Stock Analyst Program 2009 Farid Guindo Kaushik Sudharsanam March 02, 2009

Agenda MIC Portfolio Research Report Composition Macro-Economic Analysis Valuation Methodology DCF Valuation Comparables Method Precedent Transactions Investment Styles Appendix Stock Analyst Program 2008

MIC Portfolio

Research Report Composition

Macro-Economic Analysis

Valuation Methodology

DCF Valuation

Comparables Method

Precedent Transactions

Investment Styles

Appendix

MIC Portfolio

In the last 12 months our portfolio has fared better than the S&P TSX Composite Index by 10.61% and has lagged the DJIA by less than a percentage point - Current holdings include MRK, CAT, XIU, BNI Portfolio Overview Performance Summary Asset Mix Stock Analyst Program 2008

In the last 12 months our portfolio has fared better than the S&P TSX Composite Index by 10.61% and has lagged the DJIA by less than a percentage point

- Current holdings include MRK, CAT, XIU, BNI

Research Report Overview

Equity Analysis Techniques Top Down Analysis Bottom Up Analysis Investor starts analysis with global economics by observing economic indicators -GDP growth, Inflation, Interest Rates, Exchange Rates, Productivity and commodity prices Investor narrows search down to industry analysis - In this case sales, price levels, cyclical patterns, local/foreign competition, rates of return and earning per share Company analysis involves the use of valuation techniques - DCF, Industry Comparables and precedents are used to value the company Investors analyze individual companies Emphasis is on company specific or industry specific ratios Undervalued stocks can be labelled as a strong buy regardless of general macro-trends Essentially putting together “story of company and its numbers” The story component is composed of company’s business plan, outlook and other qualitative aspects The quantitative part involves a thorough look at company financials Stock Analyst Program 2008

Investor starts analysis with global economics by observing economic indicators

-GDP growth, Inflation, Interest Rates, Exchange Rates, Productivity and commodity prices

Investor narrows search down to industry analysis

- In this case sales, price levels, cyclical patterns, local/foreign competition, rates of return and earning per share

Company analysis involves the use of valuation techniques

- DCF, Industry Comparables and precedents are used to value the company

Investors analyze individual companies

Emphasis is on company specific or industry specific ratios

Undervalued stocks can be labelled as a strong buy regardless of general macro-trends

Essentially putting together “story of company and its numbers”

The story component is composed of company’s business plan, outlook and other qualitative aspects

The quantitative part involves a thorough look at company financials

Research Report Composition The key to writing a coherent SAP research report is understanding and articulating an investment time horizon - Refer to previous reports on the MIC website: Resources > SAP References Stock Analyst Program 2008

The key to writing a coherent SAP research report is understanding and articulating an investment time horizon

- Refer to previous reports on the MIC website: Resources > SAP References

Evaluation Criteria (1) Choice of industry articulated relative to other industries that would be affected by the general economy in a similar way. For example, the drug delivery industry and the drug manufacturing industry are affected by the same external economic conditions; thus it should be clear as to why one versus the other. This would include use of ratios specific to industry, dcf valuation, comps, precedents, etc... This would also include quantifiable identification of relevant catalysts and earnings growth potential specific to the company. Research Report Evaluation Stock Analyst Program 2008

Choice of industry articulated relative to other industries that would be affected by the general economy in a similar way. For example, the drug delivery industry and the drug manufacturing industry are affected by the same external economic conditions; thus it should be clear as to why one versus the other.

This would include use of ratios specific to industry, dcf valuation, comps, precedents, etc... This would also include quantifiable identification of relevant catalysts and earnings growth potential specific to the company.

