The value of stocks:A focus on the fundamentalsJoseph S. Tanious, CFA
The greatest struggle facing many financial advisors isovercoming investor emotion.The Market Insights program is designed to provide ourfinancial advisor partners with a way to address the marketsand the economy based on logic rather than emotion,enabling their clients to make rational investment decisions.To learn more, visit us at www.jpmorganfunds.com/mi. Joseph S. Tanious, Executive Director, is a Global Market Strategist on the J.P. Morgan Funds Global Market Strategy Team. In this role, Joseph is responsible for delivering timely market and economic insight to clients across the country. Since joining the team, Joseph has been instrumental in developing and leading the group’s equity research efforts. Joseph is consistently ranked as a top speaker at major industry conferences and events. He is a frequent guestJoseph S. Tanious, CFA on Bloomberg TV and CNBC, has appeared on PBS’ NightlyExecutive Director Business Report and is often quoted in the financial press.Global Market Strategist Joseph first joined J.P. Morgan in 2009, where he worked inJ.P. Morgan Funds the investment bank on mergers and acquisitions, as well as capital-raising solutions. Prior to joining the firm, Joseph held various positions in both asset management and private wealth management at Wells Fargo for nine years. Most recently, he was a regional director of institutional sales at Wells Fargo Asset Management, where he was responsible for managing key institutional relationships. Joseph is a CFA charterholder. He also obtained an M.B.A. in finance and economics from Columbia Business School and a B.A. in economics from the University of California, Irvine. Joseph also holds series 7, 63 and 65 licenses.
MARKETINSIGHTS ForewordTable of contents As we meet with investors around the country, one of the mostThe value of stocks: frequently asked questions we receive is: Why should I invest in theA focus on the fundamentals equity markets? The question is understandable. After all, this lastLooking forward p. 2The short run versus the long run p. 2 decade has been a gut-wrenching rollercoaster ride for investors.The fundamentals p. 3 Over the past 12 years, equity investors have had to stomach theProjected earnings and forwardP/E ratios p. 4 pain of seeing their portfolios fall by over 50% — twice. They’veOther valuation metrics p. 5Shiller’s P/E p. 5 seen two recessions, a collapse in the real estate market, the worstThe Q-ratio p. 6 natural disaster and terrorist events in our nation’s history and aRevenues, margins and prospectsfor earnings growth p. 8 surging unemployment rate.Checking the quality of earnings p. 10The case for equities – a trifecta p. 12 These experiences have shaped the way that investors view the world and, ultimately, theirConclusion p. 13 behavior. As a result, more money has been invested in bond funds than equity funds over the past 15 consecutive months (as shown in the Guide to the Markets chart below), despite a market that has surged by roughly 116% since March 2009. It is this clear aversion to the equity markets that prompted us to take a fresh look at an old question: Just how attractive are stocks? In this white paper, we examine what stock ownership really is, a number of ways that stocks are valued, and the prospects for future earnings growth and profitability. We arrive at the conclusion that despite the recent soft patch in economic data, stocks appear to be an attractive investment and remain a key allocation in a balanced portfolio. CHART A: Difference between flows into stock and bond funds Billions, USD, U.S. and international funds, monthly $40 Bond ﬂows exceeded equity ﬂows by $29B $20 $0 -$20 -$40 -$60Source: ICI, J.P. Morgan Asset Management. May ’08 Dec ’08 Jun ’09 Dec ’09 Jun ’10 Dec ’10 Jun ’11 Dec ’11 May ’12J.P. Morgan’s Guide to the Markets. 1
