 00 02 04 06 08 10Source: US Department of Labor, FactSet and UBS UBS 13
  • 14. U.S. Small Cap Strategy 8 September 2011Leading IndicatorsSmall Business Optimism Index 110 Confidence is the key going 105 forward 100 95 90 85 80 01 02 03 04 05 06 07 08 09 10 11Source: NFIB, Bloomberg and UBS Note: Data through July 2011Small-Cap Cyclicals vs. Non-Cyclicals 1.75 3/31: 1.70 A reemergence of cyclical 1.67 leadership would be a positive signal — we’re not there yet 1.59 1.51 6/17: 1.52 1.43 9/6: 1.44 1.35 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11Source: Standard & Poor’s, Bloomberg and UBSNotes: Cyclicals represent and equal-weighted index of Discretionary, Tech, Industrials, Financials, Energy andMaterials. Non-cyclicals represent an equal-weighted index of Health Care, Staples, Telecom and Utilities. Datathrough Sept. 6, 2011 UBS 14
  • 15. U.S. Small Cap Strategy 8 September 2011Leading Indicators10-Year Treasury Yield 4.0 We attribute a majority of the 3.7 4/11: 3.58 move down in the 10-year yield to falling growth 3.4 expectations 3.1 2.8 6/24: 2.86 2.5 2.2 9/6: 1.97 1.9 1/10 4/10 7/10 10/10 1/11 4/11 7/11Source: Bloomberg and UBS Note: Data through Sept. 6, 2011CRB US Spot Raw Industrials 650 4/12: 638 Industrial commodities may be stabilizing 600 9/2: 571 550 500 450 1/10 4/10 7/10 10/10 1/11 4/11 7/11Source: CRB, Reuters, Bloomberg and UBS Note: Data through Sept. 2, 2011 UBS 15
  • 16. U.S. Small Cap Strategy 8 September 2011Consensus Earnings GrowthConsensus 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 % Largely due to easy comps, Industrials 30.7 28.5 36.4 24.5 Russell 2000 earnings Technology 11.2 11.2 25.0 17.4 Energy 100+ 26.8 100+ 52.5 growth is expected to be 62% Materials 48.8 23.5 27.0 25.7 in 2011 and 45% in 2012Non-Cyclicals C. Staples -3.3 9.2 72.7 22.7 Health Care 100+ 3.2 100+ 19.9 Telecom Svcs 71.6 -5.3 100+ 32.9 Utilities -0.1 3.5 8.4 7.3Index ex-Fin 40.6 15.6 45.0 23.4 Financials 100+ 35.4 46.5 34.4Index 62.1 18.2 45.3 25.2Source: Russell, Standard & Poor’s, Thomson Financial, Compustat, FactSet and UBSNote: Analysis based on constituents as of August 31, 2011. Analysis excludes FBPConsensus Earnings Growth — Median Company 2011 Earnings Growth 2012 Earnings Growth R2000 S&P 600 R2000 S&P 600Cyclicals Growth rates appear more C. Discretionary 15.6 % 15.4 % 21.7 % 18.6 % reasonable looking at Industrials 30.1 22.0 25.6 21.6 median estimates Technology 16.9 15.8 21.2 17.3 Energy 52.9 42.9 70.5 56.1 Materials 19.4 16.5 21.5 19.5Non-Cyclicals Easy comps are distorting C. Staples 14.1 10.1 17.3 15.8 overall earnings growth Health Care 10.7 10.7 18.9 15.8 estimates Telecom Svcs 0.4 -2.6 44.4 59.9 Utilities 3.0 3.0 6.2 6.7Index ex-Fin 17.8 14.6 22.6 18.3 Financials 23.3 17.8 20.6 22.0Index 18.7 15.4 22.1 19.0Source: Russell, Standard & Poor’s, Thomson Financial, Compustat, FactSet and UBSNote: Analysis based on constituents as of August 31, 2011. Analysis excludes FBP UBS 16
  • 17. U.S. Small Cap Strategy 8 September 2011Consensus Earnings GrowthS&P 600 Bottom-Up Consensus 35% Analysts have been revising 30% 2011 ▼ down 2011 earnings expectations 25% 2012 ▼ However, 2012 expectations have remained largely 20% unchanged 15% 10% 01/10 04/10 07/10 10/10 01/11 04/11 07/11Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBSS&P 600 Forward PE vs. EPS 29 19.0 $28 ◄ Fwd EPS ▼ Buy-side expectations have fallen much faster than sell- 26 17.5 side forecasts 23 16.0 20 Fwd P/E ► 14.5 14.1x 17 13.0 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS UBS 17
  • 18. U.S. Small Cap Strategy 8 September 2011Earnings — RevenueRevenue Growth vs. Nominal GDP Growth 25% 9% Y/Y Y/Y 18% 7% Small-cap revenue growth 11% 5% and nominal GDP are highly correlated 4% 3% GDP ► -3% ◄ Revenue 1% -10% -1% -17% -3% -24% -5% 00 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, BEA, Compustat, FactSet and UBS Note: Analysis excludes FinancialsRevenue Surprises — Small vs. Large Small Caps 3.0 2.9 Top-line beats have been Large Caps 2.62.7 surprisingly strong over the 2.3 2.0 past three quarters 1.7 1.8 1.3 1.4 1.0 0.4 0.5 0.4 0.2 -0.1 -0.9 -2.0 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11ESource: Standard & Poor’s, Compustat, Thomson Financial and UBSNote: Analysis excludes Financials and certain other companies with missing data. UBS 18