Macro-Economic Analysis

Macro-Economic Analysis (1) Cyclical indicators are a useful tool for anticipating market movements as they help to predict economic activity - Indicators are usually released monthly in the form of index numbers, quantities, or value Cycle Significance and Composition The Indicators Cycles can be captured through four phases Expansion, peak, recession, trough These phases all vary in nature and duration as they are met under dissimilar circumstances - Policy intervention measures and business responses may differ across the same phases There are several indicators that can help us detect and measure the current and subsequent cycles - Leading, lagging, coincident Sourced to “Guide to Economic Indicators”, The Economist. Interest rates may also appear in many cases as a lagging indicator, if policy measures taken are reactionary rather than anticipatory. Time span (either maximum or minimum) by which the economic indicator usually reverses in trend in terms of total output. Stock Analyst Program 2008

Cyclical indicators are a useful tool for anticipating market movements as they help to predict economic activity

- Indicators are usually released monthly in the form of index numbers, quantities, or value

Cycles can be captured through four phases

Expansion, peak, recession, trough

These phases all vary in nature and duration as they are met under dissimilar circumstances

- Policy intervention measures and business responses may differ across the same phases

There are several indicators that can help us detect and measure the current and subsequent cycles

- Leading, lagging, coincident

Sourced to “Guide to Economic Indicators”, The Economist.

Interest rates may also appear in many cases as a lagging indicator, if policy measures taken are reactionary rather than anticipatory.

Time span (either maximum or minimum) by which the economic indicator usually reverses in trend in terms of total output.

Macro-Economic Analysis cont’d. An alternative approach to using economic indicators is to use them as directional devices in terms of specific industries in light of their broader macro-economic implications Alternative Measures (1) Sourced to “Guide to Economic Indicators”, the Economist. The producer price index may overstate cost pressures when above average discounts are offered during a recession, or understate cost pressures when inflation is rapid.ly increasing Stock Analyst Program 2008

An alternative approach to using economic indicators is to use them as directional devices in terms of specific industries in light of their broader macro-economic implications

Sourced to “Guide to Economic Indicators”, the Economist.

The producer price index may overstate cost pressures when above average discounts are offered during a recession, or understate cost pressures when inflation is rapid.ly increasing

Sourced to Wall Street Journal’s market data center. Economic Calendar Stock Analyst Program 2008

Sourced to Wall Street Journal’s market data center.

Stock Valuation Methodology

Valuation methodologies are not mutually exclusive and in fact are more effective when used to validate one another Sector coverage is important in determining which methodology to use and what to take into account Overview Stock Analyst Program 2008

Valuation methodologies are not mutually exclusive and in fact are more effective when used to validate one another

Sector coverage is important in determining which methodology to use and what to take into account

Valuation Methodology Determine the stream of revenue being generated Derive weighted average cost of capital (WACC) for firm or rate of return specific to asset Risk cash flows according to WACC Assumes time value of money General assumptions on terminal value are used Discounted Cash Flow (DCF) Precedent Transactions Determine from past transactions similarities i.e. industry composition, level of risk, size of the transaction Filtering through the assumptions being used for the precedent transaction allows transparency in your own valuation The more transactions the better -Relevant private transactions may or may not be available for use Develop case studies for the most relevant transactions to determine an appropriate range to use - Put more weight on transactions with similar assumptions Determine the relevant industry classification Use of industry based ratios If specific industry does not exist, work backwards Relative comparisons are key; company vs. company & company vs. industry average Gives a brief idea of where company lies and who key competitors are - Allows us to determine best/worst of breed Comparable Transactions Stock Analyst Program 2008

Determine the stream of revenue being generated

Derive weighted average cost of capital (WACC) for firm or

rate of return specific to asset

Risk cash flows according to WACC

Assumes time value of money

General assumptions on terminal value are used

Determine from past transactions similarities i.e. industry composition, level of risk, size of the transaction

Filtering through the assumptions being used for the precedent transaction allows transparency in your own valuation

The more transactions the better

-Relevant private transactions may or may not be available for use

Develop case studies for the most relevant transactions to determine an appropriate range to use

- Put more weight on transactions with similar assumptions

Determine the relevant industry classification

Use of industry based ratios

If specific industry does not exist, work backwards

Relative comparisons are key; company vs. company & company vs. industry average

Gives a brief idea of where company lies and who key competitors are

- Allows us to determine best/worst of breed

DCF- Methodology First determine WACC = D/V * R d (1-T) + E/V * R e - Use target (optimal) D/E ratio - Beta  CAPM - R d (1-T)  discuss importance of tax shield Mechanics of FCFF FCFF = EBIT(1-T) – CAPEX + NCC +- Δ NWC - Explain that CAPEX and NWC are all cash sources/uses that don’t affect EBIT, therefore we must adjust. Analyze historical performance to come up with future set of assumptions (COGS, SG&A, R&D, “DEP”, “CAPEX”, “NWC” as a % sales) - Therefore, we need to use revenue as a driver, and determine its growth from year to year during our explicit forecast period (5-10 yrs) Discounted Cash Flow Method Stock Analyst Program 2008