MARKETINSIGHTS The value of stocks: A focus on the fundamentals LOOKING FORWARD It’s easy to lose focus of what stock ownership really is. Some people feel that investing in the equity markets is a form of gambling. Others feel that stock ownership is a general investment in economic growth. Some people actually believe that gains or losses in the stock market are entirely driven by luck and have no rhyme or reason. So before we go any further, let’s take a step back and look at the dictionary definition of what stock ownership really is. Simply put, buying stock means buying ownership of a business. As a business owner, you are entitled to the future earnings and cash flow that the business creates. In other words, when you buy a stock, you have no claims on previous earnings, but you do hold the right to your share of the future earning stream the business generates. For this reason, before buying into a business, you should conduct thorough research to form a reasonable estimate as to what profits you believe the business will generate moving forward. It is this fundamental concept that drives our focus on forward-looking valuation metrics — a recurring theme you will see throughout this white paper. THE SHORT RUN VERSUS THE LONG RUN If there’s one thing we’ve learned from our collective experience as investors, it’s that in the long run, equity prices are determined by their fundamentals. Any time we notice a dislocation in the equity markets, we need to take a step back and ask ourselves the following question: “Have the fundamentals changed?” If the answer is “yes,” we should re-evaluate our assumptions and our investment thesis. But if the answer is “no,” then what we have is short-term volatility, which is often driven by uncertainty. Sadly, today’s environment contains no shortage of uncertainty. There’s uncertainty about how proposed legislation will affect markets, lingering questions around how Europe will resolve its sovereign debt issues, worries about the willingness of banks to lend or of businesses to create jobs — the list goes on. What’s important to recognize, however, is that eventually the uncertainty will pass, outcomes will be priced into markets and the focus will once again return to the fundamentals. CHART B: Extreme levels of volatility and uncertainty don’t last forever 3-month moving avg. of daily absolute % change in the DJIA Volatility measure ‘08 peak Avg. Latest 3.5% DJIA 3.30% 0.72% 0.71% 90 3-month VIX 80.9% 20.5% 17.1% 3.0% moving average 75 VOLATILITY [VIX] 2.5% 60 2.0% DJIA 45 1.5% 30 1.0% 0.5% 15 0.0% 0Source: Dow Jones, FactSet, J.P. MorganAsset Management. Data as of 6.30.2012. 1930 1940 1950 1960 1970 1980 1990 2000 2010J.P. Morgan’s Guide to the Markets. 1 www.investopedia.com
CHART C: Stocks are closely correlated to forward earnings estimates in the long run S&P 500 total return and next 12-month EPS S&P 500 – Total Return Index (left) S&P 500 – Earnings per Share (right) $3,000 $120 $2,500 $100 $2,000 $80 $1,500 $60 $1,000 $40 $500 $20 $0 $0Source: Standard & Poor’s, FactSet, 7/92 6/94 6/96 6/98 6/00 6/02 6/04 6/06 6/08 6/10 6/12J.P. Morgan Asset Management.Data as of 6.30.2012. THE FUNDAMENTALS There are several different ways to determine the fundamental value of a stock or group of stocks (a market). When looking at an individual security, a combination of forward and trailing multiples, along with more academic approaches to valuation (such as a discounted cash flow [DCF] analysis) are common. Creating an effective DCF for one company requires at least five to 10 years of reliable projections and assumptions for growth and the cost of capital, with the caveat that the output is only as reliable as the inputs. In other words, the quality of the research matters. While you could certainly run this type of analysis for an entire index, doing this well for 500 companies (the S&P 500 Index for example) requires an entire team of experienced analysts. When looking at a market, we generally focus on price to forward earnings. While other metrics are also useful, it appears that in the long run, stocks are closely correlated to forward earnings estimates, as illustrated in Chart C. Here, we observe an R-squared of 0.78 between forward-looking earnings estimates and the total return index for the S&P 500. This suggests that 78% of the variance in total return can be explained by variance in the earnings estimates, and that expected earnings are in fact a reasonable predictor of stock market returns. 3
