Finding Value in US Equities

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Finding Value in

US Equities

Nicholas Sordoni, CFA, Director, Portfolio Manager/Analyst

Following strong performance in recent years, US equities may not be the most obvious asset class in searching for attractively valued securities, but as stock pickers, we continue to find compelling opportunities in a range of sectors. Our analysis of the market’s performance, valuation, sector mix, profitability, balance sheets, and interest rates / inflation backdrop indicates that domestic equities are not extended relative to history, supporting our favorable bottom-up view. In particular, we are generally constructive on large banks, cable networks, and mature technology companies given compelling valuations. In each case, there are strong fundamentals, recovery opportunities, and/or attractive entry points following recent bouts of underperformance.

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With the S&P 500 Index having returned nearly 50% over the last three years, US equities may not be the most obvious asset class in searching for attractively valued securities. However, as bottom-up stock pickers, we continue to find compelling opportunities in a range of sectors. Before we highlight particularly noteworthy areas of value in the market, we will first examine the overall backdrop for US equi-ties as a reality check of our constructive bottom-up view.

Market Backdrop

While it is true that domestic stocks have generated strong returns over the past few years, a longer-term perspective suggests their perfor-mance does not appear stretched. A data series of more than 100 years shows that the trailing 10-year annualized total returns of the S&P 500 Index are actually still a bit below the historical average (Exhibit 1). While US equities are clearly well off their lows, their longer-term trailing performance does not argue against the potential for further gains going forward, in our view.

Similarly, from a valuation perspective, market multiples do not seem stretched for US stocks. The price-to-earnings (P/E) ratio for the S&P 500 Index, on both a trailing and a forward basis, is roughly in line with historical averages (Exhibit 2).

These mid-range multiples should not preclude solid long-term returns going forward. As reflected in Exhibit 3, our study of the S&P 500 Index going back 30 years suggests that the index’s forward P/E is highly correlated with subsequent 10-year annualized returns, and based on that historical relationship, the current multiple implies, on average, 8.8% annualized returns over the next 10 years.1

Further, we believe analyses based on historical comparisons actually underestimate the current fair value of US equities for several rea-sons. For example, the low interest rate environment suggests higher multiples for stocks, as demonstrated by the still-elevated equity risk premium in Exhibit 4. Moreover, low inflation—as observed cur-rently—is also consistent with higher earnings multiples for equities. In addition, historically higher P/E sectors such as technology and health care, which benefit from strong financial productivity and secu-lar growth characteristics, now comprise a higher proportion of the

Exhibit 1

Despite Recent Gains, Ten-Year Trailing Returns Are below Average, 1900–2015 -10 0 10 20 2015 1992 1969 1946 1923 1900 (%) Average

10-Year Trailing Returns As of 31 August 2015

Data are based on the S&P 500 Index. The performance quoted represents past per-formance. Past performance does not guarantee future results. This is not intended to represent any product or strategy managed by Lazard. One cannot invest directly in an index.

Source: Robert Shiller, Yale University

Exhibit 2

P/E Multiples Are Trading Near Long-Term Averages

9 16 23 30 2015 2009 2003 1997 1991 1985 (P/E)

Trailing Trailing Avg. Forward Forward Avg.

As of 31 August 2015

Data are based on the S&P 500 Index. Forecasted or estimated results do not repre-sent a promise or guarantee of future results and are subject to change.

Source: Deutsche Bank, IBES

Exhibit 3

Historical Relationship of Valuation and Future Returns

Annualized 10-Year Forward Return (%)

Forward P/E R2_{= 0.90} -6 0 6 12 18 8 14 20 26

Latest Value, Aug 2015–Aug 2025 Implied Return

Data are based on the S&P 500 Index. The performance quoted represents past per-formance. Past performance does not guarantee future results. This is not intended to represent any product or strategy managed by Lazard. One cannot invest directly in an index. Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change.

Source: Deutsche Bank, IBES

Exhibit 4

Low Interest Rates Can Be Conducive to Higher Multiples

-320 0 320 640 960 2015 2008 2001 1993 1987 (bps) Equity Optimism Tech Bubble Financial Crisis Equity Fear Euro Crisis, Fiscal Cliff/ Election

Equity Risk Premium Average (ex-Tech Bubble)

Equity risk premium is calculated as the spread between normalized EPS yield and normalized real risk-free rate. Normalized EPS yield is based on log-linear regression of S&P 500 operating EPS; normalized risk-free rate is the difference between the: 1) average of 30-year Treasury yield and 5-year rolling average of 10-year Treasury yield, and 2) 10-year TIPS spread and 5-year rolling average CPI inflation rate.

