Standard Life Global Outlook

1. Standard Life
Investments
3rd Quarter 2010
Market views
• Investors face a series of
political and regulatory
hurdles on top of normal
fiscal and monetary
decisions
• Stock market cycle
supported by corporate
profits and healthier
balance sheets
• Volatile financial markets
expected into 2011
Global Outlook Q3
www.standardlifeinvestments.com

2. Summary
04 Global Overview - Economics and politics
interact
The House View is more positive on sustained
corporate profits growth as the economic upturn
becomes more broadly based, geographically and
across sectors. However, there are growing risks for
financial markets from the degree of political and
regulatory interference being seen in more countries.
06 Focus on Change - Casting an eye over
consumer stocks
Many investors are wary of consumer stocks as some
household incomes will be under considerable pressure
in coming years. However, detailed micro level analysis
shows very different trends in consumer spending
across different groups.
08 Global Sectors - Light at the end of the
tunnel
The technology sector has emerged as one of the
bright lights of the global recovery with LEDs set to
benefit.
09 European ex-UK Equities - Broadening
horizons
Congested capital markets pose a challenge for many
European banks. We are finding the winning
contenders, alongside firms exploiting worldwide
economic growth
10 US Equities - The price is right
Pricing resilience stands several transport-related
companies in good stead, while life insurers are poised
to profit from attractively priced prospects.

3. 11 Japanese Equities - Investing for growth 17 Currency - New world order
Consolidation in Japan’s non-life insurance sector The global currency pecking order has changed
allows for better pricing, while takeover activity among following the recession and the sovereign debt crisis,
pharmaceutical firms should deliver greater balance and may not yet have found a new equilibrium.
sheet efficiency.
18 Property - Opportunities in Europe
12 Emerging Market Equities - India enjoys The outlook for European commercial property
prevailing winds remains positive despite the sovereign debt crisis. We
Strong Indian growth has propelled domestically expect a steady but slow recovery in occupier markets.
orientated stocks higher, whilst investors are also
increasingly focused on income opportunities across
Asia.
19 Global Absolute Return Strategies -
Changing tack on directional trades
The big move down in interest rate swap yields and
13 UK Equities - Differentials within the high valuation of US smaller companies has
defensives highlighted some relative value opportunities.
Several positive catalysts have prompted us to view the
telecoms sector more positively than other defensive
companies. Meanwhile, some favoured stocks are
reaping the rewards of internal change.
14 Government Bonds - The state of
European sovereigns
Concerns about sovereign debt in the Euro-zone have
had substantial and far-reaching effects both inside and
outside the single currency area.
15 Corporate Bonds - By hook or by crook
As sovereign debt levels remain elevated across the
Euro-zone, we examine the repercussions for corporate
bond investors and consider which companies are best
placed to deliver value.
16 Treasury - Active fiscal - passive monetary
The coming period of fiscal austerity will be
accompanied by an extended maintenance of low
interest rates.
Global Outlook

4. Standard Life Investments is a
dedicated investment company with
global assets under management of
approximately €163.5 billion (as at 31
March 2010), making us one
of the world’s major investment
companies. Responsible for investing
funds on behalf of over five million
retail and corporate customers
including the Standard Life Group, we
offer global coverage of investment
instruments and markets.
We are active fund managers, who
place significant emphasis on research
and teamwork. After in-depth analysis,
our Global Investment Group forms a
view of where to allocate assets, based
Foreword
on the prevailing market drivers and
on forecasts of future economic
indicators. The Global Investment
Group is made up of senior
investment managers from the
Strategy and Asset Class teams and
is responsible for providing the
overall strategic focus to the
investment process.
The House View delivers a consistent
macro-economic framework to our
investment decisions. It generates the
market and thematic opportunities for
us to add value to our customers over
the timescales they use to measure our
success. It is formulated in such a way
as to make timely investment decisions
but to also allow all members of the
investment teams to influence
its conclusions.
Keith Skeoch
Chief Executive
In a diverse, dynamic world we use
our insight and intellect to seek out
investment opportunities. Our ability
to predict, react and adapt rapidly
helps us to maintain our position as
a leading investment house.
2 Global Outlook

5. Standard Life Investments is avowedly an active investor; global agendas start to dominate the debate and it is
our Focus on Change investment philosophy has long been difficult to think of a time in the last 30 years when there
built on the view that markets are inefficient and the future have been so many moving parts. For an active investor all
is more uncertain than many investors are prepared to this change and uncertainty makes life difficult but it also
recognise. Our investment process is driven by an brings a real opportunity to add value for clients.
acceptance that in the face of uncertainty, it is important to
have a strong view on the available return opportunities. So what are the key insights to be gleaned from our Focus
Insights into return opportunities that deliver alpha are on Change philosophy and this latest edition of Global
generated by 90% perspiration through systematic, Outlook? The first is that macro still matters. The big picture
rigorous research and analysis and 10% inspiration. about where the world is heading is profoundly important
especially because so much depends on striking the right
Surveying the investment landscape a year into the balance between fiscal austerity and monetary support
recovery in financial markets the one thing that is through devaluation and Quantitative Easing. Our view
abundantly clear is the continued high level of uncertainty remains that while growth will slow we do not expect a
on so many fronts, which leaves risk appetites in such a slide back into prolonged recession. The world’s corporate
fragile state. The pace of economic recovery, the world sector remains in good shape and will continue to perform
monetary system and its impact on currencies, the policy well even in a low growth world. The continued availability
prescription for sustained growth, the regulatory of historically high risk premia reflects a good deal of the
environment especially for banks and the role of corporate uncertainty surrounding the impact of all this change.
engagement are all areas of active debate and sources of However, given that risk appetites remain on a macro hair
possible significant change in the return environment. Add trigger, the sustainability of the yield support for these
into this mix a political agenda, which during the first half premia continues to be a key theme for our asset allocation.
of the year has seen national and regional rather than
Global Outlook 3