  • 19. U.S. Small Cap Strategy 8 September 2011Earnings — Operating MarginsOperating Margin vs. Capacity Utilization 10% 85 8.9% 9% Small-cap margins tend to ◄ Small-Cap Margins 80 mirror capacity utilization 8% 7.1% We see margin expansion 7% 75 opportunities across the small-cap universe 6% Cap. Util. ► 70 5% 4.8% 4% 65 00 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, Federal Reserve, Compustat, FactSet and UBSNote: Margins have been adjusted to reflect a trailing 4-quarter basis. Capacity Utilization shows quarterly averagesCurrent & Peak Operating Margins 26 24 Peak 21 2Q11 18 17 15 15 13 14 12 13 13 11 12 12 9 10 9 10 9 8 9 9 9 9 8 8 8 7 8 7 6 6 5 5 5 5 5 2 2 Comm Svcs Food Bev Cons Svcs HC Svcs Software Telecom Transports Media HH Prod Pharma Hardware Retail Food Retail Cap Goods Energy Materials Autos Durables Semis Utilities Peak 4Q01 1Q07 1Q98 4Q98 3Q07 3Q99 1Q06 4Q02 3Q04 3Q02 2Q06 3Q10 1Q07 2Q04 1Q03 2Q05 3Q00 4Q00 3Q04 3Q98Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Margins reflect a trailing 4-quarter basis. Peak quarter is listed below chart UBS 19
  • 20. U.S. Small Cap Strategy 8 September 2011Balance SheetsNet Debt vs. Interest Coverage 40% 8.0x  Net Debt Ratio 35% deleveraging 7.0x Small-cap balance sheets Interest Cov ► remain solid 6.3x 30% 6.0x 25% 5.0x 20% 16.5% 4.0x 15% 10% 3.0x 99 00 01 02 03 04 05 06 07 08 09 10Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes FinancialsCapex & R&D 9.5% 5.5% 9.0% Capex / Sales ► 5.0% (Rolling 12M) 8.5% 4.5% R&D / Sales 7.7% 8.0% 4.0% ◄ (Rolling 12M) 7.5% 3.5% 3.6% 7.0% 3.0% 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials UBS 20
  • 21. U.S. Small Cap Strategy 8 September 2011Cash FlowsFree Cash Flow ($Bn) – Sources 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11Net Income 1.3 3.5 2.6 3.9 4.0 4.6 4.4 4.5 4.6Depreciation 4.4 4.4 4.4 4.3 4.2 4.3 4.4 4.5 4.1Working 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 1.5CF 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 4.4Free Cash Flow 8.1 7.3 7.8 5.3 4.3 4.1 6.4 1.9 4.1Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Universe excludes FinancialsCompanies focused on cash generation during the downturnWorking capital being replenished, but plenty of cash left overFree Cash Flow ($Bn) – Uses 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11Free 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 3.8Debt Iss/(Repay) (4.4) (3.2) (2.5) (2.0) 0.1 2.7 4.8 0.7 2.2L/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) 0.3Other 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) 0.9Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Universe excludes FinancialsM&A activity has picked up. We expect this to continueDividends and buybacks should gradually increase as well UBS 21
  • 22. U.S. Small Cap Strategy 8 September 2011Earnings AnalysisRussell 2000 — Earnings Summary — 2Q11E Revenue Earnings Growth Surprise Growth Surprise Rptd Total YoY (%) Pct (%) Beat Miss YoY (%) Pct (%) Beat MissCyclicals 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 30Non-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 12Russell 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 39Russell 2000 1663 1850 8.6 2.2 948 542 33.3 4.9 971 618Source: Russell, Compustat, Thomson Financial, FactSet and UBSNote: Analysis excludes companies with no analyst coverage or that are missing data in applicable databases. Results contain some UBS estimates UBS 22
  • 23. U.S. Small Cap Strategy 8 September 2011Earnings AnalysisS&P 600 — Earnings Summary — 2Q11E Revenue Earnings Growth Surprise Growth Surprise Rptd Total YoY (%) Pct (%) Beat Miss YoY (%) Pct (%) Beat MissCyclicals 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 13Non-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 6S&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 16S&P 600 564 598 16.3 2.6 313 166 14.2 1.9 327 204Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBSNote: Analysis excludes companies with no analyst coverage or that are missing data in applicable databases. Results contain some UBS estimates UBS 23