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S&P 500 Index relative to historical averages, at the expense of lower-multiple sectors like materials (Exhibit 5). This dynamic suggests that the index warrants a higher weighted-average multiple relative to his-torical levels. Finally, increasingly healthy corporate balance sheets also support a premium multiple for domestic stocks (Exhibit 6).

Comparing US equities to other geographies, rather than their history, also does little to diminish our constructive outlook. While US stocks trade at a modestly higher P/E multiple than other developed market equities, in our view this premium is warranted by a much more pro-nounced difference in financial productivity (Exhibit 7).

We believe this variation in regional ROE profiles reflects significant differences in sector mix. Specifically, the United States currently has a higher exposure to more profitable sectors, like technology and health care, and lower exposure to more capital-intensive sectors, such as materials and financials, suggesting that its financial productivity supe-riority should persist. As of August 2015 and based on the S&P 500 Index (for the United States) and MSCI index data (for Europe and Japan), technology and health care together represent 35.2% of sector weights in the United States, well above 17.5% in Europe and 18.2% in Japan. By contrast, weights for materials and financials combined are just 19.5% in the United States, versus 30.2% in Europe and 25.2% in Japan. We believe this structural advantage should support a materially higher overall P/E multiple for the United States relative to other developed markets.

The one obvious pushback to our constructive view on US equities is that corporate margins are already high, suggesting limited room for improvement and potential mean reversion. However, a deeper analy-sis of the key drivers of margin improvement suggests that these gains are sustainable rather than overextended. As demonstrated in Exhibit 8 (page 4), three factors account for more than all of the improvement in net margins since 1995.

First, average corporate tax rates have declined, largely driven by the secular trend of globalization. Second, favorable financing conditions have fueled lower interest expense, and because over 80% of the out-standing debt in the S&P 500 Index is fixed rate this benefit should be largely locked in for the foreseeable future.2_{Third, the technology} sector’s margins have improved significantly, and we view these gains as secular, led by structural shifts and internet-driven economies of scale, rather than cyclical. Considering these three key drivers, the overall mar-gins of US companies do not seem especially extended.

Looking beyond fundamental issues of margins and valuation, it is also worth noting that we currently do not see many of the indicators that might be suggestive of an imminent peak in the equity market and business cycle. For example, leverage is not elevated, credit condi-tions are still loose, inflation is well contained, the yield curve is not inverted, domestic equities have not benefited from strong fund flows, and sentiment indicators are generally not overly bullish. While the Fed’s first rate hike of this cycle may be impending, this event has not been a marker of a market peak in most prior cycles.

Exhibit 5

The Composition of the S&P 500 Index Has Changed in Favor of Higher P/E Sectors

0 12 24 36 2015 2009 2003 1997 1991 1985 Sector Weight (%) Average Materials Materials Average IT IT

Average Health Care Health Care

Source: FactSet, Lazard, Standard & Poor’s

Exhibit 6

Strong Balance Sheets Can Justify Higher Valuations

(%) (%) 5 7 9 11 13 25 50 75 100 2000 2003 2006 2009 2012 2015

Net Debt to Equity [LHS] Cash as a % of Total Assets [RHS]

As of 30 June 2015

Data are based on the S&P 500 Index. Data exclude financials as is common practice in this type of analysis, as changes in their mix as a % of the S&P 500 Index can have a large impact.

Source: FactSet, UBS

Exhibit 7

Valuation and Financial Productivity for US and Other Developed Markets Equities

NTM P/E NTM ROE (%) Continental Europe 14.4 11.4 Japan 14.2 8.9 Asia ex-Japan 14.1 10.0 Average 14.2 10.1 United States 16.1 14.8 US Premium Relative to Average (%) 13.1 46.5 As of 31 August 2015

Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. All data reflect rounding.

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Banks

One area of the US market currently offering compelling value, in our view, is large banks. While the banks have certainly recovered from the depths of the financial crisis, both in terms of fundamentals and stock performance, a long-term perspective suggests they are by no means stretched. In fact, the stocks of the six largest US banks are up, on average, only 39% over the last 10 years, versus 101% for the S&P 500 Index.3 In terms of valuation, this group is trading at an average price-to-book multiple of just 1.28 times, below the 10-year average of 1.34 times.4 We don’t expect a return to pre-crisis valuations around 2.0 times book value as the returns generated by banks have declined substantially due to the meaningful decrease in leverage allowed by regulators and other changes mandated by Dodd–Frank and Basel III. Even taking these factors into account, the stocks do not need to re-rate nearly that far to generate strong returns. On a P/E multiple basis, these large banks, on average, are trading at only 11.3 times next twelve months (NTM) earnings estimates, which we view as attractive on an absolute basis and, at a 30% discount, too low versus the market as well.5

Not only are the banks trading at an attractive multiple of earnings, those earnings have further recovery potential, in our view. The banks’ net interest margins are currently hovering around 30-year lows, and we expect these margins to rebound meaningfully when we return to a more normal interest rate environment (Exhibit 9).

