MKT Outlook Q1 2013

Market Outlook
Q1 2013
December 21, 2012
2 Our Outlook for the Stock Market

5 Outlook for the Economy
11 Our Outlook for the Credit Markets
29 Outlook for the CMBS Market
31 Basic Materials
39 Consumer Cyclical
44 Consumer Defensive
50 Energy
56 Financial Services
61 Health Care
66 Industrials
72 Real Estate
76 Tech & Communication Services
84 Utilities
Market Outlook Q1 2013

December 21, 2012
Our Outlook for the Stock Market

The environment is right for stock-picking to make a comeback.
By Heather Brilliant, CFA | Vice President of Global Equity and Credit Research
3 We continue to view the market as pretty close to fairly valued, with stocks under
Morningstar coverage trading at 92% of fair value in mid-December, using a market-capitalization-weighted average. This is not materially different than last quarter, when our
coverage universe was trading at 91% of fair value.
3 Market volatility will be a way of life in 2013, as Europe continues to work on solving its debt
problems, Chinas growth remains closely scrutinized, and the U.S. grows in fits and starts. In
this environment, we think stock-picking will make a comeback, and investors focusing on
specific stock opportunities will do well given this backdrop.
3 Despite the medias penchant for touting the fiscal cliff as a major crisis, we think it will end
up being a non-event. It has to get resolved one way or another, whether politicians finally
agree to reach a compromise, or the U.S. is forced into its own austerity. While the latter
scenario may bring recession, we think it would result more in buying opportunities than a
protracted stock market decline.
With 2012 coming to a close, its our turn to pontificate on what we expect will happen in
2013. Everywhere you turn this time of year, you will find another 2013 forecast, and most
seem to be positive this year (which we find a little scary).
Theres general agreement that a positive return in the U.S. market will come from multiple expansion, as margins are already high by historical standards. Although we agree that
margins seem pretty high already and that the markets valuation is not overly demanding
at these levels, we see two alternative outcomes for the market in 2013. First, our research
shows the market is close to fairly valued, so we dont expect much multiple expansion.
Second, we think theres the potential for positive surprise from revenue growth. There are
plenty of signs that things are improving for the U.S. economy, at least marginally, and we
expect the economy to continue to strengthen in 2013, which could mean some earnings
growth even without further margin improvement.
All that being said, as the market crawls ever closer to fair value, it becomes increasingly
difficult to predict its direction. The good news in that assessment, in our opinion, is that
stock selection is becoming increasingly important. Over the past five-plus years, there have
been never-ending comments about how correlated markets are, and that stock selection
no longer matteredall that mattered was getting the macro calls right and positioning
your portfolio accordingly. In 2012 we have seen some signs that stock-picking is starting to
have a bigger impact again, and we expect that will be a continuing theme throughout 2013.
For example, the S&P 500 is up about 15% this year, a very good year all things considered.
2
However, housing-related names we recommended in 2011 or early 2012, such as Lowes

LOW or First American Financial FAF, are up 40% and 85%, respectively, since the start
of 2012.
So where do we see the next pockets of opportunity in the market? Our top picks, as always,
come from the ranks of wide- and narrow-moat companies, because we believe these firms
will earn excess returns for longer periods of time than their no-moat counterparts. As of
mid-December, we have about 30 firms with 5-star ratings among our wide- and narrowmoat coverage list, with a decent population of European firms and energy companies
(energy is among our most undervalued sectors at 86% of fair value). However, there are also
some large, global companies on the list, such as Apple AAPL and Rio Tinto RIO.
The valuations of European firms under Morningstar coverage are no longer less demanding than we see for our North American companies, on average. Our European coverage is
trading at 93% of fair value, while our North American coverage universe is currently priced
at 92% of fair value. This could have more to do with our coverage universe in Europe than
the overall market condition; the approximately 250 European firms we cover tend to be
larger-cap, moaty, higher-quality businesses that the market has sought out over the past
year. That being said, these names did rally quite a bit in the past three months, as the
market was pricing our European coverage universe at 87% of fair value just a quarter ago.
In addition to energy, we also see the technology sector as particularly undervalued, at 86%
of fair value. Several large-cap technology companies have seen their stocks fall materially in recent quarters, from Apple to Hewlett-Packard HPQ. The list of tech stocks down
10% in the past quarter also includes names like Microsoft MSFT, EMC EMC, and Intel INTC.
Although some of these stocks have been suffering from a weak global demand picture,
others have faced more company-specific woes; in any case, we expect these challenges to
clear up in the future and see opportunity in the tech sector.
Real estate and consumer defensive remain our most overvalued sectors, trading at a 4%
and 7% premium, respectively, to our fair value estimates. Investors globally continue to
search for yield, and these sectors have benefited. We think this search can be misguided
when prices get overly inflated, and investors begin to risk capital in the search for current
income. When a wide- or narrow-moat stock trades at a discount to fair value and offers a
good yield, you may have something there. But the higher a stock trades above fair value, the
more likely it will converge to that fair value and hurt your total return. It is a rare dividend
that sufficiently compensates for that risk, so its critical to look at the whole picture when
buying stocks.
Clearly consumer defensive names have also benefited from their relative business stability and high proportion of wide moats. We do generally require a smaller margin of safety
around names like this, but we still believe some margin of safety is important. Stocks are
all about risk/reward, and the cheaper you buy a great company, the more likely you put the
risk/reward equation in your favor.
Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012
We have tried to avoid the topic everyone else cant seem to stop talking aboutthe dreaded fiscal cliffbut alas, here we are. First, we expect the fiscal cliff will get resolved, if not
by the end of the year, then shortly into the new year. Nothing actually falls off a cliff on
Jan. 1; most of the changes would start to have impacts over the course of the year. Second,
if our politicians actually do refuse to compromise, we may face a recession but at least our
fiscal situation will be much improved. I dont think Im going out on a limb in saying the first
scenario is more positive for the market, but the second scenario should not be a disaster,
either. Once resolved one way or another, we expect the global markets attention will return
to Europe and how things are progressing there over the coming year.
Please see our detailed take on each sector in the reports that follow.
Heather Brilliant, CFA, has a position in the following securities mentioned above: FAF LOW
MSFT

December 21, 2012
Outlook for the Economy

More modest growth may go hand-in-hand with a longer,
more durable recovery.
By Robert Johnson, CFA | Director of Economic Analysis
3 U.S. GDP growth, consumption, inflation, and employment could all grow by about 2%
in 2013.
3 Increased oil production, an improving housing market, and a strong agricultural market
make the U.S. a good growth pick for 2013.

3 U.S. economic growth decoupled from both world growth and corporate earnings in 2012.
3 As long as inflation remains below 4%, the U.S. should be able to avoid another recession.
My 2013 economic forecast seems to center around the number 2. I suspect that real GDP
growth, inflation, and consumption will come in at 2% or slightly more in 2013 with employment growth pulling up the rear at 1.8%.
Because of productivity growth, employment is almost always destined to trail total
economic growth. With the exception of higher housing starts and lower unemployment, the
forecast doesnt look much different than the likely results for all of 2012.
Compared with long-term averages, GDP growth and consumption growth are lower than
average, at least partially due to lower population growth. But at least a couple of pieces of
good news are embedded in that slower growth rate.
First, slower growth continues to keep a lid on inflation, with the inflation rate running just
about half the rate of the long-term average. And it appears that more modest growth may
go hand-in-hand with a longer, more durable recovery. Four of the last 10 economic recoveries (since World War II) were already over by now, and we should match the length of yet a
fifth recovery early in 2013. By the way, the recovery is now approaching 3.5 years in length.
4Q Over 4Q Growth Rates and Actual Housing Starts
Average
Post 1960
2010
2011
2012E
2013E
Real GDP Growth
3.1
2.4
2.0
1.9
2.2
CPI Inflation
4.0
1.2
3.3
1.9
2.0
Private Employment Growth
1.7
1.9
1.7
1.7
1.8
Unemployment Rate
6.1
9.4
8.7
7.8
7.0
Consumption Growth
3.3
2.9
1.9
1.8
2.0
Housing Starts (000)
1,468
586
678
876
1,000
Source: St. Louis Federal Reserve, Morningstar Calculations

5
A Slow-Rolling Recovery
While the consumer has been a relatively durable contributor to the recovery, exports,
manufacturing, and business spending have had their ups and downs. For example, yearover-year growth in industrial production peaked at 7.8% but is currently running at a more
modest 3.2%. Housing, normally the go-to factor in jump-starting a recovery, is just now
making a net contribution. Ditto for industrial construction.
And although government made some nice early contributions to the recovery, its been
pretty much downhill since mid-2010, with only one quarter of growth (3Q 2012) since that
time. This almost unprecedented trend is weighing on the economy more than many might
suspect. Since winding down the World War II war machine and the Korean War effort in
the 1950s, government spending has never declined as fast as the 4% year-over-year decline
experienced in mid-2011.
Housing the Big Change Factor in 2013
Looking to 2013, the recovery growth drivers are likely to change again. Although housing
clearly began to turn in 2012, the effects were relatively muted. While direct housing investment will be a meaningful contributor in 2013, some of the ancillary goods and services that
are housing related will also finally kick in. I am talking about things like mortgage brokers,
furniture sales, and remodeling fees that may take longer to recover than housing starts,
which are already way off their bottoms.
Consumer Spending Stable to Modestly Higher in 2013
The consumer is one thing that is not changing a lot. Thats good news and bad news. The
consumer represents about 70% of the U.S. economy, making it difficult for overall economic
activity to move more slowly than the consumer, but its also hard for it to grow faster.
The news for the consumer has been surprisingly good in 2012 and could look at least slightly better in 2013. Good news for the consumer includes slow but steady employment growth,
stable inflation, rising financial assets, and a nicely improving real estate market. On the
downside, unemployment remains high, and we still havent recovered all the jobs lost in
the recession.
No matter exactly how the fiscal cliff is resolved, it remains clear that taxes, at least on
the federal level, will be higher in 2013, especially on high-earning individuals. Although my
overall consumer spending growth rate is higher in 2013 than 2012 at 2.0%, I suspect that
lower income and especially middle income earners will do better than high income earners
in 2013. Higher taxes and potentially smaller capital gains in 2013 may put high earners in a
more negative mood. Middle income earners will likely be bigger beneficiaries of rising home
prices (and their newfound ability to refinance those homes).
Slow World Economy Could Keep Inflation Below 2% in 2013
Tame inflation should also help the consumer again in 2013. Unfortunately, my 2% inflation
forecast comes with less confidence than most other components of my analysis. Combined
energy and food prices represent more than 20% of consumer prices, and these two data are
nearly impossible to project solely on economic factors. Slow worldwide economic growth
and more controlled commodity demand from emerging markets would point to slower food
and energy prices in 2013 driving overall inflation potentially down as low as 1.5%. However,
the drought of 2012 and the potential for another crop disaster in 2013, along with oil prices
that seem more influenced by geopolitical events than supply and demand, cause me to add
at least a small fudge factor in my inflation forecast.
As Long as Inflation Remains Below 4%, I Am Not Too Worried
I can say with some degree of certainty that as long as inflation remains under about 4%,
the consumer will continue to power the economy ahead, and a recession is not the most
likely outcome. The track record of high inflation forecasting a recession is extremely solid.
And remember it is total inflation, including the volatile food and energy sectors, that counts.
Even though the core inflation levels that exclude food and energy prices may look more
muted or tame, consumers have to eat and drive, and more money spent on those items
means less available for other expenditures.
Worries About Expansive Fed Seem Premature
Although Ive talked of inflation mainly as a factor of worldwide supply and demand, at least
some economists are beginning to worry about inflation from an excessively easy Federal
Reserve. The discussions of the fiscal cliff served to hide what was one of the more expansive moves by the Federal Reserve during this recovery. The credit market outlook in this
quarter-end report details some of that news.
Perhaps the most noteworthy piece of information in the Feds December press release
was that purchases of longer-term bonds would no longer have to be matched by selling
shorter-term notes or bills, essentially printing more money instead. However, I note that
continuing tight lending requirements should keep the Feds largesse from igniting inflation in day-to-day goods. A lot of money is sloshing around on bank balance sheets, but
it remains difficult to find qualified borrowers to lend it to. Until those lending standards
get meaningfully easier, price increases are likely limited to houses, financial assets, and
perhaps commodities.
Private Sector Employment Growth Steady as She Goes; 1.8% Growth Possible
The monthly employment reports remain topsy-turvy from month to month, but year-overyear averages have been relatively consistent at 1.8% growth for some time.
At this rate, we wont have recaptured all the jobs lost in recession until sometime toward
the end of 2014. However, employment growth of 1.8% can easily support GDP growth in
excess of 2% due to higher productivity levels. For reference purposes, that translates into
approximately 170,000 private sector jobs, which basically mirrors the growth level of 2012.
Professional service (which includes temporary help), education, health care, retail, and
leisure (mainly hotels and restaurants) were the biggest contributors to job growth in 2012.
I suspect health care could be an even bigger contributor in 2013 as the Affordable Care Act
begins to kick in and becomes the law of the land.
Housing- and construction-related employment growth was nonexistent in 2012, despite
improved housing starts. In 2013, I suspect housing- and construction-related employment will
help along the monthly employment reports and is likely to help the temporary-help category
as well. Retail hiring was a big help at the end of 2012 but may suffer at least some slowing in
early 2013 before rebounding later in the year.
Unemployment Rate Will Likely Move Down
In a totally static economy, the 2 million or so jobs created could drop the employment rate as
low as 6.5%. However, each year a new class of graduates enters the job market and another
set retires. The ranks of retirees are increasing each year as the baby boomer cohort retires
while the number of new job-market entrants is relatively stagnant, but it is still running higher
than retirements. Still, the net labor market is likely to increase by about 1 million in 2013
(compared with about 1.3 million in 2012). That translates into a drop in the unemployment rate
from an estimated 7.8% in 2012 to 7.1% by the end of the 2013. At this rate, the unemployment
rate could fall below the Feds 6.5% watch point by the end of 2014, earlier than it seems to be
contemplating now.
U.S. Decoupling Really Did Happen in 2012
Although I think the IMFs estimated U.S. real GDP growth rate for the full year 2012 may be a
little high, it still seems that U.S. economic growth in 2012 was very close to the same level
as 2011.
At the same time, Europe moved into a recession, and growth in China and other developing
markets slowed dramatically (though in many cases, growth rates were at a higher level than
in the U.S.). The U.S. economy benefited from higher oil production, an improved auto industry,
decreased commodity prices, and a turn in the housing marketavenues of growth that were
not available in a lot of other countries.
In addition, at just 14% of GDP, exports represent a smaller portion of economic activity than in
other countries. And a lot of what the U.S. does ship is composed of basic necessities or falls
under long-term contract, including food, refined oil products, and jetliners. Therefore, the U.S.
economy was not as drastically affected by the world economic slowdown as many had feared.
IMF Full-Year Real GDP Growth Rates % Change
2010
2011
2012F
2013F
Europe
2.0
1.4
-0.4
0.2
Japan
4.5
-0.8
2.2
1.2
United States
2.4
1.8
2.2
2.1
China
10.4
9.2
7.8
8.2
India
10.1
6.8
4.9
6.0
Brazil
7.5
2.7
1.5
4.0
Total
5.1
3.8
3.3
3.6
Source: IMF Oct. 2012
S&P 500 earnings growth slowed more dramatically in 2012 than the overall U.S. economy
and was less immune to the worldwide economic slowdown. It is not unusual for large,
multinational firms to derive as much as 20%40% of their revenues and earnings from
non-U.S. markets. However, a lot of those overseas revenues are derived from goods
produced outside of the United States. Therefore, corporate earnings soared this recovery,
even as U.S. employment growth remained lethargic.
Now the roles are reversed as U.S. employment growth has remained stable and multinational earnings growth has slowed dramatically. A stronger dollar also contributed to weaker
corporate growth overseas. As emerging markets show signs of stabilization, there may be
more room for earnings improvement again in 2013. However, I think Europe could still be
problematic in 2013 as its fiscal issues remain far from solved.
Morningstar Analysts Have Positive U.S. View, Negative European Outlooks, and
Mixed Views on the Chinese Economy
A lot of the sector-based quarterly outlooks in this report are fairly consistent with my
outlook. A number of teams commented on and were worried about European growth. For a
change, many of the reports indicated that the U.S. might be the best place to be, with the
domestic auto and housing industries driving a lot of activity.
The outlooks on China were more varied with some sector analysts convinced of a turn
while others felt that the slowdown was not yet complete. Others argued that even as China
improves, growth was likely to be more muted and driven more by the consumer and less by
investment. This in turn would temper the rebound in commodities and metals, which have
been the typical beneficiaries of the Chinese growth story.
Morningstar Teams Guardedly More Optimistic, Though Few Bargains Remain
Being typical Morningstar, overall enthusiasm was muted, but still just a tad more bullish
than quarterly reports earlier this year. Unfortunately, most teams commented that while
equities were relatively fairly valued, very few stocks represented true bargains. Several
analysts noted that stock buyback activity, special dividends, and mergers/divestitures
seemed to be relatively important factors for corporations attempting to generate more
shareholder value. Generally, it appears that EPS growth has been helped along more by
these types of maneuvers than revenue growth as we approached the end of 2012. The
fiscal cliff and especially the potential for large sequestrations of both defense and healthcare spending also seemed to garner a fair number of mentions in the sector-based quarterly
outlooks. I am still skeptical that these cuts will actually get made when the final deal is
struck, although it obviously has given more than a few businesses cause for concern.
Weather conditions also got some attention in several reports. Our energy team seemed
particularly concerned that we may have one of our warmest winters in U.S. history. On
the other hand, a hot summer in 2012 managed to finally draw down some of the massive
piles of coal at U.S. utilities. Likewise, the drought and higher food prices are hurting some
consumer-related stocks but could help companies serving what is expected to be a very
strong U.S. spring planting season. Yet another summer drought would dash some of that
enthusiasm. Warm weather could also favorably shift some housing statistics at the beginning of the year but hurt sales of winter goods and apparel.
U.S. Economy Likely to Look Better Than the Sloppy Results in 4Q
Hurricane Sandy, machinations in the U.S. auto production schedules, gyrating soybean
sales, and odd weather patterns served to scramble and depress a lot of economic data,
especially in the fourth quarter of 2012. GDP growth is likely to drop from very close to 3% in
the third quarter to a measly 1%2% in the fourth. The true strength of the U.S. is probably
an average of these two extremes, or about 2%.
With some favorable weather trends and a successful resolution of the fiscal cliff, the first
quarter of 2013 could look better than 4Q. Dont be fooled by economists who have pulled
out their favorite tool, a ruler, to conclude that if we grew 3% in 3Q and 1% in 4Q, the next
number in the series will reflect the same 2% decline in growth rates that we saw between
3Q and 4Q, producing a 1% decline in GDP for the first quarter.
10

December 21, 2012
Our Outlook for the Credit Markets

2012 was a great year for bonds, but upside for 2013 appears limited.
By Dave Sekera, CFA | Senior Securities Analyst
3 Financials outperform in 2012 and are expected to lead during the first quarter.
3 The Fed is flooding the markets with even more liquidity.
3 The eurozone recession spreads to core countries from the peripheral.
Market implied inflation soars.

The combination of tightening corporate credit spreads and lower interest rates led to an
outstanding return for Morningstars Corporate Bond Index in 2012. Through Dec. 13, the
index has returned 10.2%, thanks to a 100-basis-point compression in credit spreads, a
20-basis-point decrease in the 10-year Treasury bond, and the return from coupon yield.
For 2013, it will be mathematically very difficult to enjoy anywhere near the same return
unless one assumes that either credit spreads return to the tightest levels recorded
(February 2007) or that interest rates will drop significantly below where they are currently
trading, which is already near the lowest rates on record. Assuming corporate credit spreads
tighten modestly and that interest rates remain steady, and considering that the yield on the
Morningstar Corporate Bond Index is currently 2.40%, investment-grade bonds appear to be
poised to return low- to mid-single digits in 2013.
As of Dec. 12, the average credit spread within the Morningstar Corporate Bond Index has
tightened to +146. Over the first quarter of 2013, credit spreads appear poised to modestly
tighten further as strong technical factors support the corporate bond market. However, over
the longer term, we think the preponderance of credit spread tightening is likely to have run
its course. The tightest average spread of our corporate bond index since the 2008 credit
crisis was +130 in April 2010, just prior to when Greece admitted its public finances were
much worse than previously reported, thus beginning the European sovereign debt crisis. The
absolute tightest level that credit spreads have reached in our index was +80 in February
2007, the peak of the credit bubble. Over a longer-term perspective, since the beginning of
2000 the average credit spread within our index is +176, and the median was +162.
From a technical perspective, the outlook for corporate bond spreads couldnt look any
better. Demand for corporate bonds remains especially strong as investors continue to
pour new money into the fixed-income markets. The new issue market reached record
levels in 2012, but yet was still unable to keep pace with investor demand. Dealer inventory in the secondary market also remains near its lows. As the Fed continues to purchase
11
mortgage-backed securities and long-term Treasury bonds, investors have increasingly

fewer fixed-income assets to choose from. This is forcing credit spreads tighter as the supply
of available fixed-income securities constricts and the new Fed-provided liquidity looks for
a home. Unfortunately, this action will further penalize savers as the Fed artificially holds
down long-term Treasury rates and fixed-income securities that trade on a spread basis clear
the market at levels that are tighter than would otherwise occur. As such, the average yield
within our corporate bond index continues to reach new all-time lows.
While technical factors have dominated in the current environment, over the long term,
fundamental considerations will eventually hold sway. From a fundamental risk perspective,
we see a number of domestic and global factors that could adversely impact issuers credit
strength in 2013.
No matter what resolution is reached regarding the fiscal cliff, we expect the result will be
a drag on domestic growth. Globally, we are concerned that slowing growth in the Chinese
economy, along with deepening recessions in Europe and Japan, could pressure cash flow
for those issuers with global operations. With these factors in mind, we recommend that
investors concentrate their holdings in those firms that have long-term, sustainable competitive advantages and strong balance sheets that can weather any economic storm.
12
For the near term, we think bonds of issuers with following attributes will outperform:
High exposure to U.S. markets where we anticipate modest economic growth will continue.
Limited exposure to the eurozone, especially the peripheral countries where austerity
measures hamper economic recovery.
Exposure to the emerging markets, where economic growth continues to be positive, albeit
moderating.
Companies that have the wherewithal to expand capital expenditures and infrastructure
investments to take advantage of competitors that lack the wherewithal to re-invest in their
businesses.
Financials Outperform in 2012 and Expected to Lead During the First Quarter
Since the beginning of August, the financial sector has been far and away the best performing sector within the Morningstar Corporate Bond Index. Considering the financial sector
had been the hardest hit by the sovereign debt crisis, it was no surprise that it outperformed
once the fear of systemic contagion from Europe began to subside.
For the first quarter of 2013, Jim Leonard, Morningstars corporate bond analyst for the
banking sector, expects credit spread tightening in the financial sector to continue to
outperform the broader market. Given the higher spread levels within the financial industry
compared with similarly rated industrials, along with improving balance sheets and credit
metrics, he expects the spread between financials and industrials to close. He does, however, caution that the long-term problems of Europe are far from being solved, and there is
always the possibility that the European Union loses control of the situation. Such an event
would cause the credit spreads of equivalently rated banks to widen further and faster than
industrials.
13
If a Little is Good, Even More Must be Better: Fed Flooding the Markets With Even
More Liquidity
In December, the Fed announced that it would purchase outright $45 billion of long-term
Treasuries after Operation Twist ends. In addition, the Fed eliminated the calendar date
guidance on how long it anticipated keeping interest rates at zero. Instead, it replaced the
calendar date with an unemployment target of 6.5% as long as one- to two-year inflation projections are below 2.5%. Based on the FOMCs current projections, unemployment
would decline to that level sometime in the first half of 2015. If the Fed were to purchase
$45 billion of Treasuries and $40 billion of MBS through then, it will increase its holdings by
approximately $2.5 trillion, nearly doubling the size of the Feds current balance sheet.
The intent of the Fed is to support the housing market by reducing rates on mortgages.
By keeping mortgage rates low and supporting the housing market, the Fed believes its
monetary policy will transmit into the broader economy as home affordability improves and
homeowners refinance into lower-rate mortgages, freeing up disposable income. The Feds
premise is that as house prices stabilize and rise, banks will become more willing to extend
credit and consumer sentiment will improve as household net worth increases. Considering
the zero interest rate policy (ZIRP) was launched in December 2008, that target would entail
six and one-half years of ZIRP. With inflation ranging from 1.5% to 2%, real interest rates
are negative through the 10-year Treasury, resulting in considerable financial repression for
savers.
One aspect of the FOMCs announcement that has been mostly overlooked is that the
committee further reduced the midpoint of its expectations for real GDP growth. Since its
January 2012 statement, real GDP growth expectations for 2012 have been reduced by
0.7%. For 2013 and 2014, the midpoint of its GDP growth projections has declined by
about 0.4%.
Market Implied Inflation Soars
Market implied inflation expectations soared higher subsequent to the FOMCs December
announcement that it would continue to purchase $45 billion of long-term Treasuries after
Operation Twist ends.
Our preferred measure of inflation expectations is the five-year, five-year forward inflation
breakeven rate, which rose to 2.90% after the FOMCs December announcement. Based
on our analysis, this is the highest market implied forward inflation rate since the Treasury
began issuing Treasury Inflation Protected Securities (TIPS).
For those who are not familiar with the five-year, five-year forward inflation breakeven rate,
it is the average annual inflation rate expectation for five years, five years in the future (i.e.,
years 6 through 10). It is calculated by stripping out the inflationary rate embedded in fiveyear TIPS from the inflationary rate embedded in 10-year TIPS.
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Eurozone Recession Spreads to Core Countries from Peripheral
The ECB recently lowered its economic forecast for 2013 GDP to a 0.3% contraction
compared with the 0.5% growth estimate it had forecasted in September. The decrease was
largely due to recent weakening in Germany and France, which together account for about
half of the eurozone GDP.
Germany, which has long been the pillar of strength, recently lowered its 2012 GDP growth
forecast to 0.7% from 1.0%, as GDP is expected to contract 0.3% in the fourth quarter. The
country also lowered its 2013 forecast to 0.4% from its June estimate of 1.6% based on its
assessment that GDP may also contract in the first quarter of 2013. The ECB held its benchmark refinancing rate steady at 0.75% at its December meeting, but as the recession in the
eurozone expands, we would not be surprised to see the ECB cut short-term rates.
While the eurozone economy is poised to contract further in the near term, Spanish and
Italian bonds rallied in the fourth quarter. The yield on their respective 10-year bonds
dropped 57 and 45 basis points to 5.37% and 4.64%, respectively. The market has priced
in lower sovereign default risk and thus lower systemic risk. The ECB created the Outright
Monetary Transactions program last fall, which will support nations that officially request
financial assistance and accept a macroeconomic adjustment program to be developed by
the EU in conjunction with the IMF. In addition, sovereign investors have taken comfort in
the continued support of Greece by the ECB, EU, and IMF. As the Troika supports beleaguered Greece, this action indicates that it would also support other countries that become
financially troubled and lose capital market access, thus lowering the probability of a nearterm default by either Spain or Italy.
15
Global Economic Pressures Adversely Impact Credit Ratings
During the fourth quarter, ratings downgrades outpaced upgrades by a ratio of nearly 2:1.
The downgrades were predominately due to issuer specific events such as debt-financed
acquisitions, spin-offs, and other actionsincluding increased share buyback programs
and special dividendswhere management is willing to enhance shareholder value at the
expense of bondholders.
However, we are also seeing some instances where slowing economic growth has led to
weaker-than-expected results and deteriorating credit metrics. For 2013, we expect that
individual issuer credit risk for domestic issuers will mostly emanate from companies that
look to financial engineering (i.e., spin-offs, acquisitions, and debt-funded share-buyback
programs) to enhance shareholder value. Among European issuers and those issuers with
greater global exposure, however, we expect credit risk will generally increase within cyclical sectors experiencing the brunt of the recession.
We expect global economic growth will continue to be sluggish in 2013, limiting opportunities for organic growth. In order to enhance shareholder value, management teams will
likely continue to look for nonorganic ways to support their equity prices. We have seen
a significant amount of activity in strategic acquisitions in 2012 and expect that trend to
continue. Depending on how these acquisitions will be structured, the credit implications
may be either neutral to negative based on the amount of debt and equity used to fund
the buyouts. As we have previously opined, leveraged buyouts in 2012 have been modest
as both domestic and European banks have been more interested in preserving capital as
opposed generating fees from financing leveraged transactions. However, as domestic banks
have rebuilt the capital on their balance sheets, we expect their willingness to fund LBOs
will increase in 2013. Private equity sponsors have significant amounts of dry powder and
may look to use any pullbacks in the equity market as an opportunity to purchase quality
businesses.
16
Ratio of Rating Upgrades to Downgrades by Quarter and by Sector