  • 24. U.S. Small Cap Strategy 8 September 2011Earnings AnalysisEarnings Surprises — Small vs. Large 19 Small Caps Large Caps Large-cap beats have been 14 higher in 2Q reports 13 12 12 10 9 9 9 8 8 7 7 6 6 5 5 2 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11ESource: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBSNote: Analysis excludes Financials and certain other companies with missing dataEarnings Surprises — Cyclicals vs. Non-Cyclicals Cyclicals 21 18 19 Cyclical sectors posted Non-Cyclicals 15 much better results relative 14 to expectations 12 10 9 8 8 8 7 5 6 5 4 3 -7 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11ESource: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBSNote: Analysis excludes Financials and certain other companies with missing data UBS 24
  • 25. U.S. Small Cap Strategy 8 September 2011Earnings Analysis2Q11E Price Response – S&P 600 vs. S&P 500 Small Cap Large Cap Revenue Surprise Revenue Surprise Beats Misses Beats Misses Misses Beats Misses Beats EPS Surprise EPS Surprise 4.20 -0.47 2.73 0.86 -0.24 0.55 -4.20 -6.25 -5.50 -2.84 -4.64 -3.89 2.18 -4.11 0.27 -2.24Source: Standard & Poor’s, Thomson Financial, FactSet and UBS1Q11 Price Response – S&P 600 vs. S&P 500 Small Cap Large Cap Revenue Surprise Revenue Surprise Beats Misses Beats Misses Misses Beats Misses Beats EPS Surprise EPS Surprise 3.21 -0.87 2.11 0.79 -0.60 0.30 -2.96 -4.10 -3.49 -1.46 -2.54 -2.04 1.73 -2.87 0.20 -1.29Source: Standard & Poor’s, Thomson Financial, FactSet and UBS4Q10 Price Response – S&P 600 vs. S&P 500 Small Cap Large Cap Revenue Surprise Revenue Surprise Beats Misses Beats Misses Misses Beats Misses Beats EPS Surprise EPS Surprise 4.27 0.96 3.10 1.49 -0.49 0.75 -2.47 -3.30 -2.86 -2.31 -2.48 -2.35 2.43 -1.18 0.81 -2.06Source: Standard & Poor’s, Thomson Financial, FactSet and UBS UBS 25
  • 26. U.S. Small Cap Strategy 8 September 2011M&ANumber of Deals – $250M to $2.5B 637 549 557 550 Deal activity picks up post 463 444 449 recessions 414 410 390 329 283 288291 289 229 232 190 108 88 92 95 98 01 04 07 10Source: Mergerstat, FactSet and UBS Note: 2011 estimated based on deals through JulyNumber of Deals – $250M and $2.5B 50 We believe macro concerns 42 41 have been holding back 40 40 37 transaction volumes 35 36 3435 32 32 30 28 2829 28 28 26 2627 24 22 22 20 1515 15 12 10 02/09 05/09 08/09 11/09 02/10 05/10 08/10 11/10 02/11 05/11Source: Mergerstat, FactSet and UBS Note: Data through July 2011 UBS 26
  • 27. U.S. Small Cap Strategy 8 September 2011M&ADeals by Sector – 2010 and 2011 YTD 114 112 Financials and Tech have seen the biggest pickup in 79 deal activity 71 70 68 55 39 29 10 Fin Tech Discr H Care Ind En Mat Stpls Util TelcmSource: Mergerstat, FactSet and UBS Note: Data through July 2011Large vs. Small Operating Margins 10% 15% Large Caps ► The difference between 9% 14% small- and large-cap margins is close to an all-time high 8% 13% 7% 12% We believe that CEOs put more credence in cost synergies than potential 6% 11% revenue opportunities 5% 10% ◄ Small Caps ▲ 4% 9% 99 00 01 02 03 04 05 06 07 08 09 10Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials UBS 27
  • 28. U.S. Small Cap Strategy 8 September 2011Dividends & BuybacksPayout Ratio 125% 100% Total payout is way below ◄ Dividends + Buybacks prior peaks 75% 50% 43% 25% 11% 0% Dividends ▲ -25% 94 96 98 00 02 04 06 08 10Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials and UtilitiesPayout Ratios by Sector 401 Peak 201 278 Room to return cash across 2Q11 164 sectors 131 127 93 87 69 64 69 46 47 37 40 38 31 30 600 x- Ind Discr Mat En Tech H Care Stpls Telcm Fin & Util Pk Qtr 4Q08 1Q08 3Q08 4Q00 4Q10 2Q02 3Q07 2Q06 3Q05Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials and Utilities UBS 28
  • 29. U.S. Small Cap Strategy 8 September 2011Cash & Working CapitalCash & Inventories (% Total Assets) 18% ◄ Inventories Cash balances remain high 15% 13.5% 12% 12.2% Cash ► 9% 6% 00 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes FinancialsWorking Capital (% of Sales) 10% Working capital management 9% has been stellar over the past few years 8% 7.1% 7% 6% 99 00 01 02 03 04 05 06 07 08 09 10Source: Standard & Poor’s, Compustat, FactSet and UBS Note: Analysis excludes Financials UBS 29
