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MORGAN                              STANLEY                            RESEARCH                                           ...
MORGAN              STANLEY                  RESEARCH                                                                     ...
MORGAN             STANLEY              RESEARCH                                                                          ...
MORGAN        STANLEY        RESEARCH                                                                    January 2, 2012  ...
MORGAN                     STANLEY                                        RESEARCH                                        ...
MORGAN              STANLEY           RESEARCH                                                                            ...
MORGAN                  STANLEY           RESEARCH                                                                    Janu...
MORGAN                 STANLEY                     RESEARCH                                                               ...
MORGAN               STANLEY                 RESEARCH                                                                     ...
MORGAN               STANLEY               RESEARCH                                                                       ...
MORGAN            STANLEY             RESEARCH                                                                       Janua...
MORGAN        STANLEY        RESEARCH                                                                                     ...
Ms 2012-forecast
Ms 2012-forecast
Ms 2012-forecast
Ms 2012-forecast
Ms 2012-forecast
Ms 2012-forecast
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  1. 1. MORGAN STANLEY RESEARCH NORTH AMERICA Morgan Stanley & Co. LLC Adam S. Parker, Ph.D +1 212 761 1755 Brian T. Hayes, Ph.D Antonio Ortega Antonio.Ortega@morganstanley.comJanuary 2, 2012 Adam J. Gould, CFA Adam.Gould@morganstanley.comUS Equity Strategy Phillip Neuhart Phillip.Neuhart@morganstanley.comThe 2012 PlaybookWe are establishing a 2012 year-end price target of Our three overweight sectors are utilities, health care,1167, representing 7% downside from today’s price. and consumer staples. We are recommendingThe consensus top-down view has coalesced, with underweights in consumer discretionary and energylimited variation, around 1350, making our forecast 13% stocks (Exhibit 1). We make two major sectormore conservative than the “muddle through” scenario changes to start 2012. We have downgradedimplied by consensus. energy from market-weight to underweight, and upgraded industrials from underweight toWhile 2011 was about multiple contraction, and market-weight (see details, pages 9 through 11).further contraction is likely, we think 2012 and 2013 Exhibit 1are likely more about earnings than the multiple.We are posting a 2013 EPS estimate for the S&P500 of Our Current Sector Recommendations Retain$103.1, 15% below the consensus bottom-up view of a Defensive Bent Morgan Stanley Sector Recommendations$121.1. We have modestly lowered our 2012 earnings 5% As of January 2012 4%forecast, from $103 to $100. We are most below the 3%bottom-up 2012 forecasts in materials, financials, and 2%technology. In 2013, most sectors appear to have 1% 0%estimates more than 10% too high (Exhibit 10). Of note, (1%)BAC is forecasted by analysts to drive 14% of the entire (2%) Overweights - Utilities, Health Care, Staples Market-Weights - Technology, Industrials, Telecoms, Financials, MaterialsS&P500 EPS growth for 2012 vs. 2011 (Exhibit 7). (3%) Underweights - Discretionary, Energy (4%) (5%) Discretionary Health CareOur more cautious view on earnings stems from three Materials Technology Telecoms Energy Staples Financials Utilities Industrialskey factors. 1) We see global GDP decelerating overthe next few months in nearly every major geography(Exhibit 15). 2) Recent company results have beenweak (Exhibit 11), with companies like TXN, INTC, MU, Source: Morgan Stanley ResearchORCL, CRM, RHT, DRI, COST, FDX, and WAGreducing their outlook. This likely portends weak This week, we are removing BHI and WAG from theJanuary results or April guidance. 3) The dollar has portfolio and adding UTX, TFM, and TGT. For detailsmaterially strengthened against the euro over the last on our portfolio, its characteristics and performancefew months (Exhibit 12) and our analysis shows this is see Exhibit 24-Exhibit 27. To search for stock ideashighly correlated to earnings downside, with select or decompose individual names to assess what isstaples, technology, and materials likely impacted. driving our quantitative outlook, go toFurthermore, inventory levels remain crucial, as several now have inventory-to-sales ratios wellabove five-year averages (Exhibit 14). Morgan Stanley does and seeks to do business withWith record high cash balances, we see capital use and companies covered in Morgan Stanley Research. Asits consequences as key (Exhibit 18), with dividend yield a result, investors should be aware that the firm maylikely a continued successful factor. CVX, JPM, TGT, have a conflict of interest that could affect the objectivity of Morgan Stanley Research. InvestorsBEN, CBS, WU, SPLS, and ABC are our top ideas for should consider Morgan Stanley Research as only asustainable yield (Exhibit 20). 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.