As the yield curve becomes more favorable, we believe net interest income growth should be a tailwind for banks’ earnings growth. Longer term, we also see an additional margin tailwind as legal and regulatory costs roll off over time.

Cable Networks

Another attractively valued industry within US equities is the cable networks. As demonstrated in Exhibit 10, the seven largest US cable network companies, down 19.2% on average over the last year, have dramatically underperformed the broader market on concerns that the TV ecosystem is in the midst of total upheaval, with lower television viewership and increased dropping of traditional video bundle sub-scriptions offered by cable and satellite providers (i.e., “cord cutting”).

Admittedly, the TV ecosystem is mature and the video (telco, cable, and satellite) subscriber numbers for the second quarter of 2015 were indeed a bit soft. However, when considering that the second quarter has consistently been seasonally weak in recent years due to factors such as college disconnects, we do not see a dramatic change in cord-cutting trends (Exhibit 11, page 5).

Furthermore, we believe the second-quarter softness may have been exacerbated by elevated subscriber losses at AT&T and DirecTV as they neared their recently completed merger. Overall, while video subscrip-tions clearly have reached a plateau, we expect greater stability going forward than implied by the recent sell-off in cable network stocks. We would also note that, while traditional TV viewership is in modest decline, overall video consumption including newer plat-forms, such as connected TVs, over-the-top devices, and game consoles, continues to grow.6

In our view, the valuation of cable networks seems to discount very little possibility that they will be able to monetize the consumption of their content over newer distribution media, as they have done suc-cessfully through previous platform evolutions. Non-traditional video consumption is currently not well captured by ratings measurements, but technological advances should drive more complete measurement and monetization over time.

Exhibit 9

Recovery Potential in Banks’ Net Interest Margin

2.5 3.5 4.5 5.5 2015 2010 2005 2000 1995 1990 1985 (%)

Net Interest Margin

As of 30 June 2015 Source: US Federal Reserve

Exhibit 10

US Cable Network Stocks Have Fallen Sharply

-30 -20 -10 0 10 Aug 2015 Jun 2015 Apr 2015 Feb 2015 Dec 2014 Oct 2014 Return (%) S&P 500 Index Cable Networks As of 31 August 2015

The performance quoted represents past performance. Past performance does not guarantee future results. This is not intended to represent any product or strategy managed by Lazard. One cannot invest directly in an index.

Source: FactSet, Lazard

Exhibit 8

Contribution to the Increase in S&P 500 Index Non-Financials Net Margin, 1995–2014 2014 Net Margin Other Sectors Tech Lower Interest Expense Lower Effective Tax Rate 1995–2004 Net Margin 7.7 + + + + = 0.6 0.7 1.5 -0.4 _10.0 (%) As of 31 December 2014 All data reflect rounding.

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With the recent underperformance, the large cable networks are trading at only 12.3 times NTM earnings, a 23% discount to the market multi-ple despite returns on equity nearly twice as high, on average (Exhibit 12). Given the strong free cash flow generated by these highly financially-productive business models, we believe that the cable networks warrant higher P/E multiples, as video subscription and viewership concerns are overly discounted in current valuations. Indeed, the group’s relative P/E multiple contraction, from a historical premium to the market to a significant discount, as illustrated in Exhibit 13, is striking. We believe this rapid de-rating reflects worries about video subscription and viewership trends that, at this point, are overblown.

“Mature” Technology

While investors may be enamored with hyper-growth internet companies like Facebook and its smaller brethren, they seem to be overlooking many of the “mature” (which we defined as non-internet-based and with over $50 billion in market cap) technology companies, another area where we’re finding compelling value. The ten largest mature technology companies, down 8.6% on average, have sig-nificantly lagged the S&P 500 Index over the past year, creating an attractive opportunity, in our view (Exhibit 14).

While these companies are no longer in hyper-growth mode, consen-sus expectations call for forward earnings per share (EPS) growth of 9.2%, on average, as fundamentals remain intact.7_{Indeed, a recent} survey of CIOs indicated that the expected growth of their external IT budgets is stable at 4%–5%, (Exhibit 15, page 6). In fact, the 4.4% average expected growth in 2014–2015 is actually an acceleration rela-tive to the average of 3.3% for 2010–2013.

In our view, the outlook for continued stable revenue growth is sup-ported by industry dynamics including global build-outs, data center consolidation, and recurring maintenance revenues, while operating leverage and cost management efforts should sustain margins. Due to the low asset intensity of these businesses, stable growth and margin prospects point to continued robust free cash flow generation and financial returns. The group’s return on invested capital, despite being weighed down by significant excess cash balances (a high quality prob-lem, in our view), averages 14.9%, well above capital costs.8

Exhibit 12

Valuation and Financial Productivity for Cable Networks

Cable Networks S&P 500 Index

NTM P/E 12.3 16.1

Trailing P/E 12.6 18.1

Trailing ROE (%) 26.8 14.3

Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change.

