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Market Outlook: Raise Cash, or Put It to Work?

× Pat Dorsey, CFA× Director of Equity Research, Morningstar

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Morningstar Equity Research

×One of the largest independent equity research groups in the world.

×Broad coverage: 90 analysts covering 1800 companies across the globe

×Consistent, disciplined research approach focused on intrinsic values and economic moats.

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Our Approach× We evaluate stocks as small pieces of a business.

× We do primary research by reading filings & trade journals, visiting companies, talking to competitors & customers, and attending industry conferences.

× We have a long-term perspective.

× Our recommendations are driven by valuation, but we are not “value investors” in the most traditional sense.

× We believe that competitive advantages–“economic moats”–add intrinsic value, and we rigorously assess the competitive position of the companies we cover.

× We believe that the ability of a business to generate returns on invested capital (ROIC) above cost of capital is the primary test of shareholder value creation.

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Morningstar Approach to Equity ResearchWe evaluate stocks as pieces of a business

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Big Picture: The Bad Stuff

× Unemployment will likely take some time to come down× Many of the jobs created during the last expansion are not

coming back soon. Construction, finance, real estate, etc.× High U-6 rates (includes people who are involuntarily part-

time) mean that employers can increase hours rather than hiring when demand recovers.

× Consumer spending is still ugly× Demand for credit has declined considerably – it may stay

down for a while. The politicians squawking about the supply of credit are barking up the wrong tree.

× Deleveraging will take a long time. × Credit markets are terra incognita

× The Fed has never before intervened on this scale in the bond and mortgage markets. What happens as the much-ballyhooed “exit strategy” goes forth is anyone’s guess.

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Big Picture: More Bad Stuff

× Washington’s balance sheet is in bad shape

× Gov’t finances were stretched before crisis, and things are much worse now.

× There is zero political will to deal with mandatory spending. Unless we raise taxes, cut defense spending, cut Medicare spending, or cut social security benefits, we’ll be living with a lot of debt for a long time.

× Don’t shoot me – that’s the math. 75% of spending is defense + entitlements.

× Valuation is no longer compelling in most markets× Tough to make a “cheap” argument for most assets. Relatively

attractive in spots, maybe, but not cheap.× Our median price/fair value for 1800-stock coverage universe is

1.07. × Our rolled-up FV for the S&P 500 is ~1250.

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Defense + Entitlements Are The Big Kahunas

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Not Expensive…But Not Cheap, EitherShiller 10 Year PE

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Not Expensive…But Not Cheap, Either

Dividend Yield and Subsequent 7-Year Average Total Return

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Round Trip

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Big Picture: The Good Stuff

× Truly massive global stimulus – liquidity is still flooding the system ×Intervention is working. The question is what happens when it

stops. × Credit markets have thawed.

×Spreads are down across the board, most to normal (pre-Lehman) levels.

× Housing market seems to be thawing×Sales volumes up, prices stabilizing.×A big positive for consumers and for banks.

× Manufacturing is coming back nicely ×Manufacturing jobs are only 15% of the employment base, but

they tend to be relatively well-paying, so the knock-on effect is large. × Earnings could surprise on the upside.

×The US economy ≠the S&P 500’s earnings stream.

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Big Picture: More Good Stuff

× Maybe valuations aren’t all that bad×Heck, 12x for JNJ is a steal!×Many high-quality mega-cap stocks are pretty reasonably priced.

× Massive cost-cutting may mean that high margins are sustainable

דWe’ve done three years of restructuring in the past year.”×MMM revenues down 14%, op margins went from 22.8% to

21.7%. (4Q09)×UNP revenues down 25%, op margins went from 25% to 26%.

(4Q09)×U.S. productivity growth was excellent in 2009.

× Retail investors are very skeptical of the rally.×Equity flows have been barely positive, and bond flows are off

the charts×Typically, retail fund flows are a great contrarian indicator

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Sherman, set the WABAC machine to 1999!

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Equity Net Fund Flows(3 Mo MA, $US bn)

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WABAC Investing

× In 1999-2000, money was pouring into equity funds, and out of bond funds. Why? The 90s were better for stocks than for bonds.

× Fast-forward 10 years. From 1999-2009, the S&P 500 was basically flat, while Treasuries have returned 6.5% annually. Result? Now everyone is buying bonds!

+$15bn 1-Yr +$400bn 1-

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Fixed Income Net Fund Flows(3 Mo MA, $US bn)

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Net Equity Fund Flows Minus Bond Fund Flows(Morningstar, 3 Mo MA, $US bn)

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01020304050

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10

Investors are skeptical of the rally

March 2000S&P=1500

October 2002S&P=820

April 2006S&P=1300

March 2009S&P=700

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Valuations are a lot better than ten years ago

S&PWeigh

tTTMP/E

DivYield

Microsoft 4.9% 72 0.0% General Electric 4.1% 47 1.0% Cisco 3.0% 133 0.0% Wal-Mart 2.5% 57 0.3% ExxonMobil 2.3% 34 2.1% Intel 2.2% 35 0.2% Lucent 1.9% 56 0.2% IBM 1.6% 29 0.5% Citigroup 1.5% 17 1.1% America Online 1.4% 110 0.0%

Total / Average 25.5% 59 0.5%

S&PWeight

TTMP/E

Div Yield

ExxonMobil 3.4% 12 2.3% Microsoft 2.6% 18 1.8% Wal-Mart 2.0% 15 2.1% Apple 1.8% 30 0.0% P&G 1.8% 16 2.9% Google 1.8% 46 0.0% JPM 1.7% 14 0.5% GE 1.7% 11 2.5% J&J 1.7% 13 3.2% IBM 1.7% 13 1.7% Chevron 1.6% 9 3.4% AT&T 1.6% 13 6.2% Pfizer 1.4% 15 4.5%

Total / Average 24.8% 17 2.4%

December 1999

December 2009

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Wild Cards

× Inflation / Deflation×Last January, 10-year TIPS were forecasting 0.5% inflation –

now over 2%. Over the same time span, 5-year TIPS have gone from deflation to about 2%.