  • 30. U.S. Small Cap Strategy 8 September 2011U.S. Equity ReturnsU.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 5.8 R. 2000 Value (8.8) (11.8) (8.5) 16.9 (0.6) (0.6) 4.3 6.5 R. 2000 Growth (8.6) (12.1) (4.6) 27.5 2.1 3.6 6.6 4.9 R. Mid-Cap (6.9) (10.3) (3.0) 21.3 2.9 3.0 7.0 7.2 R. Mid-Cap Value (6.9) (10.2) (4.2) 17.5 2.0 1.4 6.4 7.5 R. Mid-Cap Growth (6.8) (10.3) (1.7) 25.6 3.8 4.3 7.4 5.9 R. 1000 (5.8) (7.8) (1.9) 19.1 0.8 1.1 4.0 3.2 R. 1000 Value (6.2) (9.4) (4.0) 14.4 (1.4) (1.6) 3.0 3.4 R. 1000 Growth (5.3) (6.2) 0.2 24.0 3.1 3.7 4.9 2.7 S&P 600 (7.7) (10.6) (3.9) 24.4 2.1 2.7 6.4 7.0 S&P 400 (7.1) (10.4) (2.7) 22.9 4.0 4.6 7.6 7.3 S&P 500 (5.4) (7.4) (1.8) 18.5 0.5 0.8 3.5 2.7 Dow (4.4) (6.5) 0.3 16.0 0.2 0.4 1.9 1.6 Nasdaq (6.4) (7.0) (2.8) 22.0 2.9 3.4 5.0 3.6 Index Value 2010 2009 2008 2007 2006 2005 2004 R. 2000 727 26.9 27.2 (33.8) (1.6) 18.4 4.6 18.3 R. 2000 Value 956 24.5 20.6 (28.9) (9.8) 23.5 4.7 22.2 R. 2000 Growth 419 29.1 34.5 (38.5) 7.0 13.3 4.2 14.3 R. Mid-Cap 25.5 40.5 (41.5) 5.6 15.3 12.7 20.2 R. Mid-Cap Value 24.8 34.2 (38.4) (1.4) 20.2 12.6 23.7 R. Mid-Cap Growth 26.4 46.3 (44.3) 11.4 10.7 12.1 15.5 R. 1000 16.1 28.4 (37.6) 5.8 15.5 6.3 11.4 R. 1000 Value 15.5 19.7 (36.8) (0.2) 22.2 7.1 16.5 R. 1000 Growth 16.7 37.2 (38.4) 11.8 9.1 5.3 6.3 S&P 600 26.3 25.6 (31.1) (0.3) 15.1 7.7 22.6 S&P 400 26.6 37.4 (36.2) 8.0 10.3 12.6 16.5 S&P 500 1,219 15.1 26.5 (37.0) 5.5 15.8 4.9 10.9 Dow 11,614 11.0 18.8 (33.8) 6.4 16.3 (0.6) 3.1 Nasdaq 2,579 16.9 43.9 (40.5) 9.8 9.5 1.4 8.6Source: Russell, Standard & Poor’s, Dow Jones, NASDAQ, FactSet and UBS Note: All returns include dividends except the Dow and NASDAQ UBS 30
  • 31. U.S. Small Cap Strategy 8 September 2011Sector ReturnsRussell 2000 SectorsIndex 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) 3.5Russell 2000 (8.7) (12.0) (6.5) 22.2 0.8 1.5 5.5Index 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 2.0Russell 2000 100.0 26.9 27.2 (33.8) (1.6) 18.4 4.6Source: Russell, FactSet and UBS Note: All returns include dividends UBS 31
  • 32. U.S. Small Cap Strategy 8 September 2011Sector RecommendationsOverweight Consumer Discretionary We expect employment trends to gradually improve over the We’re most favorable toward remainder of 2011, and expectations for the sector are low. Media and names exposed to Earnings results have been solid and valuations appear high-end consumer spending 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 In our view, Tech has cyclical sector. Notably, Tech carries roughly 25% of its assets become the most defensive in cash, which can be used to fund M&A activity, buybacks and cyclical sector 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 We expect continued benefit from an improving demand outlook. However, recent commodity price volatility earnings results have been somewhat disappointing. Moreover, we expect energy prices to remain volatile over the next several quarters. UBS 32
  • 33. U.S. Small Cap Strategy 8 September 2011Sector RecommendationsMarket 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, Many Banks will have to particularly relative to their larger peers, and that REITs will reinvest profits into their most likely underperform if interest rates rise. Moreover, new balance sheets rather than regulations could pose challenges to longer-term returns on loan growth 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 Staples look expensive and near term. Additionally, we continue to believe that the sector cyclical sectors should have has strong secular growth prospects. However, we expect the more earnings leverage 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. UBS 33
  • 34. U.S. Small Cap Strategy 8 September 2011Sector RecommendationsConsumer: Retailers vs. Food Retailers 0.95 116 LEI ► If a recession in avoided, 0.85 111 ◄ Retail vs. Food Retail Retailers could see significant outperformance 0.75 106 0.65 101 0.55 96 0.45 91 0.35 86 0.25 81 00 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, FactSet, and UBSIndustrials: Capital Goods vs. Comm. Services 1.65 116 LEI ► 1.55 111 Currently, we favor Capital Goods companies with later- 1.45 106 cycle end market exposure 1.35 101 1.25 96 1.15 91 ◄ Cap Goods vs. Comm Svcs 1.05 86 0.95 81 00 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, FactSet, and UBS UBS 34