  2. 2. MORGAN STANLEY RESEARCH January 2, 2012 US Equity StrategyBrief Review of 2011 S&P stocks in 2011. FSLR, CREE, ANR, ROVI, and NFLX were the five worst performing stocks.In retrospect, the resiliency of the US equity market in the face Adjusting for market capitalization (to better show the biggestof macro volatility was surprising in 2011. The SPX ending the contributors to a portfolio manager’s performance) changes theyear essentially unchanged and the Dow ending up 6% in 2011 list. AAPL, XOM, IBM, PM, PFE, CVX, MCD, WMT, V, andwere better outcomes than we anticipated, with the former INTC were the biggest 10 contributors, adjusting for size, inslightly above our year-end target of 1238 established on 2011. The biggest stocks to avoid included BAC, C, GS, HPQ,January 3rd of 2011. However, the multiple contracted as we and JPM. Making a bet on integrated oil and select technologyexpected, given that SPX earnings appear to have grown within mega caps, and avoiding financials, were keys toroughly 17% in 2011. Multiple contraction remains our core success.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: Our 2012 S&P500 ForecastCould the Multiple Go to 10x?). This view is consistent withMorgan Stanley chief US Economist Vincent Reinhart’s “After The switch of the calendar is more psychological than anythingthe Fall” paper, which focused on low growth rates post else and doesn’t necessarily mean huge rotations will occur byfinancial crises (C. Reinhart and V. Reinhart, "After the Fall," style, substance, or size. As such, we think some of the majorFRB Kansas City, Jackson Hole Symposium, August 2010). themes we saw in 2011 are still in place today. We prefer mega caps to the broader market, growth over value, andUnderlying the total market performance were some quality to junk.interesting major themes. Quality outperformed junk bynearly 12%, and growth outperformed value by almost 10%, Our year-end 2012 price target for the S&P500 is 1167, aboth of which we anticipated (see January 18th, 2011: The price implying 7% downside from today’s price byQuality / Junk Debate and May 23rd, 2011: Do You Have year-end (Exhibit 2). The consensus top-down view for 2012Style?). Further, mega caps began outperforming in May and is 1350, making our outlook 13% more cautious than theoutperformed small caps by almost 540 basis points in 2011, consensus top-down call. While top-down expectations aresomething we previewed on March 21st, 2011 (Will Mega and clearly less sanguine for 2012 than they were for 2011 at thisLarge Caps Remain an Inferior Asset Class?). We offered time a year ago, there is little variation among the top-downspecific mega cap stock ideas on May 9th, 2011: A Five-Year forecasts, implying that a “muddle-through” scenario for theView of the $100 Billion Market Cap. Club). economy and earnings is the consensus. We think the risk-reward is skewed to the negative. Our bear case forSector betting was skewed toward the defensive, with the S&P500 is 944, and our bull case 1450. Accounting forutilities, health care, and staples the top 3 performing the probabilities we see as likely, our expectation for thesectors in 2011 (all of which we overweight). We did not S&P500 by year-end 2012 is 1167.recommend financials, materials, or industrials all year, thethree worst performing sectors in 2011 in the GICS ten. OurMOST Strategic Portfolio, a combination of fundamental and Exhibit 2quantitative disciplines, outperformed the market by 190 basis Our Year-End 2012 Price Target Is 1167, 7% Downpoints in 2011. For those unfamiliar with the portfolio, please from Current Levels and 13% Below the Consensussee the back part of this note, which lists current stock picks as Expectation of 1350 for End-2012well as those deleted during the year. The portfolio had 60% Morgan Stanley S&P 500 Price Target Methodologyturnover in 2011 and has an average market capitalization of Probability Scenario Upside / EPS Landscape of Scenario 2011E 2012E 2013E Multiple Target (Downside)over $50 billion, in order to enable avid followers to mirror the Bull Case 15% 99.2 107.1 117.0 12.9x 1450 15.3%portfolio composition. 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%)It truly ended up being a flat year. Within the top 500 market Growth 15% (14%) (9%) Probability Weighted S&P 500 Price Target 1167 (7.2%)capitalization stocks, 246 ended the year down, and 254 up. Source: Factset, Morgan Stanley ResearchWinners and losers: Petrohawk Energy (acquired), El Paso We are launching our 2013 EPS estimate of $103.1, 15%(acquired), ISRG, ALXN, and MA were the best five performing below the bottom-up consensus forecast of $121.1. 2