First determine WACC = D/V * R d (1-T) + E/V * R e

- Use target (optimal) D/E ratio

- Beta  CAPM

- R d (1-T)  discuss importance of tax shield

Mechanics of FCFF

FCFF = EBIT(1-T) – CAPEX + NCC +- Δ NWC

- Explain that CAPEX and NWC are all cash sources/uses that don’t

affect EBIT, therefore we must adjust.

Analyze historical performance to come up with future set of assumptions

(COGS, SG&A, R&D, “DEP”, “CAPEX”, “NWC” as a % sales)

- Therefore, we need to use revenue as a driver, and determine its growth

from year to year during our explicit forecast period (5-10 yrs)

DCF- Methodology Determine FCFF’s each year using assumptions driven off of revenue Determine TV at last year of forecast period 1) Growing perpetuity - Assumes constant growth rate (2-3%) – not really used 2) Terminal multiple - Assumes an exit multiple of an operating metric like EBITDA or FCFF, to determine a value for the enterprise at that point in time Bring everything back to present value at WACC Now we have the value of the enterprise (Enterprise Value = Net Debt + Equity + Minority Interest) Discounted Cash Flow Method Stock Analyst Program 2008

Determine FCFF’s each year using assumptions driven off of revenue

Determine TV at last year of forecast period

1) Growing perpetuity

- Assumes constant growth rate (2-3%) – not really used

2) Terminal multiple

- Assumes an exit multiple of an operating metric like EBITDA or FCFF, to determine a value for the enterprise at that point in time

Bring everything back to present value at WACC

Now we have the value of the enterprise (Enterprise Value = Net Debt + Equity + Minority Interest)

Precedent Transactions, Basic Steps 1. Find historical take-overs in industry Again, look for similar size if possible, and most recent first 2. Try to cover at least on economic cycle in terms of precedent transactions, as some take-over premiums might reflect a take-over boom in an industry 3. Multiply relevant multiple (P/E, EV/EBITDA, EV/Sales, etc.) by company’s figure to obtain firm’s value in event of a take-over Precedent Transactions Method Stock Analyst Program 2008

1. Find historical take-overs in industry

Again, look for similar size if possible, and most recent first

2. Try to cover at least on economic cycle in terms of precedent transactions, as some take-over premiums might reflect a take-over boom in an industry

3. Multiply relevant multiple (P/E, EV/EBITDA, EV/Sales, etc.) by company’s figure to obtain firm’s value in event of a take-over

Relative Valuation, Basic Steps 1. Determine the target company’s EPS, EBITDA, or Sales for current year and possibly forward year (using analyst estimates) - Always use recurring income 2. Determine the set of comparable companies (comp universe) and their trading multiples (based on recurring figures!) Similar companies based on industry, size, business model, risk, capital structure – anything you can control for 3. Multiply average industry multiple by current or forward performance to determine the relative value of the firm Relative Method Stock Analyst Program 2008

1. Determine the target company’s EPS, EBITDA, or Sales for current year and possibly forward year (using analyst estimates)

- Always use recurring income

2. Determine the set of comparable companies (comp universe) and their trading multiples (based on recurring figures!)

Similar companies based on industry, size, business model, risk, capital structure – anything you can control for

3. Multiply average industry multiple by current or forward performance to determine the relative value of the firm

Investment Styles

Summary Based on the stock’s intrinsic value - Low PE, P/BV, P/CF multiples - Long term time horizon Value Investing Growth Investing Contrarian Investing GARP Investing Personal risk preference, time horizon, and skill set determine the best investment style to employ Seeking future growth potential and earnings strength A hybrid combination of growth and value strategies Brought to main stream use by Peter Lynch - Emphasis on the PEG ratio Goes against conventional market wisdom - Crowd behaviour creates mispricings Stock Analyst Program 2008