Exhibit 13

Cable Networks’ Historical Valuation Premium Deteriorated into a Discount 0.6 0.8 1.0 1.2 1.4 Aug 2015 Feb 2015 Aug 2014 Feb 2014 Aug 2013 Feb 2013 Ratio Premium Discount Average Cable Networks (P/E)/S&P 500 Index (P/E)

Exhibit 14

The Recent Underperformance of Mature Technology Companies Presents an Opportunity

-18 -9 0 9 Aug 2015 Jun 2015 Apr 2015 Feb 2015 Dec 2014 Oct 2014 Return (%) S&P 500 Index Largest US Mature Tech Companies As of 31 August 2015

The performance quoted represents past performance. Past performance does not guarantee future results. This is not intended to represent any product or strategy managed by Lazard. One cannot invest directly in an index.

Exhibit 11

Video Subscribers Trend

98.5 99.5 100.5 101.5 102.5 2015 2013 2011 2009 (Millions) Total Undajusted Video Suscribers Seasonally Adjusted Video Suscribers As of 30 June 2015

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With its recent underperformance, the group trades at only 12.0 times NTM earnings, well below the S&P 500 Index, despite superior financial productivity and balance sheet strength (Exhibit 16). This P/E multiple discount relative to the S&P 500 Index is unusually wide (Exhibit 17). Given stable fundamentals, high-return business models, and very low financial leverage, we believe this discounted valuation is compelling. Still, we believe stock selection is especially important in this industry, as technology shifts may eventually erode the financial productivity of some of these companies. In our view, a number of them are well entrenched and trade at valuations implying much more fundamental erosion than we expect, making them attractive investment opportunities.

Conclusion

On the back of a strong multi-year rally, many observers may dis-miss US equities as overvalued. However, a closer look reveals that opportunities exist in specific areas of the market. In terms of broad market indicators, valuations do not look stretched relative to history and balance sheets are strong. When contrasted with other regions, we believe a higher P/E in US stocks may be warranted given the higher financial productivity relative to other developed markets. We note that the sector composition, as well as the current low rate/low inflation environment is also supportive of a higher overall valuation premium for the US market.

As bottom-up stock pickers, we are generally constructive on large banks, cable networks, and mature technology companies given attractive valuations. In each case, there are strong fundamentals, recovery opportunities, and/or attractive entry points following recent bouts of underperformance.

Exhibit 17

Premium/Discount for Mature Technology Companies

0.6 0.8 1.0 1.2 Aug 2015 Feb 2015 Aug 2014 Feb 2014 Aug 2013 Feb 2013 Ratio Premium Discount

Mature Technology (P/E)/S&P 500 Index (P/E) Average

Exhibit 16

Attractive Fundamentals for Mature Technology Companies

Mature Technology

Companies S&P 500 Index

NTM P/E 12.0 16.1 FCF Yield (%) 9.1 5.6 ROE (%) 23.6 14.3 Net Debt/Total Capitalization (%) 0.4 32.2 As of 31 August 2015

Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change.

Exhibit 15

External IT Spending Growth Expectations

(%)

'10 Budget '07 Budget '08 Budget '09 Budget

'15 Budget 2010–2013 Avg. 2014–2015 Avg.

'14 Budget '11 Budget '12 Budget '13 Budget

-6 -3 0 3 6

Apr 2009 Jan 2011 Jul 2012 Jan 2014 Jun 2015

As of June 2015

Please note that materials that are referenced comprise excerpts from research reports and should not be relied on as investment advice. This material is only as cur-rent as the publication date of the underlying Morgan Stanley research. For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of the underlying Morgan Stanley research, see www.morganstanley. com/researchdisclosures. Copyright 2015 Morgan Stanley.

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Notes

1 Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. 2 As of May 2015. Source: Bloomberg, J.P. Morgan

3 As of 31 August 2005. Source: FactSet, Lazard, Standard & Poor’s 3 As of 31 August 2005. Source: FactSet, Lazard, Standard & Poor’s 3 As of 31 August 2005. Source: FactSet, Lazard, Standard & Poor’s 6 As of April 2015. Source: eMarketer

7 As of 31 August 2015. Source: FactSet 8 As of 31 August 2015. Source: Bloomberg

Important Information

Published on 6 October 2015.

Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opin-ions expressed herein are as of the published date and are subject to change.

The securities and/or information referenced should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any of the referenced securities were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss.

Certain information included herein is derived by Lazard in part from an MSCI index or indices (the “Index Data”). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom.

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