  3. 3. MORGAN STANLEY RESEARCH January 2, 2012 US Equity StrategyWe made some minor changes to our 2011 and 2012 EPS showed that several times in our work in 2011. Is it possible toestimates, modestly raising 2011 from $96 to $97.4, in-line with forecast year-ahead changes in US earnings and/or multiples,the consensus forecast. For 2012, we are lowering our using only information available today? We tested a range ofestimate from $103 to $100. Less labor productivity and a macro and financial variables for their effectiveness atstronger US dollar are among the key drivers for plateauing predicting changes to the market multiple. Since our priceprofits in our base case. Our 2013 EPS forecast of $103.1 is target objective requires an estimate for next 12 months (NTM)well below the $121.1 forecasted by bottom-up analysts earnings one year from now (i.e., at the end of 2012, what is(Exhibit 3). our view of 2013 S&P500 earnings), together with an earnings multiple for that date, we need to analyze those quantities one year out.Exhibit 3We Are 15% Below Consensus on 2013 Earnings As predictor variables (Exhibit 4) we considered a number of logical macro variables. These include: Morgan Stanley and Consensus S&P 500 Earnings Estimates As of December 2011 • change in the level and slope of the yield curve Consensus $121 • change in credit spreads MS Estimates • change in dividend yields $107 • percent change in crude oil prices $103 $98 $97 $100 • 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. 2011E 2012E 2013E small-cap stocks • the lagged performance of the change in earnings orSource: Factset, Morgan Stanley Research 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 aThree Key Themes for 2012 123-quarter period starting in 1980.1) We forecast continued market multiple We found that forecasting the multiple a year out iscontraction. fruitless using these major macro factors, with the exception of the prior year’s large vs. small capThis represents a continuation of our main theme in 2011. We performance.know that low and volatile growth is bad for multiples andExhibit 4We Attempted to Model the SPX Earnings and Multiples a Year Out from Macro Factors – Few Obvious MacroFactors Held Any Statistical Significance Forecast Models 1980 Through November 2011 Factors Tested (Check Indicates Significance) Slope of Level of Growth- Large- Lagged Yield Yield Value Small Baa-Aaa Dividend Top 500 Dollar Dependent Model Curve Curve Return Return Spread Yield Return Index Crude Oil Variable NTM Earnings Growth NTM P/E GrowthSource: Factset, Morgan Stanley Research 3
  4. 4. MORGAN STANLEY RESEARCH January 2, 2012 US Equity StrategySo why do we think there will be further multiple multiple-contraction thesis as contrarian, despite the fact wecontraction? had the same call last year and it worked throughout 2011.While valuation for the overall US stock market may look Moreover, having received dozens of investors’ questionsattractive versus recent history, if one examines a longer over the last couple of weeks, we are confident that thehistory, the top 500 stocks in the US have traded significantly consensus view is that a “muddle through” scenario forbelow current levels for extended periods of time, particularly EPS growth is “likely” and that modest multiple expansionwhen interest rates were much higher. So, while on the will be a byproduct.surface, the valuation of the S&P500 may appear cheap, wethink there are some important underlying explanations and The major pushback we received in 2011 on our multiplethat the market is less attractively valued than the conventional contraction thesis took two forms:wisdom might otherwise dictate. Analysts earnings estimateshave been posted in a central place since 1976. Relative to 1. Relative to bonds and other asset classesthis complete history, the US equity market is trading slightly equities look cheap and therefore will see inflows,lower (cheaper) than its median (Exhibit 5), at the 39th driving multiples higher. Our response is that there ispercentile versus its long-term history and particularly no empirical evidence to show that inflows drivecheap compared to the last ten years. multiple expansion, the same as there is no evidence that outflows drive multiple contraction. As anExhibit 5 example, in 2009, the equity market nearly doubledThe Market Is in the 39th Percentile vs. History on while there were substantial outflows.Price-to-Forward Earnings Top 500: Price to Forward Earnings 2. There is a popular thesis that when rates are low 1976 Through December 2011 the multiple is usually high. We have frequently 35x 30x acknowledged over the last year that this argument resonates with us. Holding certain high yielding 25x equities, where the dividend is safe (i.e., at least twice Median = 13.6 20x covered) and earnings that ought to grow over the 75th Percentile = 15.6 15x next decade does seem like a sensible approach relative to holding the 10-year US government bond 10x 25th Percentile = 10.0 yielding less than 2%. As such, we have 5x recommended stocks like MCD and PM in our 0x portfolio all year. However, we don’t subscribe to the 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 thesis that low rates mean a high multiple. In fact, weSource: Factset, Morgan Stanley Research believe it is quite the opposite. When interest rates are high, it is reasonable to expect that the equity riskHowever, our judgment is that over the medium term, EPS premium rises, as a fixed equity risk premium wouldgrowth is likely to be at-or-below its long-term average of 7%, give less proportional compensation for investing inowing to a muted economic backdrop and volatility induced by equities. What’s subject to some debate is whether aabove-normal government intervention and regulation, higher or lower equity risk premium is required whendemographics, European sovereign debt woes, and Chinese rates are low. In fact, part of the Fed’s strategy (i.e.,inflation, to name a few of the macro issues. We believe that by Operation