MARKETINSIGHTS PROJECTED EARNINGS AND FORWARD P/E RATIOS In considering forward price/earnings (P/E), the critical step is to decide which “E” — or earnings value — to use. When trying to assess the opportunity in the equity markets, rather than relying on one particular analyst or team’s estimates of projected earnings, we believe that using consensus estimates across Wall Street will yield a better prediction with less variance. The trouble with this, of course, is that analysts typically don’t nail earnings projections on the head. For example, in the last three quarters, roughly 75% of S&P 500 companies have actually exceeded analyst estimates, as analysts tend to overshoot earnings during a recession and undershoot earnings during a recovery. According to disciples of behavioral finance, this is a function of a phenomenon known as “anchoring.” Additionally, these estimates look 12 months into the future, while stock values depend on much more than just that. However, despite what seem to be shortfalls in these numbers, analyst estimates have directionally been rather accurate and, as such, are useful for P/E analysis. In looking at forward P/E ratios as of June 29, 2012, Wall Street expects S&P 500 operating earnings to be $103 in 2012 and $118 in 2013. Based on the S&P 500’s closing price of 1,362 (6/30), the index was trading at 12.3x forward earnings (next 12 months of earnings). Chart D, from the Guide to the Markets, illustrates this price/earnings ratio for the S&P 500 over the past 20 years. Although forward P/E ratios have limited historical data, based on a 20-year average, equity markets appear undervalued. Thus, it is worth understanding what has helped to compress the P/E multiple. As this is being written, a stock market correction has depressed the numerator (“P”), while earnings projections in the denominator (“E”) continue to move higher. The dislocation in direction between the numerator and denominator of the P/E ratio highlights how short-term price movements can deviate from the fundamentals. The last time we saw a multiple this low in the S&P 500 was in late March 2009, when the equity markets began an epic 70% rally over the following 12 months. CHART D: S&P 500, forward P/E ratio Average +/- one standard deviation 28x 24x 20x Average: 16.2x 16x 12x Most recent: 12.3xSource: Standard & Poors, FactSet, J.P. Morgan 8xAsset Management. Data as of 6.30.2012. ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12 Source: Standard & Poor’s, FactSet, J.P. Morgan Asset Management. Data as of 6.30.2012. Guide to the Markets, page 10
CHART E: Valuation matters S&P 500 valuation measures H istorical Averages Valuation 1-Year 3-Year 5-Year 10-Year 15-Year Measure Description Latest Ago Average Average Average Average P/E Price to Earnings 12.3x 12.4x 12.9x 13.0x 14.4x 16.8x P/B Price to Book 2.3 2.3 2.1 2.2 2.5 3.1 P/CF Price to Cash Flow 8.5 8.4 8.4 8.5 9.8 11.1 P/S Price to Sales 1.2 1.2 1.2 1.2 1.3 1.5 PEG Price/Earnings to Growth 1.5 0.8 1.0 1.2 1.2 1.2 Source: Standard & Poor’s, FactSet, J.P. MorganAsset Management. Data as of 6.30.2012. Div. Yield Dividend Income 2.3% 2.1% 2.2% 2.3% 2.1% 1.9% J.P. Morgan’s Guide to the Markets. OTHER VALUATION METRICS Some argue that earnings can be manipulated by companies and, therefore, analysts should study other metrics in determining the market’s value. One example would be cash flow, which is much harder to manipulate in the long run. So, in addition to looking at earnings, we also look at other multiples to determine whether equities are over-, under- or appropriately valued. In Chart E, from the Guide to the Markets, you can see how the S&P 500 is trading relative to earnings as well as cash flow, book value, sales and dividends. What’s really interesting to see is that by almost any metric you choose to look at, and by any historical average shown, equities appear undervalued. SHILLER’S P/E While our preferred method of using forward earnings to value equities suggests the stock market is undervalued, there are other valuation methods that suggest the opposite. One of the most popular trailing multiples currently used is Shiller’s Cyclically Adjusted P/E ratio2 (CAPE) as shown in Chart F. This method, developed by Yale University’s Robert Shiller, uses an inflation-adjusted price for the S&P 500 (at a point in time), divided by average inflation-adjusted earnings over the previous 10 years. The idea behind this is that earnings are both volatile and cyclical; however, if you adjust earnings for inflation and take an average of these numbers over a 10-year period, you should be able to identify whether the market is appropriately valued. As of June 29, 2012, Shiller’s P/E ratio was approximately 21x earnings, whereas