  • 35. U.S. Small Cap Strategy 8 September 2011Sector RecommendationsTechnology: Semis vs. Hardware 2.4 116 LEI ► We expect Semis to 2.2 111 outperform if the economic ◄ Semis vs. Hardware outlook improves 2.0 106 1.8 101 1.6 96 1.4 91 1.2 86 1.0 81 00 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, FactSet, and UBSFinancials: Loan Loss Reserves (% Assets) 5 Smaller banks are still 4 ◄ Banks with avg assets >$15B building loan loss reserves 3 2 1 Banks with avg assets <$1B ▲ 0 84 86 88 90 92 94 96 98 00 02 04 06 08 10Source: Federal Reserve, FRED database and UBS UBS 35
  • 36. U.S. Small Cap Strategy 8 September 2011UBS Return DriversUBS Market Leadership Framework I. Early Phase II. Middle Phase III. Late Phase Different investment characteristics are rewarded at each stage of the Earnings Fundamentals investment cycle Op Leverage Valuation Volatility Quality Cyclicals Non-CyclicalsSource: UBSRussell 2000 Cyclicals vs. Non-Cyclicals 1.80 117 LEI ► 1.60 113 Cyclicals and Non-Cyclicals tend to trade in-line during 1.40 109 the middle of the cycle 1.20 105 1.00 101 0.80 97 ▲ 0.60 ◄ Cyclicals v Non-Cyclicals 93 0.40 89 03 04 05 06 07 08 09 10 11Source: Russell, Conference Board, Bloomberg and UBS UBS 36
  • 37. U.S. Small Cap Strategy 8 September 2011UBS Return DriversUBS Small Cap Return Drivers Apr 11 - Aug 11: Reemerging Concerns 3.8 1.4 1.5 Initially, the recent defensive -3.7 -3.3 -2.8 -1.3 0.2 rotation was about slowing growth; now it’s primarily about credit concerns Vol Op Lev Sm Cap PEG Ern Surp Rev Div Yld ROE Grwth Offense Middle Defense Sept 10 - March 11: Entering the Middle Innings 4.7 4.3 2.5 2.5 Revenue Growth was a big 1.8 1.2 winner during the market’s -0.1 -1.4 strong run from September to March Op Lev Vol Sm Cap PEG Ern Surp Rev Div Yld ROE Grwth Offense Middle Defense May 10 - Aug 10: Credit Concerns 3.8 3.0 2.1 1.9 Credit concerns drove a -4.7 -3.3 -1.4 -1.9 defensive rotation last summer Vol Sm Cap Op Lev PEG Earn Surp Div Yld Rev Gwth ROE Offense Middle Defense Mar 09 - Apr 10: Junk Rally 27.0 26.7 17.2 The “junk” trade was on during the initial phases of 3.4 -5.4 -8.4 -13.7 -17.3 the market rally See Appendix for UBS Return Driver calculation Vol Sm Cap Op Lev PEG Earn Surp Div Yld Rev Gwth ROE methodology Offense Middle DefenseSource: Standard & Poor’s, Compustat, Thomson Financial, Worldscope, FactSet and UBS UBS 37
  • 38. U.S. Small Cap Strategy 8 September 2011UBS Return Drivers — Revenue GrowthRevenue Growth Return Driver 120 ◄ Rev Growth ▼ 120 LEI ► Companies producing the 115 111 highest revenue growth have performed surprisingly well 110 in recent months 102 105 93 100 March 09 95 Oct 02 84 90 75 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBSRevenue Growth — Sector Performance Sep 10 - Aug 11 Relative Outperformance 30.9 Revenue Growth has been working broadly 16.8 8.7 6.9 5.8 5.4 5.2 2.4 1.9 0.8 -2.4 Relative Underperformance STPL EN MAT FIN SP600 DISC HC UTIL TECH IND TLCMSource: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS UBS 38
  • 39. U.S. Small Cap Strategy 8 September 2011UBS Return Drivers — PEGPE to Growth (NTM) Return Driver 109 120 PEG generally works in the ◄ PEG ▼ 111 middle innings of the cycle 104 102 ▲LEI ► 99 93 March 09 94 84 89 75 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBSPE to Growth (NTM) — Sector Performance Sep 10 - Aug 11 9.3 Relative Outperformance 9.0 8.3 PEG is working broadly as 7.3 well 3.3 2.8 2.1 1.7 0.7 -2.8 -3.2 Relative Underperformance STPL EN MAT FIN SP600 DISC HC UTIL TECH IND TLCMSource: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS See Appendix for UBS Return Driver calculation methodology UBS 39
  • 40. U.S. Small Cap Strategy 8 September 2011UBS Return Drivers — Cap & Op LeverageSmall Market Cap Return Driver 135 120 130 Cap is not a primary driver of 111 125 returns in the middle innings ▼ LEI ► of the cycle 120 102 115 93 110 ◄ Small Market Cap 105 84 100 95 75 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBSOperating Leverage Return Driver 120 120 Operating Leverage should 115 111 continue to add value in ▼ LEI ► cyclical sectors if recession is avoided 110 102 105 93 100 84 ◄ Op Leverage 95 75 01 02 03 04 05 06 07 08 09 10 11Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS UBS 40