Sector
1Q
2010
2Q
2010
3Q
2010
4Q
2010
1Q
2011
2Q
2011
3Q
2011
4Q
2011
1Q
2012
2Q
2012
3Q
2012
4Q
2012
Total
Ratio
Total
Issuers
Covered
Basic Materials
0/0
1/0
1/0
0/0
2/4
0/3
0/0
0/2
0/0
1/4
0/0
0/1
5/14
53
Communication Services
0/0
0/1
0/0
0/0
1/0
0/0
0/0
0/1
0/2
0/0
1/0
1/0
3/4
36
Consumer Cyclical
0/0
1/0
2/0
2/0
2/0
2/4
0/1
0/2
1/5
1/0
7/3
2/5
20/20
100
Consumer Defensive
0/0
0/1
0/0
0/0
0/0
0/0
0/1
0/1
0/1
1/2
0/1
0/0
1/7
55
Energy
0/0
0/0
0/0
0/0
0/1
0/1
0/0
0/1
0/0
0/0
0/3
2/0
2/6
50
Financial Services
0/0
0/0
0/0
0/1
4/0
2/1
4/0
1/1
0/2
0/7
0/1
1/0
12/13
126
Healthcare
1/0
1/1
2/2
0/6
0/1
7/3
1/1
0/2
0/3
2/1
3/2
0/2
17/24
72
Industrials
0/0
4/0
0/1
0/0
4/7
4/3
1/1
1/11
1/2
1/4
1/3
1/2
18/34
90
Real Estate
0/0
0/0
0/0
0/0
0/0
0/0
0/0
0/0
0/0
0/0
0/0
0/0
0/0
27
Technology
0/0
0/0
0/1
0/1
0/0
0/1
0/0
0/1
0/0
0/3
0/0
0/3
0/10
52
Utilities
0/0
0/0
0/0
0/1
1/2
0/0
0/0
0/0
0/0
0/0
1/0
0/0
2/3
39
Total
1/0
7/3
5/4
2/9
14/15
15/16
6/4
2/22
2/15
6/21
13/13
7/13
80/135
700
1.00
2.33
1.25
0.22
0.93
0.94
1.50
0.09
0.13
0.29
1.00
0.54
0.59
Ratio Upgrades to Downgrades
Credit Outlook: Sector Updates and Top Bond Picks
Banks
For both large U.S. banks and U.S regional banks, this last quarter was much more of the
same from a balance sheet perspective. Nonperforming loans as a percentage of total loans
continue to drop, tangible common equity continues to build, and the deposit base for most
banks continues to grow. We expect this trend to continue for the next few quarters, with
the only major caveat being a severe breakdown in fiscal cliff negotiations, which would
likely lead to a recession in the U.S. The momentum of recovery for U.S. banks is so strong
that minor problems, or even actually going over the fiscal cliff for a few days, should not
weaken it. One metric that we do expect to stop its improving trend is the percentage of
reserves to nonperforming loans. For many banks this figure is at or near the high of precrisis
levels, allowing banks to release reserves in an effort to boost net income. The boost to net
income is needed as an offset to falling net-interest-margin levels as overall fixed-income
yields continue to drop. Given the recent actions and comments from the Federal Reserve,
we expect falling all-in yields to persist as the latest round of quantitative easing will remain
into the foreseeable future, which will force further compression in the net-interest-margin
for banks.
The banking sector did see one dramatic change in this last quarter, compared with the last
few quarters, and that was spread volatility. Spreads for the banking sector were comparatively stable and tightened slowly throughout the quarter. For example, the Morningstar
financial index tightened 36 basis points to 159 from 195 compared with the Morningstar
industrial index, which only tightened 14 basis points from 150 to 136. For many investors,
the higher spread levels of the financial industry compared with similarly rated industrials,
especially for the large six U.S. banks, were too hard to ignore, and investors were willing
Average NRSRO Difference by Sector*

Sector
Avg. NRSRO
Difference
Basic Materials
-0.25
Communication Services
+0.22
Consumer Cyclical
+0.26
Consumer Defensive
+0.53
Energy
-0.04
Financial Services
-0.29
Healthcare
+0.87
Industrials
+0.09
Real Estate
-0.29
Technology
+1.27
Utilities
+0.24
Total Universe
+0.24
The Average NRSRO Difference shows how many notches

away Morningstars issuer rating is from the average issuer rating
assigned by Standard & Poors and Moodys. For example, if
Morningstar rates an issuer BB+ and the agencies rate that issuer
BBB-/Baa3, the Average NRSRO Difference is -1.0. This metric is first
calculated for each issuer in Morningstars coverage universe, and
then we calculate the average NRSRO Difference by sector.
17
to expose themselves to greater possible volatility in the search for higher yields. Possible
negative headlines from the fiscal cliff negotiations, or any further European sovereign
debt concerns, could bring a dramatic spike in volatility back to the financials sector. We
expect, however, that Congress will eventually reach some reasonable compromise and
that the European Central Bank will be able to contain any possible European flare-ups over
the short term. We, therefore, expect the spreads of large U.S. banks to tighten during the
next quarter as the spreads are generally 25 to 50 basis points wide of the general index. It
should be noted, however, that the long-term problems of Europe are far from being solved,
and there is always the possibility that the European Union loses control of the situation in
the near future. Such an event would cause the credit spreads of equivalently rated banks to
widen further and faster than industrials.
Contributed by Jim Leonard
Basic Materials
The bond market has certainly adopted our view that Chinese economy has indeed slowed
down measurably in 2012, but we think spreads of high-cost metal and coal producers
will face additional challenges in 2013. Consider the case of iron ore miner Cliffs Natural
Resources (CLF, rating: BBB-), whose 4.875% 2021 issue was placed on our Bonds to Avoid
List at the beginning of August. The bond went from T+360 basis points in early August
to T+396 basis points on Dec. 11 (while the underlying BBB- Morningstar Industrial Index
moved roughly 10 basis points in the opposite direction) which underscores the markets
worry that Cliffs relatively high-cost structure makes the company particularly vulnerable as
iron ore prices take another leg down. Although the iron ore market has stabilized somewhat
compared with the rapid slide in prices in the past summer (which we would argue might
be short-lived), we think the company will continue to face mounting challenges in both its
iron ore and metallurgical coal operations, hence, further spread widening. Considering the
companys heavy debt load after years of acquisitions and capital expenditures, we think
the current spread comes up short in compensating bondholders for the significant downside
risks facing this company.
Although our view on metallurgical coal demand is less than rosy, we are gradually warming
up to thermal-coal producers, particularly the Powder River Basin, or PRB, coal companies
such as Cloud Peak (CLD, rating: BB+). Even though the scorching summer did little to help
our global food production, it was more than ideal to get the overflowing domestic steamcoal inventory situation under control. Heading into 2013, we think coal producers are facing
a much more benign pricing environment, particularly as natural gas prices rebound from
their nadir. This environment is in stark contrast to the few years prior to 2013. We think
PRB coal producers should have an easier time generating positive cash flows in 2013, which
ideally should be used toward repairing their battered balance sheets, granting them some
much-appreciated breathing room should steam-coal prices head downward again.
The weak global economy is not doing much favor to any of the steel companies under our
coverage. An uncertain demand picture is pressuring steel companies profit generation in
2013 despite some reprieve from raw-materials prices. Order books look quite sparse at this
18
point compared with years prior, which bodes ill for the credit quality of the industry.
Looking ahead, we continue to favor the bonds of companies that can comfortably weather
a sharp and sustained slump in commodity prices. With this in mind, we prefer low-cost
producers like Southern Copper (SCCO, rating: BBB+), Vale (VALE, rating: BBB+), and Cloud
Peak over comparably higher-cost operators like Cliffs and Appalachian coal producers such
as Arch Coal (ACI, rating: UR-/B) and Alpha Natural Resources (ANR, rating UR-/B+).
Contributed by Min Tang-Varner
Consumer Cyclical
After a stellar 2012, we dont expect to see material additional spread tightening in 2013
among our consumer cyclical names. We expect solid, stable credits that target a certain
capital structure will outperform the sector, as there are a number of names facing fundamental headwinds or self-inflicted wounds.
We are monitoring the tenuous credit situations as they unfold at J.C. Penney (JCP, rating:
B), Best Buy (BBY, rating: BB-), and RadioShack (RSH, rating: CCC). Positive results from the
turnaround effort continue to elude J.C. Penney, and we believe it will be some time before
the firms efforts bear fruit. J.C. Penneys earnings have declined sharply, which has driven
lease-adjusted leverage to 14.4 times from 4.4 times at year-end 2011, despite a $230
million reduction in debt.
Best Buy and RadioShack are facing severe fundamental headwinds, including the inability to defend market share from Amazon, mass merchants, and key vendors such as Apple
as well as the dilutive impact that digital distribution will have on productivity. Best Buys
margin compression, coupled with weaker sales, has pushed lease-adjusted leverage,
which is now 3.3 times from 2.7 times at year-end 2011. However, the firms debt maturities are manageable as the five-year cash flow cushion is greater than 1 times our base-case
expense and obligation forecast. RadioShack is burning cash as it continues to post operating losses, and we have concerns with its longer-term liquidity.
We are also mindful of companies rewarding shareholders at the expense of the balance
sheet, such as entertainment companies Time Warner (TWX, rating: BBB+) and Discovery
Communications (DISCA, rating: BBB). We recently downgraded our issuer credit rating for
Discovery Communications to BBB from BBB+ as the firm has been continually rewarding
shareholders at the expense of its balance sheet strength. Discovery has issued $1 billion
in debt this year and repurchased more than $1 billion in shares. As a result, the firms
leverage has ticked up to just over 3 times as of Sept. 30 from 2.3 times at year-end 2011.
Additionally, Time Warners net leverage has increased to around 2.5 times in its thirdquarter (managements target), from the 2 times level that it has been at during the past
few years. Thus far in 2012, Time Warner has spent $2.8 billion in share repurchases and
dividends, relative to $1.9 billion in free cash flow. Entertainment peer Disney (DIS, rating:
A+), on the other hand, has returned cash to shareholders in earnest, yet maintained a stable
credit profile.
Contributed by Joscelyn MacKay
19
Consumer Defensive
The drought last summer in the U.S., as well as severe weather conditions in other agricultural-export nations, has driven prices for many agricultural commodities well above
historical averages. Elevated soft commodity costs will put additional pressure on gross
margins as consumers remain vigilant about maximizing their limited income amid continued economic uncertainty, particularly in developed markets where high unemployment
levels and austerity measures constrain discretionary spending. Consumers in emerging
markets will likely feel a disproportionate amount of the rising commodity costs as food
expense represents a much larger portion of household budgets than in the developed world.
However, we note that higher input costs will affect firms throughout the consumer defensive space to varying degrees. Firms that we believe have wide or narrow economic moats
will have substantially greater ability to pass through cost increases, support their brands
with targeted marketing spend, and invest in product innovation. We expect firms with wide
economic moats and strong brand equity, such as SABMiller (SAB, rating: A), McCormick
(MKC, rating: A+), and Diageo (DGE, rating: A-), are best-positioned to be able to both defend
volumes and market share as well as pass through price increases. Relative to firms with
these long-term sustainable competitive advantages, companies whose portfolios consist of
second- and third-tier brands will likely struggle.
In the consumer defensive sector, sluggish growth has limited opportunities for organic
growth, leading management teams to identify nonorganic ways to grow their businesses
or reward shareholders. For example, after repeated attempts, ConAgra (CAG, rating: A-/
UR)which has been on our Bonds to Avoid Listwas finally successful in its attempts to
acquire RalCorp (RAH, rating: BBB+/UR). ConAgra paid 12 times fiscal 2012 adjusted EBITDA
on an enterprise value basis for the private-label manufacturera hefty price, in our view.
Although the largest by far, this is the sixth acquisition ConAgra made this year and considering the private-label segment remains fragmented, we suspect ConAgra isnt done with
acquisitions yet.
Dean Foods (DF, rating: B+) announced that it would spin-off its WhiteWave-Alpro business
in its attempt to increase shareholder value. As this segment is a much higher-margin and
higher-growth business than the firms remaining segments, management believes this
segment will garner a higher multiple in the equity market. Dean plans on using proceeds
from this spin-off along with proceeds from the sale of its Morningstar (unrelated to
Morningstar, Inc. the publisher of this article) division to repay debt and reduce leverage.
Although we are encouraged by the reduction in leverage, we are concerned that the volatility inherent in Deans remaining businesses would negatively affect the firms credit metrics
during downturns. Beyond strategic acquisitions and spin-offs, a number of firms such
as Campbell Soup (CPB. rating: A-) and Brown-Forman (BF.B, rating: A+) declared special
dividends. Depending on the outcome of the negotiations to resolve the fiscal cliff, if tax
rates on dividends are increased, it could lead to a slowdown in dividend growth and prompt
issuers to favor share repurchases. In a best-case scenario for creditors, it may prompt
management teams to reinvest cash flow in their businesses to further organic growth.
Contributed by Dave Sekera
20
Energy
As we suggested in our outlook for the fourth quarter, strength in the offshore deep-water
market helped drive spreads tighter for oilfield services companies, while exploration and
production firms, such as Devon Energy (DVN, rating: BBB+), which had lackluster production gains, experienced significant spread volatility. The initial reaction in the E&P space
following lower production growth and third-quarter earnings that missed estimates was to
widen spreads, but we view the discipline companies have shown by not chasing production
growth as a credit positive.
Natural gas drilling has been scaled back across the industry, and production from existing
wells has declined, pushing gas storage levels down from 11% above the five-year average
at the start of the fourth quarter to only 5% now. We recently updated our analytical
approach to estimating the marginal cost of domestic natural gas production, which lowered
our 2015 estimate from $6.50 per thousand cubic feet to $5.40 per mcf. Despite our lower
2015 estimate, given current trends, we reiterate our bullish take on natural gas prices,
as U.S. natural gas production is poised to decline in 2013 and storage levels are closer to
normal.
We believe supply and demand will begin to normalize in the first half and thus shift our
attention away from concerns about near-term spread movements for natural gas-focused
E&P companies toward those companies which will benefit the most from higher natural gas
prices. As the market becomes comfortable with Devons disciplined drilling and weaker LTM
credit metrics, we believe there is potential upside in Devons debt. The company has roughly 20% of its 2013 natural gas production hedged, which allows the company to substantially
benefit from higher prices. In high yield, both Cimarex Energy (XEC, rating: BBB-) and Range
Resources (RRC, rating: BBB-) will benefit from higher prices, though we favor Best Idea
Cimarex, as we believe Range debt already reflects higher prices. Cimarex has a minimal
hedging program such that higher prices will reverse the recent trend of capital expenditures
outstripping operating cash flow. Cimarexs concentrated portfolio and low equity valuation make it an attractive valuation target, adding additional return potential as natural gas
markets improve.
Contributed by David Schivell
Health Care
With President Obama re-elected, we suspect health-care players will focus on the implementation of the Patient Protection and Affordable Care Act and results of the fiscal cliff
negotiations going forward. Specifically, the PPACA may usher in paradigm-shifting changes in the managed-care industry, which is the primary cause for the current consolidation
wave in this niche. For example, last quarter, Humana (HUM, rating: BBB) agreed to buy
Metropolitan Health Networks (MDF). In the third quarter, WellPoint (WLP, rating: BBB+)
agreed to acquire Amerigroup (AGP, rating: BBB+), Aetna (AET, rating: BBB) announced plans
to buy Coventry (CVH), and United Health (UNH, rating: A-) agreed to buy the top health
insurer in Brazil, Amil. These moves are all efforts to gain scale and diversify revenue to
offset expected negative consequences of the PPACA in the sector. For example, the act
21
will create state-based exchanges through which individuals and small businesses can
purchase standardized health insurance policies, receive government subsidies to offset
premiums and cost sharing, and determine Medicaid eligibility. We think these exchanges
and other PPACA-related changes might result in heightened rivalry and new entrants to the
managed-care industry, including accountable care organizations (ACOs) which may become
insurance entities themselves one day. Although a long-term threat, this shift is beginning
to take shape now and could affect our view of managed-care organizations going forward.
Also, with the fiscal cliff looming, caregivers are facing 2% reimbursement cuts on U.S.
entitlement programs (Medicare and Medicaid) if sequestration is implemented. That would
directly squeeze profitability of health-care providers, including the highly leveraged hospital
chains we cover, such as HCA (HCA, rating: B+) and Tenet Healthcare (THC, rating: B).
On the higher end of the credit-quality spectrum, we suspect capital-allocation practices will remain in focus, as many firms are facing weak earnings-growth outlooks that are
testing the patience of shareholders. With cash-rich balance sheets and borrowing costs
near historic lows, wed expect health-care firms to continue seeking ways to fill gaps in
profitability growth by making debt-funded acquisitions, increasing share repurchases, and
increasing dividends to appease shareholders. For example, in the Big Pharma niche, wed
highlight AstraZeneca (AZN, rating: AA) as the most likely to use practices that are unfriendly to debtholders to fill its profitability gap.
Contributed by Julie Stralow
Industrials
Across the industrial landscape, balance sheets and credit metrics generally held steady
during the past quarter. However, spread levels began moving wider late in the quarter,
likely affected by the uncertainty surrounding the outcome and potential economic impact of
the pending fiscal cliff. As an SAIC (SAI, rating: BBB+) executive noted on a recent conference call, As we continue to accelerate toward the fiscal cliff, from our perspective the
fog is getting thicker. If the full budget cuts as mandated by sequestration are enacted,
defense companies could see sharp declines in orders almost across the board. We see
this as putting pressure on credit metrics and spreads, which supports our cautious view
of the sector as it already trades tight. During the quarter, however, Raytheon (RTN, rating:
A-) issued 10-year bonds at a spread of +90 which we viewed as rich relative to Lockheed
Martin (LMT, rating: A-) and Northrop Grumman (NOC, rating: A-) and well inside the
Morningstar Industrials Index. We generally prefer lower-rated credits which might benefit
from being acquired, such as Alliant Techsystems (ATK, rating: BB+).
Across other key subsectors that we follow, fundamentals still look good for the rail sector,
though low natural gas prices continue to adversely affect utility coal volumes. The Eastern
rails, Norfolk Southern (NSC, rating: BBB+) and CSX (CSX, rating: BBB+) are most affected
given their exposure to high-cost Appalachian coal. Although spreads across the sector
remain relatively tight, within the sector we still like the bonds of Union Pacific (UNP, rating:
A-) given its exposure to cheaper Powder River Basin coal and attractive relative value. We
also like the bonds of Kansas City Southern (KSU, rating: BBB-) as it continues its push to
22
investment grade at the Nationally Recognized Statistical Rating Organizations. Within the
waste management space, we think the bonds of both Waste Management (WM, rating:
BBB+) and Republic Services Group (RSG, rating: BBB+) look attractive relative to other
defensive sectors, such as the rails. Continued growth in the U.S. economy should lead to
gradually improving margins and stable credit metrics for both names. In the agricultural and
construction equipment sector, fundamentals have improved out of the downturn; however, weakness in Europe and slower growth in emerging markets are near-term headwinds.
In addition, the drought conditions experienced this past growing season could crimp new
equipment demand from North American farmers. We generally view the sector as fairly
valued at this time, but like the bonds of AGCO (AGCO, rating: BBB-), given its relatively wide
spreads for what we view as investment-grade risk.
One sector that continues to show positive momentum is auto. The monthly U.S. SAAR
reached a new high for the year at 15.5 million units in November after a similarly strong
October. We believe that robust domestic demand will continue during the next several
quarters as pent-up demand remains strong and the fleet is aging. This will support our
investment-grade Best Idea Ford Motor Credit (rating: BBB-) as well as the junk-rated auto
dealers and auto suppliers. In November we published a report on Delphi (DLPH, rating: BBB)
whose junk-rated bonds offer very attractive spreads in the low-300s relative to our much
more constructive view of the credit. We also like Tenneco (TEN, rating: BB) for more pure
junk buyers as the firms 2020 bonds offer yields around 4.75%.
Contributed by Jeff Cannon and Rick Tauber
Tech & Telecom
The purported death of the PC has driven a wedge into the technology sector. Spreads
across much of the sector have followed the broader credit market during the past three
months, ending the period more or less unchanged. Firms with heavy PC exposure, on the
other hand, have dramatically underperformed: Dells (DELL, rating: A+) 4.625% notes due
2021 have widened 35 basis points to +207, Hewlett-Packards (HPQ, rating: BBB+) 4.05%
notes due 2022 are out 55 basis points to +280, and Intels (INTC, rating: AA) 3.30% notes
due 2021 have moved 29 basis points wider to +107. We believe that the death of the PC has
been exaggerated and that these firms have the ability to manage through the maturation of
this market.
We believe HP bonds are particularly attractive, and the firm is on our investment-grade
Best Ideas list. HP posted an 11% drop in PC sales during fiscal 2012 (ended in October), but
the firm still managed to post a 5% operating margin in this segment, down only 1 percentage point from the year before. The nice thing about the PC business is that HP doesnt have
to invest heavily in research and development, and costs are highly variable. We expect PC
sales will continue to fall into 2013 as more consumers turn to tablets and other devices,
but we also believe that HPs PC business will remain profitable. Of course, HPs problems
extend beyond PCs, and the firm is working to turn around a struggling services business
and integrate a poor software acquisition. Ultimately, though, the diversity of HPs
23
businesses provides creditors with a hedge should a precipitous decline in PC demand