Twist) is to lower the 10-year yield to makethe middle-to-end of 2012, the view of forward one-year growth risk assets like equities look more attractive. But ourwill be markedly lower than today’s consensus view. As such, view is that the relationship between rates and thethe market multiple is more likely to contract than expand over equity risk premium is actually a smile (non-linear), asthe medium to long term – unless we see a recovery where opposed to a line (see the theoretical drawing in2012 EPS growth is higher than 2011 EPS growth. At present, Exhibit 6). When rates are close to zero, we think youwe assign only a 15% probability to this bull case. need a higher equity risk premium because the reason rates are near zero is that everything is out ofBecause the consensus view is that the multiple will remain kilter. Today, that means high deficit / debt, intensestable or gradually expand as earnings grow, we see our political polarization, massive fiscal stimulus that needs to be unwound, high unemployment, and a 4
  5. 5. MORGAN STANLEY RESEARCH January 2, 2012 US Equity Strategy pretty severe hangover from the housing crisis, Exhibit 7 among other issues. Hence, lowering the 10-year Analysts Forecast that Bank of America Will Drive yield doesn’t necessarily make equities more 14% of the Entire S&P500’s EPS Growth in 2012 attractive, as extremely low rates and risk-aversion, % Growth not risk-seeking, are synonymous. $ Growth Contribution (2012 Vs To S&P 500 Company 2011E 2012E 2011) (2012) S&P 500 Index 883,520 970,617 87,097Exhibit 6 Bank of America Corp. (2,478) 9,777 12,255 14.1%In Our View the Relationship between the 10-Year Apple Inc. 28,858 33,514 4,657 5.3% Goldman Sachs Group Inc. 2,361 6,293 3,932 4.5%and Equity Risk Premium Is a Smile, not a Line 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% Theoretical Drawing Schlumberger Ltd. 4,914 6,589 1,675 1.9% 18% Equity Risk Premium vs Treasury Yields International Business Machines Corp. 15,794 17,469 1,675 1.9% 16% Allstate Corp. 391 1,856 1,465 1.7% 14% Caterpillar Inc. 4,518 5,918 1,401 1.6% 10-Yr. Treasury Yield JPMorgan Chase & Co. 17,103 18,428 1,325 1.5% 12% Feds Target? Total Top 6 Financials (including GE) 26.3% 10% Source: Factset, Morgan Stanley Research 8% 6% 4% Theoretical Smile At the sector level, analysts are forecasting that financials will 2% account for over 35% of total S&P500 EPS growth in 2012 0% (Exhibit 8). As investors look to 2013 EPS, they may notice 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% that the energy sector earnings are expected to rebound, with Equity Risk Premium bottom-up forecasts currently embedding 18.6% earningsSource: Morgan Stanley Research growth, such that the energy sector will account for 20% of total S&P500 earnings in 2013 if these numbers prove to be accurate.2) We believe the 2012 and 2013 analyst estimates Exhibit 8are too high. Financials Are Forecasted to Account for over 35% of 2012 EPS Growth…We analyzed the 2012 consensus EPS estimates and have 2012 vs. 2011 and 2013 vs. 2012 EPS Growth Contribution to S&P 500 by Sectorseveral observations. (If anyone wants the spreadsheet details, 45%please don’t hesitate to contact us.) According to the 40%consensus 2012 bottom-up estimates, 14% of the entire 35% 2012 vs. 2011 30%2012 S&P500 EPS growth is slated to come from Bank of 2013 vs. 2012 25%America and over 25% of the EPS growth from the largest 20%six financials. 15% 10%Only 51 of the 500 companies are forecasted to have 5% 0%declining earnings in 2012 vs. 2011. Furthermore, Technology Discretionary Materials Energy Health Care Financials Industrials Staples Utilities Telecom (5%)analysts are currently forecasting that only 15 companiesin the S&P500 will have lower earnings in 2013 than in2012. For context, 103 companies are forecasted to havelower earnings in 2011 than 2010. Source: Factset, Morgan Stanley Research 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). 5
  6. 6. MORGAN STANLEY RESEARCH January 2, 2012 US Equity StrategyExhibit 9 Recent corporate results and guidance have been soft.…But Accounted for 3% of the Growth in 2011 EPS Contribution to S&P 500 The number of companies issuing negative guidance during the fourth quarter has increased, and this perhaps has flown aSector 2011E vs 2010 2010 little under the radar screen over the last few weeks in ourEnergy 34% 12% judgment. In terms of breadth, we have seen the highest ratioInformation Technology 20% 19% of negative to positive guidance in several quarters (Exhibit 11).Industrials 13% 9% Companies like TXN, INTC, MU, ORCL, CRM, RHT, DRI,Consumer Discretionary 10% 9% COST, FDX, WAG, among others, have guided down orHealth Care 7% 14% discussed slowdowns over the past several weeks. We thinkMaterials 6% 3% this may portend weak guidance or soft results during theConsumer Staples 6% 10% January earnings season and the corresponding guidance forFinancials 3.5% 16% April.Utilities 0% 4%Telecommunication Services 0% 3% Exhibit 11 2011 EPS Growth vs 2010 More Companies Have Issued Negative Guidance vs. Total EPS in 2010 Recently than Any Time in Over a YearFinancials 3.3%Source: Factset, Morgan Stanley Research Ratio of Negative-to-Positive At T-1 S&P 500 Guidance Relative to Consensus Expectations 2.5 T=0 is end of QuarterAt the sector level (Exhibit 10) we are most below consensus in 2.02012 for materials, financials, and technology. For 2013, ourtop-down estimates are 10% or more lower than the bottom-up 1.5outlook in industrials, energy, materials, consumerdiscretionary, telecoms and financials. 