the long-term average is approximately 16x earnings. This suggests that equities are possibly overvalued, and certainly not undervalued. While we believe that investors should take trailing metrics into account, we also think they can generate misleading results, as illustrated in the timeline in Chart G. Price is defined as the closing price of the index at one specific point in time. Trailing earnings are often defined as the sum of the last four quarters of earnings. As a result, a trailing P/E ratio equals a current price divided by the last year’s results. While these trailing multiples can be useful as a reality check and to gauge future estimates, the ratio is entirely backward-looking. If, for example, earnings over the last four quarters were extremely depressed due to a recession, the multiple might suggest stocks are expensive (a result of a small denominator), when in fact the U.S. may be entering an economic recovery, and stocks are actually cheap.2www.econ.yale.edu/~shiller 5
MARKETINSIGHTS As we mentioned at the start of this paper, when investing in equities, it’s important to note that the intrinsic value of a stock is determined by its expected future cash flows, not its trailing results. When an investor buys a stock, he or she is buying ownership, or a share, in what is ultimately the future earnings stream of a company. And while trailing results can be used to build expectations, the investor must realize that past performance is no guarantee of future results, and must try his or her best to estimate future earnings. For this reason, we believe that trailing metrics should not be the sole determinant of market valuations. While they can help keep investors from making overly aggressive estimates about future earnings, they are historic results, and do not take into account a changing economy or growth prospects. As a trailing metric, Shiller’s P/E is not much different. This past decade saw two severe earnings recessions that have ultimately depressed the denominator in Shiller’s P/E ratio. It is also worth noting that Shiller’s P/E uses “earnings as reported” in the denominator, and thus includes massive write-offs. While this ratio takes 10 years of historic earnings in an attempt to normalize earnings throughout the business cycle, it still takes the price of the index at one point in time (determined by expected future earnings) and divides it by historic results (which, in this case, are skewed downward), leaving out potential growth. THE Q-RATIO In addition to trailing multiples, another valuation metric that is used is the Q-ratio3 (developed by James Tobin), which also suggests that equities may be overvalued. This ratio, shown for all non- financial corporations in the Chart H, measures a stock’s price divided by the replacement cost of the company’s assets. The idea is that, over time, you should see consistency in the price investors are willing to pay for assets. Therefore, if the long-term average Q-ratio is 0.8, and the current Q-ratio is 1.0, investors are paying too much for assets, and equity markets are overvalued. CHART F: Price/earnings ratio S&P 500, annual data, 1880-2012 50 45 2000 Price/Earnings Ratio (CAPE) 40 35 1929 30 21.82 1901 1966 25 20 15 1921 10 5 1981 0Source: Robert Shiller, Standard & Poor’s, 1880 1900 1920 1940 1960 1980 2000 2010J.P. Morgan Asset Management. Data as of 7.3.2012. Year 3 “Asset Markets and the Cost of Capital.” James Tobin and W.C. Brainard, 1977, Economic Progress, Private
CHART G: Stock price is determined by expected future earnings P Today E+1 E+2 E+3 E+4 E-4 E-3 E-2 E-1 (Price is determined by expected earnings)Source: J.P. Morgan Asset Management. The ratio is calculated by taking the market price (often by using the stock price), and dividing it by the replacement cost of tangible assets (such as equipment, inventories, etc.) along with financial assets. First, it should be noted that financial assets as a share of total assets have risen dramatically over the years. In 1950, financial assets comprised 23.2% of total assets, whereas they make up 50% of total assets, today4. If it is the case that investors find financial assets more liquid or attractive than physical ones, this might imply that the Q-ratio should have risen over the years. A second issue to consider is that this calculation doesn’t take into account certain intangible