actually materialize.
Perhaps nothing illustrates the irrational disdain investors have for the PC market as clearly
as the early-December debt issuances at Intel and AT&T (T, rating: A-). Intels 10-year notes
priced at a spread of +115 basis points over Treasuries, 10 basis points wider than AT&Ts
10-year issuance that priced two days later. Following the new debt issuance, Intel holds
$21 billion in cash and investments versus about $13 billion in debt (less than 0.6 times
EBITDA). While Intel will certainly continue to buy back stock, the firm, if it chose to do
so, could repay its entire debt load solely out of cash flow in about three years while also
funding its dividend. AT&T also generates steady cash flow, but it carries far greater leverage today and recently indicated a willingness to take net leverage higher still to 1.8 times,
excluding its sizable pension obligations, as it ramps up capital spending. AT&Ts increased
capital budget is in direct response to competitive pressures from Verizon Wireless, which
has gained a clear lead in the race to build out LTE technology. AT&T also faces competitive
threats from the industrys smaller players, as T-Mobile USA plans to gain scale through the
acquisition of MetroPCS (PCS, rating: BB-) and Sprint Nextel (S, rating: BB-) has built a war
chest via Softbank. AT&T is also increasing investment in its fixed-line networks to better
compete with the cable companies. Although we expect both AT&T and Intel will successfully navigate the challenges in front of them, each still clearly faces risks to future cash flow.
Given Intels far stronger balance sheet, we just dont think relative spreads on the firms
bonds make sense.
Contributed by Mike Hodel
Utilities
Two environmental regulations the U.S. Environmental Protection Agency finalized in 2011
continue to cloud the sectors near-term landscape. Coal plant retirements and increased
capital investment are two likely outcomes we expect from final versions of the EPAs CrossState Air Pollution Rule, or CSAPR, and the air toxics rule, or MATS. While CSAPR was fully
vacated in August 2012 after having been stayed in December 2011, we believe the EPA will
revise the rule rather than advance it up to the Supreme Court. Additional environmental
rules could follow in 2013 addressing water cooling and coal ash disposal. All of these likely
will raise costs for consumers and put more rate pressure on regulated utilities. Additionally,
we believe President Obamas re-election will provide continued support for subsidized
renewable energy investments in 2013.
Despite environmental-compliance risks, we view regulated utilities as a defensive safe
haven for investors skittish about ongoing domestic and European-induced market volatility. As economic and geopolitical uncertainties begin to fade, we expect moderate spread
contraction, particularly down the credit-quality spectrum. However, given historically tight
parent company spreads on higher-quality utilities facing lackluster earnings growth and
the prospect of falling allowed returns on equity (in line with low interest rates), we urge
bond investors to approach investment-grade utilities with caution. Specifically, we advise
investors to focus on a shorter-medium-term duration yield orientation as any potential rise
24
in interest rates in 2013 could quickly erode spread outperformance given historically tight
trading levels.
We expect high-quality parent company utilities issuers to maintain their elevated pace of
debt market issuance in 2013, taking advantage of low rates to refinance and/or prefinance
up to $85 billion of projected capital investments. Environmental capital expenditures will be
a significant component of debt-funded capital expenditures, though also highly dependent
on the severity of ongoing regulatory rulings, implementation timelines, and energy-efficiency initiatives. Utilities are eager to secure financing ahead of potential allowed ROE cuts as
regulators align their outlook with a sustained lower interest-rate environment. In 2012, we
note that several state regulators approved or proposed allowed ROEs below 10%, limiting
creditors margins of safety as regulatory lag diminishes.
Unregulated independent power producers face high uncertainty levels in 2013 and beyond.
Power prices will remain severely strained as long as natural gas prices remain low. Excess
natural gas supply and a potential unseasonably warm 2013 winter could push gas prices,
currently hovering around the $3.50/mmBtu mark, back down to historic lows ($1.91/mmBtu).
Furthermore, we recently revised our midcycle power prices downward to reflect a $5.40/
mcf gas price (versus $6.50/mcf), negatively affecting projected margins. High natural gas
storage levels of 3,804 billion cubic feet (as of Nov. 30, 2012) remain 5% above the five-year
average storage level of 3,636 billion cubic feet. Moreover, we believe coal prices will generally remain under pressure in 2013 as environmental compliance stymies coal demand.
As such, we continue to expect merchant power producers to experience elevated liquidity constraints, especially within companies that own older coal plants in need of control
upgrades. Restructuring or reorganization at Edison Internationals (EIX rating BBB-)
merchant generation company, Edison Mission Energy, will be the first casualty following
Dynegy Holdings 2011 fourth-quarter bankruptcy filing and 2012 fourth-quarter emergence.
The industrys broad desire to accumulate regulated assets, whereby offsetting and/or
shedding merchant power plants, fueled M&A activity in 2012, but we expect this pace
to moderate in 2013. Representative deals that closed in 2012 include all-stock mergers
between Northeast Utilities (NU, rating BBB) and Nstar; Exelon (EXC, rating BBB+) and
Constellation Energy; and Duke Energy (DUK, rating BBB+) and Progress Energy.
In July, independent power producer NRG Energy (NRG, rating: BB-) announced it had agreed
to acquire GenOn Energy (GEN, rating: BB-) for $1.7 billion in an all-stock transaction which
remains on track to close in the first quarter of 2013. Rationale for this transaction includes
greater scale (highlighting NRGs retail expansion), generation fuel and revenue diversity,
and reduced liquidity needs. Although we view GenOn as the weaker performer of the two,
NRG announced that it will reduce leverage by $1 billion, principally at GenOn, following
the merger.
We expect any further industry consolidation to capture cost efficiencies, geographic diversification, and growth opportunities in new retail markets, particularly in Ohio. Along these
25
lines, we highlight ongoing regulatory action in Ohio that could force American Electric
Power (AEP, rating: BBB+) to divest its power-generation business from its transmission and
distribution business by 2015.
Contributed by Joe DeSapri
Our Top Bond Picks
We pick bonds on a relative-value basis. Typically, this means comparing a bonds spread
against spreads on bonds that involve comparable credit risk and duration. Following is a
sample of a few issues from our monthly Best Ideas publication.
When selecting from bonds of different maturities from a single issuer, we weigh a variety
of factors, including liquidity, our moat rating (were willing to buy longer-dated bonds from
a firm with sustainable competitive advantages), and our year-by-year forecast of the firms
cash flows in comparison with the yield pickup along the curve.
Top Bond Picks
Ticker
Issuer
Rating
Amgen
AMGN
AA-
Potash Corporation
POT
Maturity
Coupon
(%)
Price
(USD)
Yield
(%)
Spread to U.S.
Treasuries
2022
3.63%
$108.38
2.62%
105
2020
4.38%
$116.00
2.46%
138
Cameron International CAM
A-
2022
3.60%
$104.50
3.04%
148
Mattel
MAT
A-
2020
4.35%
$109.63
2.96%
176
Scana
SCG
BBB+
2022
4.13%
$103.88
3.62%
211
Data as of 12-12-12. Price, yield, and spread are provided by Advantage Data, Inc.
Amgen (AMGN, rating: AA-)
We still believe Amgen investors are getting a higher yield than warranted for this highquality biotech issuer. The market and rating agencies dont appear to be giving Amgen
credit for the cash it plans to hold on its books, which nearly offsets its recently inflated
debt position even after large share repurchases and a dividend increase. Even if we strip
out all of the cash from Amgens balance sheet, wed still only cut our rating by about two
notches to A. However, Amgens on-the-run 2022 notes trade about 30 basis points wider
than the average A credit, revealing an opportunity for long-term investors. Of note, Amgen
recently reported progress with several pipeline candidates; this progress gives us more
confidence in its ability to replace lost sales on older products facing biosimilar competition, which should reduce Amgens need to make a large acquisition that could deplete its
cash resources. Also, while the market experienced some indigestion from Amgens heavy
issuance in 2011 and 2012, management announced in the second quarter that it had enough
financing to fully fund its planned repurchase program. Therefore, we suspect Amgen will be
a more modest debt issuer going forward.
Potash Corporation of Saskatchewan (POT, rating: A)
Potash Corp. is the largest independent agricultural chemical company in the world. The
company has a wide economic moat, fostered by its strategic potash assets that are by far
26
at the lowest end of the global potash-production curve, long reserve life, and crucial role
in setting global potash prices by leading negotiations between the Canadian exporting
association (Canpotex) and foreign buyers. During the past seven years, Potash Corp. has
embarked on significant capacity-expansion projects supported by its internally generated
cash flows, and we expect the capital outlay to come to a close in the next 1218 months.
Although the additional capacity might not directly boost Potash Corp.s near-term sales
volume, we think the higher capacity should boost Potash Corp.s share of exporting quota
against its rivals (the exporting quotas among Canpotex producers are driven by capacity, much like Saudi Arabias role in the Organization of the Petroleum Exporting Countries).
In addition, weak crop harvests in the North American Corn Belt, along with elevated corn
and soybean prices, provide an ideal environment for healthy farm economics, which should
strongly support fertilizer prices for an extended period.
Potash Corp.s prominent position in this industry should support its bond performance both
on a relative value basis and a fundamental perspective. We still see compelling value for
this rating, as the firms enviable cost profile and low leverage would allow it to weather
even a sharp and sustained drop in global economic growth. We also like Potash Corp. on a
relative-value basis. For instance, the 2020 bonds are trading roughly 45 basis points wide
of similar-dated debt of chemical peers such as E.I. du Pont de Nemours (DD, rating: BBB+),
which sports a two-notch-lower rating and a 2021 maturity bond indicated at a spread of
100 basis points over Treasuries, a gap we dont think is merited given our more favorable
assessment of Potash Corp.s underlying credit quality. In addition, Agrium (AGU, NR), another agricultural chemical company that is significantly smaller in size, has a 2022 bond thats
trading at a spread of 152 basis points over Treasuries. We believe Potash Corp. should trade
at least 25 basis points inside of Agrium.
Cameron International (CAM, rating: A-)
Camerons third-quarter earnings support our thesis that, after 20 years of low volumes of
new deep-water drilling-rig deliveries, a surge in new rig orders to replace the aging fleet
will benefit the company. Accounting for the recent acquisition of TTS Group, Cameron is
now positioned to capture even more value from new deep-water rig construction. The
recently announced OneSubsea joint venture with Schlumberger (SLB, rating: A+) should
allow Cameron to capture even more value from the deep-water market. OneSubsea
combines Camerons equipment design, manufacturing, and installation expertise with
Schlumbergers reservoir knowledge and well-completions expertise to develop complete
subsea production systems with the goal of increasing reservoir recovery from deep-water
wells. As the JV improves Camerons competitive position, we have raised Camerons moat
trend to positive from stable, supporting our positive outlook for Camerons bonds.
The company is exiting a period of high capital expenditures that outstripped operating cash
flows and should begin to generate significant positive free cash flow in the coming quarters.
As such, we believe current gross leverage of 1.9 times on a LTM basis will decline to 1.2
times in 2014. Camerons net leverage of 1.0 times on a LTM basis approaches that of larger
peers Schlumberger at 0.6 times net leverage and Halliburton (HAL, rating: A) at 0.5 times
net leverage. Due to the firms increasing free cash flow, we predict that net leverage will
27
decline to 0.4 times by 2014. With the companys liability to the Macondo oil spill sufficiently ring-fenced, we believe spreads will continue to tighten in the coming quarters as
Cameron monetizes its strong order backlog. Schlumberger and Halliburton are appropriate
upside comps, with both trading roughly 55 basis points tight to Cameron, while peers Ensco
(ESV, rating: BBB) and Noble (NE, rating: BBB-) are good downside comps, trading 25 and
30 basis points wide of Cameron, respectively. Additionally, the 3.60% notes trade flat with
the Morningstar Industrial BBB+ index, offering potential outperformance on a risk-adjusted
basis even if spreads move in line with the index.
Mattel (MAT, rating: A-)
Mattels bonds trade nearly 70 basis points wide of Morningstars 10-year A- index, but
also look compelling when compared with other A-, narrow-moat consumer cyclical names
with similar leverage. Retailer Nordstrom (JWN, rating: A-) and entertainment company
Viacom (VIAB, rating: A-) are two such examples, as they both have narrow economic moats
and lease-adjusted leverage around 2 times. Nordstrom and Viacom have 10- and 30-year
bonds that trade around 100 basis points and 145 basis points, respectively. Given resilient
consumer spending in the toy category, we see no reason these two firms should trade that
much tighter than Mattels bonds of similar maturities.
Scana (SCG, rating: BBB+)
Benefiting from leading regulated shareholder returns (mid-10%), Scana operates in a highly
supportive Southeastern regulatory environment. Scana will further profit from a vast
pipeline of infrastructure investments that will earn the firm its leading utility returns on
equity. Scanas 2022s trade roughly 35 basis points wide of the average utilities BBB+ rated
issues in the Morningstar Corporate Bond Index. They also trade about 5085 basis points
wide of similar-duration paper issued by comparably rated regulated utility peers, such as
Duke Energy (DUK, rating: BBB+) and Xcel Energy (XEL, rating: BBB+). We believe Scanas
2022 bonds represent a compelling positive carry opportunity that is positioned for upside
upon the successful completion of two new units at its V.C. Summer nuclear power plant in
South Carolina, expected in 201718. In the worst-case scenario, assuming Scanas nuclear
plant is stalled or permanently derailed, we believe South Carolina laws will allow Scana to
recover its capital investment as well as any stranded costs through rate-base increases.
Last March, Scana successfully attained its combined license from the Nuclear Regulatory
Commission. Clearing this last significant regulatory hurdle, Scana now has the right to
construct and operate its planned V.C. Summer nuclear plants.
Dave Sekera, CFA, has a position in the following securities mentioned above: INTC
28

December 21, 2012
Outlook for the CMBS Market

Investor demand, coupled with expected continued government bond
buying, is fueling optimism of increasing growth for CMBS next year.
By Mike Biddle | Director of Quantitative Research for Structured Ratings
3 Investor demand for CMBS persists, but macroeconomic uncertainty could quickly change
market dynamics and derail improving CMBS fundamentals.

3 Different commercial real estate sectors may experience different economic pressures
within the same environment.

3 The CMBS delinquency rate has decreased from one-year prior, and the dollar amount of
delinquencies should trend in a favorable direction if investor demand remains high.

Many observers of the CMBS market are asking the question, What can I expect in 2013?
The industry consensus appears to answer this question with a resounding better than
2012. In the closing months of 2012, CMBS deals were well oversubscribed, and commercial mortgage-backed securities priced in the past month have sold at or near the tightest
yield spread premiums since 2007, confirming investor demand in the wake of increased
supply. This investor demand, coupled with the expected continued government bond buying,
is fueling optimism of increasing growth from 2012s more than $40 billion of issuance to a
possible $50 billion$75 billion next year.
Even though many in the market are optimistic, there is macroeconomic uncertainty that
could quickly change market dynamics and derail the improving CMBS fundamentals. If the
EU debt crisis flares or the fiscal cliff comes to fruition, widening spreads and lowering new
issuance profitability could stifle the market. Also, components of the ongoing Dodd-Frank
legislation could cause the reduction of investor demand, especially for B-piece buyers.
Commercial real estate tends to lag the overall economy, but different sectors may experience different economic pressures within the same environment.
Office Sector: Employer demand and supply of office space are the key drivers of the office
sector. The demand for office space has been suppressed by high unemployment and the
increased telecommuting of employees, both trends we believe will continue. Since the
development of new office space can take years to come to market, there is a risk that newly
built supply will outpace demand even though unemployment is expected to slowly improve.
Retail Sector: The retail sector is made up of traditional bricks-and-mortar stores to secure
CMBS loans. The traffic to retail stores has been reduced by increasing e-commerce, a trend
we expect to continue. Additionally, we expect that unemployment shall remain at elevated
levels and discretionary spending shall remain low next year, limiting shopper demand. These
29
risk factors will continue to put pressure on retailers and negatively affect retail property
performance.
Multifamily Sector: The multifamily sector was the first type of commercial property to
recover from the meltdown in 2007. The weak residential housing market led to increased
foreclosures, and a large number of people seeking new housing. One of their options, if not
their only option, is to move into rental housing provided by multifamily apartment units,
increasing the demand for this property type. We expect that the weak housing market will
continue providing for high demand of multifamily properties.
The CMBS delinquency rate reached 9.05% through November, which is a 0.37% decrease
from one year prior. The dollar amount delinquent was $53.76 billion, which is a $6 billion
year-over-year change from 2011. We expect the dollar amount to trend in a favorable direction, but this assumption is predicated upon the CMBS market demand and special servicers
actions to resolve delinquency. If investor demand remains high and spreads remain tight,
the lenders will be able pass on the cost savings to borrowers. This will facilitate more
liberal underwriting and financially beneficial mortgage terms to borrowers. Additionally, the
majority of the outstanding loans were originated between 2004 and 2007, many of which
will have balloon payments over the next four years. If CMBS investor demand remains high,
there will be increased probability that refinancing into another loan will be available. If the
financing is not available, the ability of the special servicer to extend maturity or modify the
mortgage terms will dictate performance.
30

December 21, 2012
Our Outlook for Basic Materials Stocks

Companies with more exposure to the United States should fare
better than those tied to demand in Europe and China in 2013.
By Elizabeth Collins, CFA | Director of Basic Materials Equity Research
3 Fundamentals in U.S. thermal coal should continue improving next year, thanks to rebounding
natural gas prices, a hot summer in 2012 that helped whittle down overflowing coal inventories, and significant curtailment in domestic coal production.
3 We think pricing pressure for most industrial metals will continue in 2013, as Chinathe most
important source of demandinevitably shifts away from its investment-driven growth model.
3 The outlook for steel demand growth in 2013 is strong in the Americas, but we think there is
downside risk in Europe and China.

The outlook for basic materials companies in 2013 is quite mixed. Broadly speaking, companies with more exposure to the United States should fare better than those tied to demand
in Europe and China, in our view. In particular, our outlook for companies leveraged to U.S.
construction activity is much more favorable than that for the miners dependent upon
Chinese consumption. This is a sharp reversal of the landscape that has prevailed over the
last several years. Today only 6% of our basic materials coverage universe sports a 5-star
rating, compared with 9% three months ago.
Industry-Level Insights
Agriculture
While the scorching temperatures in the United States are several months in the rearview
mirror, crop supplies remain tight and prices elevated. This is good news for farmers, many
of whom will see the volume component of their revenue calculation drop because of lower
yields. Given recent USDA estimates, it looks like total farm income in 2012 will end up in the
same ballpark as 2011, which was a very strong year. For this reason, we think growers will
have ample resources to purchase crop inputs for the 2013 growing season. Further, were
expecting another big number of planted acres in the U.S., as farmers look to take advantage
of high crop prices.
With North American growers likely planting fence row to fence row in the spring, demand
for crop inputs should be strong in 2013. In potash, producer inventories are working down
after Russian imports and dealer uncertainty caused inventories to balloon early in 2012.
However, near-term global uncertainty for potash remains. China and India have yet to sign
new contracts for potash. This has led not only to lower volumes shipped to the two
countries, but has also led to hesitation from other international buyers expecting potash
31
prices to come down when new contracts are signed. Meanwhile, in the United States there
has been talk that potash application rates could be pressured in the hardest-hit drought
areas. All of this makes for heightened near-term uncertainty. However, none of the recent
developments have materially changed our long-term view of the potash market. Were still
expecting prices to creep down in the long run, as supply grows faster than demand.
With corn prices remaining high and natural gas costs low, conditions are still very favorable
for North American nitrogen producers. Corn requires nitrogen application each season, and
were expecting another huge number of planted corn acres in the United States next
season. The phosphate market has shown some softness recently, but inventories remain
relatively tight. Along with potash, phosphate application rates could see pressure next year
from the drought in the United States. Also, the Indian subsidiary policies that are supporting
nitrogen application and harming potash buying are also denting phosphate demand in
the country.
Building Materials
The stocks of most building materials producers performed quite well over the course of
2012 thanks to improving conditions in U.S. infrastructure and housing starts as well as
cost-cutting and price improvements across the globe. The outlook for demand in 2013 in the
U.S. is solid thanks to housing starts, an increase in private nonresidential awards, and an
expected increase in contract awards following the recent passage of a new highway bill.
The outlook for demand in Europe is much more muted. However, building materials companies are engaging in massive cost-cutting programs and pricing initiatives that are both
lowering their break-even levels during this time of weak demand and increasing their
leverage to improving volumes once demand eventually improves. However, most building
materials producers shares imply that some of that future profit improvement is expected.
We dont see a sufficient margins of safety in valuations in our coverage universe at
this time.
Chemicals
The third-quarter story for chemical producers was similar to the first half of 2012, with
demand softness in China and Europe constraining revenue. The slow demand environment
has led several prominent players including Dow Chemical DOW and DuPont DD to restructure operations to better fit demand. Many cuts will focus on downsizing European
operations, where demand is especially weak. Further, operating costs for companies making
basic chemicals in Europe have also been higher relative to costs in the U.S., due to the
discrepancy between natural gas and naphtha costs in the two regions. Despite a tough
environment, demand has not fallen off a cliff, as exhibited by Dows flat year-over-year
operating rate in the third quarter. Prices for some chemical players are under pressure, but
this has been at least partially offset by lower feedstock costs.
As we have mentioned before, we expect large diversified chemical players to lean on less
cyclical specialty products in this uncertain demand environment. In particular, companies
have been steadied by results from crop chemicals and genetically-modified seeds. We think
32
chemical players will continue shifting portfolios to specialty products in an effort to