×We’ve expanded the money supply and the Fed’s assets big-time…the source of all those scary charts you see.

×Long-term disinflationary tailwinds – productivity growth, increased labor supply from China/India – may be waning.

×BUT…the velocity of money hasn’t increased much. Most of the money that’s been printed is sitting in bank accounts. In some ways, the Fed hasn’t really “printed money” – it has “created deposits.”

×Also, the output gap is quite large in the U.S. – in terms of labor and manufacturing – so perhaps we can grow for a little while before pushing up against any capacity limits.

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Wild Cards

× Valuation×Three sources of returns from equities: Dividends, earnings growth,

and changes in valuations (earnings multiples.) Dividends are ~2%. ×We’re somewhat above the mean long-run multiple now, so future

returns depend on multiple expansion or earnings growth. Peak earnings for S&P were $92. If the next peak is lower

due to de-leveraging and muted growth…well, put a 15 multiple on $80 and you get 1200. BUT if the next peak is just 9% higher than the last one, and

the S&P 500 earns $100, then the market is worth 1500 before any multiple expansion.

×So, substantial upside from here (S&P ~1200) requires that either the next peak in earnings be higher than the 2006-2007 peak, or that multiples expand.

×My best guess? It will be a tug of war between a weak U.S. consumer (negative), and higher global growth + the sustainability of higher margins (positives.) Stay tuned!

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Wild Cards

× China×All OK for now – after all, when Beijing says jump, Chinese bankers ask,

“how high?”×But never in the history of mankind has credit expanded at the pace it

did in China in 2009 without some eventual fallout. It’s not humanly possibly to expand your loan book at >50% year-over-year and maintain prudent lending standards.

×Longer-term, demography will be a headwind:×Dependency ratio will increase very rapidly for a relatively

low-income country that lacks a social safety net. Currently 11 over-65s per 100 working adults -- this ratio will be 38 in 2050. (Equals Japan today, or U.S. in 2050.)

×One-child policy + female infanticide = tens of millions of young men who cannot marry or start a family. A potential source of social unrest.

×When does the bubble burst? Can Beijing sweep things under the rug like the last time it bailed out the banks? What are the external repercussions? How do the demographics play out? Tough questions to answer.

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So Now What?

× Avoid long-dated Treasuries. Unattractive returns from a borrower with a weakening balance sheet. Jim Grant has called them “return-free risk” – I agree.

× Be careful of high-yield as a group – went from a fat pitch to a bubble in < year. Also, HY bond funds have seen massive inflows -- a good contrarian indicator.

× Emerging markets no longer look cheap. Some look downright bubbly. Long-term fundamentals are good, but you’re paying a high price for a cheery consensus.

× Blue chips (wide moats) with strong balance sheets are very attractive. Go for yield.

× Large stocks, on balance, are cheaper than small stocks.

× Health Care, Financials look cheap, Tech seems pricey.

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A Few Ideas

× Health Care: Thermo Fisher TMO, Novartis NVS, Stryker SYK

× Financial Services: J.P. Morgan Chase JPM, Wells Fargo WFC, BofA BAC, Discover DFS, Capital One COF

× Consumer: Apollo Group APOL, Lowe’s LOW, Molson Coors TAP

× Energy: Spectra SE, Range RRC, ExxonMobil XOM

× Utilities: National Grid NGG, Westar WR, Exelon XC

× Tech: KLA-Tencor KLAC, Applied Materials AMAT, France Telecom FTE

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Accessing Morningstar Equity Research:Analyst Research Center

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Institutional Service: Access to Analysts and DCF Models

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Morningstar Corporate Credit Ratings

× Issuer ratings: AAA, AA, A, BBB, etc.

× Applies to any senior, unsecured debt of the company

× Initial coverage list is 100, growing to 700+ in 2010

× Will include roughly 100 non-U.S. companies (mostly European)

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Four Scores that Determine the Morningstar Credit Rating× Business Risk

× Economic Moat, Uncertainty, Stewardship× Size, Concentration, Dependence on Capital Markets

× Cash-Flow Cushion ™ × Based on our proprietary cash-flow models. Uses our five-

year forecasts of cash flow, and compares that to debt coming due

× No one else has systematic cash-flow forecasts that they can compare with debt coming due

× Solvency Score ™× Based on equation we derived from historical backtesting× Four variables: leverage, interest coverage, liquidity, and

profitability× Distance to Default

× Market-based measure of financial health× Academically tested

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Morningstar’s Corporate Credit Rating Process

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Credit Research and Ratings for Advisors

× Analyst commentary covering× Financial Health× Capital Structure × Enterprise Risk× Thesis & Economic Moat

× Data on× Four “pillars” of our

framework× Key credit metrics× Annual cash-flow forecasts × Bond issues and related data

(prices, yields, maturities)

× Related Services× Feed of credit ratings and

rating changes× Conference calls with

analysts × Access to Research Liaison

Desk

Advisor