  • 41. U.S. Small Cap Strategy 8 September 2011UBS Return Drivers — ValuationEarnings Yield Return Driver 170 160 Buying cheaper stocks tends to add value over time 150 140 130 120 110 100 00 01 02 03 04 05 06 07 08 09 10Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBSDividend Yield Return Driver 120 Dividend Yield is a cyclical 115 characteristic 110 105 100 95 00 01 02 03 04 05 06 07 08 09 10Source: Standard & Poor’s, Compustat, Thomson Financial, FactSet and UBS See Appendix for UBS Return Driver calculation methodology UBS 41
  • 42. U.S. Small Cap Strategy 8 September 2011Small vs. LargeRelative Performance – Russell 2000 vs. 1000 170 150 We expect small caps to outpace large companies 130 over the medium term 110 90 70 50 78 81 84 87 90 93 96 99 02 05 08Source: Russell and UBS Note: Recessionary periods highlightedSector Weights R2000 R1000 DifferenceCyclicals 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 -4.8Non-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 -0.1Index ex-Fin 78.3 85.2 -6.9 Financials 21.7 14.8 6.9Index 100.0 100.0 0.0Source: Russell, FactSet and UBS UBS 42
  • 43. U.S. Small Cap Strategy 8 September 2011Small vs. LargeRelative P/E 1.9 Small Caps Expensive Small caps’ relative valuation 1.7 is near the high end of the historical range 1.5 1.3 1.1 Small Caps 0.9 Cheap 0.7 00 01 02 03 04 05 06 07 08 09 10 11Source: Russell, Thomson Financial and UBSSmall 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 19.3 We believe small caps’ Technology 11.2 15.5 25.0 11.6 premium is justified given Energy 100+ 36.0 100+ 12.8 higher expected earnings Materials 48.8 43.9 27.0 14.8 growthNon-Cyclicals C. Staples -3.3 8.4 72.7 9.4 Health Care 100+ 7.0 100+ 7.6 Telecom Svcs 71.6 10.9 100+ 22.1 Utilities -0.1 1.7 8.4 1.0Index ex-Fin 40.6 17.5 45.0 12.1 Financials 100+ 14.0 46.5 33.7Index 62.1 16.9 45.3 15.4Source: Russell, Thomson Financial, FactSet and UBS Note: Analysis excludes FBP UBS 43
  • 44. U.S. Small Cap Strategy 8 September 2011Growth vs. ValueRelative Performance 150 We expect Growth to 130 outperform Value 110 90 70 50 30 10 78 81 84 87 90 93 96 99 02 05 08Source: Russell and UBSSector Weights Growth Value DifferenceCyclicals 66.8 % 48.2 % 18.6 % Technology is over 20% of C. Discretionary 14.8 11.7 3.2 Growth 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 Financials is over 35% ofNon-Cyclicals 20.9 13.5 7.4 Value 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 -7.3Index ex-Fin 92.0 64.6 27.4 Financials 8.0 35.4 -27.4Index 100.0 100.0 0.0Source: Russell, FactSet and UBS UBS 44
  • 45. U.S. Small Cap Strategy 8 September 2011Growth vs. ValueRelative P/E 3.5 On a relative basis, Growth 3.0 Growth and Value P/Es are within Expensive historical norms 2.5 2.0 1.5 1.0 Growth Cheap 0.5 90 92 94 96 98 00 02 04 06 08 10Source: Russell, Thomson Financial and UBSGrowth vs. Value Cons. Earnings Estimates 2011 Earnings Growth 2012 Earnings Growth Growth Value Growth ValueCyclicals C. Discretionary 22.0 % 1.2 % 23.5 % 68.9 % Industrials 42.6 22.8 29.8 43.9 Earnings growth differentials Technology 18.3 3.7 23.0 24.1 are largely explained by easy Energy 100+ 100+ 100+ 100+ comps Materials 74.5 32.4 22.8 27.3Non-Cyclicals C. Staples 70.5 -32.6 32.0 100+ Health Care 85.7 3.0 100+ 95.0 Telecom Svcs 72.7 44.5 100+ 100+ Utilities 22.2 -0.9 18.6 8.4Index ex-Fin 84.5 12.9 39.0 49.1 Financials 18.0 100+ 39.3 50.3Index 75.5 44.9 39.0 49.5Source: Russell, Thomson Financial, FactSet and UBS Note: Analysis excludes FBP UBS 45
  • 46. U.S. Small Cap Strategy 8 September 2011Fund PositionsSelect Small-Cap Core Funds —Relative Sector Positions 4.1 Many Core managers are 3.7 3.4 overweight commodity sensitive areas and 1.1 0.9 underweight Financials -0.7 -0.9 -1.3 -1.6 -1.9 -6.9 En Mat Ind Other Stpls Telcm HCare Util Discr Tech FinSource: Lionshares, Russell, FactSet and UBSNote: Analysis is based on 2Q11 holdings data for six large small-cap core funds. 2Q11 holdings data for one of thefunds is as of May 31, 2011Select 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 -8.2Source: Lionshares, Russell, FactSet and UBSNote: Analysis is based on 2Q11 holdings data for six large small-cap core funds. 2Q11 holdings data for one of thefunds is as of May 31, 2011 UBS 46