improve margins and reduce cyclicality, and recent restructuring could help speed
this transition.
Coal
The last three months of 2012 have provided some respite for the beleaguered coal mining
equities after they endured a painful thrashing during the first nine months of the year. We
believe domestic coal prices are due for a rebound in 2013, which could help many of the
U.S. coal miners we cover. However, recovery will not arrive evenly across the coal sector, in
our view, with thermal coal producers faring better than metallurgical coal miners, and coal
miners producing from the western United States (particularly from the Powder River Basin)
outperforming peers focused on the eastern regions of the country.
2012 saw extreme looseness within the domestic coal supply and demand dynamic, which
was at its loosest during the second quarter of 2012. Supply and demand for domestic coal
began to gradually tighten during the back half of 2012, however, boding well for coal prices
heading into 2013. The improving fundamentals of the U.S. coal market are due to a number
of factors, including natural gas prices rebounding from their nadir, a hot summer that helped
whittle down overflowing coal inventories, and significant curtailment in domestic coal
production, particularly from the eastern U.S. coal miners. The EIA projects 2013 domestic
coal burn for power generation to rebound by 40 million50 million tons from the dismal 2012
levels, assuming that normal weather patterns return, and natural gas prices remain at
current levels. With natural gas prices now hovering around $3.50 per MMBtu, lower-cost
coal from the western parts of the U.S. can effectively compete against natural gas on a
price/energy basis. Low-cost coal from the Powder River Basin (PRB), in particular, looks
underpriced versus natural gas at its current spot price of roughly $10 per ton. Coal miners
with large exposure to the PRB include Peabody Energy BTU, Cloud Peak Energy CLD, and
Arch Coal ACI, with Cloud Peak representing the purest play on PRB coal prices.
Despite our optimistic outlook, coal inventories at the utilities still remain well above the
historical average, which we think will hinder domestic coal prices from rising to higher
normalized levels. Nevertheless, we are looking for domestic coal prices to slowly rebound in
2013 as this inventory overhang continues to be worked down, continuing the trend that
started this summer. We believe rising domestic coal prices will not lift all coal miners
equally, however. Higher-cost Appalachian coal still cannot compete versus natural gas at
current prices, and many of the production curtailments and mine closures announced by the
Appalachian coal miners this year may very well become permanent. Coal miners with heavy
exposure to Appalachian coal basins include Arch Coal, Alpha Natural Resources ANR, and
Consol Energy CNX. We are also not as sanguine about the prospects for metallurgical coal,
which is affected more by global economic activity than by domestic power generation
dynamics. We project slower global steel-making activity combined with significant supply
expansions in response to recent high metallurgical coal prices to cap gains in met coal
prices over the long term. Coal miners we cover with significant exposure to metallurgical
coal include Arch, Alpha, and Consol. For Arch and Alpha, our tepid price outlook for
33
metallurgical coal is exacerbated by the fact that these two firms leveraged their balance
sheets to gain additional exposure to metallurgical coal via major acquisitions in 2011.
Forest Products
The recovery in U.S. housing starts continues to benefit timber and wood products companies like Weyerhaeuser WY, only partly offset by weaker conditions in the export market due
to a slowing China. We see prospects for strong improvement in 2013. While domestic
residential construction activity has recovered substantially from trough-level lows, the pace
of new building remains well below the potential underpinned by U.S. demographic drivers.
A number of major bleached eucalyptus kraft, or BEK, producers, such as Fibria Celulose FBR,
Suzano, and Ence aim to increase BEK prices starting Jan. 1. This comes on the back of an
October price increase that had mixed results, as BEK inventory remains slightly overstocked.
Buyers generally resisted the announced price increases to the point where producers
needed to offer larger discounts to retain volumes. Further, Eldorado recently launched a
large BEK mill in Brazil that should more than offset the supply lost from capacity closures
elsewhere in the market. As such, we are not convinced that a planned BEK price increase
will be a major driver for narrow-moat Fibria in 2013. Rather, we think much of Fibrias
outlook depends on a stronger Brazilian real relative to the dollar.
Metals and Mining
Industrial metals prices enjoyed a fairly strong fourth quarter, buoyed by encouraging
macroeconomic readings from China, the announcement of QEIII in the U.S., and improved
sentiment on the European debt crisis.
Notwithstanding a fairly strong conclusion to the year, 2012 must be regarded as a disappointment for bulls that had expected to see fresh price records set in many commodities. As
it turned out, 2012 will go down in the books as a down year for every major industrial metal
we cover. This marks a sharp contrast to what has been a fairly strong year for equities, at
least in the U.S., where the S&P 500 is up 14% YTD as we write.
Decelerating growth in China, particularly on the metals-hungry investment side of the
economy, was the biggest downdraft for prices this past year. Notably, the biggest price
declines in 2012 were in those commodities most levered to the Chinese investment boom.
That list is topped by iron ore and metallurgical coal, where China accounts for over half of
global demand.
Recent indicators ranging from the manufacturing PMI to production data from the steel and
cement industries have been interpreted by many that Beijing has successfully engineered a
soft landing and expect growth to accelerate strongly into 2013, which would augur very
well for industrial metals prices.
This interpretation of the data seems predicated on the idea that the slowdown was
principally a cyclical phenomenon wrought by some combination of monetary tightening,
34
policy-induced weakness in the all-important real estate market, and poor external demand.
In other words, for China, its back to business as usual in 2013.
Wed suggest that this interpretation ignores the possibility that the investment-driven
growth model that defined the Chinese economy for the past decade is wholly exhausted.
From this perspective, the recent uptick in investment spending is likely to be short-lived. For
our part, we think this will mean renewed pricing pressure on most industrial metals in 2013,
making most of our metals mining coverage list a comparably unattractive place to be.
As for the precious metals sector, the big story during the second half of the year was the
mining strikes in South Africa that paralyzed the platinum, palladium, and gold miners in the
country. While work has now resumed at most of these South African mines, we believe the
recent labor strikes illustrate the ongoing labor tensions that have relegated South Africa as
the marginal cost supplier of precious metals around the globe, especially for gold. In
addition to the labor woes, South African gold miners are contending with geological
headwinds as they chase thin subterranean gold reefs ever deeper. Power cost inflation also
remains a major headache on the cost side for South African gold miners, as national power
provider Eskom is proposing double-digit power rate increases over the next several years in
order to fund investments in the countrys aging power infrastructure. All of these factors
will cause South African gold miners to remain as the marginal cost producers of gold going
forward, in our opinion.
We believe the recent South African mining strikes have reminded investors in both the
precious and industrial metals space of the importance of controlling ones geopolitical risk.
Of the gold miners we cover, we regard Agnico-Eagle Mines AEM, Goldcorp GG, and Yamana
Gold AUY as exhibiting relatively lower geopolitical risk based on where their mining assets
are primarily located. We believe the continued underperformance of the marginal-cost
South African gold miners also reinforces our notion that gold mining investors should focus
on low-cost gold miners that would be more insulated from downward movements in the
bullion price. Along that front, we would mention Eldorado Gold EGO and Yamana Gold as
being the two lowest-cost gold miners we currently cover.
Steel
The fourth quarter typically ends with a surge in U.S. steel pricing but this has yet to
materialize this year, partially because raw material costs have shown little strength.
Seasonal trends usually dictate scrap pricing in particular, but hesitant demand appears to
be the primary driver in the current environment. An uncertain steel demand outlook for
Europe and China combined with fiscal cliff concerns in the U.S. are causing steel buyers
to be more selective than typical for the season, a trend were also seeing in steel producers
with their raw material purchases. Lead times are reportedly only one month for hot-rolled
coil, compared with previous years that had order books full through February by the time
the winter holidays were in full swing. There seems to be some slowing in certain end
markets, namely agriculture and energy, but this is balanced by brighter signs from residential and non-residential instruction. Any improvement in these anemic markets could really
move the needle on domestic demand in 2013. Meanwhile, the supply/demand balance in the
35
U.S. appears to have stabilized, with capacity utilization moving back into the 70%75%
range after dipping below 70% in October.
Any concerns about the U.S. are playing second fiddle, however, with the World Steel
Association lowering its 2013 demand growth expectations for most of the world, while
raising the U.S. forecast. The outlook for Latin American steel demand remains strong, but
China and Europe are less encouraging, particularly if raw material demand can be used as a
gauge. Scrap exports from the U.S. plunged in recent months, with Europe and Asia the top
destinations, and iron ore inventories at the major Chinese ports have also fallen sharply.
Current forecasts for steel demand growth in Europe and China for 2013 are around 3%, but
we believe these have more downside risk than forecasts for the U.S. and Latin America.
Our Top Basic Materials Picks
Our Top Basic Materials Picks
Star Rating
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Cloud Peak
QQQQ
$28.00
Narrow
High
$16.80
Compass Minerals
QQQQ
$93.00
Wide
Medium
$65.10
Nucor
QQQQ
$57.00
Narrow
High
$34.20
Potash Corp.
QQQQ
$50.00
Wide
High
$30.00
Steel Dynamics
QQQQ
$22.00
Narrow
High
$13.20
Data as of 12-12-2012.
Cloud Peak CLD
Cloud Peak is a pure play on Powder River Basin, or PRB, coal prices, which we believe will
head much higher over the intermediate to long term. While investors wait for PRB coal
prices to head higher, Cloud Peak should provide a relative safe haven to ride out current low
domestic thermal coal prices thanks to the firms sturdy balance sheet, low production costs,
and conservative contract pricing. The company enjoyed a nice pop in its stock price after
the firm released third-quarter earnings, but we still see considerable upside in Cloud Peak
shares given our fair value estimate of $28 per share. Our investment pitch on Cloud Peak is
largely driven by our bullish forecast for PRB coal prices, which are currently trading for
roughly $10 per ton in the spot market. This price is significantly below the marginal
production cost in the basin of roughly $11 per ton on a cash basis, in our estimation, and we
regard this situation as being unsustainable. Also, with natural gas prices now hovering
above $3.50 per million BTUs, we estimate that PRB coal would be cost-competitive versus
gas in large regions of the country even if PRB coal prices were to rise to $15 per ton. Also,
the U.S. Energy Information Administration expects domestic coal burn to increase 40
million50 million tons in 2013 from 2012 given the unusually warm winter and low natural
gas prices that prevailed earlier this year. In the meantime, we believe Cloud Peaks modest
financial leverage, low-cost position in the PRB, and contract pricing that have fixed 2013
coal selling prices at favorable rates for more than 80% of the firms estimated production
next year, should help shield investors from low PRB coal prices over the near term.
36
Compass Minerals CMP
Unfavorable weather events are hurting Compass near-term earnings. This company has
very strong and sustainable competitive advantages for the production of highway deicing
salt and sulfate of potash specialty fertilizer. The companys rock salt mine in Goderich,
Ontario is the worlds largest and has access to a deep-water port, which allows Compass to
deliver salt cost effectively to customers throughout the Great Lakes region. Further, the
companys Great Salt Lake solar evaporation facility allows the company to produce sulfate
of potash specialty fertilizer at a much lower cost than most other producers that use ore
mining or a chemical process. We think the stock is currently depressed because the
companys near-term profitability is being weighed down by a trio of unfavorable weather
events: tornado damage costs and production interruptions at the Goderich rock salt mine,
rainfall-related production shortfalls at the Great Salt Lake facility, and mild winter weather
in the Midwest that is hurting demand for deicing salt. Contract prices between highway
deicing salt producers and government entities are determined during the summer bidding
season. The mild winter of 201112 has resulted in excess inventory at both the producer
and customer level. Customers have reduced their bid volumes for 201213 (they assume
normal winter weather but adjust for inventory on hand). This has resulted in pricing thats
weaker than the 3%4% annual average increase that the industry is used to. Compass
earnings should grow long term as these issues are resolved, and as the company expands
its sulfate of potash fertilizer production and grows into its expanded rock salt capacity.
Nucor NUE
Nucors favorable cost structure and low financial leverage should withstand tepid U.S. steel
fundamentals. Nucors operational flexibility with a more variable cost structure and captive
raw material sources help navigate a volatile demand environment and provide a hedge
against the potential for higher raw material costs. Scrap costs have trended lower this year
despite still strong iron ore and coking coal costs, which should play to Nucors benefit as
the company still depends heavily on ferrous scrap metal for its steel production. While
flat-rolled steel has seen the most demand recovery due to strong auto and machinery
sectors, Nucor still has considerable upside potential from its exposure to long products,
which typically comprise 40% of sales and have less overcapacity risk. These products are
more commonly used in the construction sectors, which have been anemic for the last three
years. While an eventual recovery might still be a few years ahead, any signs of life there
would be a bonus. Our fair value estimate for Nucor implies an EBITDA multiple only one turn
above its historical average, a premium we think is justified in a year of cyclically low
earnings. Further, with a conservative approach to financial leverage, Nucor has historically
had one of the strongest balance sheets in our steel coverage. Nucor also has one of the
highest dividend yields among developed-economy steel companies.
Potash Corp. POT
Potash Corp. is one of the lowest-cost producers of potash fertilizers in the world, and its
capacity expansion projects should further entrench that competitive position. The company
is nearing the end of its capital expansion program, leaving management and the board
plenty of dry powder to further increase its dividend payments and initiate sizable stock
37
repurchases. In our opinion, uncertainty concerning near-term potash purchases by India and
China is holding down Potash Corp.s stock price. Over the long run, we expect India and
China will return to the potash market, as both countries will need to feed growing populations. Even given our forecast for potash price declines in the long term, we think Potash
Corp. looks undervalued. The stock is currently trading at about 80% of our fair value
estimate.
Steel Dynamics STLD
Steel Dynamics has been one of the most profitable U.S. steel producers during the four
challenging years since the onset of the recession. As a relative newcomer to the steel
sector and still in an early stage of its growth story, it represents an attractive way to play
the cyclical upturn, in our view. With nearly 100% exposure to North America, the company
is shielded from the most fragile regions, namely Europe and China. We expect another tepid
earnings year in 2013 with midcycle margins unlikely to materialize before 201415, but there
are a few earnings catalysts in the near term. Its largest capital projectthe Mesabi
Nugget iron ore operationwill begin to ramp up next year with low-cost iron concentrate
that should yield some margin expansion. The company has invested in new retail yards and
recovery technology to improve margins in metal recycling. Some of these initiatives will roll
out in early 2013. On the demand front, steel consumption continues to gradually improve but
Steel Dynamics has seen only the early signs of life from its largest end market, construction. The construction-focused Fabricated Products segment finally reported a profit for the
last two consecutive quarters following three years of losses. Backlogs have steadily grown
and while the pace is slow, Steel Dynamics is highly leveraged to any improvement in the
U.S. construction markets. The companys balance sheet still carries a lot of debt at nearly 3
times trailing EBITDA, but we think this is manageable for a company that has not reported a
quarterly loss since 2009 (a rare achievement across the steel sector) with 70% of capital
spending on growth initiatives.
Elizabeth Collins, CFA, has a position in the following securities mentioned above: WY FBR
38

December 21, 2012
Our Outlook for Consumer Cyclical Stocks

Channel diversification, infrastructure investments, and share
buybacks should allow consumer cyclicals to see low-double-digit
earnings-per-share growth in 2013.
By Peter Wahlstrom, CFA | Director of Consumer Equity Research
3 The consumer cyclical industry appears fairly valued, but we still see selected opportunities for
gains in 2013.
3 E-commerce continues to both augment and disrupt the traditional retail business model.
3 Management teams are still routing free cash toward share repurchases and dividends to
boost total returns.

Consumer Cyclical Sector Fairly Valued but Some Opportunities for 2013
Its true that we are concerned about lackluster economic growth in the United States and
fears of fiscal austerity which could result in near-term volatility in sales and profits, but 2012
operating performance was modestly better than we originally projected. There have been
hiccups along the way, particularly for consumer firms with exposure to continental Europe
and those without an economic moat (which make them more susceptible to competitive
pressures). Still, many management teams have done well to navigate a challenging environment. Closing in on year four of the U.S. recovery, were thinking hard about whether the
high-end consumer has the will and inclination to support the next leg of economic growth,
while questioning the health of the traditional working-class citizen.
For some time weve held the position that the global macroeconomic recovery following the
Great Recession of 200810 would be relatively slow and, at times, volatile. As 2012 comes
to a close, weve been encouraged by the decline in U.S. unemployment, improving real wage
growth, a rebound in the manufacturing and service sectors, an improved housing market
outlook, and normalizing inflation. However, we maintain some caution, as fiscal austerity
(domestic and international) and macroeconomic pressure in Europe could remain an overhang
on equities over the short run. Even with continued government stimulus, we generally forecast
a mild deceleration in both sales and operating margin expansion across much of our coverage universe against more difficult year-over-year comparisons in early 2013 (but with resilient
earnings-per-share growth backed by new share-repurchase authorizations).
Despite the elevated uncertainty which has almost become the norm, we peg the average
price/fair value ratio for our coverage cyclical universe at approximately 1.05. There are few
outright bargains, though we continue to focus on factors such as value, brand ownership,
and differentiated products/services, and later-cycle categories such as mens apparel and
39
home, which may strengthen as the economy expands. We would become more interested if
the market were to trade down another 10%, but were quick to gravitate toward firms with
established economic moats, which might be in a better relative position to withstand potential
near-term volatility. Notably, we generally bake in a deceleration in retail sales in 2013 at this
pointroughly consistent with U.S. gross domestic product trendswith stable pricing and
selective promotional activity (amid lower comparable-store inventory levels) as a partial offset
to slowing consumer spending.
E-Commerce Still Helping and Hurting Traditional Retail Business Model
Looking at the 2012 holiday season, doorbuster and heavy promotional ads were prevalent
across retail (similar to prior years), which drove plenty of consumers into stores. Early signs
suggest that overall sales could be up 3%4% year over year, which would be encouraging,
however were still focused on the steady shift toward e-commerce, a channel which continues
to gain steam (and take share from undifferentiated brick-and-mortar retailers). According to
comScore, online holiday spending is up 13% year over year and the total number of billiondollar spending days (through mid-December) has reached seven.
Sounding a familiar tune, we still see a number of secular headwinds plaguing traditional brickand-mortar consumer electronics retailers going forward, driven by increased price competition
from Amazon.com AMZN and other mass merchants and consumers increasing comfort with
digital media distribution. Amazon remains poised to be one of the big winners this holiday
season and beyond. With fewer overhead costs and (currently) the avoidance of sales tax in
many states, Amazon already enjoys structurally lower costs, so it is nearly impossible for
physical retailers to compete at the same price point for comparable goods, especially because
the company has shown a willingness to sacrifice margins in order to breed customer loyalty. Simply put, low prices, a rapidly expanding assortment, and timely delivery (facilitated by
recent fulfillment-center investments) are a powerful combination in a value-conscious consumer environment which should help Amazon take even more share from traditional retailers.
We do see ways for the traditional retailer to actually benefit from the secular shift toward
e-commerce and rise above the holiday noise and competition, but its not easy. In short, we
believe that a successful firm must be able to more actively: 1) control the distribution of its
brand and/or 2) differentiate its product or service. For example, Williams-Sonoma WSM has
created a unique multichannel model which includes enhancing the in-store customer experience and layering in exclusive products, while also embracing the Web (a channel which
represents nearly 40% of consolidated sales), in part by limiting third-party distribution of its
products. Other firms, like Polo Ralph Lauren RL, VF Corp VFC, Gap GPS, and Vera Bradley VRA
have launched country-specific international websites in an attempt to build brand equity and
ultimately help the customer purchase Whatever, wherever, and whenever she wants. As the
economics of a traditional store model become more challenging amid competition (both online
and brick-and-mortar), higher-margin Web order and fulfillment has become one lever which
has shown in recent quarters to be a modest tailwind to sales growth.
40
Management Teams Continue Using Cash for Share Repurchases and Dividends
Several consumer cyclical names have accumulated sizable cash stockpiles coming out of the
downturn, aided by aggressive cost-cutting efforts and conservative capital budgets. In a nearzero interest-rate environment, we doubt the market is willing to reward companies for sitting
on this cash, though having a sizable cushion can convey benefits in this environment. As a
result, its not surprising that an increasing number of consumer cyclical companies announced
dividend increases, one-time payouts, and/or expanded their share-repurchase programs as
part of their quarterly updates.
Collectively, were forecasting low-double-digit earnings-per-share growth across our consumer
cyclical coverage universe in 2013, which might seem somewhat aggressive in the context of
our industry expectations for mid-single-digit comparable-store sales growth, negligible overall
unit expansion, and modest operating margin expansion. However, were comfortable with the
notion that consumer cyclical firms will be able to support aforementioned channel diversification, infrastructure investments, and other asset renovations while simultaneously buying back
shares, indicating another year of earnings growth. If realized, more retailers may opt to return
cash to shareholders, even after fully funding domestic-, international-, and e-commercegrowth initiatives. In our view, we wouldnt be surprised to see additional first-time dividends
coming out of the consumer cyclical sector during the next several months.
Our Top Consumer Cyclical Picks
After a choppy yet impressive ride (the S&P 500 is up double digits year to date), we peg the
average price/fair value ratio for our consumer cyclical universe at 1.05 (implying that the
category is modestly overvalued). There are few outright bargains, though we continue to focus
on later-cycle categories such as home improvement and furnishings, which may strengthen
as the recession cycles. We would become more interested if the market were to trade down
another 10% or so, but were quick to gravitate toward firms with established economic moats,
which might be in a better relative position to withstand near-term revenue and operating
margin volatility.
In general, we like companies possessing a combination of brand ownership, scale, pricing
power in categories where perceived differentiation matters, exposure to emerging markets
(particularly China), resources to extend brand reach, and strong dividend-growth potential.
Top Consumer Cyclical Picks
Star Rating
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
HKD 14.50
MGM China
QQQQQ
HKD 29.00
Narrow
Very High
Kohl's
QQQQ
$61.00
Narrow
Medium
$42.70
Weight Watchers Int'l
QQQQ
$74.00
Wide
High
$44.40
Starbucks
QQQ
$57.00
Wide
Medium
$39.90
NetEase
QQQQQ
$67.00
None
High
$40.20
Data as of 12-18-12.
41
MGM China Holdings 02282
The market is effectively pricing in flat revenue and cash flow for the next five years, with the
stock trading at a next-year P/E ratio of approximately 12 times. We expect, over the long term,
positive Macau gaming growth and sustainable long-term growth by MGM China to drive the
stock toward our fair value estimate, though the stock faces near-term headwinds of slower
economic growth in China, and a slowdown in VIP gambling in Macau.
Kohls Corp KSS
A return to positive comp-store sales and the demonstration that store openings will continue
should still drive the stock higher, though we believe the 2012 fourth quarter will be important
to indicate the start of the turn. Kohls should benefit from input-cost pressures easing and
middle-class employment improvement in the back half of 2012 and 2013, in our view. Other
pressures on middle-class consumers, such as gas prices, food-price inflation and domestic
fiscal worries, should also ease at some point, taking pressure off Kohls presently tepid comps.
We also believe the market is underappreciating the impact of share buybacks, which could
even accelerate if cash flow generation continues at the $2 billion-plus current run rate.
Weight Watchers WTW
Shares of Weight Watchers could remain in the penalty box for some time as investors absorb
the early 2012 modified Dutch tender offer and recent operational missteps which have hurt
meeting attendance. There is plenty to like in the firms long-term story including current
obesity trends around the world, the upgrade of its current North American locations, and
penetration of the more profitable online business. Meanwhile, we think that even though
growth stagnated in 2012, the firms program upgrade, further corporate account gains, and
a renewed marketing campaign at year-end could spur a nice rebound in enrollments, which
should drive margins and free cash flow generation.
Starbucks SBUX
Starbucks possesses tremendous long-term product, channel, and geographic expansion

opportunities, with more potential sources of cash flow than much of our consumer coverage universe. In particular, were confident that channel-development efforts (VIA, K-Cups,
and Verismo), emerging-markets expansion (namely China, India, and Brazil), and a complementary brand portfolio (Evolution Fresh, La Boulange, and Teavana) provide the company
with an exceptionally long runway for growth. We believe the current share price offers an
attractive entry point for a name that is uniquely positioned to capture share in the retail and
wholesale specialty coffee categories for years to come. Although the first quarter will be a
heavier-than-normal investment period to facilitate the Verismo launch, we expect continued
same-store-sales momentum in the United States and China and easing coffee cost pressures
to provide a positive near-term stock catalyst.
NetEase NTES
NetEase relies mostly on organic growth, and we think catalysts in the near term include
the new release of several in-house games with new graphics and features as well as the
launch of more World of Warcraft games following the extension of licensing agreements
42
with Blizzard. Although the overall gaming market remains volatile and increased scrutiny over
the structure of Chinese ADRs are a concern, we expect investors to build more confidence in
steady top players such as NetEase given its strong and balanced portfolio of in-house and
licensed games, unrivaled research capabilities to keep the gaming experience fresh and exciting, and operational expertise in managing the gaming platforms.
Peter Wahlstrom, CFA, does not own shares in any of the securities mentioned above.
43

December 21, 2012
Our Outlook for Consumer Defensive Stocks

Headwinds surrounding raw material inflation and regulatory oversight fail to stem
strategic actions, as consumer defensive firms look to enhance the value proposition
for shareholders.
By R.J. Hottovy, CFA and Erin Lash, CFA | Director of Consumer Equity Analysis and Senior Stock Analyst
3 While continued commodity cost pressures are unlikely to derail the profitability of consumer
product firms, a buying opportunity could emerge.

3 The looming fiscal cliff prompts a flurry of strategic actions from consumer defensive firms
throughout the quarter.

3 Increased energy drink oversight probably wont prompt significant change, similar to the recent
push for modifications to tobacco packaging abroad.