assets. How do you determine the value of the Coca Cola brand? How about the Apple brand? If you looked at each of these company’s balance sheets, you wouldn’t actually find a line item with the brand’s value, and you certainly couldn’t dream up a replacement cost. To the extent that the value of certain intangible assets (such as a brand) can grow over time, the Q-ratio, which cannot capture these assets, might understate the value of stocks. A third issue — and perhaps the biggest — lies in the fact that the Q-ratio compares price to the replacement value of a structure, not the projected value that the actual business creates. The best way to illustrate this point is by using an example. Consider a street vendor in New York City who sells chicken over rice from a cart (delicious). These vendors work consistent hours on particular street corners in an attempt to draw repeat business from customers in the local area. Their repeat business is largely dependant on how good their food is. One street vendor in particular has become very famous by word of mouth, even though he only operates between the hours of 7 p.m. and 4 a.m. The Q-ratio for this vendor would equal the price (whatever the market calls for it), divided by the replacement value of his cart, stove and license to operate on the street. This ratio could conceivably be quite high. But it doesn’t take into account the fact that he has a queue of at least 30 people waiting in line at all hours of business, even at 3 a.m., rain or snow. Rumor has it this vendor grosses over $1 million per year operating his cart. For this reason, we’d stress the same point we’ve made a couple of times earlier: When an investor buys a stock, he or she is buying ownership and, ultimately, the future earnings stream of a company. While we are open to different measures and interpretations of valuation, one of the Q-ratio’s major shortcomings is that it simply doesn’t capture everything. 4 B.102 Balance Sheet of Non-farm Non-financial Corporate Business 7
MARKETINSIGHTS REVENUES, MARGINS AND PROSPECTS FOR EARNINGS GROWTH While the recent growth in earnings has been impressive, we often hear the argument that it has been entirely driven by margin improvement as companies have slashed costs. While it’s certainly true that operating margins have improved, it’s also true that revenues have bounced back significantly. Chart I illustrates the year-over-year percent change in sales per share for the S&P 500; it’s clear that there has been a sharp rebound in revenue growth. Another takeaway from this chart is to observe the relationship between gross domestic product (GDP) growth and revenue growth for the S&P 500. Over the last 10 years, we have observed a strong correlation between year-over-year percent change in sales per share for the S&P 500 and year-over-year percent change in GDP. The R-squared of 0.88 suggests that 88% of the variance in revenue growth can be explained by the variance in economic growth. This relationship shouldn’t really surprise anyone. If you think about it, as the economy continues to grow, the largest companies in the U.S. should benefit from that growth in the form of increased demand. Additionally, U.S. companies function in a global marketplace, with S&P 500 companies deriving over 40% of their revenues from business outside the United States. Thus, even if you believe the domestic economy will grow at a very low rate, any positive nominal GDP growth should still translate into revenue growth for S&P 500 companies, with their international business only adding additional fuel to the fire. In addition, as companies have improved their operating margins over this past economic cycle, each incremental dollar of sales today should translate into stronger earnings as compared with the fourth quarter of 2008, when S&P 500 operating earnings hit an all-time low (Chart J). Although the recovery in margins should slow as companies continue to hire, we believe there’s still room for improvement, as we are well off the high of 2007. CHART H: Q-ratio, stock price relative to company assets Price to net asset value, all U.S. non-financial corporations Less Attractive 2.0x 1.5x Most recent: 1.0x 1.0x 40-year average = 0.8x More Attractive 0.5x 0.0xSource: Federal Reserve table B.102, ’70 ’75 ’80 ’85 ’90 ’95 ’00 ’05 ’10J.P. Morgan Asset Management.Data as of 3.31.2010.