  • 47. U.S. Small Cap Strategy 8 September 2011Fund PositionsSelect Small-Cap Growth Funds —Relative Sector Weights 6.3 Many Growth managers are underweight Tech 1.6 0.8 0.5 0.2 0.0 0.0 -1.3 -1.6 -2.8 -3.6 Discr Fin En Util Other Telcm Mat Stpls Ind Hcare TechSource: Lionshares, Russell, FactSet and UBSNote: Analysis is based on 2Q11 holdings data for six large small-cap growth fundsSelect Small-Cap Value Funds —Relative Sector Weights 7.5 4.6 2.7 2.6 Many Value managers are 0.9 0.8 0.4 -0.2 -1.5 -2.3 -15.8 underweight Financials En Tech Ind Mat Hcare Stpls Other Discr Telcm Util FinSource: Lionshares, Russell, FactSet and UBSNote: Analysis is based on 2Q11 holdings data for six large small-cap value funds. 2Q11 holdings data for one of thefunds is as of May 31, 2011 UBS 47
  • 48. U.S. Small Cap Strategy 8 September 2011Investment RegimesDow Jones Industrials — Super Cycle Log Scale 10,000 all Equities experience prolonged booms or periods 5,000 4,000 or of anemic returns 3,000 nothing 2,000 1,000 500 These “investment regimes” 400 hold the key to stock prices 300 200 100 50 40 10 20 30 40 50 60 70 80 90 00 10Source: Dow Jones, FactSet and UBSS&P 500 E/P vs. Inflation (Disco Regime) 16 In the 1970s “Disco Regime,” 14 inflation was the primary driver of stock values Earnings Yield ▼ 12 Inflation ► 10 8 6 4 72 74 76 78 80Source: Standard & Poor’s, Dept. of Labor, Thomson Financial, FactSet and UBSNote: Earnings Yield based on trailing earnings; CPI (+2%) is lagged by 3 months UBS 48
  • 49. U.S. Small Cap Strategy 8 September 2011Investment RegimesS&P 500 E/P vs. 10 Yr Yield (Great Moderation) 16 ◄ Earnings Yield 14 During the “Great Moderation” the Fed Model explained returns 12 10 8 6 10-year Yield ▲ 4 82 84 86 88 90 92 94 96 98Source: Federal Reserve, Standard & Poor’s, Thomson Financial, FactSet and UBSS&P 500 E/P vs. Baa Yields (Millennium Regime) P/E Anchored to Slower Recession 10 Baa Bond Yields Growth Fears P0 pr pr1 Stocks look attractively 9 = 1 = valued relative to bond E1 k − g (i + rrf + erp) − g equivalents 8 Earnings Yield ► We believe long-term growth concerns will restrain 7 multiple expansion 6 ▲ Baa Yield 5 04 05 06 07 08 09 10 11Source: Moody’s, Standard & Poor’s, Thomson Financial, FactSet and UBS UBS 49
  • 50. U.S. Small Cap Strategy 8 September 2011Russell 2000 ValuationRussell 2000 — Forward P/E 40 Overvalued 36 Small caps are trading below 32 historical averages on an absolute basis 28 24 20 16 12 Undervalued 8 00 01 02 03 04 05 06 07 08 09 10 11Source: Russell, Thomson Financial and UBSRussell 2000 vs. Russell 1000 — Forward P/E 1.9 Small Caps Expensive Small caps look expensive 1.7 on a relative basis 1.5 1.3 1.1 Small Caps 0.9 Cheap 0.7 00 01 02 03 04 05 06 07 08 09 10 11Source: Russell, Thomson Financial and UBS UBS 50
  • 51. U.S. Small Cap Strategy 8 September 2011Russell 2000 ValuationRussell 2000 – Price-to-Book 3.0 Overvalued The Russell 2000 appears 2.5 reasonably valued on a price-to-book basis 2.0 1.5 Undervalued 1.0 00 01 02 03 04 05 06 07 08 09 10 11Source: Russell, Compustat, FactSet and UBSRussell 2000 vs. Russell 1000 – Price-to-Book 1.0 Small Caps 0.9 Expensive 0.8 0.7 0.6 Small Caps Cheap 0.5 0.4 00 01 02 03 04 05 06 07 08 09 10 11Source: Russell, Compustat, FactSet and UBS UBS 51
  • 52. U.S. Small Cap Strategy 8 September 2011Inter-Sector Relative ValuationIndustrials vs. Technology 20 20 Overvalued 15 15 Industrials and Technology 10 10 appear reasonably valued ◄ Industrials P/E Multiple Points 5 5 0 0 -5 -5 -10 Technology ► -10 -15 -15 Undervalued -20 -20 94 96 98 00 02 04 06 08 10Source: Thomson Financial, Russell, FactSet and UBSConsumer Discretionary vs. Financials 10 Overvalued 10 Financials ► 5 5 P/E Multiple Points 0 0 -5 -5 -10 -10 ◄ Discretionary -15 -15 Undervalued -20 -20 94 96 98 00 02 04 06 08 10Source: Thomson Financial, Russell, FactSet and UBS UBS 52
  • 53. U.S. Small Cap Strategy 8 September 2011Inter-Sector Relative ValuationEnergy vs. Materials 20 Overvalued 20 15 15 ◄ Energy The divergence between 10 10 Energy and Materials valuations has recently P/E Multiple Points 5 5 closed 0 0 -5 Materials ► -5 -10 -10 -15 -15 -20 Undervalued -20 -25 -25 94 96 98 00 02 04 06 08 10Source: Thomson Financial, Russell, FactSet and UBSHealth Care vs. Staples Overvalued 15 15 ◄ Health Care 10 10 Consumer Staples appears modestly overvalued 5 5 P/E Multiple Points 0 0 -5 -5 -10 Staples ► -10 -15 -15 -20 -20 Undervalued -25 -25 94 96 98 00 02 04 06 08 10Source: Thomson Financial, Russell, FactSet and UBS See Appendix for inter-sector relative valuation methodology UBS 53