Commodity Cost Pressures Unlikely to Derail Profitability of Most Consumer Product
Firms, but Buying Opportunity Could Emerge
The drought across much of the Midwestern United States this past summer has driven
prices for many agricultural commodities well above historical averages, and we expect
these elevated prices will continue to challenge the cost structures of many packaged food
companies over the near term (particularly since the impact of the drought is now taking a
toll on waterway transportation of raw materials). Most companies routinely focus on reducing supply chain inefficiencies, but cost-cutting has its limits, and many firms have been
unable to completely offset higher commodity prices through cost reductions alone.
Given that commodity pressures are unlikely to abate during the first half of 2013 (as there is
a lag between when costs go up and when firms ultimately incur raw material inflation, given
that firms tend to hedge commodity needs by locking in prices in advance), we expect volume
could remain lackluster if companies take additional pricing. However, as weve discussed
in the past, moaty consumer product firms that possess significant brand equity (Hershey
HSY, McCormick MKC, Coca-Cola KO, Diageo DEO) are likely to be relatively unscathed by
such pressures. Conversely, for firms that operate with a more commodified portfolio (Tyson
TSN, Dean Foods DF) the impact could be more sizable. Despite this, all is not lost, as we
think any downward pressure could create a buying opportunity in the shares if the market
overemphasizes the quarterly impact the drought may have on near-term profits while ignoring the potential boost in profitability that could occur with a bountiful 2013 crop.
The challenge for meat processors reflects the fact that grains represent a disproportionately large percentage of their production costs, at more than 40% of the total cost for
chickens and about 80% of the costs of producing feed, versus just 5%10% of the costs
for a packaged food firm like General Mills GIS. For instance, Hormel HRL indicated during
its fourth-quarter earnings report that roughly $100 million in higher grain costs could
44
flow through results in fiscal 2013 (ending October), which represents a 120-basis-point hit
to gross margins, all else equal. We estimate that Tysons chicken segment margins will
be hardest hit by elevated grain prices over the near term, compared with its beef and
pork businesses, as the segments vertical integration requires that the company directly
purchase grains used to feed broilers (birds used for chicken consumption).
We believe that coordinated decreases in industry supply would help to stabilize prices
and potentially provide some buffer to falling margins, but this depends on whether other
industry participants are rational in reducing supply. Hormel is decreasing production in the
1%2% range, in line with meat processors, which we think should help to reduce costs.
However, we expect the company will look to drive innovation and may take selective pricing
to completely cover elevated grain prices. We also think Tyson should be able to take pricing;
by our calculations, a 10% increase in prices could result in 1%2% of volume reduction, as
cash-strapped U.S. consumers will continue to focus on maximizing limited income. However,
declines in chicken volume (which accounts for more than one third of Tysons sales) may be
more muted than declines in other proteins, primarily because chicken products are often
perceived to offer relatively good value.
Despite these headwinds, we think long-term industry fundamentals are relatively
unchanged. Meat processors shares have proved volatile, reflecting concerns that profitability could be challenged in the short term, but we believe the fundamental trends affecting
total demand for proteins should lead to long-term upside. Although the risk/reward
opportunity is less compelling than it was in the late summer and early fall, we still see an
opportunity for patient fundamental investors as the market extrapolates lackluster
earnings.
Looming Fiscal Cliff Prompts Strategic Actions From Consumer Defensive Firms
Even before the threat of the fiscal cliff, the flurry of activity from consumer staples firms
looking to wring additional value out of their businesses was in high gear. Earlier this
quarter, Kraft separated its North American grocery business (Kraft Foods Group KRFT) from
its global snack operations (named Mondelez MDLZ)a move that it first announced in
August 2011. In our opinion, Krafts motivation was to unlock a higher multiple for its fastergrowing snack business that had been unappreciated when combined with the more mature
North American grocery brands. We think investors looking for sweeter growth prospects
from a packaged food firm may want to consider the Mondelez global snacks business, while
income investors will likely find the new Kraft Foods shares appetizing because paying a
top-tier dividend is to be the firms main use of cash.
Dean Foods was also fast at work in the quarter, as the dairy processor spun-off 12% of
its high-growth, high-margin WhiteWave-Alpro business (the intentions of which were first
disclosed in August) as a means of unlocking value. In addition, Dean announced plans to
sell its Morningstar segment (with a portfolio that includes creamers, ice cream mix, valueadded milks, sour cream, and cottage cheese) to Saputo for $1.45 billion. (This segment is
unrelated to Morningstar Inc., the publisher of this note.) Dean intends to direct the $300
45
million of proceeds from the IPO, the funds from a new $870 million credit facility (which
will reside on WhiteWave-Alpros balance sheet but ultimately will be consolidated because
of Deans majority ownership), and the nearly $900 million in proceeds from the sale of
Morningstar toward the reduction of debt, which would effectively reduce leverage to 3.0
times by the end of the year from 3.7 times at the end of the third quarter, according to
the company. While weve been encouraged that the dairy processor hasnt merely paid
lip service to the need for debt paydown, we are concerned that Deans ability to service
its debt could be challenged following the IPO of WhiteWave-Alpro and the sale of the
Morningstar business, given our expectations for continued volatility in the operating income
of the fluid milk business.
Further, despite its repeated rebukes just a year ago, Ralcorp RAH) is now set to be acquired
by ConAgra CAG. The deal, which values the private-label manufacturer at 12 times its
fiscal 2012 adjusted EBITDA on an enterprise value basis, strikes us a great strategic fit for
ConAgra (even in light of the lofty price tag) and a very good deal for Ralcorp shareholders. This caps a year over which ConAgra has announced five other deals, and given that the
private-label segment (which ConAgra management has identified as a priority for expansion) still remains highly fragmented, with hundreds of companies that generate revenue of
less than $75 million annually, further consolidation could be in the cards. We suspect that
Ralcorp management was more open to a deal this time around due to pressure from activist
investor Corvex Management, which disclosed in August that it had amassed a 5% ownership stake in the private-label food manufacturer.
Beyond the flurry of deals, consumer staples firms (including Campbell Soup CPB and Brown
Forman BF.B) have also been declaring special dividends in rapid succession, which is a
prudent use of cash and reflects the uncertainty surrounding future tax rates on dividends. If
current negotiations in Washington ultimately lead to increased taxes for dividends, we think
that slower dividend growth could be in the cards next year, and share buybacks may take
precedence. However, if shares trade at a premium to our fair value estimate, other uses
of cash (such as reinvesting in the business) may be more appropriate. While we think its
possible that other CPG firms could look to return additional cash to shareholders, we expect
the pace of other strategic actions (i.e. acquisitions) could be on hold until more clarity is
garnered surrounding the potential tax implications.
Increased Energy Drink Oversight Probably Wont Prompt Significant Change, Similar
to Recent Push for Modifications to Tobacco Packaging Abroad
Heightened government regulations and taxation can have drastic impacts on any companys
bottom line, and hence valuation. In the past, increased tax rates and marketing restrictions
have negatively impacted the growth rates for brewers, distillers, and cigarette companies. However, recently shares of Monster Beverage MNST have been on a roller coaster
ride following the receipt of a subpoena from the New York Attorney General and plenty of
pressure on the FDA from Senator Durbin and Senator Blumenthal, regarding investigations
into whether excessive energy drink consumption is linked to death. We continue to believe
46
the outcome of the FDAs efforts will be benign and the impact on Monster Beverage will
be minimal.
Although the FDA is willing to work with the Senators, it must make science-based decisions
within the bounds of its statutory authority and mandate. While we believe it is unlikely that
Monsters ingredient list will be drastically altered, we would not be surprised to see new
labeling requirements (such as disclosure of caffeine levels). Overall, we believe that the
bulk of the FDAs letter supports our overall positive thesis on Monster, but the situation still
carries some risk. As the FDA further digs into the adverse event reports and likely brings
in outside experts (such as the Institute of Medicine) to conduct more studies, additional
labeling and marketing restrictions could pop up. Consequently we are maintaining our high
uncertainty rating on Monster Beverage, but arent making any changes to our fair value and
view the shares as fairly valued. However, if concerns surrounding heightened regulation
weigh on the stock, long-term investors may find value in Monster.
This follows increased regulation in Australia related to the introduction of plain olivegreen packaging with graphic health warnings for tobacco productsa law that has been
challenged by Philip Morris International PM, British American Tobacco BTI, and Imperial
Tobacco IMT. These tobacco titans believe that plain packaging will encourage illicit trade by
making it easier for knock-off (and excise-tax free) cigarettes to enter the supply chain; usurp
their intellectual property rights; and will neither prevent anybody from starting nor compel
anyone to stop smoking. We believe that plain packaging will ultimately backfire for governments. Uniform packages would make it easier for tobacco bootleggers to enter the market.
These scofflaws dont pay excise taxes, so governmental tax receipts will likely fall faster
than the rate of smoking cessation.
We believe this is a case of better the devil you know, meaning, tobacco bootleggers are
frequently associated with organized crime. Plain packaging initiatives could help these
mobsters fund their other criminal enterprises, whereas the large tobacco companies are
heavily regulated, follow the rules, and pay billions in excise taxes. The biggest risk for the
tobacco companies would be if other countries follow suit. In the past, countries such as
the United Kingdom, Canada, New Zealand, and Lithuania have considered plain packaging; depending on how the Australian decision pans out, politicians in these countries may
once again consider plain packaging initiatives. Although we view it as unlikely, if the plain
packaging movement gains global momentum our bear-case scenarios for the tobacco
companies could come to fruition.
Our Top Consumer Defensive Picks
Consumer staple firms continue to be viewed as safe havens in this uncertain economic
landscape, and shares subsequently have trended higher, given the consistent cash flows
and total shareholder returns (including dividend and share repurchases) that tend to characterize these firms. As such, we tend to view the space as fairly valued to slightly overvalued
at this point in time. However, we think that long-term investors looking for exposure to the
consumer staples industry should still keep an eye on the moaty names in this space. While
47
outsized growth is unlikely, solid cash flow generation and a history of enhancing shareholder returns (with increased dividends and additional share repurchases) should appeal to
income-seeking investors. If stocks within the consumer products industry trade down on
concerns surrounding rising input costs or competitive pressures, we may look to recommend
the shares. We have provided a summary of our most undervalued and overvalued names
below.
Under- and Overvalued Consumer Defensive Sector Stocks
Star Rating
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Molson-Coors
QQQQ
$55.00
Narrow
Medium
$38.50
Kraft
QQQQ
$53.00
Narrow
Medium
$37.10
Costco
QQQQ
$109.00
Narrow
Low
$87.20
Church & Dwight
QQ
$42.00
None
Medium
$29.40
Coca-Cola FEMSA
$90.00
None
High
$54.00
Undervalued
Molson Coors TAP
Although a recovery could be more than a year away, we still think the market is currently
undervaluing Molson Coors intrinsic value. Our $55 fair value estimate assumes 3%4%
annual revenue growth and 27% operating margins by the end of the decade. With Molson
Coors shares trading at just 10.5 times 2013 earnings and delivering a 3% dividend yield, we
view the stock as attractive. The ongoing economic malaise has resulted in elevated levels
of unemployment for young men who are key beer drinkers, and we believe that a rebound in
the economic conditions in North America and the United Kingdom will serve as a catalyst
for Molson Coors stock price.
Kraft KRFT
Following its split from the global snacks business earlier this year, Kraft Foods still possess
sizable competitive advantages, including a solid brand portfolio (Kraft, Oscar Mayer, and
Maxwell House each generate more than $1 billion in annual sales and another 20-plus
brands produce more than $100 million in sales each year) and substantial economies of
scale in the North American market (with more than $19 billion in annual sales). One of the
opportunities for the domestic grocery business, in our view, lies in the fact that as a part
of the consolidated organization these brands had been underinvested in; we think it was
more or less the cash cow that funded the growth of the global snack business. We think
the market is overlooking the substantial cash flows that Krafts grocery business generates
(which we forecast at 10% of sales on average), and income investors likely will find Kraft
appetizing as the firms top priority for cash is to fund a highly competitive dividend, which at
$2 per share is yielding around 4%.
48
Costco COST
We expect federal fiscal contraction causes a consumer pullback in 2013, which should
pressure all of the stocks in our defensive sector, including Costco. However, over the long
term the loss leader capabilities of Costcos narrow-moat business model should continue
to drive disproportionate market-share gains. Consistent and steady market-share gains
should deliver sustained double-digit EPS growth, potentially acting as a catalyst for relative
outperformance.
Overvalued
Church & Dwight CHD
We still think the market is too optimistic with regards to Church & Dwights prospects, with
the shares up around 20% year to date and trading at 20 times the midpoint of managements fiscal 2013 earnings per share estimatea lofty multiple for a firm that derives
the bulk of its revenue from the mature U.S. market and faces significant competition from
much larger peers. While investments in product innovation and marketing support behind
core brands have resulted in sales growth and margin improvement, the firm faces intense
competition from its significantly larger peers. In addition, the firm lacks the size and scale
advantages of the dominant industry players (which possess more diversified product portfolios and deeper pockets), potentially making Church & Dwights future expansion quite costly.
Coca-Cola FEMSA KOF
Coke FEMSA operates in a number of emerging-market countries with solid growth

prospects, including Mexico, Brazil, and Argentina. However, these are regions in which
geopolitical events could lead to volatile commodity and currency fluctuations and ultimately disrupt normal operations. We expect Coca-Cola FEMSA will continue to benefit from
Cokes brand equity, which should help it to generate solid free cash flow over the long term.
However, at a price/fair value of more than 1.6, we think the current market price appears
rich after taking into account the number of risks facing the firm.
Neither R.J. Hottovy, CFA, nor Erin Lash, CFA, owns shares in any of the securities mentioned
above.
49

December 21, 2012
Our Outlook for Energy Stocks

Weve introduced a new marginal cost estimate for domestic
natural gas.
By Stephen Ellis | Senior Stock Analyst
3 There has been no real progress on the ongoing eurozone crisis. Oil and gas prices remained in
a fairly tight band over the last quarter, while politicians in Europe generally didnt contribute
anything substantial toward resolving the crisis. Economic data points out of the region tended
to be poor, keeping the scenario of lower oil demand and weak oil prices on the table.
3 China, as typical, took center stage again this quarter. The Canadian government approved the
$15.1 billion Nexen/CNOOC deal as well as the Petronas/Progress merger after its initial
rejection of Petronas deal to acquire Progress placed both deals in regulatory limbo. However,
the government has indicated that future oil sands acquisitions will be subject to intense
regulatory scrutiny. In addition, Chinese economic data points continued to indicate a
slowdown is at hand, pointing to weaker demand for oil.
3 Weve introduced a new marginal cost estimate for domestic natural gas of $5.40 per thousand
cubic feet versus our prior projection of $6.50 per mcf. Despite the lower price forecast and the
negative gas demand implications from the warm winter, were seeing positive data points at
the industry, state, and company levels that support a more bullish out-year take on natural gas
prices.
Since our last quarterly outlook, there has been virtually no progress on resolving investors
concerns around the eurozones struggles, and China has continued to make headlines for a
variety of reasons. Weve also introduced a new estimate for the marginal cost of domestic
gas after updating our analytical approach. During this time frame, oil and gas have traded
between $85 and $95 per barrel (West Texas Intermediate oil) and $2.80 and $4.00 per mcf.
In Europe, there has been very little progress on resolving the ongoing crisis. At best, the can
has been kicked down the road yet again. We cant expect up-and-to-the-right progress here,
and European Central Bank President Mario Draghis plan last quarter to purchase unlimited
amounts of bonds issued by struggling members of the euro was effectively a line in the
sand by the ECB against the euro falling apart. This quarter, the news out of the European
Union was generally poor. Per Eurostat, the eurozone is officially in a recession, as GDP fell
0.1% in the quarter following a 0.2% decline in the prior quarter. The weakness in the peripheral nations (Greece admitted its debt load will be around 190% of GDP in 2013, making a
2020 goal of reaching 120% of GDP unrealistic) is spreading to the core nations. For example,
Germanys industrial production was down 1.8% for September, and the United Kingdoms
outlook is weak enough that the credit agencies are considering rating downgrades. The ECB
and Bundesbank have made substantial cuts in their growth forecasts for the EU as a whole
50
(to negative 0.3% from positive 0.5%) and Germany (to 0.4% growth from 1.6% growth)
in 2013.
Furthermore, Italian Prime Minister Mario Monti said he intended to resign following the
loss of party support. Monti was asked to form a government last year following the resignation of former Prime Minister Silvio Berlusconi, and now as Berlusconi appears to be
attempting to return as the leader of the country, more turmoil seems to be the only reasonable forecast. In the wake of the resignation, Italian borrowing costs widened, as the bond
market worried about Italys commitment to the reforms needed solve its crisis. Thanks to
these concerns from Italy as well as the wider EU, the risks of slowing demand for oil from
Europe and the subsequent negative impacts on oil prices still seem very much in play.
China also continued to be a source of headlines this quarter. The $15.1 billion acquisition
of Nexen NXY by the state-owned CNOOC CEO and the Petronas/Progress merger were
approved by Canadian regulators after their initial rejection of Petronas takeover offer for
Progress Energy placed both deals in regulatory limbo. However, Canadian Prime Minister
Stephen Harper indicated that future investments by state-owned companies would only be
approved under exceptional circumstances without detailing what those circumstances
would be. The government has indicated that it no longer sees any net benefit to Canada
from these types of deals. Harper is treading a very fine line between encouraging international investment and relations with China, which will be a key source of incremental
demand for Canadian oil, and letting it get too much influence over a national asset. Minority
stakes and joint ventures, particularly around gas assets, seem to be acceptable, but controlling stakes in oil assets will be receiving much tougher levels of scrutiny going forward.
Of note is the fact that CNOOC has promised to provide the Canadian government with an
annual compliance report that promises increased transparency while at the same time U.S.
securities regulators are in a brutal stand-off with their Chinese counterparts over access to
the auditors files for the largest Chinese American depositary receipts.
Despite the excitement over Canadian oil this quarter, Chinese data points continue to
indicate a slowdown in growth, with the latest numbers (export growth of 2.9% in November
versus expectations of 9% and October growth of 11.6%) indicating that weaker, not stronger, demand for oil is likely to be a key energy theme. This situation presents a headache for
OPEC, where social tensions are continuing to promote unrest, with conflicts in Syria, nuclear
ambitions in Iran, and a fragile oil recovery in Iraq. Many OPEC members need oil prices in
the range of $90$120 per barrel in order to meet social commitments made to their citizens
lest more governments topple.
Lower demand combined with a potentially higher oil supply cushion could equate to a nasty
scenario for OPEC and oil prices. For example, the International Energy Agency indicates
that global oil demand growth could average around 660,000 barrels per year to 2020 versus
average annual demand growth of 1.3 million barrels per day over 200008. While that is
a fairly low bar, there are still unresolved oil supply challenges for the industry that have
largely remained in the background, given the focus on the oil demand side of the story. For
51
example, some of the largest oil and gas companies (ExxonMobil XOM, Shell RDS.A, BP BP,
Total TOT, and Chevron CVX) plan to lay out a little more than $120 billion in capital spending
as a group in 2012, which is roughly triple the amount they spent in 2001, yet production for
the group remains well below 2001 levels.
Were more sanguine about our outlook for natural gas this quarter, thanks to our updated
natural gas price deck and recent industry events. First, weve lowered our estimate of the
marginal cost of domestic natural gas to $5.40 per thousand cubic feet from $6.50 per mcf,
driven primarily by our updated analytical approach. We examined production, reserves,
assets, capital spending, and operating results of the top 25 U.S. gas producers over the
past 15 years and divided costs for each firm into three buckets: production, development,
and capital charge. We then employed a statistical method, maximum likelihood estimate,
to isolate costs associated with natural gas from costs associated with oil production.
Our approach is distinct from that of most other research firms, which rarely go beyond
estimating break-even levels for the major U.S. unconventional plays (and such analysis
unfortunately ignores the majority of domestic production). Moreover, cost estimates (or
estimated returns) tend to be presented on a blended oil-gas basis, which fails to isolate
the true cost of natural gas production, and, in the case of returns, requires an additional
assumption regarding oil or natural gas liquid prices. Over the long run, we believe our model
is a more reasonable predictor of prices; accordingly, we think natural gas prices will move
toward our $5.40 per mcf forecast over the next few years.
However, following one of the warmest summers in recent memory, were setting up for an
unusually warm winter as well, which could put a damper on the improving natural gas story.
In fact, per the National Climatic Data Center, we are in line for the warmest winter in the
United States on record (since 1895), which points to a weak outlook for natural gas demand.
Despite this scenario, natural gas storage levels have continued to fall and are now only 5%
above five-year averages versus an 11% difference last quarter. The Baker Hughes natural
gas rig count has also continued its steady decline in the fourth quarter, with another 31
natural gas rigs being laid down as of Dec. 7, following a 75-rig decline in the third quarter.
In fact, the natural gas rig count has been nearly cut in half since the start of the year, with
almost 400 rigs being laid down. In our view, the natural gas rig count, while not a perfect
indicator, is certainly a leading one with regards to U.S. natural gas production, which as of
September 2012 is at 73 billion cubic feet per day, up 2.7 bcf since last September.
At a more granular level, were already seeing production declines. For example, monthly gas
production in Texas was down 15% year over year in August; in Louisiana, gas production
was down 19% over the same time frame; and in Colorado, gas production was down 11% as
of September. Combined, these states make up more than 40% of U.S. natural gas production. At a company level, we are also seeing positive data points for natural gas prices. In
the third quarter, BPs U.S. gas production declined 15% year over year, Chevron saw a 6%
decline, and ExxonMobils production dropped 5%. Were seeing declines because the majors
are seeing poor returns. For example, Shell indicated that it had earned $1.2 billion over the
past 12 months from shale gas, whereas its capital employed is around $50 billion, indicating
52
unacceptable levels of returns on capital. We dont think the majors are alone in their
assessment of the returns available in todays natural gas price environment, so we expect
natural gas prices to improve as companies continue to pursue rational economic outcomes,
which include reallocating capital away from poor-performing gas plays and dropping rigs.
Given current trends, we reiterate our bullish take on natural gas prices. The industry, state,
and company data points indicate we are getting closer to an inflection point around natural
gas production; we expect natural gas volumes to eventually flatten and decline, leading to
higher U.S. natural gas prices and increased levels of drilling activity as gas producers seek
to produce more gas to meet stronger U.S. gas demand. Overall, we believe these trends will
benefit natural-gas weighted exploration and production companies and North Americanfocused oil services firms the most, leading to share price outperformance over the next
1218 months.
As a group, energy stocks have remained modestly undervalued this quarter with a median
price/fair value of 0.86 compared with 0.88 last quarter. E&Ps remained among the cheapest subsectors with a median price/fair value of 0.78 compared with 0.76 last quarter. The
biggest shifts on a quarterly basis came from the oil services and refining subsectors, where
the price/fair value ratios moved to 0.83 from 0.91 and to 0.93 from 1.11. The integrated and
midstream subsectors continue to offer limited opportunities to investors with price/fair
value ratios of 0.88 and 0.91 versus 0.94 and 0.90 last quarter.
Energy Stocks for Your Radar
Most of our favorite names are making a repeat appearance this quarter as some of the
best opportunities in the energy sector. Ultra Petroleum UPL, Devon DVN, Suncor SU, and
Halliburton HAL continue to offer some of the best risk/reward prospects on our coverage
list per our analysts careful assessments. We are adding Occidental Petroleum (OXY) to
our favorites list this quarter. Oxy has stumbled recently on its plans to develop its attractive Californian and Permian acreage, but it is going all out to fix the issues. We think as
Oxy executes on its returns improvement plan, which involves dropping rigs, cutting capital
spending, and driving cost improvement, shareholders will eventually be rewarded.
Top Energy Sector Picks
Star Rating
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
$40.00
Narrow
High
$24.00
Ultra Petroleum
QQQQQ
Devon Energy
QQQQ
$99.00
Narrow
High
$59.40
Occidental Petroleum
QQQQ
$107.00
Narrow
Medium
$74.90
Suncor
QQQQ
$52.00
Narrow
Medium
$36.40
Halliburton
QQQQ
$50.00
Narrow
Medium
$35.00
Data as of 12-13-12
53
Ultra Petroleum UPL
Ultras Pinedale and Marcellus assets represent one of the best one-two punches in North
American upstream. The company remains well positioned to take advantage of a secular
recovery in natural gas prices, thanks to its low cost structure and long runway for growth.
Ultras balance sheet could experience further tightness over the next few quarters as
hedges roll off, although under current strip prices the company should be fine from a
covenant perspective. A takeout offer from one of the majors or a larger independent could
help fast-track value realization: As a company, Ultra is both scalable enough and bite-size
enough to attract a wide range of potential suitors. If Ultra is acquired, its takeout price
could exceed our fair value estimate on a stand-alone basis.
Devon Energy DVN
Unlike some of its competitors, Devon isnt new to the oil- and liquids-rich game, having
had a fairly balanced production mix throughout its history. We expect a similar mix going
forward, given the firms sizable liquids opportunity set. Devons superior financial footing
should help the firm weather the current low gas price environment and, with the help of two
recently closed joint ventures, should also provide enough dry powder to aggressively develop existing inventory and capture acreage in emerging plays. The firms acreage includes
sizable positions in the Permian, Barnett, Cana-Woodford, Granite Wash, Mississippian, and
Utica plays, as well as a handful of Canadian oil sands projects. Despite a number of Devons
oil- and liquids-rich plays being in the early innings, were bullish on their ability to contribute
to the firms production and reserve growth in the years ahead.
Occidental Petroleum OXY
Occidentals plan to develop the promising unconventional discoveries on its existing

California and Permian has been more difficult than originally anticipated. With returns
suffering and the stock underperforming peers, Oxy is dropping rigs, cutting capital spending, and driving cost improvement. Additionally, management has signaled a willingness to
increase returns of capital to shareholders to compensate for the lagging share price. The
ongoing sell-off of Oxys stock has pushed it into 5-star territory, making shares compelling,
in our opinion. Ultimately, we think Oxy delivers reduction in capital and operating costs that
lead to improved returns. As a result, we are also maintaining our positive moat trend as the
resource potential in California still exists, which, combined with an improved cost structure,
should allow Oxy to improve its competitive position relative to peers.
Suncor SU
While Suncor production growth to 2016 has been trimmed to reflect delays to the oil sands
mining expansion plans, it remains on track to delivery robust growth in liquids production.
Over the next five years (201216), in situ production is expected to see an 18% compound
annual growth rate as expansions at Firebag come on line. Growth from its offshore assets
is expected in 201415, contributing to an expected 5% production CAGR for the company,
offsetting an expected negative 15% CAGR from natural gas. By 2016, we look for total
production of 682,000 barrels per day.
54
Despite the growth potential, the market seems overly concerned about cost inflation, in our
opinion. Although we expect cost inflation to return to the region with the acceleration of
development, most of the oil sands players appear ready to avoid the rampant rise in costs
that accompanied the last investment cycle. For its part, Suncor has expressed willingness
to delay mining projects if necessary (and transfer capital to in situ projects) to avoid higher
costs, which may otherwise damage returns. Continued near-term strength is expected from
its downstream operations, which are able to sell refined products at global prices, while
securing a significant amount of feedstocks at depressed Mid-Continent prices.
Halliburton HAL
The list of challenges Halliburton faces over the next few quarters and years is long, but
the firm is best of breed in the key North American oil services market. Some challenges
are temporary (guar costs and other supply-chain inefficiencies, pressure pumping oversupply, gas-to-oil rig switching), and some may retard Halliburtons prospects (slowing demand
from Europe and China for oil, weaker prospects for further services intensity growth in
North America) for a longer time frame. In the short run, the collapse of guar prices should
be a very positive event for the industry, but weak NGL pricing could continue to drive
more gas-to-oil rig switching and pressure pumping oversupply. Slower demand for oil from
Europe and China could also push down global oil prices, hurting demand and international
margins for Halliburton over the next few years. However, Halliburtons industry leadership
in North America through its integrated model provides it with a significant edge over peers.
Furthermore, we believe investors are mostly focused on the short-term issues while ignoring some of the more attractive secular elements of Halliburtons story, such as the shift
toward exploiting more services-intensive offshore reservoirs and revitalizing old and
mature fields.
Stephen Ellis does not own shares in any of the securities mentioned above.
55

December 21, 2012
Our Outlook for Financial-Services Stocks

A further rally in financial stocks is unlikely without continued
economic improvement.
By Jim Sinegal | Director of Financial-Services Equity Research
3 With a sector price/fair value estimate ratio of 90%, few opportunities exist in the risky
financial-services sector, which has the highest uncertainty rating of all the sectors we cover.
3 High refinancing volumes are boosting mortgage-related businesses, but such support is likely
to be relatively short-lived.
3 Macro concerns remain at the forefront, with troubles brewing in Europe and Canada, and low
rates damaging profits in the United States.