CHART I: Revenues are rebounding S&P 500 sales per share growth, year-over-year GDP growth (% 1YR) S&P 500 – Sales Per Share (left) (% 1YR) Gross Domestic Product (right) 40 0.06 30 0.04 20 0.02 10 0 0.00 -10 -0.02 -20 -0.04 -30 -40 -0.06Source: Standard & Poor’s, FactSet, 9/92 9/94 9/96 9/98 9/00 9/02 9/04 9/06J.P. Morgan Asset Management. 9/08 9/10Data as of 3.31.2012. On a side note, we’ve recently heard the argument that earnings growth must slow down; we know that companies are starting to hire, albeit slowly, (which is good for the overall economy) and, as a result of the increased cost, margins have begun to shrink and earnings growth is approaching zero. This is a little ironic. Late last year when we were talking about the opportunity in equities, the pushback we received was that “all the earnings growth is coming from margin improvement from layoffs, and there’s no revenue growth — how can earnings keep growing?” Today, we hear the argument that “sure, revenue growth has come back, but it doesn’t matter because companies are hiring and margins can only get worse from here — how can earnings keep growing?” Sometimes, we just can’t win. For that reason, we take a chapter from our microeconomics textbook and offer the following thought. When business owners see increased demand for products or services, they have a choice to make. Their instinct may be to pay their current workers overtime to meet the additional demand but, eventually, the workers’ productivity will max out. Once that happens, business owners must make a simple choice: Should they forego the additional sales, or hire additional workers to meet the incremental demand? The laws of microeconomics suggest that business owners should continue adding workers until they reach a point at which their marginal cost to hire an additional worker equals the marginal revenue provided by the worker. In other words, assuming that the business is profitable, owners should continue hiring each additional worker until they meet that incremental demand. It also means that business owners shouldn’t hire any extra workers beyond what they need to meet the demand. Otherwise, the extra cost of hiring that nth worker won’t be offset by the incremental sale, and it will ultimately eat into their profits. Looking at the broader market, this means that the rate at which costs begin to increase (margins deteriorate) should be lower than the rate at which companies see their revenues grow. Ultimately, these wide margins are healthy in a growing economy as increased sales should translate into strong earnings over the subsequent quarters. 9
MARKETINSIGHTS CHECKING THE QUALITY OF EARNINGS In an effort to understand corporate fundamentals and get a better sense of the quality of earnings, it helps to take a look at profitability ratios and compare them over time. One of the most commonly used profitability ratios is return on equity (ROE), which is calculated as net income/equity. As the name suggests, ROE attempts to quantify the investment return on a company’s shareholders’ equity. Chart K illustrates annualized ROE for the S&P 500 back to 1993. The cycles of profitability are apparent throughout economic expansions and contractions, and it appears that ROE is improving in the current recovery. As a side note, we’ve added corporate cash as a percentage of current assets to the same chart. Emerging from a deep recession, companies are holding on to excess cash in a manner that we’ve never seen. The interesting part is that ROE is continuing to rise even though companies haven’t begun to deploy their cash. This excess cash, beyond what’s needed to fund a company’s operations, is essentially fuel sitting in the reserve tank waiting to be spent, and can ultimately further stimulate growth and profitability. As we take a closer look at ROE, we notice another interesting trend. Charts L-N highlight the breakdown of ROE over the same time period. Using what is known as a DuPont analysis, we can get a sense for how companies have generated profits over the last two business cycles. The DuPont analysis breaks down ROE into three components: net income/sales, sales/assets and assets/equity. (If you multiply these three ratios together, algebraically, you end up with net income/equity, which is ROE.) CHART J: Margins still have room for improvement S&P 500 operating margins, quarterly profits S&P 500 – Operating Margin (left) Quarterly proﬁts (right) 30% $18 25% $16 $14 20% $12 15% $10 10% $8 $6 5% $4 0% $2 -5% $0Source: Standard & Poor’s, FactSet, 3/03 3/04 3/05 3/06 3/07 3/08 3/09 3/10 3/11 3/12J.P. Morgan Asset Management.Data as of 3.31.2012.