6. Global Overview Chart 1
Business surveys
Economics and politics interact
70 30
65 20
60 10
55 0
50 -10
The House View is more positive on sustained corporate profits
growth as the economic upturn becomes more broadly based, 45 -20
geographically and across sectors. However, there are growing risks 40 -30
for financial markets from the increasing degree of political and 35 -40
regulatory interference in many countries.
30 -50
25 -60
2005 2006 2007 2008 2009
L.H. scale: US ISM Chinese PMI German IFO
R.H. scale: Japanese Tankan
Andrew Milligan Source: Bloomberg
Head of Global Strategy
countries, forced to make some extreme changes in recent
months. However, the details of the packages do need to
be examined carefully. While individual nations such as
Greece or Portugal have implemented programmes worth
2-4% of GDP in a single year, such nations are only a small
part of the Euro-zone. On balance, the fiscal tightening
across the region is only about 1% of GDP, by no means
unimportant but manageable in the absence of further
major shocks. In reality, there is no definitive conclusion
amongst economists to this key question about the impact
of a major fiscal tightening. While some commentators
argue that the reduction in public sector demand will
Introduction inevitably push fragile economies into a further recession,
historians can show successful examples across a range of
The good news for investors is that the world economy is countries where the process resulted, at worst, in slow
making continued progress in recovering from the after growth.
effects of the major financial crisis of 2007-09. The bad
news for investors is that the process is by no means over, Certain aspects require careful analysis. One is the efficacy
hence we expect to see volatile financial markets for some of past public sector spending; can productivity be raised,
years as investors try to price in correctly some of the long- so that services can be provided in a more cost efficient
term implications. Investment processes need to include manner? A second is the time horizons of businesses and
not only analysis of economic cycles but also political and households. If they believe that the fiscal tightening is
regulatory developments. While valuation signals will be credible and public sector finances will be brought onto a
helpful in some markets, more often behavioural signals will sustainable path, then they should be prepared to run
matter. down their savings and wealth to cushion the blow. A third
issue is the danger of not acting on the fiscal position, and
Steady as she goes allowing debt levels to build up to unsustainable levels. This
In most respects our House View economic forecasts have could provoke a damaging market reaction such as much
not changed markedly in the past year. As we expected the higher borrowing costs. On balance the House View
world economy has exited from its deep recession, and concludes that the most likely outcome is a slow-growth,
indeed the recovery is broadening out across geographies low-inflation recovery with interest rates kept lower for
and sectors. The key driver in this respect remains the longer. Plan B would include further quantitative easing by
corporate sector; having re-built profits and strengthened central banks to deal with unwanted shocks.
balance sheets, firms are starting to engage in some capital
spending and new hiring. Consumer income growth is The only ‘double dip’ recessions in advanced economies in
moderate but it is sufficient to support spending, albeit this recent history have been the US in the early 1980s, which
remains below levels usually seen in a recovery as many was an intentional policy decision to drive inflation out of
households are unable to access credit. While these factors the system, and Japan in the mid 1990s when a consumer
mean a slow growth recovery by past standards in most tax increase accidentally coincided with the Asian debt
OECD economies many of the Global Emerging Markets crisis. In this respect, it remains very important that the
(GEM) are showing strong growth driven by long-term primary drivers of the world economy, namely the US and
structural trends. All in all, global GDP growth looks set for the larger GEM, do not slow markedly. Recent policy
4-5% a year in 2010-11. decisions are helpful. The US is not following Europe into
tighter fiscal policy. Parts of Asia are facing inflationary
What could bring this uptrend to an end? One risk is the pressures, either in CPI measures or property markets.
error of tightening fiscal policy too quickly. After all, However, countries such as Australia and China have taken
countries equal to about 40% of global GDP are in the early action and it looks likely that they are on top of the
process of cutting spending and raising taxes. The most issues, even if others such as India look to be lagging a
obvious concerns are amongst many of the Euro-zone little. In this respect, the recent Chinese decision to allow
4 Global Outlook