Over the past few months, financial-services stocks continued to perform well, with the
aggregate Morningstar price/fair value estimate ratio for stocks in the sector rising to 90%
from 87% over the summer. As we pointed out last quarter, most bargains are accompanied by
risk, and many will require a further macroeconomic rebound in order to demonstrate their full
potential earnings power.
Dangers Still Lurk in Europe, but Banks Are Making Slow Progress
European bank share prices continued to rally in the fourth quarter as European politicians did
the minimum amount necessary to preserve the stability of the eurozone. They cobbled
together a back-door Greek bailout that kept the country from defaulting and announced a
centralized bank regulator for 200 of Europes largest banks.
However, wed hesitate to buy shares of most European banks at current prices, given the
significant danger we see lurking on the horizon. Much of Europe appears to be in recession,
and any recovery in 2013 is likely to be tepid. As a result, we expect that European bank profits
will remain subdued, at best, with thin net interest margins and ever-growing nonperforming
loans.
Were unimpressed by the planned central regulator for European banks, as the current plans to
do not include centralized deposit insurance and therefore dont help to weaken the link
between the health of a sovereign and its banks. If turmoil in the eurozone increases and
Portuguese banks begin to fail, for example, Lisbon will be called upon to bail them out and
likely wont have the resources to do so.
Macroeconomic risk aside, we see reason to be hopeful. Some of Europes most troubled banks
have made significant progress toward turning themselves around. KBCs KBC fourth-quarter
capital raise, for example, took place at near tangible book valuesomething unmanageable in
the middle of the yearand helped the bank repay a significant chunk of its government
56
bailout. Separately, UBS UBS announced a major restructuring and the closure of most of its
fixed-income tradingthe source of most of its losseswhich we think puts the bank ahead
of peers in preparing to operate under Basel III capital standards. For others, like Barclays BCS,
many of these painful decisions are likely to be made in early 2013.
P&C Insurers Could See Better Pricing, While Life Insurers Are Playing Defense
Looking ahead, the first quarter, in general, tends to be relatively calm for property-casualty
insurers. The period typically has a seasonal lack of high severity, major catastrophe events.
That said, losses definitely can occur and are difficult to predict and tend to involve snow or ice
caused by winter storms. Most losses tend to be related to winter storms.
In recent quarters the news has been getting increasingly optimistic on the top line for property
and casualty insurers, a trend we expect to continue into the first quarter. In the past few
quarters insurers have been positing mid-single-digit price increases. While not necessarily
indicative of a hardening market, where prices can increase well into the double-digit levels,
any positive news on the pricing front is undoubtedly welcome after many years of declines
during the soft market period. The losses caused by Hurricane Sandy in the fourth quarter will
be a negative for reported profitability in that period, but at the same time, they may motivate
a more widespread change in the insurance pricing market, which would drive higher prices in
upcoming quarters.
Persistent low interest rates continue to be a major challenge for the life insurance industry.
We expect life insurance companies to lower their earnings outlook for 2013, as they are going
to incur charges related to liability revaluation and are forced to invest premiums in low-yield
securities. On top of that, the industry is facing the regulatory uncertainty surrounding the
systemically important financial institutions (SIFI) classification. Against this backdrop, we think
that life insurance companies will continue to focus on protecting their capital solvency.
There are several trends that are emerging in the life insurance industry. First, to lessen the
overall capital burden, many life insurers are looking beyond traditional insurance and moving
into alternative businesses, such as corporate pensions and asset management. Second, we
believe life insurers will continue to de-risk the risk profile by selling off insurance assets and
reducing exposure to annuities. Several European insurers have announced plans to unload
their U.S. and Asia units, in part because they want to trim their balance sheet before the new
solvency rules roll in. U.S. insurers have also significantly cut back on new annuity sales to
reduce capital market exposure. Finally, we expect life insurers to increase allocation to
high-yield bonds and other less-liquid investments to get a higher yield. Private lending to
corporations can be another way for insurers to obtain a higher rate while holding less liquid
securities.
Exchanges Also Looking for New Sources of Growth
Financial exchanges wont be sorry to put 2012 in the rearview mirror. The year was a difficult
one for trading activity, and as the industry heads into 2013, we are cautiously optimistic for
improvement. But given the swings that trading revenue can experience, exchanges that have
57
good other sources of revenue will probably continue to look for ways to expand those in order
to promote stability. NASDAQ OMX Groups NDAQ plan to expand its corporate-solutions
business (which includes products such as investor-relations tools) through an acquisition is
part of this trend, as is NYSE Euronexts NYX continuing effort to grow technology-related
income.
In general, we think these businesses do have the potential to help stabilize exchanges
revenue trends, but we also think that a healthier trading environment would do the sector
significant good. Operating efficiently in lean times will continue to be a focus for exchanges,
and although targeted merger-and-acquisition activity is certainly possible, we think that
large-scale, cross-border deals are less likely.
Refinancing Volumes Remain a Key Factor in the Mortgage Market
Sale volumes in the U.S. residential housing market have yet to meaningfully recover. However,
the mortgage business has not vanished in the post-bubble environment thanks to refinancing
activity. In response to record low rates and government assistance, refinance volumes have
picked up sharply over the past year. This has led to a much more favorable environment for the
title insurers and mortgage processors, as well as increased origination business for banks.
Although refinance volume has been a boon to financial firms in recent quarters, it could prove
to be a double-edged sword. A return to normal sales volumes, especially if accompanied by an
improving economy and higher interest rates, could merely offset declining refinancing volumes
in a rebounding housing market.
At banks, cost-cutting will remain in focus as management teams attempt to deal with
continued top-line weakness and low interest rates. Citigroup C recently announced yet
another round of planned expense reductions, and we think other banks could follow as
management teams attempt to regain a modicum of economic profitability. As credit quality
has stabilized, reserve releases are likely to taper off as well, leaving few avenues for banks to
boost their bottom lines.
Canadian Banks Continue to Demonstrate Resilience
Despite a flatter yield curve and concerns about the impact surrounding a housing bubble,
Canadian banks continue to post strong earnings. Although loan growth has not been as strong
as in past years, it is still very respectable, averaging upper single digits.
Strong earnings are primarily led by their largest segment, personal and commercial banking,
though many of these banks experienced lower net income from this segment due to the lower
rate environment and slightly higher loan loss provisions. However, all of the banks showed
stronger results from their wealth management and capital markets segments, which made up
the difference for lower Canadian banking income.
Over the course of the quarter, some of the banks (i.e., Toronto-Dominion Bank TD, Royal Bank
of Canada RY, and Bank of Nova Scotia BNS) have looked to reinvest some of their cash by
making acquisitions to enhance market share, build fee-based businesses, or expand
58
geographically to help diversify their revenue streams. Canadian bank investors closely watch
for any common dividend increases from these companies. This quarter, only one of the six
major banks raised its common dividend, National Bank of Canada NA. Nevertheless, common
dividend yields remain high, ranging from 3.8% to 4.8%. In terms of future dividend increases,
we expect the banks to review the potential of dividend hikes following their first-quarter 2013
results.
Over the long term, we think the Canadian banks will continue to generate significant capital.
However, we are cautious about the housing market, which appears significantly overpriced. At
this point, the debt-service capabilities of the Canadian consumer appear manageable.
However, if the Bank of Canada decides to raise rates, we worry about the impact upon the
highly leveraged consumer and subsequent effects upon the banks.
Our Top Financial-Services Picks
Given the trends outlined above, we are finding only scattered opportunities in the sector. We
believe there is some value left in a few names, but the economy may need to give these
companies a boost if investors are to make much money in them over the next 12 months.
Top Financial-Services Sector Picks
Star Rating
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
City National
QQQQ
$64.00
Narrow
Medium
Julius Baer Gruppe
QQQQ
CHF 42
Wide
High
Old Republic
QQQQ
$15.00
Narrow
Very High
Consider
Buying
$44.80
CHF 25.20
$9.00
City National CYN
City National is one of our favorite lenders among U.S. regional banks. Its focus on wealthy
business owners and its low-cost structure garner the bank a narrow economic moat. With a
solid balance sheet, City National is well positioned to take advantage of the dislocation in its
markets and grow internally by gaining share from troubled lenders or acquiring failed or
distressed banks.
Julius Baer Gruppe AG BAER
Were optimistic about Baers acquisition of Merrill Lynchs non-U.S. wealth management
operations, which we think will help the bank to build scale in fast-growing markets and lessen
its dependence on Swiss offshore banking. While Julius Baer may not enjoy the same worldwide name recognition as some of its Swiss competitors, we see that as an advantagethe
private banks brand has been relatively untarnished by scandals or heavy losses during the
financial crisis. While the bank faces currency risk because its expenses are predominantly
denominated in Swiss francs (which eventually could appreciate against dollars and euros), we
think the risk is balanced by its quality business and its current discount to our fair value
estimate.
59
Old Republic International ORI
At its heart, Old Republic is a well-run commercial property-casualty insurer, and although
some of its forays into other areas in the past have not worked out as well as intended, the
strength of the primary business line has kept the ship afloat. The stock has been battered ever
since one of its primary operating subsidiaries, mortgage insurance, suffered skyrocketing
claims from residential mortgage foreclosures and was placed into run-off. Though its troubles
are not yet over, we think management is focused on the difficulties at hand, and that it is
capable of guiding the business profitably through these uncertain times.
Jim Sinegal does not own shares in any of the securities mentioned above.
60

December 21, 2012
Our Outlook for Health-Care Stocks

Election and potential sequestration emerge as key topics for
health care.
By Alex Morozov | Director of the Health-Care Equity Research
3 Like it or not, Obamacare is here to stay.

3 Less uncertainty creates more opportunity for the health-care industry.
3 Sequestration can still be avoided, but if not, expect a rather challenging year for health care.
PPACA: Nearly 3 Years Later, It Is the Law
Regrets? He might have had a few, but he did what he said he would and saw it through
without exemption. Indeed, President Obama did it his way, and the Patient Protection and
Affordable Care Act is the law of the land after the Democrats retained the White House and
majority in the Senate in the November elections. So now, we are about to witness the biggest
overhaul of the U.S. health-care system since the Medicare introduction back in 1965. Below
is the timeline for some of the more important provisions of the law (note: a few PPACA provisions have been already quietly introduced during the past few years):
2013:
3 Excise tax on medical devices
3 Further subsidies to close the Medicare Part D doughnut hole
3 Elimination of tax deduction for employers receiving retiree drug subsidy payments
2014 (a key year for reforms):

3 State-based health insurance exchanges (note that this is probably the most contentious piece
of the puzzle now since the repeal is off the table with many states taking a stance against
exchanges, though we believe that at the end of the day, most if not all states will have
exchanges set up).
3 Premium and cost-sharing subsidies
3 Regulations on health insurers: community rating, guaranteed issue and renewability, standardization of coverage, and so on.
3 Expansion of Medicaid eligibility (states may, however, opt out as a result of the Supreme Court
ruling)
3 Individual mandate (and penalties based on the 2014 taxable income)
3 85% floor on Medicare Advantage plans
3 Health insurance industry fees
2018:
3 Cadillac taxexcise tax on high-value employer-sponsored health plans
61
Weve written ad nauseam about what the PPACA means for the health-care sector in detail,
so heres a quick summary:
Managed Care: It Could Have Been Way Worse
Although most managed-care firms were probably secretly hoping that the PPACA would get
the boot, the industry evaded a major kick in the gut in June when the individual mandate
requirement got upheld by the Supreme Court. While the PPACA doesnt offer many positives
for the industry, we note that managed care has long been in the crosshairs of politicians and
regulators, so the PPACAs passage in itself hasnt made the future overly bleak for companies
everyone loves to hate. What the reform did give the industry, however, is an option to capture
a sizable chunk of new patients coming into the system starting in 2014. Even with the industry
fees and MCR floors (calculations which allow MCOs plenty of wiggle room), health insurers,
particularly the ones with Medicaid operations, arent faced with extinction. Even more so,
there is definitely more clarity on the regulatory front now than there had been during the past
decade. With most insurers having ample time to prepare, the industry prospects are actually
fairly decent, and the stocks by and large appear to reflect that. The lone exception, WellPoint
WLP, has been plagued by execution issues and recently ousted its CEO; the companys
business model and scale still position it as one of the top names in the industry, so we view its
operational mishaps as repairable and shares as attractive.
Pharmaceutical Industry: Pay Up and Wait for the Next Shoe to Drop
The reform in itself doesnt materially affect most pharmaceutical firms, with fees levied on the
industry largely offset by the inflow of new patients. A much bigger deal, however, is the likely
sequel, Health Care 2.0: The Attack on Dual Eligibles, which, surprisingly, gets enough love
from both sides of the political aisle. Getting 9 million patients who qualify for both Medicare
and Medicaid yet reimbursed at Medicare pricing levels which are switched to Medicaid
pricing (roughly 20%30% below Medicare) would save the overall system $86 billion$135
billion during the next 10 years (sources: House Oversight and Government Reform Committee,
CBO, and the Presidents Plan for Economic Growth). Although we still anticipate less than a
50% chance that the conversion will actually happen, the magnitude of the impact on individual
companies earnings is somewhat material, particularly for companies with significantly greater
exposure to Medicare Part D. We estimate Bristol-Myers BMY, Eli Lilly LLY, Celgene CELG, and
Actelion ALIOF could see a 7% or greater hit to earnings if the legislation is passed. The impact
on most other pharmaceutical and biotechnology companies is far less meaningful.
Devices: Reform Is a Blessing in Disguise
Clearly, the medical-device segment fared worse than any other part of the health-care industry as a result of the PPACA, and we struggle to find many positives directly related to the
reform. But the increased regulatory and reimbursement scrutiny, along with the 2.3% excise
tax commencing in 2013, at the very worst provided a nice wake-up call for the industry previously mired in complacency. Even before the PPACA, we had seen some warning signs flashing
regarding the Food and Drug Administrations changing stance on the device-approval process
and hospitals balking at the device makers insistence to charge higher prices for products
providing limited benefits to patients. At the same time, the device industry wasnt very swift
62
to adjust its cost structure to align it more closely with both the shifting demand for technological advancement as well as demographic patterns. The horse is out of the barn now, and while
device companies will probably point to the device tax as key reason why they are moving
more of their operations overseas, particularly into emerging markets, it is clear that the developed world isnt quite as lucrative for the industry now as it was a decade ago, and the bloated
infrastructure in the U.S. needed to be adjusted sooner or later. The emphasis on emerging
markets as well as truly innovative products is a positive for an industry desperate for growth,
so at the very least, the reform serves as a catalyst for these changes. Arguably, the reform
actually widens the moats of some of the larger device players; raising the costs for start-ups/
emerging technologies has in turn put more power in the hands of industry behemoths, making
them even more appealing as partners or acquirers of intriguing technology at earlier stages.
Thus, we still have a number of recommendations in the device space, most notably Covidien
COV, St. Jude STJ and Abiomed ABMD.
Health-Care Providers: Not All Roses
Hospitals stocks popped with the Democrats win as investors decided that close to one fifth
(depending on the hospital) of the revenue service providers previously wrote off to charity
care/uninsured discounts is coming back straight to the bottom line. Well, first of all, it isnt
quite that simple. Hospitals are clearly better off now than they were before the PPACA
(particularly with unemployment soaring and the commercial insurance ranks tanking). But not
all individuals will enroll in 2014, and many of the ones who do are likely to receive Medicaid
reimbursement (which is much stingier than that of private payers or Medicare). Second, hospitals have an unenviable stuck-in-the-middle position, where reimbursements in general are
coming down, yet the hospitals ability to pass down these cuts in the form of ASP decreases
and lower salaries is generally limited. As such, hospitals, being the no-moat industry, are likely
to bear the brunt of federal governments health-care cost-squeezing efforts. Additionally,
new efforts to tie provider payments to quality-control measures have also forced hospitals to
invest in IT. The segment doesnt have much positive going for it, from our perspective. At this
point, we dont recommend any hospital stocks.
Sequestration Cuts Will Be Felt Throughout Health-Care Sector
It is becoming a real possibility that there will be no deficit-reduction compromise attained

before the end-of-the-year deadline, and automatic budget cuts will take effect in January
2013. The magnitude of these cuts varies from 2% to Medicare to as much as 8.2% to nondefense nondiscretionary spending such as National Institutes of Health funding. Weve been
operating under the assumption that these cuts have a reasonable chance of happening, and as
result, most of our valuations for health-care providers, and to a lesser degree device suppliers,
have incorporated reimbursement reductions.
Ultimately, this is not a devastating outcome for many health-care industries, but some
mainly providerswill be left reeling, especially given an already-challenging reimbursement
environment. If sequestration occurs, we estimate reimbursement growth will be essentially
flat for most service providers in 2013 based on the current reimbursement levels set by the
Centers for Medicare and Medicaid Services. Our investment thesis on the provider segment
63
contends that slowing Medicare-reimbursement growth is likely to erode most benefits

obtained by the health-care providers from the decline in uncompensated care under the
PPACA. This industry remains largely at a mercy of the government, and no current provider
carries an economic moat as a result of the few levers available to combat any reimbursement
headwinds.
The life science sector is the other area directly affected by sequestration. If the NIH does in
fact lose 8.2% of its funding, it is very likely that new grant awards will come to a screeching halt, suppressing the demand for life science research instrumentation and consumables.
Academic and government customers account for a meaningful chunk of most life science firms
revenue streams, but the extent of sequestration damage is probably overblown. First, most
firms in the sector have been operating in a spending-constrained environment for the past 12
months, as research labs preemptively tightened their spending in anticipation of future cuts.
Second, with the exception of a few firms (Illumina ILMN, for example), no life science company
is at the complete mercy of the NIH budget; academia and government typically dont represent
the majority of total revenue, mitigating a potential high-single-dig it decline in orders from that
end market. Our expectations for 2013 are muted for the sector, but there are a few interesting investment opportunities likely to stem from this uncertainty. Our top pick here is Thermo
Fisher Scientific TMO.
Top Health-Care Sector Picks

Star Rating
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Covidien
QQQQ
$76.00
Narrow
Medium
$53.20
Express Scripts
QQQQ
$73.00
Wide
Medium
$51.10
Icon
QQQ
$32.00
Narrow
High
$19.20
WellPoint
QQQQQ
$91.00
Narrow
Medium
$63.70
Covidien COV
As weve been advocating for several years, Covidien is spinning off its underperforming
pharmaceutical business. We believe this transaction will allow investors to appropriately
judge the company and its core device business; we consider the shares undervalued. The
companys moat trend is now positive. Covidiens device-growth prospects are compelling,
as the latest product launches have been well-received by the marketplace and the company
successfully integrated a number of sizable acquisitions. Although a weak macroeconomic
environment continues to hamper the elective procedure volume, the companys revenue
growth in the device segment remains strong, particularly in energy and vascular, where
Covidien continues to gain market share. With emerging markets also fueling growth, we
expect strong revenue and earnings momentum despite ongoing investments in research and
development and sales.
64
Express Scripts ESRX
Were big fans of Express Scripts high-return-on-capital business model as well as its
exemplary management. The company has established a wide economic moat through a
series of acquisitions, which have granted Express Scripts unmatched bargaining power over
suppliers, the ability to leverage fixed costs, and differentiated pharmacy benefit management capabilities. With the Medco integration barely under way, Express Scripts has already
stared down major suppliers like Walgreen WAG and the pharmaceutical distributors and made
progress toward realizing at least $1 billion in synergies. We see the company continuing to
create shareholder value for the foreseeable future.
Icon ICLR
Icons growing scale has helped it gain entrance into the upper echelon of the contract
research industry, and we think the firm will continue to benefit from industry tailwinds provided by drug companies increasing tendency to outsource R&D work. However, a slowdown
in drug-development spending has led to capacity underutilization and losses in the firms
central lab division, and hiring in anticipation of an uptick in demand has weighed on earnings.
We think the firms results hit a low point in the third quarter of 2011 and earnings will regain
traction throughout 2012 as central labs pass break-even and new partnership deals begin
to meaningfully contribute to revenue. As demand returns, Icon should see high-single-digit
top-line expansion and operating margins return to the double digits by the second half of this
year as it leverages new staff and infrastructure across an expanded revenue base.
WellPoint WLP
WellPoints 14 Blue Cross and Blue Shield plans endow the company with a unique combination of regional and national scale. The former is the key to negotiating favorable provider
rates, while the latter is essential for leveraging administrative costs. The company has failed
to capitalize on its competitive strengths in recent years, which we attribute to poor execution.
WellPoint is on the hunt for a new CEO, with several promising external candidates available.
In the meantime, the management team is being strengthened with acquired talent. Following
President Obamas re-election, investors are as fearful as ever about the effects of health
reform. We see opportunities as well as risks under the reform law but believe investors enjoy
a substantial margin of safety at current stock prices. Long-term investors should benefit from
the depressed stock, which is facilitating highly effective share repurchases.
Alex Morozov, CFA, has a position in the following securities mentioned above: WLP
65