Based on the stock’s intrinsic value

- Low PE, P/BV, P/CF multiples

- Long term time horizon

Personal risk preference, time horizon, and skill set determine the best investment

style to employ

Seeking future growth potential and earnings strength

A hybrid combination of growth and value strategies

Brought to main stream use by Peter

Lynch

- Emphasis on the PEG ratio

Goes against conventional market wisdom

- Crowd behaviour creates mispricings

Value Investing: A Closer look Both Graham and Buffet are fundamental value investors who use long term strategies to benefit from relatively cheap companies 1. Sourced to John Reese, Todd Glassman; “Market Gurus.” Time Horizon Risk Level Effort Stock Analyst Program 2008

Both Graham and Buffet are fundamental value investors who use long term strategies to benefit from relatively cheap companies

Ratios and Techniques; Value Investing Benjamin Graham Warren Buffet 1. Sourced to John Reese, Todd Glassman; “Market Gurus.” Stock Analyst Program 2008

Buffett’s Due Diligence First Stage Analysis Take a look at the nature of the company’s business A viable company will have the size, depth, and breadth of brand recognition Inflation sustainability and ability to pass on costs Look for ability to increase cost of main product relative to inflation Products are understandable and business lines are comprehendible Company is able to have predictability in terms of earnings Earnings growth or expansion is also a requirement A short dip in earnings growth is acceptable given certain circumstances Consideration given to companies with conservative finances This includes low levels of debt relative to net income Close scrutiny towards managements use of retained earnings towards shareholder wealth ROE over the past 10 years should be greater than 15% on average High free cash flow and low capital expenditures - Capital expenditures should not be excessive 1. Sourced to John Reese, Todd Glassman; “Market Gurus.” Stock Analyst Program 2008

Take a look at the nature of the company’s business

A viable company will have the size, depth, and breadth of brand recognition

Inflation sustainability and ability to pass on costs

Look for ability to increase cost of main product relative to inflation

Products are understandable and business lines are comprehendible

Company is able to have predictability in terms of earnings

Earnings growth or expansion is also a requirement

A short dip in earnings growth is acceptable given certain circumstances

Consideration given to companies with conservative finances

This includes low levels of debt relative to net income

Close scrutiny towards managements use of retained earnings towards shareholder wealth

ROE over the past 10 years should be greater than 15% on average

High free cash flow and low capital expenditures

- Capital expenditures should not be excessive

Second Stage Analysis Determine if the company is priced appropriately Step 1 . Calculate IRR - Determine through EPS/Market Price Step 2. Compare calculation made in step 1 to the long term bond yield - Exceptions can be made if company’s expected yield growth is high Step 3 . Calculate Future EPS: First calculate 10 year average ROE from balance sheet figures, then calculate average dividend payout ratio in order to find the average retained earnings - Since % ROE retained = (Avg ROE/ 100) ×(1- (Avg payout/100), - Multiply ROE retained by 100 and use as interest rate to solve for FV (equity per share) given PV as current equity per share - Take FV (equity per share) multiply by 10 year average ROE to get future EPS Step 4 . Use the above future EPS and multiply by average PE (last 10 years) to get projected future stock price - Include dividend pool to stock price by taking company’s estimated EPS for current year adjusted for growth rate in dividends to give you a projected EPS Buffett’s Due Diligence cont’d 1. Sourced to John Reese, Todd Glassman; “Market Gurus.” Stock Analyst Program 2008

Determine if the company is priced appropriately

Step 1 . Calculate IRR

- Determine through EPS/Market Price

Step 2. Compare calculation made in step 1 to the long term bond yield

- Exceptions can be made if company’s expected yield growth is high

Step 3 . Calculate Future EPS: First calculate 10 year average ROE from balance sheet figures, then calculate average dividend payout ratio in order to find the average retained earnings

- Since % ROE retained = (Avg ROE/ 100) ×(1- (Avg payout/100),

- Multiply ROE retained by 100 and use as interest rate to solve for FV (equity per share) given PV as current equity per share

- Take FV (equity per share) multiply by 10 year average ROE to get future EPS

Step 4 . Use the above future EPS and multiply by average PE (last 10 years) to get projected future stock price

- Include dividend pool to stock price by taking company’s estimated EPS for current year adjusted for growth rate in dividends to give you a projected EPS