1.0Exhibit 10 0.5For 2012, We Are Most Below the Bottom-UpForecasts in Materials, Financials, and Technology- 0.0 4Q10 1Q11 2Q11 3Q11 4Q11We Are More than 10% Below Consensus for MostSectors in 2013 Source: Factset, Morgan Stanley Research S&P 500 Earnings Per Share Summary Table As of July 2011 2011E 2012E 2013E 2011E 2012E 2013E Currency will continue to be an important issue, withS&P 500 97.5 107.2 121.1 15% 10% 13% tailwinds turning into headwinds.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% For some reason whenever I think of currency, I think of IBM’s MS Consumer Staples 9.2 9.4 9.6 6% 2% 2%Energy 14.9 15.3 18.1 41% 2% 19% July 2011 earnings report. They reported 12% revenue growth, MS Energy 14.9 14.9 15.5 41% 0% 4%Financials 14.3 18.0 20.3 10% 25% 13% with 7% coming from currency. The dollar weakened by 9% MS Financials 14.3 15.8 16.4 9% 10% 4%Health Care 12.6 13.1 14.1 5% 3% 8% from January 2011 through early May 2011. IBM was the third MS Health Care 12.6 12.7 12.9 5% 1% 2%Industrials 9.7 11.0 12.4 22% 13% 13% best stock in the S&P500 last year by market capitalization MS Industrials 9.7 10.4 10.0 21% 7% (4%) contribution. What’s our point? It has to be related. The dollarInformation Technology 18.7 20.6 23.1 14% 10% 12% MS IT 18.7 19.0 20.0 14% 2% 5% has strengthened materially against the euro since, particularlyMaterials 3.4 3.9 4.4 33% 14% 14% MS Materials 3.4 3.0 3.0 32% (12%) 0% since late October (Exhibit 12).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 97.4 100.0 103.1Source: Factset, Morgan Stanley Research 6
  7. 7. MORGAN STANLEY RESEARCH January 2, 2012 US Equity StrategyExhibit 12 Exhibit 13The Dollar Has Meaningfully Strengthened Against Companies Are Making Record Profits – This Couldthe Euro Recently Continue but We Think Risk-Reward Is Skewed to the Negative US Dollar/Euro Spot 1.50 Top 500 Net Margin 10% Through 2013E 1.45 9% 8% 1.40 7% 6% 1.35 5% 1.30 4% 3% 1.25 2% Jan-11 Apr-11 Jul-11 Oct-11 1%Source: Factset, Morgan Stanley Research 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: Factset, Morgan Stanley Research We are not saying that everything is cyclical and mean-revertsWe measured the sensitivity of overall US equity earnings to in our margin outlook. There are real reasons why the marginscurrency moves using a highly quantitative approach. Our are higher today, including better productivity. However, weconclusion is that each 1% appreciation in the US dollar don’t see incremental margin expansion as accelerating. Wecorresponds to an expected 0.97% decline in aggregate made a big point of this in 2011, and expectations for 2012earnings. Historically, swings in earnings have been more profit margins have begun to moderate. Nonetheless, labordramatic than swings in currency, so currency overall is not a productivity, currency, and factory utilization will be keys fordominant factor in overall earnings growth, but it does matter at further profit margin expansion. In addition, we are closelythe margin. Morgan Stanley’s Currency Strategist Hans monitoring corporate inventory levels, which have begun toRedeker is forecasting a further weakening of the euro to grow and may limit margin progress in 2012. In fact, there areUS$1.20 by the end of 2012. For most sectors in the US, a several industries where current inventory-to-sales levels arestrengthening dollar is negative for earnings growth, with a well above average levels seen over the past five yearspositive but statistically insignificant impact on consumer (Exhibit 14), including machinery and metals and mining.discretionary, financials, and telecom earnings being counterto the negative impact on the other seven GICS sectors. Exhibit 14Materials, technology, and staples are typically most negatively We Are Monitoring Corporate Inventory Levels,impacted by currency moves, and we would avoid high beta Which Are Rising in Machinery and Metals andbets in these sectors heading into earnings season. Mining, Among Other Sectors Top 1500 Inventory-to-Sales by Industry 1974 - Q3 2011Overall, we think the risk-reward is skewed to the negative on Percentilecorporate profitability, although our base case is for continued, vs. 5-Year Industry Current Median Example Tickersthough quite modest, growth. The starting point is of course Aerospace & Defense 19.3% 100.0% UTX, BA, HON, PCP, GD, LMT Machinery 15.9% 100.0% CAT, DE, ITW, CMI, ETN,relevant, and we now have record profit margins and record Leisure Equipment & Products 18.1% 100.0% MAT Food & Staples Retailing 8.7% 94.7% WMT, CVS, COST, WAG, SYYexpectations for margins over the next year (Exhibit 13). Containers & Packaging 13.2% 89.4% BLL, CCK Construction & Engineering 7.5% 84.2% FLR, JEC Household Durables 12.9% 84.2% GRMN Metals & Mining 15.4% 78.9% FCX, NEM, SCCO, NUE, AA Auto Components 7.9% 78.9% JCI, BWA Gas Utilities 6.9% 78.9% OKE Industrial Conglomerates 10.9% 73.6% GE, MMM, DHR, TYC Automobiles 41.0% 73.6% F, GM, HOG Source: Morgan Stanley Research 7