December 21, 2012
Our Outlook for Industrials Stocks

Prospects are looking positive for autos, railroads, and staffing, while
possible sequestration could bode ill for defense.
By Keith Schoonmaker, CFA | Director of Industrials Equity Research
3 Macro industrial indicators are mixed but slightly positive in our view: Domestic industrial
production rose 2.5% in November, but PMI remains below the critical 50 mark in both the U.S.
and eurozone, though the latter increased to a nine-month high.
3 Domestic auto demand remains robust: November was the best month this year for U.S.
light-vehicle seasonally adjusted sales; General Motors GM and Ford F are still 5-star buys.
3 The fourth quarter brought a flurry of dividend activity ahead of potential U.S. income tax rate
changes.
The quarters overall industrial climate was mixed but slightly positive in our view. The
November U.S. industrial production index improved 2.5% from the prior-year period, following 1.7% and 2.8% year-over-year gains in September and October. However, the past four
months mark the weakest percentage growth rates since February 2010. Within the Federal
Reserves industrial production report, November manufacturing expanded 2.7% year on
year, and comparisons with 2011 are positive but also slowing.
The Institute for Supply Management reported the U.S. manufacturing PMI dipped below 50
again in November, to 49.5 from 51.7 in October and 51.5 at the end of the third quarter. The
12-month mean domestic PMI of 51.9 is elevated due to stronger indications in the first half
of 2012. Providing some encouragement, however, new orders remain above 50 (at 50.3) and
the new order/inventory ratio again climbed due to the inventory reading falling five points
to 45. Turning to overseas surveys, the Dec. 14 HSBC flash China factory PMI rose to 50.9
the fifth consecutive monthly gain and the highest mark since October of last yearand
the Markit eurozone flash estimate PMI rose to a nine-month high in December, but at 47.3
remains below the 50 demarcation.
In addition to broad indicators and survey results, we look to transportation volumes for near
real-time insight into the health of the economy. North American trucking and rail volumes
remain positive overall, but plenty of commodities are also weaker than the year-ago cumulative volumes. The ATA Trucking Tonnage Index slipped 2.2% in October from the prior-year
period, but a fraction of this decline might be due to disruption from Hurricane Sandy during
the final days of the month. Prior to October, the truck tonnage index had increased year over
year in every month since December 2009. The Association of American Railroads reported
that through early December intermodal volume was up 4.3% from the prior-year period and
carloads were down 1.8%; excluding coal, cumulative carloads improved 2.6%. Among major
66
commodity classes, year-to-date coal is down 9.6% year over year, grain is off 6.8%, and
chemicals declined 1.9%. The sharpest gainers are autos (up 14.1%) and petroleum products
(up 37.4%).
U.S. Auto Sales Remains Robust
Automakers reported November U.S. light-vehicle sales that were the best of the year so far
on a seasonally adjusted annualized basis. Total vehicles delivered to consumers increased
15% from the prior-year period to 1.13 million. Automotive News reported that the seasonally adjusted annualized selling rate, or SAAR, was 15.56 million, above 13.57 million in
November 2011 and 14.31 million in October 2012. The trade journal stated that was the best
SAAR since 15.59 million in January 2008. Ford estimated that Hurricane Sandy contributed
20,00030,000 units of industry volume, mostly October sales that the storm delayed until
November. General Motors estimated that the storm increased the SAAR by 400,000 units
and that in total, the storm will require 50,000100,000 vehicles to be replaced. Although
management at major automakers would like to see the uncertainty of the fiscal cliff be
resolved, we do not detect a major slowdown in automotive demand.
Indeed, we remain optimistic about the continued recovery of the U.S. auto industry from
its severe low of 10.4 million vehicles sold in 2009. Consumer credit is readily available, the
fleet age remains at record highs, and the Japanese automakers have inventory. Additionally,
GM will have plenty of key product launches next year, including the next generation of fulland midsize pickups trucks, the Chevrolet Impala full-size sedan, and the Buick Encore small
crossover. We expect new high-volume vehicles, such as trucks and crossovers, to drive
traffic to showrooms next year. We maintain our Morningstar Ratings for Stocks of 5 stars
on both Ford and GM. Adjacent to the consumer vehicle space is another of our other strong
buy recommendations, RV manufacturer Winnebago WGO. The stock has appreciated 85%
year to date and thus ratchets to a 4-star rating on valuation, even as we slightly increased
our fair value estimate.
The Fourth Quarter Brought a Flurry of Dividend Activity
Unusual return of cash to shareholders was a phenomenon hard to miss in industrials this
quarter. Trucking in particular is rife with high cash balances and significant founding family
share ownershipa recipe for special dividends in the face of potentially higher dividend
income tax rates if weve ever seen one. Heartland Express HTLD and Knight Transportation
KNX paid special dividends in 2010 and announced another this quarter, along with Marten
Transport MRTN and Werner Enterprises WERN. A handful of firms in other sectors (such as
Fastenal FAST, Kforce KFRC, and Paccar PCAR) announced specials, too, and some companies (Johnson Controls JCI, for example) pulled normal first-quarter payments into the
fourth quarter to spare shareholders the uncertainty of 2013 dividend tax-rate changes.
Landstar System LSTR pulled forward anticipated 2013 and 2014 quarterly dividends into
December 2012 and will evaluate its payout policy in late 2014. In addition to changes in
normal dividend-payment schedules, several firms (including Delphi Automotive DLPH and
TRW Automotive TRW) indicated that uncertainty on dividend tax policy will likely increase
emphasis on share-repurchase programs. Were no fans of higher taxes, but recognize that
67
even in the likely worst-case scenario, many personal investors may realize lower than the
peak (low-40% range) income tax rate being bandied about for 2013 dividends because of
less severe actual legislation, the fact that theyre holding investments in tax-sheltered
retirement accounts, or the fact that theyre falling below peak progressive income tax rates.
Still, these special dividend payments reduce our ex-dividend per-share valuation slightly
because they reduce the enterprise value. This aside, we consider the sector as a whole to
be slightly undervalued and maintain interest in individual stocks that we think offer material
upside potential.
Near-Term Prospects for Diversified Industrials Mixed by Geography
We see two overarching themes driving near-term growth for diversified industrial companies: stagnant activity in Europe and Asia, and a rebound in residential construction activity
in the U.S. Corporate executives and industry participants continue to voice long-term
concerns about Europe to the extent that even at bargain prices available in the market
right now, management would be reluctant to buy any new assets in that region. In China,
the broader concern is the change in top leadership and resulting changes that will come
at major corporations. With so many moving pieces, it is quite possible that the country
muddles along in the short term before regaining its footing.
After more than five years of weakness, U.S. residential construction looks positive going
into 2013, supported by homebuilder confidence, consumer confidence, and, importantly,
actual construction. We expect electrical products companies such as Hubbell HUB.B, as
well as an assortment of building products firms such as Stanley Black & Decker SWK,
Mohawk Industries MHK, and Masco MAS, to deliver meaningful top-line growth in these
markets next year. Although commercial construction has yet to show similar signs of recovery, that market typically lags the residential market by 12 to 18 months.
Railroads: UP and Kansas City Southern Benefit From Mexican Manufacturing
We think shares of all U.S. Class I rails are undervalued at present and point to Union Pacific
UNP as a low-risk option. Its coal exposure is lower than that of the eastern rails, CSX CSX
and Norfolk Southern NSCeach have about 30% of revenue from coal versus 22% at
Union Pacificand the coal it carries is cheap-to-mine Powder River Basin coal, not the
hard-to-retrieve Central Appalachian variety. UP is also the only rail that still has a legacy
contract repricing benefit, and price is a powerful lever. If manufacturing accelerates in the
U.S. and Mexico due to relative attractiveness of total cost in wages and transportation
(versus Asian plants), UPs attractiveness increases, as it operates a material intermodal
business at Los Angeles/Long Beach for importing parts for U.S. production and earns 10%
of its revenue on traffic to/from Mexico via multiple interfaces at the border. UP also owns
26% of the Ferromex Mexican railroad. Even more exposed to Mexican nearsourcing is
Kansas City Southern KSU, which derives about 45% of sales from its Mexican operation.
Kansas City Southern has some additional powerful growth drivers in highway conversions
to intermodal at Laredo, Texas, where it has exclusive rail passage at this busy crossing, and
in several new auto plants developing in Mexico. Video of our conversation with Kansas City
Southern is on Morningstar.com.
68
Canadian Pacific Railway CP during the quarter hosted an investor meeting to lay out the
plans its new CEO has for this ripe-for-turnaround rail, the only remaining margin laggard.
We believe iconic CEO Hunter Harrison (at the helm since summer) has begun to catalyze
significant change at CP. We hear great progress and plans, but its still early to credit the
rail with an operating ratio near its peers within a few months of Harrisons arrival. That
said, Harrisons history of turning around two railroads make him the low-risk leader for this
rail with strong potential for operating improvement and commensurate earnings-per-share
growth.
Defense Sell-Off Possible Without Sequestration Resolution
The Budget Control Act of 2011 outlined cost reductions to offset debt-ceiling increases
of up to $2.1 trillion in multiple steps. In late November 2011, a bipartisan supercommittee tasked with identifying reductions announced it had failed to do so, paving the way for
across-the-board cuts to begin Jan. 2, 2013. This messy and illogical process, called sequestration, could cut the Department of Defenses budget by nearly $1 trillion over 10 years,
unless Congress takes action to avert it. We note the exposure to short-cycle IT services
is a headwind, while international sales has been a tailwind for sales growth. Of the prime
contractors, General Dynamics GD and Northrop Grumman NOC have high IT exposure, while
Raytheon RTN is tops in international exposure.
Looking at our fair value estimates that attempt to embed significant cuts to the DoD budget
and comparing them with current market prices, the market seems to believe Congress will
take some action to avert the planned cuts, which are currently law. Should sequestration
occur, we think the defense sector would likely experience a knee-jerk investor reaction
to sell shares. However, we believe that the companies could manage their businesses to
the new revenue opportunity. Although the $160 billion of sales that are expected in 2012
would likely fall in 2013, we expect the companies to aggressively right-size their footprints,
in concert with historical practices. Prime contractor operating margins have averaged
10.5% during the past five years, and we think that is a reasonable estimate in three to four
quarters following sequestration.
Staffing
Since the beginning of 2010 through November 2012, nonfarm payrolls have increased by
more than 4 million jobs. We believe growth for the U.S. employment market should remain
moderate during the next several months, but we also expect this trend to accelerate during
the course of 2013. Given the Federal Reserves stated goal of easy monetary policy until
unemployment reaches 6.5%, and barring another steep economic downturn, an accelerating trend is in the cards for job growth, in our opinion. This dynamic will benefit firms that
provide employment services to businesses.
The employment-services industry has rebounded sharply from recessionary levels with
many players experiencing solid operating improvement. Businesses have used human
resources outsourcing services to a greater degree in order to build efficiency. We believe
this trend is a long-term positive for our employment-services coverage list. Secular
69
tailwinds for the employment-services industry should especially benefit payroll processor Paychex PAYX. The firm has produced returns on invested capital averaging above 70%
during the last 15 yearsits triumvirate of high customer switching costs, solid scale advantages, and a respected brand image constitute a wide economic moat. We believe the stock
is currently undervalued, and investors have an opportunity to gain a decent return from a
top-tier business.
Our Top Industrials Picks
We consider most of our industrials coverage universe to be fairly valued. Since last quarter,
the ratio of industrials sector prices to Morningstars fair value estimates crept upward
from 0.91 to 0.93; as price/fair value approaches the value of 1.00 in this manner, we find
less margin of safety below our estimated intrinsic value. Auto manufacturers and autoparts suppliers remain the greatest pockets of value in our opinion (0.71 and 0.77 respective
current price/fair value), and heavy farm and construction equipment manufacturers, logistics, and staffing sectors offer the next most attractive valuations by our metric. We have
picked several individual stocks that we consider to be on sale at this time and suggest
investors keep these names on their radar.
Top Industrials Sector Picks

Star Rating
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Caterpillar
QQQQ
$106.00
Wide
High
$63.60
Expeditors Intl of Washington
QQQQ
$51.00
Wide
Medium
$35.70
Gentex
QQQQQ
$27.00
Narrow
Medium
$18.90
WMS Industries
QQQQQ
$33.00
Narrow
Medium
$23.10
Caterpillar CAT
Cat holds sizeable exposure to mining equipment (25%30% of total sales), and the firm
is still heavily leveraged to the ongoing North American recovery in both residential and
nonresidential construction. Near term, the company will face headwinds in its European
and Asian operations (about half of sales), but we expect U.S. operations to enjoy strong
results in the coming quarters. The long-term potential remains strong for this market leader.
In addition, the recently declining stock price (off about 3% year to date, versus about 15%
positive year-to-date performance for the S&P 500 Index) offers a decent margin of safety
for this wide-moat firm, in our opinion.
Expeditors International of Washington EXPD
We maintain our opinion of Expeditors as one of the highest-quality transport stocks we

cover, and we believe shares are attractively priced at this time. This non-asset-based, thirdparty logistics firm produces fantastic 25%-plus ROICs by arranging international air and sea
shipping and handling customs brokerage so clients can focus on core operations. Although
the firm has faced demand headwinds for more than a year, we think expectations of modest
70
or no near-term airfreight volume growth are already incorporated into the share price. We
believe shares of well-managed, well-capitalized Expeditors are trading at recessionlike
multiples and at a significant discount to our fair value estimate. Expeditors owes no debt,
holds more than $6 per share in cash, and yields about a 1.5% dividend.
Gentex GNTX
We highlighted Gentex in our prior quarterly commentary but reiterate our interest to point
investors to a pending government ruling that might affect the share price. Gentex holds a
commanding 88% global market share in auto-dimming rearview mirrors, and we consider this nonunion technological innovator to be a top-shelf auto supplier. Weak European
demand is a present headwindand Germany constitutes about a quarter of total sales
but we think that the firms fortress balance sheet (debt free and boasting about $4 per
share of cash and investments) can weather a storm. Dec. 31 is the deadline for the National
Highway Traffic Safety Administration to issue a final ruling on automaker compliance with
the Kids Transportation Safety Act of 2007 signed by President Bush. Thats right: 2007.
Clearly deadline means something different to the government than it does to us mere
mortals, as this due date has been pushed back multiple times, but share-price movement
surrounding this scheduled announcement date could afford alert investors an opportunity to buy Gentex at a discount (its already attractive at 5 stars and pays a 2.8% dividend
yield). This ruling will specify details about the timing of mandated compliance and possibly
the placement of a rear camera display (could be in Gentex RCD mirrors, or in a navigation
screen or dashboard). We model just 10% of the industry to use RCD mirrors to comply with
this act, but emphasize that the actual rate is highly uncertain. That said, our valuation relies
more heavily on general industry health than on the NHTSA ruling.
WMS Industries WMS
Overexpansion by gaming operators during the early 2000s created a lackluster operating
environment for the gaming manufacturing industry. The confluence of this secular dynamic
and recent operational missteps have hampered WMS. The firm has reported disappointing
results for most of the last few years as a result of poor gaming development and production
execution. However, WMS has recently started to correct these problems and its business
seems to be operating at a healthier level. We believe customers will eventually need to
replace aging machines as gambling patrons seek the most entertainment per dollar spent.
This variable will drive accelerating demand for WMS beyond the near term, and with an
improved operational structure, we expect the firm to expand its revenue and operating
margins materially over the medium to long term. Shares of the gaming-machine manufacturer have been decimated during the last two years, falling from a high of approximately
$50 per share to its current low of approximately $16. However, negative trends are limited
to the near term, in our opinion, and we believe improving operational conditions will boost
the firms results.
Keith Schoonmaker, CFA, does not own shares in any of the securities mentioned above.
71

December 21, 2012
Our Outlook for Real Estate Stocks

Equity REIT fundamentals remain healthy, but per-share valuation
premiums warrant selectivity.
By Philip J. Martin | Director of REIT Research
3 We believe equity REIT valuation premiums and persistent global economic uncertainty and
volatility require REIT investors to be more cautious and selective.

3 We believe equity REITs have traded at premiums to our estimated fair value throughout 2012
based on attractive growth and income characteristics and solid operating and balance sheet
fundamentals.
3 Healthy capital structures and dividend payout ratios should allow equity REITs to maintain,
and in many cases, increase dividends, even in an uncertain economic environment.

3 Favorable commercial real estate supply fundamentals and an improving economic environment continue to provide a boost to equity REIT operating fundamentals, cash flow, and
underlying portfolio valuations.
Equity REITs Continue to Benefit from Solid Growth, Operating, and
Dividend Fundamentals
After trading at 10%15% premiums to our estimate of fair value throughout most of 2012,
shares of equity REITs currently trade at a 5%10% premium. Rather than anything specifically related to weakening equity REIT operating or sector fundamentals, the reduced
premium is more a reflection of macroeconomic concerns related to the fiscal cliff and
Europe. According to the National Association of Real Estate Investment Trusts, equity REITs
delivered year-to-date and quarter-to-date total returns, through November, of 14.1% and
negative 0.9%, compared with the 15% and negative 1.3% for the S&P 500, respectively. Of
note is the strong year-to-date performance of several more economically cyclical real estate
sectors. For example, after posting negative full-year 2011 total returns, the industrial and
retail shopping center sectors are among the top performers in 2012, with year-to-date total
returns of 22.6% and 23.0%, respectively. The outperformance from the more economically
cyclical sectors perhaps indicates a more sustainable economic recovery going forward.
The respectable overall performance, relative to the broad market, has resulted in equity
REIT shares continuing to trade at valuation premiums, with the catalysts being relatively
high and sustainable dividend yields, improving portfolio operating fundamentals, healthy
capital structures and the potential benefits as a hedge against eventual higher interest
rates and inflation. For example, on average, equity REIT dividend yields are 3.6% (range
average 2.5%6.5%), well above the 10-year Treasury and S&P 500 yields of 1.6% and
2.1%, respectively. Dividend-payout ratios averaging 68% should allow for average annual
72
near-term dividend growth of 5%. Add to this improving cash flow as same-store real estate
portfolio operations are either stabilizing or beginning to experience renewed growth from
increased occupancy and rental rates. Equity REITs also maintain healthy balance sheets,
with debt/EBITDA and fixed-charge coverage ratios averaging 7.0 times and 2.6 times,
respectively. We believe another factor contributing to premium valuations is the shifting
attitude toward equity REITs by investors. For example, equity REITs continue to be more
widely utilized, by an increasingly broader investor base, as part of an overall growth and
income strategy, as opposed to an income only. This is driven by a unique combination of
relatively attractive yields and equity REIT business-model growth leveraged to an improving
economy, potentially benefiting portfolio operations for years to come. We estimate equity
REIT shares are currently trading 5%10% above fair value, in line with average historical
premiums. We believe valuation premiums will persist as investor appetite for sustainable yield and dividend growth persists, and equity REITs continue to benefit from healthy
commercial real estate supply and a slowly improving economic environment, which should
continue to provide a boost to portfolio operating fundamentals, cash flow, and underlying
portfolio valuations.
Equity REIT Valuation Premiums Likely to Continue, but Selectivity Required
Heading into 2013 we believe the combination of continuing equity REIT per-share valuation premiums and persistent global market and economic uncertainty and volatility require
equity REIT investors to be more cautious and selective. Differentiating factors will largely
revolve around a combination of dividend-growth potential, balance sheets and capital structures not overly dependent on the capital markets, and business models characterized by a
diverse operating skill set and more durable cash flows. Equity REITs not possessing these
attributes will be relatively less competitive and more vulnerable to rising interest rates and
economic and financial setbacks, in our view. From a dividend perspective, for example, we
are not just focused on sustainability, but long-term growth potential as interest rates will
eventually begin to rise, pressuring dividend-paying stocks. We therefore will be targeting,
among other items, equity REITs with adjusted funds from operations, or AFFO, dividendpayout ratios below 85%, a level allowing for both relatively greater downside protection
and growth potential.
In terms of capital structure, equity REITs with lower leverage and less dependent on capital
markets for growth and refinancing should be relatively better-positioned to expand balance
sheets opportunistically and/or weather economic and financial volatility. As for consistency
of cash flow we tend to concentrate on equity REIT business models possessing a broad
operating skill set and/or a portfolio less dependent on the economic cycle, such as health
care, where demand is more need-driven. We define broad operating skill to include cash
flows throughout market cycles, as well as acquisition, development and property management capabilities, which we feel more appropriately positions the REIT to exploit growth
opportunities and manage risk. By contrast, equity REITs too one-dimensional are often less
competitive and sidelined at points throughout the market cycle and/or forced to consider
less-than-ideal or less-than-appropriate investment opportunities.
73
Real Estate Sector Picks for Your Radar

Star Rating
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Projected
Yield (%)
Ventas
QQQ
$64.00
Narrow
Medium
4.1
HCP
QQQ
$44.00
Narrow
Medium
4.6
Health Care REIT
QQQ
$59.00
Narrow
Medium
5.1
Senior Housing Properties Trust
QQQ
$25.00
Narrow
High
6.7
Alexandria Real Estate Equities
QQQQ
$87.00
Narrow
Medium
3.5
AvalonBay Communities
QQ
$118.00
Narrow
Medium
3.1
From a real estate sector standpoint, we remain most positive on health-care REITs based on
valuation, along with sustainability of dividends, operating performance, and cash flow. We
estimate shares are trading in line with fair value and that business models and portfolios
should continue to benefit, through economic cycles and uncertainty, from the need-driven
nature of health-care services. Supply and demand fundamentals are among the strongest in commercial real estate. Incremental new health-care real estate supply has been
extremely limited the last five to 10 years. But demand growth has continued to increase
due to consistent annual long-term health-care industry growth nearly 2.5 times inflation, a
large and aging population older than 65 in need of a wide range of health-care services, and
the fact that care providers/health-care systems need reliable and cost- and care-efficient
real estate financing and services. We would suggest investors consider shares of Ventas
VTR, HCP HCP, and Health Care REIT HCN, especially on a pullback as the companies have
diversified health-care portfolios across the acuity-of-care spectrum, manageable exposure
to Medicare and Medicaid reimbursement risk, a broad operating skill set with significant
organic-growth potential, healthy balance sheets, and track records of creating long-term
shareholder value. Add to this dividend yields ranging from 3.9% to 7.7%, many of which are
secure and positioned to grow an average of 3.0%5.0% during the next few years. Senior
Housing Properties Trust SNH offers a compelling valuation, a secure 6.9% dividend yield
and strong balance sheet. Offsetting the positives, however, and differentiating it from the
other health-care REIT peers, is a lack of tenant diversification, related-party transactions,
and a higher weighted average cost of capital, which limits competitiveness and profitability.
Staying with our health-care theme we cannot fail to mention Alexandria Real Estate
Equities ARE, which remains on our best idea list and is trading 20% below our fair value
estimate. Our investment thesis is based on a niche and high-barrier-to-entry business model
benefiting from an excellent management team and business model focused on well-situated life science real estate clusters leased to very high-quality tenants in the life science,
biotech, and pharmaceutical sectors. The tenant base is less cyclical, and Alexandrias diversified real estate skill set affords more consistent operating margins and organic growth
through economic cycles relative to many REIT peers. Our investment thesis also considers a
valuable and very difficult-to-replicate development pipeline, above-average annual dividendgrowth potential of 5%, and a healthy balance sheet able to support growth without being
overly dependent on the capital markets.
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Multifamily REITs continue to trade 15% above our estimate of fair value. Behind the premium valuation has been limited multifamily supply and increasing demand associated with an
uncertain single-family housing market, foreclosures, and a difficult home-lending environment, all of which have increased the pool of potential renters. The result has been strong
multifamily occupancies and annual rental-growth rates averaging 95% and 5%, respectively. We believe multifamily REIT share-price valuations are ahead of mid- to longer-term
sustainable operating fundamentals, assume five- to 10-year average annual rental growth
of an unrealistic 5%, and have not fully accounted for historically low interest rates and
the eventual improvement in single-family affordability and ownership in some markets.
Having said this, we cannot deny that the combination of limited multifamily supply, a weak
economy, and a difficult housing environment is likely to continue to drive demand and incrementally higher operating cash flows and performance into 2013. For valuation reasons, we
feel investors interested in maintaining a multifamily REIT weighting should be selective,
focusing on business models with more sustainable long-term rental-growth and operating cash flow potential. We suggest targeting multifamily portfolios in more unaffordable
single-family housing markets or those that cater to younger residents where affordability,
practicality, and mobility are the primary deciding factors. We would therefore recommend
investors consider AvalonBay Communities AVB on a meaningful share-price pullback.
Philip J. Martin does not own shares in any of the securities mentioned above.
75