  • 54. U.S. Small Cap Strategy 8 September 2011Appendix: UBS Return DriversWe define market leadership by specific stock characteristics, such as Size (small vs. large),Valuation (expensive vs. cheap), Growth, Momentum, and Volatility. We track fifteen suchcharacteristics, 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 GrowthSource: UBSComputationEach Return Driver is calculated as a hypothetical long/short portfolio built around a singlequantitative decision variable. Our calculations assume monthly rebalancing and no transactionor 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 Sectors Industry Groups Energy Energy Materials Materials Industrials Capital Goods; Commercial & Professional Services; Transportation Consumer Cyclicals Autos; Consumer Durables & Apparel; Consumer Services; Media; Retailing Food & Staples Retailing; Food Beverage & Tobacco; Household & Personal Consumer Staples 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 UtilitiesSource: 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 Buy (Top 1/3). Top 1/3 Stock returns equal-weighted within industry group Middle 1/3 Sell (Bottom 1/3). Bottom 1/3 Stock returns equal-weighted within industry groupSource: UBS UBS 54
  • 55. U.S. Small Cap Strategy 8 September 2011(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 ÷2 Factor 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 Cap-weighted result S&P 600 of Sector Average Cap-weighted result of Sector Sector Industry Group Average Industry Group Industry GroupSource: 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. UBS 55
  • 56. U.S. Small Cap Strategy 8 September 2011Appendix: Inter-Sector ValuationThe goal of our inter-sector valuation work is to gauge whether each Russell 2000 GICS sector isundervalued or overvalued relative to the overall market. Our analysis is based upon the historicalvaluation relationships between sectors. Importantly, we normalize sector valuations for three dynamicsthat 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 OverviewIn order to properly normalize inter-sector valuations over time, our analysis focuses on how manystandard deviations away each sector’s P/E is from the market’s P/E. (For our fellow math geeks, this isknown as cross-sectional standard deviation analysis.) We then put this calculation into a historicalcontext 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 (1) Sector Fwd P/E Fwd P/E (Current) Std Dev Current (Trail 36M) Current Rank Materials 13.54x 13.2x 0.3 1.4 0.2 1.1 -0.86 1 Technology 13.13x 13.2x -0.1 1.4 -0.1 0.7 -0.80 2 Financials 11.71x 13.2x -1.5 1.4 -1.1 -0.6 -0.47 3 Energy 12.09x 13.2x -1.1 1.4 -0.8 -0.6 -0.15 4 Health Care 12.19x 13.2x -1.0 1.4 -0.7 -0.9 0.15 5 Cons. Staples 14.71x 13.2x 1.5 1.4 1.0 0.7 0.34 6 Utilities 13.35x 13.2x 0.1 1.4 0.1 -0.4 0.47 7 Cons. Discretionary 15.20x 13.2x 2.0 1.4 1.4 0.9 0.51 8 Industrials 15.23x 13.2x 2.0 1.4 1.4 0.7 0.72 9 Telecom 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/ESource: First Call, Russell and UBS UBS 56
  • 57. U.S. Small Cap Strategy 8 September 2011Step-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 (P/E Sector − P/E Market ) Sector Z - Score = σ P/E MarketSource: 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 Net Z - Score = Z - Score minus Z - Score Current 36 - Month AverageSource: 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 2 Overvalued 1 P/E Multiple Points 0 -1 -2 Undervalued -3 97 99 01 03 05 07 09Source: Standard & Poor’s, Thomson Financial, FactSet and UBS UBS 57
  • 58. U.S. Small Cap Strategy 8 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 58
  • 59. U.S. Small Cap Strategy 8 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 59
  • 60. U.S. Small Cap Strategy 8 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: Chip Miller, CFA; Jonathan Golub, CFA.Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report. UBS 60
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