  8. 8. MORGAN STANLEY RESEARCH January 2, 2012 US Equity StrategyThe Bear Case Is a Meaningful Slowdown in Earnings Exhibit 16While not a dramatic decline, our Global Economics Team is US Companies Have More than $1.4 Trillion in Netcurrently forecasting decelerating GDP for the next couple of Cash on Their Balance Sheets Todayquarters in nearly every major global economy. Moreover, Cash Balancestheir base case includes a recession with deceleration in $1.8 Top 1,500 Stocks (Ex-Financials, $T)Europe (Exhibit 15). Not only is this likely to impact corporate $1.6 Through Q3 2011profits, it is also likely to change sentiment around corporate $1.4spending from managements, as well as the multiple investors $1.2are willing to pay for the reported earnings. $1.0 $0.8 $0.6Exhibit 15 $0.4The GDP of Most Major Regions Will Likely $0.2Decelerate Over the Next Few Months $0.0 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 Morgan Stanley GDP Growth Estimates 4% Source: Factset, Morgan Stanley Research Q4 2011 3% Q1 2012 Much of that cash (about 80%) is concentrated in four sectors: 2% technology, industrials, health care, and consumer discretionary, and these will likely be places where some 1% small-to-mid cap exposure is prudent for capitalizing on M&A 0% (Exhibit 17). (1%) Exhibit 17 (2%) 80% of that Cash Is Concentrated in Four Sectors – G10 US Euro Area Technology, Industrials, Health Care andSource: Factset, Morgan Stanley Research Discretionary Share of Cash Balances by Sector (Ex-Financials) 35% As of Q3 2011In particular, the slowdown in the emerging markets and China 30% 30%will be important. Data points in China have clearly been weak 25%over the last couple of months. Economic surprise indices are 20% 19% 15% 16%markedly worse than in the early fall, and property, rail car, and 15%corporate spending data points, among others, have also 10% 7% 9% 5%stalled. While fears of a hard landing have already episodically 5%weighed on multiples, the reality of lower growth will likely 0% Other Healthcare Energy Discretionary Technology Industrials Staplesimpact reported earnings in 2012.3) Capital Use and Its Consequences Will Matter Source: Factset, Morgan Stanley ResearchCash balances are at record highs and continue to expand.We argued early last year that the market was paying anincreasingly lower multiple for cash on the balance sheets of Of late, the market has rewarded dividend yielders the mostcompanies, in part due to uncertainly about future uses. Apple (Exhibit 18), though companies buying back stock were alsois probably the best current example. With over $1.4 trillion in handsomely rewarded in 2011, in fact more than over thenet cash on the balance sheets of the largest 1500 US previous several years (not shown here). Acquirers werecompanies (Exhibit 16), deployment of this capital will continue punished, particularly those who did all-stock deals. Highto be a major theme for US equity investors. capital spenders lagged the market. 8
  9. 9. MORGAN STANLEY RESEARCH January 2, 2012 US Equity Strategy in the top two quintiles of our MOST (3-month) and BESTExhibit 18 (two-year) quantitative models, are shown in Exhibit 20.Investors Rewarded Dividend Yield the Most in 2011– M&A Was Punished, Particularly All-Stock Deals Exhibit 20 Efficacy of Capital Uses by Time Period: One-Year Return Stock Ideas with EPS Growth and Sustainable Top vs. Bottom Tertile (T1-T3), 2011 Dividend Yields Include CVX, JPM, TGT, and ABC, Capital Spending (6.2%) Among Others Internal Growth R&D Expenditures (5.9%) Sustainable Dividend Stock Ideas M&A 1.9% Market Cash Only (0.4%) Ticker Company Name Sector Cap ($ B) BEST MOST External Growth Stock Only (6.4%) CVX Chevron Corp. Energy 211.9 Q1 Q1 Blend 2.1% JPM JPMorgan Chase & Co. Financials 126.3 Q1 Q1 TGT Target Corp. Consumer Discretionary 34.4 Q2 Q1 Reduce Change in Debt-to- BEN Franklin Resources Inc. Financials 20.9 Q2 Q1 Leverage Assets (3.4%) CBS CBS Corp (Cl B) Consumer Discretionary 17.8 Q2 Q2 WU Western Union Co. Information Technology 11.3 Q2 Q1 Total Yield 16.8% SPLS Staples Inc. Consumer Discretionary 9.7 Q1 Q1 Return to ABC AmerisourceBergen Corp. Health Care 9.7 Q1 Q1 Dividend Yield 17.0% Shareholders Share Buybacks 12.6% Stocks with Market Cap of $5 Billion or Greater Dividend Yield > 2.5% or Buyback Yield > 2%. Payout Ratio < 55%. T1 defined as high capx, high R&D, high shareholder yield, low change in total debt Top two quintiles of BEST and MOST. For M&A the figures represent median performance of acquires vs. the market Source: Factset, Morgan Stanley Research. Stock prices: CVX: $106.40, JPM: $33.25, TGT:Source: Factset, Morgan Stanley Research $51.22, BEN: $96.06, CBS: $27.14, WU: $18.26, SPLS: $13.89, ABC: $37.19We believe dividends will continue to work as a factor inpredicting subsequent stock return. Investors have asked us Sector Recommendationswhether the strong efficacy of this factor since May of 2011means that it will stop working early in 2012. We don’t think so. Our three overweight sectors are utilities, health care, andTaking a longer-term perspective, dividends have accounted consumer staples. We are recommending underweights infor over 40% of S&P500 return over the past century (Exhibit consumer discretionary and energy stocks (Exhibit 21).19). We are making two major sector changes to start 2012. We have downgraded energy from market-weight toExhibit 19 underweight, and upgraded industrials from underweightDividends Have Accounted