December 21, 2012
Our Outlook for Tech & Communication Services Stocks

Investment opportunities exist in unloved areas.
By Grady Burkett, CFA | Associate Director of Tech Equity Research
3 The technology and telecom sectors are undervalued in aggregate, but investors should be
selective.
3 We see attractive buying opportunities in names that are currently out of favor with the
market.
3 We highlight five high quality names that generate strong free cash flows whose stocks are
attractively priced.
The technology and telecom sectors each look moderately undervalued, based on a marketcapitalization weighting of our price-to-fair value estimates. Still, we see a fair amount of
dispersion among individual stocks in both sectors, and investors seem to be shunning any
firm that faces uncertainty, regardless of the strength of the underlying business.
In the telecom sector, we are seeing this market sentiment manifest itself in a market
valuation divergence between the sharply undervalued European telecoms and fully valued
U.S. and Canadian telecom firms. Currently, investors are buying U.S. and Canadian firms
for yield, while shunning European firms on the belief that current dividends, even where
reduced, are unsustainable. Although many European service providers face a host of nearterm pressures, the market has pushed down the valuations of generally strong companies,
such as France Telecom FTE, much lower than we believe is warranted on macroeconomic
concerns.
In the technology sector, market sentiment surrounding the PC supply chain grew increasingly negative throughout the fourth quarter, and both Intel INTC and Microsoft MSFT sold
off. Both businesses are now priced for long-term decline, despite the fact that each firm
has pricing power in the PC supply chain and will generate substantial free cash flow even if
the PC market shrinks further. Moreover, we expect Microsoft and Intel to experience strong
growth from business segments unrelated to PCs, mitigating the long-term risks associated
with the firms PC exposures. We find each firms stock attractive, as we think the market is
overlooking the underlying competitive advantages that each firm possesses.
Interestingly, Apples AAPL fourth-quarter sell-off has pushed the firms stock into 5-star
territory, as the market seems to believe that this business is also about to decline. In other
words, the market is telling us that Intel and Microsoft, key beneficiaries of PC demand, face
secular decline, and that Apple, a key beneficiary of smartphone and tablet demand, faces
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secular decline. We find it highly unlikely that none of these firms capitalizes on growing
global demand for computing devices, whether desktop, notebook, tablets, smartphones, or
some other form factor.
Telecom
Three major events of the past quarter promise to permanently remake the U.S. telecom
landscape: T-Mobile USAs plan to merge with MetroPCS PCS, Softbanks capital injection
into Sprint S, and the Federal Communications Commissions decision to remove restrictions on the wireless spectrum that DISH Network DISH acquired in 2011. The first two
moves are designed to improve competitive positioning versus industry giants AT&T T and
Verizon VZ. The T-Mobile deal is all about spectrum and synergies. MetroPCS and T-Mobile
own spectrum portfolios that line up very well, which should enable a stronger LTE network
deployment. The deal should also improve marketing and purchasing scale while duplicating network assets such as tower rent and backhaul costs. The Sprint agreement provides
capital needed to fix the firms balance sheet and provide ammunition to buy additional
spectrum or make acquisitions.
The DISH spectrum action, on the other hand, adds additional uncertainty for DISH and the
smaller wireless carriers. DISHs spectrum holdings had originally been designated for satellite use but will now be available for traditional terrestrial wireless services. The FCC also
plans to move forward in 2013 with an auction for spectrum known as the H-block, which
partially sits between DISHs holdings and the spectrum that Sprint is using to deploy its
LTE network (the G-block). DISH has said that it will evaluate the new FCC rules and then
decide how best to proceed. This decision could have a major impact on our view of DISHs
valuation. As weve seen with Clearwire CLWR, a deep spectrum portfolio isnt worth much
without a viable business plan.
Speaking of Clearwire, rumors continue to swirl around Sprints intentions for the firm. Based
on Sprints past comments and the array of options in front of it, we believe the firm will take
its time in moving forward with Clearwire. Sprint is clearly interested in adding the H-block
to its spectrum holdings to directly augment the capacity of its LTE network. We believe this
spectrum could cost Sprint up to $3 billion, a figure that likely has to figure into its broader strategic planning. Given the proximity of DISHs spectrum to Sprints, we believe the
firms likely remain engaged in discussions to form a partnership. A deal between the firms
could allow DISH to meet build-out requirements far more cheaply and quickly than it could
independently while easing the pressure on Sprint to acquire additional spectrum. Finally,
Sprint also has to consider the potential benefits of a bid for MetroPCS prior to that firms
merger with T-Mobile USA. Ultimately, Sprint wont do anything in the near term that could
interfere with progress on its own network initiatives. Sprint has also said that it would
like to see how Clearwires LTE network upgrade progresses before making a decision on
the firm.
Despite the economic headwinds in Europe, carriers there also continue to push forward
with network enhancements. On Dec. 6, Deutsche Telekom DTEGY announced plans to spend
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EUR 4 billion over the next three years to speed up deployment of fiber-to-the-curb (FTTC)
and LTE technology. DT has been in a multiyear spat with European regulators, resulting in
one of the slowest fiber rollouts in Europe. However, Neelie Kroes, the European telecom
commissioner, has stated the need to produce durable regulatory guidance after previously
commenting that the EU would allow much greater flexibility on the pricing of wholesale fiber
sales. With these pronouncements, DT is ready to build FTTC to cover 65% of the German
population once the regulations are formally approved. In the past three years, particularly
since Liberty Global LBTYA acquired UnityMedia, cable operators have pressed their network
advantage to gain broadband customers. An easing regulatory burden is a big positive for DT
as it combats these rivals.
DT has joined another trend seen across Europe: In order to help pay for the additional
network spending, the firm followed fellow European incumbents Telefonica TEF, Telecom
Italia TI, France Telecom FTE, and KPN KKPNY in reducing its dividend, cutting it to EUR 0.50
per share for 2013 and 2014 from EUR 0.70 per share.
Elsewhere, France Telecom announced plans to deploy LTE technology more quickly in an
attempt to distinguish its network, especially relative to new entrant Iliad. FTs roaming
agreement with Iliad doesnt include LTE service, and FTs management has stated it doesnt
plan to add it. FT originally stated the same thing regarding 3G roaming; we suspect the
French government, which still owns 26.7% of FT, pressured the firm to sign a deal. In our
opinion, the political climate has since changed. With a new French president that is more
concerned with layoffs, which the other French telecom operators have announced recently,
we dont expect much government pressure to sign another deal. We believe the government
wants Iliad to increase its own capital expenditures, which will add jobs and also hinder its
ability to offer exceptionally low prices.
After adding stakes in KPN and Telekom Austria during the second quarter, America Movil
AMX now says it has no imminent plans to further increase its European exposure. Instead,
the firm will turn its focus back to Latin America. In Brazil, changes in the regulatory framework have definitely bled into the competitive landscape, as carriers have been a bit less
aggressive with their SIM card promotional offerings of late. Thats good news as margins
have been declining across the board. Mobile termination rate cuts, a choppy economic
backdrop, and aggressive promotional activity have all conspired to weaken the industrys
profitability. We believe, however, that margins should turn around in 2013 as firms restructure their commission frameworks and realize cost savings from their respective mergers.
In Mexico, competition is definitely heating up as marketing expenses have been on the
rise thanks to greater subsidies on smartphones. Through the first nine months of the year,
America Movils EBITDA margin in Mexico was down 320 basis points year over year (to
45.6%). The near-term prospects dont look much better, with NII Holdings NIHD recently
making its long-awaited 3G launch, and Iusacell now receiving cash injections from its new
deep-pocketed parent Televisa TV. Thankfully, America Movils scale economies allow it to
hold its margins stable amid a turbulent operational backdrop.
78
Semiconductors
The semiconductor market has continued to slow in the past couple of months, as softening
macroeconomic conditions have damped global chip demand. The weakness has been fairly
broad and includes the industrial, automotive, and consumer segments, though chipmakers
exposed to the PC market have had to endure a particularly tough business environment.
Semiconductor behemoth Intel is one of the chipmakers that has been affected by the PC
slowdown, which we believe is partly secular and partly cyclical. While PC sales in developed countries are being pressured by the popularity of tablets, the situation in emerging
markets appears to have more to do with uncertain economic conditions. Over the long term,
we think that PC chipmakers can still see some growth, as PC demand recovers in emerging
countries (such as China), though overall PC unit growth in the future will certainly fall short
of historical rates. As for Intel, we believe the firm has growth opportunities outside of its
core PC microprocessor business, particularly in server processors. The firm also continues to
make headway on smartphone and tablet processor opportunities.
The one bright spot in the semiconductor space continues to be in smartphones. Qualcomm
QCOM, the leading wireless chipmaker and licensor of key 3G and 4G technologies, has been
a major beneficiary of the smartphone phenomenon. Not only does the firm have a number
of marquee chip design wins, such as in Apples iPhone 5, but the shift to more advanced
wireless technologies, such as 4G LTE, is enabling Qualcomm to collect higher average
selling prices per chip. ARM Holdings ARMH, Broadcom BRCM, and Skyworks Solutions
SWKS all appear poised to profit handsomely from the secular shift toward smartphones and
tablets, which require additional chip content per device than basic flip phones, in the years
ahead.
Internet
In the Internet sector, we believe that headline risk around regulatory issues should be
ignored in favor of larger, more fundamental trends toward increased programmatic buying
and selling of digital advertising.
As advertising spending continues to move toward where users are, our optimism around
growth in digital advertising remains steadfast. In our view, we still believe that Facebook FB
and Google GOOG are two giants that will continue to help advertisers target their audience,
and we believe the maturity of the Google platform may be underappreciated. Google has
continued to integrate its advertising technology assets into its DoubleClick product, allowing buyers and sellers to purchase multiple ad formats, prices, and channels (including mobile
and desktop) with a simplified process. In order to replicate Googles path, we would expect
Facebook to acquire technology capabilities to eventually become a broader clearinghouse
for advertising. While we believe Facebooks recent stock price appreciation has been driven
by advertising success within the Facebook walled garden, our long-term thesis depends on
its ability to catch up to Googles mature advertising platform, offering advertisers an alternative way to reach their audience.
79
On the mobile front, we believe investors are overly focused on the smartphone wars
without understanding the key assets that companies need to hold onto their competitive
advantages. Googles relaunch of Google Maps for Apples iOS platform is a great reminder
that Google will be successful wherever users access its applications, and that squashing
Apple is not in its best interests, at least over the near term. We also look to Yahoo YHOO to
invest more heavily in core products such as Flickr and Yahoo Fantasy Sports in an attempt
to drive greater adoption on smartphones and tablets. Although some of these investments
in mobile applications may not immediately drive massive revenue growth, we are more
optimistic about the longer-dated revenue opportunities and the protection of these firms
economic moats.
Software
In the world of enterprise software, we continue to like Oracle ORCL, even in the face of the
potential threats of software-as-a-service (SaaS) companies in the applications segment
and of in-memory databases from competitors such as SAP SAP in the database segment.
Currently, our investment thesis for Oracle depends on its ability to hold onto its customer
base while continuing to flex its muscle and protect its pricing and operating margins. While
we expect revenues to grow at a modest low- to mid-single CAGR over a longer-time frame,
we expect the market to continue to focus on companies such as SAP and Workday WDAY
that it believes are disrupting Oracles moat. We believe these fears are overstated, and we
continue to rate Oracles moat as wide with a stable moat trend.
Microsofts MSFT launches of Windows 8, Surface tablet, and Windows phone are the
headline catalysts this year. Windows 8 incorporates a significant change in the user interface for desktop users and is also the foundation of a combined operating system for PCs,
tablets, and mobile phones. On the PC side, we expect little immediate uplift as enterprises
have become more deliberate about staging new software investments than in past upgrade
cycles. We are focused on the early results of Windows 8, Microsoft Surface tablets, and
Windows phone sales. We believe the recent success of Android phones and Apples iOS
phones and tablets represent a clear threat to Microsofts Windows franchise. We are
cautiously optimistic that the company can establish beachheads in the mobile and tablet
segments, which should help slow the recent decline in Windows market share.
Hardware
Despite a global macroeconomic malaise, the smartphone and tablet industries continue to
thrive, and Apple and Samsung remain at the head of the pack, gaining share from struggling
competitors like RIM RIM, Nokia NOK, and HTC. Apples stellar integration of hardware,
software, and services into easy-to-use devices has driven the firms strong revenue growth
and profitability in recent years. As long as Apple can continue to build upon its success (and
we see little evidence to the contrary thus far), we think the company will remain a leader in
the premium smartphone market for years to come.
Meanwhile, Samsung took advantage of a window of opportunity between iPhone refresh
cycles, delivering strong sales of its Galaxy S III smartphone in the summer of 2012 that
80
incorporated 4G LTE compatibility and larger screen sizes than the smaller, 3G-only iPhone
4S. Apples larger 4G iPhone 5 is back on par with Samsung in terms of technical specifications, and were interested to see what Samsung can do for an encore in 2013 with its next
generation of smartphones.
Meanwhile, both Nokia and RIM are making last-ditch efforts to emerge as the third smartphone ecosystem alongside Apples iOS and Googles Android. Nokias Windows-based
Lumia phones show some promise, but given Nokias former dominance in the handset industry, the company will have to sell tens of millions of devices in the coming months in order to
bring its struggling smartphone business back to profitability.
RIM will arrive late to the smartphone operating system party, as its long-anticipated
Blackberry 10 o/s will be launched in January with devices to be sold in the first quarter of
2013, thus missing out on the 2012 holiday season, where so many other hardware vendors
are focused. However, RIMs loyal subscriber base in certain countries and with certain
enterprise customers could allow the firm to see some decent BB10 acceptance. We remain
skeptical that either Nokia or RIM will set the smartphone world on fire in the coming
months, and their stocks are currently valued as such. Thus, either company could see a nice
bounce-back if near-term smartphone sales deliver better-than-expected results.
IT Services
The fourth quarter is typically a mixed bag for IT services firms, as they have to work with
numerous holidays and year-end furloughs. In the past, service providers were able to more
than offset this with budget flush as companies rushed to spend unspent budget dollars by
the end of the calendar year. In recent years, budget flush has been quieter, and so far all
signs point to a continuation of this trend in 2012. Additionally, quite a few companies made
cautious statements warning that Hurricane Sandy has made things slightly more difficult
during the quarter.
At a higher level, we would characterize the current demand environment as choppy with
some sectors/geographies showing signs of growth and others showing signs of near-term
weakness. Rebound in demand from the banking, financial services and insurance (BFSI)
vertical is a positive development as BFSI remains the major vertical for most offshore IT
service providers. On the other hand, IT spending by health-care institutions has slowed in
recent quarters, and recent bookings indicate that the demand will likely remain anemic in
the near term. Despite its recent struggles, Europe continues to be a bright spot for offshore
IT service providers, and growth here was mainly driven by increased adoption of outsourcing by European companies. On the contrary, the U.S, despite economic improvements,
continues to be cautious on IT services spending.
On the margin front, we dont expect to see any major divergence from historical ranges.
With demand remaining relatively light, we think wage inflation and employee attrition will
be a non-factor in the near term. Additionally, employee utilization rates continue to remain
at the low end of the historical range for most of the companies, offering some cushion if
81
demand were to unexpectedly spike. Variations in the exchange rate of the Indian rupee
against the U.S dollar, British pound, and euro also impact margins. However, companies
use currency hedges to nullify the effect. Rupee depreciation positively impacts operating
margins (a 1% downward move leads to a 3040 bps expansion in margins) for the offshore
IT service providers. However, since most of the service providers hedge against exchangerate movements, any benefits from rupee depreciation at the operating income level will be
largely offset by hedging losses reported in other income.
Our Top Tech and Communication Services Picks
We generally favor financially strong firms that have solid competitive positions and generate solid cash flow throughout the business cycle. The five firms below fit these criteria and
are trading at attractive valuations, in our view.
Top Tech & Communication Services Sector Picks
Star Rating
Applied Materials
QQQQQ
Oracle
QQQQ
Apple
QQQQQ
Check Point
Intel
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Price/
Fair Value
$17.00
Wide
Medium
0.66
$39.00
Wide
Medium
0.84
$770.00
Narrow
Medium
0.69
QQQQ
$61.00
Narrow
Medium
0.77
QQQQ
$27.00
Wide
Medium
0.77
Applied Materials AMAT
Applied is the behemoth of the semiconductor equipment industry, with unmatched scale
and a broad product portfolio, making it the closest thing to a one-stop shop for chip
manufacturers. Although the firms foray into the solar equipment industry has weighed on
financial results, the stock has been overly punished, in our view. As semiconductor circuit
sizes continue to shrink, demand for Applieds complex tools and services will continue to
grow.
Oracle ORCL
Oracle is one of the highest-quality names in our tech coverage universe, and we expect its
core software business (which accounts for 68% of revenue) will continue to perform well in
the near term. Although Oracles hardware segment could generate underwhelming results
in the next few quarters, we believe this business has solid long-term prospects, and it will
enable the firm to drive additional software sales over time and further strengthen its wide
economic moat.
Apple AAPL
Although Apples current market price implies maturity, we expect continued growth.
Smartphones still account for less than 40% of total handset shipments, and we expect this
penetration rate to continue to grow. Additionally, Apple still retains a dominant position in
the tablet market, which should grow quickly over the next several years. Apples success
82
in tablets and smartphones has helped the firm drive strong sales of its Macs, even as the
overall PC market shrinks. As Apple sells more devices to its customers, it can increase
customer switching costs around its software and services.
Check Point CHKP
Check Point is a leading provider of network security solutions. The network firewall market
is a slow-growth area, but we expect the companys appliance strategy and software
blade architecture will enable it to grow faster than the core firewall market. High switching costs and risks make Check Points network security solutions very sticky, enabling the
firm to deliver high operating profitability. Although upstarts like Palo Alto Networks pose a
legitimate threat, we expect Check Points market price to rise toward fair value as investors
realize that the firms competitive advantages are intact.
Intel INTC
Concerns over the demise of the PC are exaggerated, in our view. Regardless, Intel still has
a strong growth driver in its server microprocessor business, where the firm is dominant,
and has opportunities to break into smartphones and tablets with its low-power Atom chips.
With a 4.4% dividend yield, rock-solid balance sheet and one of the most durable competitive advantages in the technology sector, we think Intels stock is attractive.
Grady Burkett, CFA, does not own shares in any of the securities mentioned above.
83

December 21, 2012
Our Outlook for Utilities Stocks

Pegging the direction of utilities stocks in 2013 is not for the faint
of heart.
By Travis Miller | Director of Utilities Equity Research
3 Utilities are on track to be the worst-performing sector in 2012 with 2% year-to-date total
returns through November compared with 15% for the S&P 500.
3 Utilities average 4.1% dividend yield still looks historically attractive compared with sub-2%
U.S. Treasury yields. Recent history suggests this could mean 20% upside is still available.
3 Power prices have stabilized and 2013 will be a key year as forward markets start pricing in
2015 environmental regulations.

Pegging the direction of utilities stocks in 2013 is not for the faint of heart. After trouncing
every sector and the S&P 500 with a 19% return in 2011, utilities are on track to post just a
2% return in 2012, well below every other sector and the S&P 500s 15% return. Wither go
interest rates, power prices, the worldwide economy, and taxes?
Setting aside the weak U.S. power markets that have constrained earnings and dividend
growth for diversified utilities and independent power producers, the utilities sector looks
historically attractive with an average 4.1% dividend yield and sub-2% U.S. Treasury yields
as of mid-December. The current 250-basis-point spread is well above the 100-basis-point
spread that domestic utilities sported going into the 2011 rally. The relationship between this
yield spread and valuations the last decade suggests regulated utilities could have another
2025% upside during the next two years. On the other hand, the market could already be
pricing in higher dividend tax rates and higher future interest rates, which would make
utilities less attractive despite their higher nominal yields.
Internationally, European utilities continue feeling the pain from the economic dislocation
across the region. GDF Suez GSZ and Iberdrola IBE were the latest to revise their outlook for
2013 downward . German utility E.ON EOAN has also said that it is reviewing its previous
201315 outlook. Long-term investors willing to endure a bumpy ride could enjoy attractive
upside in these cyclical stocks if the European economy rebounds. Even in Latin America
where we saw attractive opportunities just a few months agoutilities are facing less
certain growth outlooks after recent populist government intervention suggests lower
returns are on tap. Copel ELP faces the most risk.
Power market developments remain the key focal point in 2013 for the largest diversified
utilities such as Exelon EXC, FirstEnergy FE, and Entergy ETR. Forward power prices have
hardly budged the past six months even as other energy prices have climbed. There remains
84
a fundamental disconnect between the shrinking generation supplycoal plants closing,

unable to meet pending environmental requirementsand market power prices.
Stagnant power prices and generation margins are crimping the 201415 cash flow outlook
for some diversified utilities, notably Exelon, and independent power producers such as NRG
Energy NRG and GenOn Energy GEN. We think Exelon might have to cut its 2013 dividend at
least 30% based on our mark-to-market cash flow projections. With the stock trading at a
7% yield as of mid-December, we think the market already is incorporating that dividend cut.
Were watching closely key power market auctions during the first quarter in Ohio,
Pennsylvania, and New Jersey to see what margins Exelon, FirstEnergy, Public Service
Enterprise Group PEG, and others are able to lock in for power sales as far out as 2016.
Exchange-traded forward power contracts tend to be thinly traded, so the deeply liquid and
competitive state-run auctions will offer a true assessment of forward power prices.
Favorable auction results could push Exelons dividend cut out a few quarters and bolster
cash flows for other diversified utilities.
Regulated utilities also face earnings uncertainty going into 2013. Average allowed returns
granted last quarter hit 9.8%, the lowest in at least 20 years. Most recently, SCANA SCG
settled on a 10.25% allowed return in South Carolinaa 45-basis-point cutand allowed
returns on equity in California for PG&E PCG, Edison International EIX, and Sempra Energy
SRE look set to drop nearly 100 basis points. Still, the spread between allowed returns and
U.S. Treasuries remains 200 basis points above the 20-year average. If allowed ROEs
continue to fall or interest rates start rising, utilities could have a significant earnings
headwind.
Electricity and gas demand also bears watching in 2013. The 2012 winter was abnormally
warm, with heating degree days 21% below normal. A reversion to normal could mean a big
earnings pickup for natural gas utilities and propane distributors such as AmeriGas Partners
APU and Suburban Propane SPH. On the other hand, summer weather was warmer than
normal for the second consecutive year, creating a headwind for electric utilities if summer
cooling usage returns to normal.
Our Top Utilities Picks
On a market capitalization-weighted basis, the average sector price/fair value estimate ratio
is 0.89, down from 0.90 last quarter. But the utilities sectors median 1.03 median price/fair
value still shows the valuation divide we see between the relatively cheap, large diversified
utilities and the relatively pricey, smaller regulated utilities. That gap is closing after
regulated utilities weak 2012 returns. We now think regulated utilities on average are just
5% overvalued compared with 16% overvalued going into 2012.
Among diversified utilities, we think Public Service Enterprise Group is best positioned to
offer investors dividend growth and long-term upside from a recovery in power markets
despite its less attractive relative valuation as of mid-December. Its New Jersey regulated
utility is poised for 15% earnings growth the next three years, offering all the cash it needs
85
to continue funding 3% dividend growth despite flat earnings at its wholesale generation
segment. Cheaper diversified utilities such as Exelon, PPL PPL, and Entergy we think offer
more upside but also more risk.
We split the regulated utilities into two groups. One group comprises companies like
American Electric Power AEP, which is going through a strategic makeover as Ohio deregulates, and PG&E PCG, which faces regulatory uncertainty still tied to the 2010 San Bruno
pipeline explosion and its upcoming 201416 general rate case filing. These uncertainties
offer investors opportunities to pick up quality companies at what we think is a discount to
their peers and fair values. The other group comprises high-quality utilities with stable,
transparent cash flow and dividend growth. Some of these like Southern Company SO,
Westar Energy WR, and Alliant Energy LNT have less attractive upside but still offer
historically attractive yields topping 4%.
Top Utilities Sector Picks

Star Rating
Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Dividend Yield
(%)
Ormat Technologies
QQQQ
$27.00
Narrow
Medium
0.80%
Exelon
QQQQ
$42.00
Wide
Medium
7.00%
NRG Energy
QQQQ
$28.00
None
High
1.60%
American Electric Power
QQQQ
$46.00
Narrow
Low
4.30%
Westar Energy
QQQQ
$30.00
Narrow
Low
4.70%
Ormat Technologies ORA
Ormats baseload geothermal plants offer utilities a more appealing renewable resource
than wind and solar generation, which are less reliable and more expensiveprovided you
can find the geothermal resource. Ormats growth from development at more proven
geothermal sites will be impressive, but we expect a bumpy ride as growth has become
more dependent on exploration. The companys portfolio provides a consistent profit stream
and should grow at a rate unmatched by its peers without dependence on fossil fuels,
supporting consistent cash returns on invested capital. Reservoir issues at Brawley caused
fears about the land portfolio that we think are overblown, despite the hit to recent profits.
New projects will help ease concerns. Investors looking for an established, pure-play
renewable energy developer should find Ormats 13% annual growth in EBITDA through 2014
enticing. Ormat also has significant exposure to emerging markets, supporting cash flow
growth.
Exelon EXC
Even with Constellations countercyclical distribution and retail businesses in the fold and
cost synergies flowing through, Exelon still cant escape its overwhelming leverage to
Eastern U.S. power prices. These power prices, highly correlated with sluggish natural gas
prices, continue to drag down Exelons earnings prospects for the next three years. If current
86
markets persist, we expect management will opt to cut its $2.10 per share dividend 30%50%
as early as the first quarter of 2013. But leverage works both ways, and Exelon is the utilities
sectors biggest winner if our outlook for higher power and natural gas prices materializes.
Coal plant environmental regulations are tightening and utilities are shutting down plants, all
supporting our bullish outlook. With this view, we think Exelons midcycle earnings power is
$4.25 per share, nearly double our 2014 mark-to-market earnings estimate.
NRG Energy NRG
NRG Energys $1.7 billion merger with GenOn Energy this year is another example of what we
think is managements keen eye for value-creation opportunities. This downcycle has been
tough on NRGs wholesale generation fleet, and thats likely to continue until power markets
rebound. But NRGs aggressive move into countercyclical retail and stable-return renewable
energy businesses is cushioning earnings and shareholder returns. Even as wholesale
generation earnings plummet, we expect flat EBITDA the next two years. By 2014, we expect
the renewables business alone will support its newly initiated $0.36 per share dividend. NRG
also is in a race to prove it can establish a low-cost economic moat by serving its retail supply
needs with its wholesale generation fleet, notably in Texas. If it can expand this wholesaleretail strategy with GenOns generation fleet, management once again will prove its
prescience.
American Electric Power AEP
With diverse operations and strong earnings growth prospects, we believe American Electric
Powers 4.5% dividend yield is attractive. In August 2012, Ohio regulators provided regulatory
clarity by approving most of AEPs revised electric security plan, allowing AEP partial recovery
for generation investments until deregulation in 2015. The deal postpones AEPs plans to
close some of its coal plants, but poor economics and environmental liabilities still likely will
result in a significant reduction in its coal generation capacity. Despite these plant retirements, we think AEP remains well positioned to benefit from a future recovery in Midwest
power prices. We see 6% consolidated earnings growth the next four years, with our
projected 9% earnings growth based on aggressive capital investment plans at the companys
regulated utilities offsetting the near-term weakness at its Ohio generation fleet.
Westar Energy WR
By the end of 2014, Westar is on track to nearly double its asset base since 2006 with
investment in generation, transmission, and environmental controls. With cash flow tight,
investors have had to settle for pedestrian 3% annual dividend growth. But as Westars
investment pace slows and rate increases flow in, dividend growth should accelerate. In
addition, as Westars investment mix shifts to higher-return transmission projects, earned
returns and cash flow should grow. Still, Westar must finish its environmental controls
projects and navigate a likely 2015 rate case without another cut in allowed returns like
Kansas regulators issued in 2012. Assuming fair rate recovery, we think earnings per share
can approach $2.50 by 2016, a 6% annual growth rate from 2011. With a 60%75% payout
target range and a 4.7% yield as of mid-December, we think attractive returns are in store.
Travis Miller does not own shares in any of the securities mentioned above.
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Market Outlook

2 Our Outlook for the Stock Market

Market Outlook Q1 2013

Our Outlook for the Stock Market

However, housing-related names we recommended in 2011 or early 2012, such as Lowes

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Market Outlook Q1 2013

Outlook for the Economy

make the U.S. a good growth pick for 2013.

Real GDP Growth

Private Employment Growth

Housing Starts (000)

Source: St. Louis Federal Reserve, Morningstar Calculations

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Source: IMF Oct. 2012

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Market Outlook Q1 2013

Our Outlook for the Credit Markets

By Dave Sekera, CFA | Senior Securities Analyst

Market implied inflation soars.

mortgage-backed securities and long-term Treasury bonds, investors have increasingly

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Eurozone Recession Spreads to Core Countries from Peripheral

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Global Economic Pressures Adversely Impact Credit Ratings

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Ratio of Rating Upgrades to Downgrades by Quarter and by Sector

Ratio Upgrades to Downgrades

Credit Outlook: Sector Updates and Top Bond Picks

Average NRSRO Difference by Sector*

The Average NRSRO Difference shows how many notches

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

businesses provides creditors with a hedge should a precipitous decline in PC demand

Cameron International CAM

Amgen (AMGN, rating: AA-)

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Market Outlook Q1 2013

Outlook for the CMBS Market

market dynamics and derail improving CMBS fundamentals.

within the same environment.

delinquencies should trend in a favorable direction if investor demand remains high.

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Market Outlook Q1 2013

Our Outlook for Basic Materials Stocks

downside risk in Europe and China.

chemical players will continue shifting portfolios to specialty products in an effort to

Cloud Peak CLD

Compass Minerals CMP

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Market Outlook Q1 2013

Our Outlook for Consumer Cyclical Stocks

boost total returns.

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Weight Watchers Int'l

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

MGM China Holdings 02282

Starbucks possesses tremendous long-term product, channel, and geographic expansion

Morningstar Market Outlook Q1 2013 | Report Released December 21, 2012

Market Outlook Q1 2013