CHART K: Corporate profitability S&P 500 return on equity & cash as % of current assets ROE (left) Cash as % of Current Assets (right) 20% 30% 18% 16% 14% 25% 12% 10% 8% 20% 6% 4% 2% 0% 15%Source: Standard and Poor’s, Compustat,FactSet, J.P. Morgan Asset Management. 12/00 12/01 12/02 12/03 12/04 12/05 12/06 12/07 12/08 12/09 12/10 12/11Data as of 12.31.2011. Net income/sales (Chart L), also known as the company’s net profit margin, measures bottom-line profitability: For each dollar of sales, how effective is the company at translating sales into earnings? Sales/assets (Chart M), also known as the asset turnover ratio, measures the company’s efficiency: How effective is the company in generating sales given the size of its balance sheet? Assets/equity (Chart N), also known as financial leverage, measures the leverage on a company’s balance sheet: Given the size of assets, what portion of a company is capitalized with debt rather than equity? Coming out of this economic cycle, we notice a clear trend in the quality of earnings. The breakdown of ROE shows that companies have cut costs to improve margins and, as a result, net profit margins have risen substantially, ultimately driving the recent pickup in profitability (Chart L). Over the same period, companies managed to maintain, if not improve, their asset turnover ratio by increasing overall efficiency throughout this past recession. One can also argue that if dividend payments pick up, the asset turnover ratio will increase (less cash on balance sheet = smaller denominator) thereby further lifting ROE (Chart M). While financial leverage always has and will continue to play a powerful role in profitability, the bounce back in ROE throughout this recovery hasn’t been dependent on leverage. In fact, like the household sector, companies appear to be actively deleveraging. Presumably, this will eventually come to an end and, once companies begin to use leverage, we should see a corresponding increase in overall ROE (Chart N). 11
MARKETINSIGHTS CHART L: Net profit margin S&P 500 net income / sales 8.5% 10% Net Income / Sales Average 9% 8% 7% 6% 5% 4% 3% 2% 1% 0%Source: Standard and Poor’s, Compustat,FactSet, J.P. Morgan Asset Management. ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12J.P. Morgan’s Guide to the Markets. Source: Standard and Poor’s, Compustat, FactSet, J.P. Morgan Asset Management. Guide to the Markets, page 12 CHART M: Asset turnover ratio S&P 500 sales / assets 51% Sales / Assets Average 48% 45% 36.4% 42% 39% 36% 33% 30%Source: Standard and Poor’s, Compustat, ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12FactSet, J.P. Morgan Asset Management.J.P. Morgan’s Guide to the Markets. THE CASE FOR EQUITIES — A TRIFECTA We are believers in diversification — both across and within asset classes. A well-balanced portfolio with a variety of relatively uncorrelated assets is the best approach for investors over the long run; it is important to protect against the possibility of what could go wrong, while at the same time being able to take advantage of what could go right. It goes without saying that one of these asset classes, for most investors, is equities. But beyond the obvious “diversification case” for equities, for long-term investors, we feel that there is a more specific case for equities in today’s environment, based on three key points. First, the valuations look attractive: Whether we look at earnings, cash flow or any other forward multiple, equities appear to be fundamentally undervalued. Second, profitability is improving: ROE has risen and appears to be nearing its long-term average only one year following the deepest recession since the Great Depression. Third, companies are sitting on reserves and are waiting for the opportunity to spend: As we look at the level of cash sitting on balance sheets and the power of leverage that companies have yet to utilize, we suspect that profitability will continue to improve in the years to come. As we think about these three forces coming together in combination with a low inflationary, low interest rate environment (generally a positive business environment), we believe that equities are poised to outperform. We would argue that this warrants a higher stock multiple, and further solidifies our view that equities are attractive.
CHART N: Financial leverage S&P 500 assets / equity 640% Assets / Equity Average 600% 560% 469.0% 520% 480% 440%Source: Standard and Poor’s, Compustat, ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12FactSet, J.P. Morgan Asset Management.J.P. Morgan’s Guide to the Markets. Conclusion • e believe that fundamentals ultimately drive the price of stocks and that long-term investors W should focus on forward earnings and profitability. • we look at a variety of forward valuation metrics, including price-to-earnings and price-to-cash As flow, it appears that equities remain fundamentally undervalued. • Profitability as measured by return on equity has come back to its long-term average while companies have managed to retain record amounts of cash over the same period. • Growth in profitability has been driven by improved margins and operational efficiency; leverage has actually declined over this cycle as companies have focused on strengthening their capital structures, resulting in quality earnings. As we hope for the best, we encourage investors to be prepared for the worst. The biggest risks to equity markets are those that cannot be predicted. For this reason, while we are bullish and believe that equities are attractive, it’s important that investors maintain a balanced approach, with exposure to equities as well as other asset classes that will help reduce volatility over the long term. 13