for Over 40% of SPX to market-weight. This moves industrials to our 5th rankedReturns over the Last Century sector versus a prior rank of 9th (out of ten). We clearly S&P 500 Total Return: Price and Dividend Contribution prefer industrials to energy at this juncture. To embody Total Price Income As a Share of Total Return this in our portfolio, we removed Baker Hughes and added Return Appreciation Return Price App. Div. Income United Technologies. We have also added Target to the1930s 0.1% (5.3%) 5.7% na na portfolio for its dividend yield and the potential of its Canada1940s 8.9% 3.0% 5.7% 33.6% 64.5%1950s 18.9% 13.6% 4.7% 72.0% 24.7% operations (per our analyst Mark Wiltamuth’s thesis). We1960s 7.7% 4.4% 3.1% 57.2% 41.0% removed WAG and added TFM, which modestly increased our1970s 5.8% 1.6% 4.1% 27.8% 71.1%1980s 17.2% 12.6% 4.1% 73.2% 23.8% exposure to the consumer discretionary sector, viewing the1990s 18.0% 15.3% 2.3% 85.1% 12.9% growth profile of TFM as superior to WAG.2000s (0.9%) (2.7%) 1.8% na na2010 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 ResearchStocks that currently offer dividend yields above 2.5% that aretwice covered, have forecasted long-term EPS growth above5%, are Overweight rated by our analysts and screen well, i.e., 9
  10. 10. MORGAN STANLEY RESEARCH January 2, 2012 US Equity StrategyExhibit 21 Exhibit 22We Are Overweight Health Care, Utilities and Staples, Incremental Margin Expectations for Industrialsand Underweight Energy and Consumer Have Moderated Meaningfully Since Last MayDiscretionary Industrials: 2012 Incremental Margins 5% Morgan Stanley Sector Recommendations 40% As of January 2012 4% 3% 35% 2% 30% 1% 0% 25% (1%) (2%) Overweights - Utilities, Health Care, Staples 20% (3%) Market-Weights - Technology, Industrials, Telecoms, Financials, Materials Underweights - Discretionary, Energy (4%) 15% (5%) 10% Discretionary Health Care Technology Materials Energy Telecoms Staples Financials Utilities Industrials Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Source: Factset, Morgan Stanley ResearchSource: Factset, Morgan Stanley Research Moreover, the multi-industry conglomerates and defense industries, which represent a large percent of earnings and market capitalization of the sector, look more attractivelyWhy our sector changes? valued than the sector as a whole, as multiples have contracted over the last several quarters (Exhibit 23).Industrials: We have upgraded industrials fromunderweight to market-weight today. The industrials sectorwas the third worst performing sector (behind only materials Exhibit 23and financials) in the S&P500 last year. Doubts about The Valuation of Conglomerates and Aerospace andsustained growth and negative earnings revisions occurred in Defense Has Become More Attractivethe middle of the year, driving down valuations that hadpreviously been less compelling than other parts of the market. Relative Price-to-Forward EarningsWe feel relatively more balanced about the outlook today, Industrial Conglomerates and Aerospace & Defense Industries vs. Industrials Sector (excludes GE)primarily because the analyst expectations for 2012 profit 1.4x 2008 Through 2011margins have meaningfully moderated since last spring 1.3x(Exhibit 22). In May, analysts were expecting industrialcompanies to get 35 cents of profit from every dollar of revenue 1.2xgrowth. Now, the expectations are for a more reasonable 13 1.1xcents. Reductions to the outlook are true across the board, not 1.0xjust for GE, which is the largest security in the sector. 0.9x 0.8x 08 09 10 11 Source: Factset, Morgan Stanley Research 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 10
  11. 11. MORGAN STANLEY RESEARCH January 2, 2012 US Equity StrategyMOST and BEST and are low quality or junk according to our Our Portfolioquality model. We publish our portfolio each week. The strategy we use forEnergy: We downgraded energy to underweight from stock selection is to combine the fundamental analystmarket-weight today. recommendations with our quantitative models. We have been able to show that when both fundamental and quantitativeWe started 2011 with energy as our largest overweight, and in disciplines are used in combination, a synergy results thatmid-April downgraded it to market-weight. We briefly oscillated historically had produced excess return. In 2011, ourback to overweight over the summer, but became portfolio outperformed the S&P500 by 190 basis pointsmarket-weight the sector again since August. Netting it out, the (Exhibit 24). We view the portfolio as “Core” more thansector allocation had almost no impact on our portfolio last year. “Growth or Value” as our analyst recommendations andWhy are we cautious now? quantitative frameworks are ostensibly style neutral.Estimates for 2013 look too high: The bottom-up energy Exhibit 24sector expectations for 2013 of 18.6% EPS growth seem The MOST Strategic Portfolio Outperformed the S&Pexcessive, and downward revisions are likely without a 500 (Total Return) in 2011 by 190 Basis Pointsmaterial rise in oil prices. MOST Strategic Portfolio Performance December 31, 2010 to December 30, 2011 4.0% 3.7%Global economy is decelerating: We see strong demand as 3.5%unlikely, as the global economy is slated to decelerate in nearly 3.0%every region of the world over the next few months. Moreover, 2.5%if we are