Second Stage Analysis Buffett’s Due Diligence cont’d Step 4 cont’d . - Use the projected EPS in each year, multiply by (average dividend payout/100) . - Use the sum of the above value and add back to the stock price calculated above Step 5. Use the above calculations to determine expected return using the ROE method PV- Current Stock FV- Future stock price adjusted for dividends from step 4. N- number of periods (in this case 10) i- Solve Refer to ratio criteria to determine expected return threshold Step 6. Determine the expected return using the EPS growth (average) - First take the average EPS growth for last 10 years - Project the 10 year EPS figure by using this growth rate and current EPS - Determine Future stock price by multiplying by 10 year PE (average) Step 7. Calculate expected return as per step 5, using the EPS growth method Step 8. Compare the results using the average of the expected returns from both the ROE and EPS method 1. Sourced to John Reese, Todd Glassman; “Market Gurus.” Stock Analyst Program 2008

Step 4 cont’d .

- Use the projected EPS in each year, multiply by (average dividend payout/100) .

- Use the sum of the above value and add back to the stock price calculated above

Step 5. Use the above calculations to determine expected return using the ROE method

PV- Current Stock

FV- Future stock price adjusted for dividends from step 4.

N- number of periods (in this case 10)

i- Solve

Refer to ratio criteria to determine expected return threshold

Step 6. Determine the expected return using the EPS growth (average)

- First take the average EPS growth for last 10 years

- Project the 10 year EPS figure by using this growth rate and current EPS

- Determine Future stock price by multiplying by 10 year PE (average)

Step 7. Calculate expected return as per step 5, using the EPS growth method

Step 8. Compare the results using the average of the expected returns from both the ROE and EPS method

Growth Investing Time Horizon Risk Level Effort “ Buy High, Sell even Higher!”, according to O’Neil the best of breed companies are supposed to be expensive - His strategy involves continuously monitoring your investments 1. Sourced to John Reese, Todd Glassman; “Market Gurus.” Stock Analyst Program 2008

“ Buy High, Sell even Higher!”, according to O’Neil the best of breed companies are supposed to be expensive

- His strategy involves continuously monitoring your investments

Growth Investing cont’d William O’Neal In addition to his “growth metrics” O’Neal also looks for potential catalysts within the company’s industry or within the company as a driver for growth 1. Sourced to John Reese, Todd Glassman; “Market Gurus.” Stock Analyst Program 2008

In addition to his “growth metrics” O’Neal also looks for potential catalysts within the company’s industry or within the company as a driver for growth

Value versus Growth 1. Sourced to Bloomberg Financial. Both Value and Growth index are from BARRA. Relative Price Performance Until recently the Value Index has outperformed the Growth Index Stock Analyst Program 2008

Until recently the Value Index has outperformed the Growth Index

Value versus Growth Time Horizon Risk Level Effort Lynch combines growth and value strategies in his investment thesis Emphasize on what you already know Known for PEG ratio: determines if stock is fairly priced relative to growth 1. Sourced to John Reese, Todd Glassman; “Market Gurus.” Stock Analyst Program 2008

Lynch combines growth and value strategies in his investment thesis

Emphasize on what you already know

Known for PEG ratio: determines if stock is fairly priced relative to growth

Against Conventional Wisdom Time Horizon Risk Level Effort Dreman goes after out of favour companies whose stock have taken a serious beating 1. Sourced to John Reese, Todd Glassman; “Market Gurus.” Stock Analyst Program 2008

Dreman goes after out of favour companies whose stock have taken a serious beating

Against Conventional Wisdom cont’d David Dreman 1. Sourced to John Reese, Todd Glassman; “Market Gurus.” Stock Analyst Program 2008

Appendix

Important Ratios Activity Ratios Liquidity Ratios 1. Sourced to CFA institute, Financial Statement Analysis. Stock Analyst Program 2008

Important Ratios Solvency Ratios Profitability Ratios 1. Sourced to CFA institute, Financial Statement Analysis. Stock Analyst Program 2008

Important Ratios Performance Ratios Coverage Ratios 1. Sourced to CFA institute, Financial Statement Analysis. Stock Analyst Program 2008

Resources Stock Analyst Program 2008