wrong, and the global economy improves more 1.9% 2.0% 1.8%materially than we expect, we think select industrials, 1.5%technology, and financials might represent more attractive beta 1.0%than energy. The reason is because nearly every year for the 0.5%last several, a global geopolitical issue has surfaced that has 0.0%negatively impacted energy stocks. S&P Portfolio Relative PerformanceSupply fears are possible: This matters, because supply Source: Morgan Stanley Research. Past performance is no guarantee of future returns. Performance includes dividends but excludes transaction costs.constraints are the other major reason that oil rises. But ourprior work has shown that the energy sector underperforms The portfolio is comprised of stocks that currently averagewhen supply fears drive oil higher. Why? Because these are nearly $56 billion in market capitalization, and we turned thetypically coincident with geopolitical risks, like Libya in 2011, portfolio over less than 60% in 2011. Our goal is to provide aand potentially Iran or Russia in 2012 or 2013. portfolio where clients can follow our additions and deletions, and closely mirror our results if they so choose, given our lowNormally, the “chicken energy” trade is effective in a “risk off” turnover and focus on large capitalization names. Our portfolioregime. Given the huge size of the biggest three energy is cheaper on price-to-operating cash flow and EV-to-cash flowcompanies today (CVX, COP, and XOM are more than $700 than the broader market (Exhibit 25), and trades in-line with thebillion market capitalization) it is typically the case that owning broader market on other classic valuation metrics. Ourthese high yielding, lower growth integrated oil companies will portfolio has a higher free cash flow yield, higher cashbe prudent. In fact, that was the case in 2011. However, we balances, lower capital spending, less accruals, and lowerbelieve a rotation out of XOM and some of the large gross margins than the benchmark. The sales stability iscapitalization integrated oil names is possible in the first part of higher and the beta is markedly lower. We think this is the2012. We don’t think incremental dollars will flow into a stock correct positioning for a risk-neutral to risk-averse environmentlike XOM given its massive outperformance last year. As a as we head into 2012.portfolio strategy we see using a stock like XOM as a source offunds in divergent scenarios in 2012 – if you are bearish youreduce energy and buy MSFT or other quality names that havenot performed as well. If you are bullish, you sell energy andbuy beta energy which is relatively cheap. 11
  12. 12. MORGAN STANLEY RESEARCH January 2, 2012 US Equity StrategyExhibit 25 Portfolio changes: This week, we are removing BHI andOur Portfolio Is Cheaper, Larger Capitalization, and WAG from the portfolio and adding UTX, TFM, and TGT.Lower Beta than the Benchmark The MOST Strategic Portfolio vs S&P 500 as of End-December, 2011 UTX is rated Overweight by Heidi Wood and screens in the top Portfolio vs quintile of our MOST and BEST models. It is a high quality Factor Portfolio Benchmark Benchmark Price-to-Book 2.0x 2.0x 1.0x industrial that fits our dividend mandate. Price-to-Fwd. Earnings 11.4x 11.9x 1.0x Price-to-Sales 0.8x 1.2x 0.7x Price-to-Oper. Cash flow 8.1x 8.5x 0.9x TFM is in the top quintile of our MOST model and middle Valuation EV-to_EBIT 9.1x 10.1x 0.9x EV-Free Cash Flow 17.3x 23.1x 0.7x quintile of BEST. It is rated Overweight by Mark Wiltamuth and Dividend Yield 2.4% 2.4% (0.1%) is we view it as a classic growth stock gaining share. TGT is in Total Yield 4.7% 4.8% 0.0% Free Cash Flow Yield 5.7% 4.3% 1.4% the top quintile of MOST and the second quintile of BEST and Total Cash-to-Market Capitalization 12.7% 11.4% 1.1x Capex-to-Sales 5.8% 8.5% 0.7x Mark also rates it Overweight. Both these names replace WAG, Capital Use Accruals 3.8% 9.4% 0.4x which Mark recently downgraded to Underweight. and Incremental Margin 8.2% 12.5% (4.3%) Profitability Asset Turnover 118.0% 89.7% 1.3x Gross Margin 37.9% 41.6% (3.7%) Changes in Shares Outstanding 0.2% 0.1% 0.1% We removed BHI. It is in the fourth quintile of MOST. While it 9-Month Price Momentum 3.1% 0.7% 2.4% appears cheap and is in the top quintile of BEST, we think the Growth and 3-Month Smoothed Earnings Revisions 1.0% 0.4% 0.6% Investor Up-to-Down Revisions (8.2%) (7.0%) (1.2%) timing for beta energy likely will be better later in the year. Sentiment Sales Stability 12.0% 18.7% (6.8%) Beta 0.89 1.02 0.9x Size Market Cap 55,991 23,991 2.3x The full portfolio is shown in Exhibit 27. For those interested in our quantitative output, please go toSource: Factset, Morgan Stanley Research and use the alpha screener product for output from our 3-month model (MOST)In 2011, our sector bets in utilities and health care and our and our 24-month model (BEST). A video tutorial is availableavoidance of industrials aided portfolio performance (Exhibit there, or we or your Morgan Stanley salesperson can give you26). Stock selection in discretionary, materials, health care, a brief demonstration.and staples provided the remainder of the outperformance.Exhibit 26Sector 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 Portfolio S&P 500 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%Source: Factset, Morgan Stanley Research 12