7. Chart 2 Chart 3
Sovereign stresses Interest rates lower for longer
bps bps % %
1,200 1,200 5.0 5.0
4.5 4.5
1,000 1,000
4.0 4.0
800 800
3.5 3.5
600 600 3.0 3.0
2.5 2.5
400 400
2.0 2.0
200 200
1.5 1.5
0 0 1.0 1.0
2009 2010 2009 2010
5-year CDS spreads for: December 2011 futures market 3-month interest rate expectations for:
Greece Portugal Spain Ireland UK Germany US Euro-zone UK
Source: Bloomberg Source: Bloomberg
the RMB more flexibility against a basket of currencies is an recent Australian proposal to impose a tax on mining
important trigger. It signals that over time the authorities companies, and whether such windfall taxes, say on the
wish the economy to rebalance towards domestic utilities sector, become more popular especially in countries
consumer spending, eventually a more helpful backdrop for where the fiscal position is tight and the corporate sector
Western exporters. All in all, global leading indicators reflect profitable.
the momentum of future growth is slowing rather than a
slide back into prolonged recession (see chart 1).
Sources of volatility On top of this there are various problems relating to a
While financial markets are underpinned by better profits financial system which in many countries remains reliant on
growth, there remain major uncertainties about the upside central bank support. Wholesale money markets are not yet
and downside estimates. Some of the concerns relate to the functioning properly, while the lack of capital amongst many
economic cycle, but more of them relate to political issues investment banks means that trading liquidity can seize up in
in one form or another. Most evident in the minds of many markets remarkably quickly. All in all, it is understandable that
investors are the pressures on the Euro-zone. The House the time horizons of many investors are understandably short
View assumes that the recent ECB/IMF package has bought term in the face of such an uncertain environment.
time but Greek debt will eventually see some form of
restructuring. The unknown factors are the impact of this House View
on the balance sheet of the commercial banks, pension The House view has not made material changes to its asset
funds and other holders of debt, including the damage allocation in recent months. Our broadly cautious stance has
caused to the ECB’s balance sheet, as it could make losses already proven correct in this environment. Valuations have
on debt bought under its QE programme. Chart 2 shows been a useful trigger on occasion in some areas. For
the CDS spreads on various European countries, one example, we decided to reduce our positions in European
measure of investor concern about these issues. government bonds when yields were considered too
expensive, moving into relatively more attractive high
Another prime example would be future regulation, yielding corporate debt. It does appear to be the case that
primarily relating to the financial services sector. A stream of equity and bond investors have become more realistic about
international and domestic proposals are making their way their return expectations in recent weeks, although a major
through legislative systems and technical committees: Basel change in the economic or corporate environment would still
3, Solvency 2, the Dodd legislation in the US, the banking warrant a further adjustment in prices. While most of the
commission in the UK, as just some examples. We are major asset classes are relatively close to fair value on our
concerned that some of the recent discussions have not measures, we consider other factors are currently more
shown much evidence of politicians listening to significant drivers of investor activity. We are paying more
practitioners, such as the Alternative Investment Fund attention to behavioural finance signals in our tool kit; value
Managrs (AIFM) directive in Europe. On balance the on its own is rarely sufficient to spark the correct time to
complexity of much of the international discussions, often renew interest in an asset class, but investor sentiment and
under G20 auspices, suggests that many of those decisions positioning measures can help with timing.
could well be delayed into 2011 or even beyond. This will
mean an untenacity risk premium hanging over markets for The House View continues to favour sustainable yield in the
some time to come. As the financial services sector makes current environment. It remains the case that central banks
up a significant proportion of total stock market profits in are unlikely to tighten monetary policy in most OECD
the major economies, the outcome of these regulatory economies until well into 2011 (see chart 3 showing how
discussions for future profits growth is important. interest rate expectations have altered) in the face of
generally weak inflationary pressures, fiscal tightening and a
Other political factors could well cause volatility in coming banking sector still under pressure. Hence, a diversified
months. One issue to monitor is the result of the US mid- portfolio of income seeking assets, inclined towards credit
term elections, any losses by the major parties and the rise but including commercial property and dividend paying
of politicians calling for smaller government or the degree equity, is making attractive returns year to date.
of the backlash against big business. A second would be the
Global Outlook 5

8. Chart 1
Focus on Change Added value in luxury goods
Casting an eye over consumer stocks
180 180
Many investors are wary of consumer stocks as some household 160 160
incomes will be under considerable pressure in coming years. However,
140 140
detailed micro level analysis shows very different trends in consumer
spending across different groups. 120 120
100 100
80 80
60 60
40 40
2009 2010
Share price performance relative to the Dow Jones global luxury goods index for
(01/01/09=100): LVMH Swatch Saks
Thomas Moore Magdalene Miller Source: Bloomberg,Thomson Datastream
Investment Director, UK Larger Cos Investment Director, Asia/Japan
Focusing on the consumer recovery What is changing?
Our investment process is based on a foundation of There are a number of positive and negative factors affecting
rigorous research, guided by our Focus on Change household finances in the early stages of the recovery from
investment philosophy. Central to this is our Common the recession. While unemployment looks to be peaking in
Investment Language, which we use to validate all our many economies, employment prospects differ considerably
investment decisions. In previous editions of Global across sectors. For example, in parts of Europe the public
Outlook, we examined how Focus on Change drives sector is seeing actual salary reductions, while a pay freeze
specific asset allocation and corporate profits growth, as has been announced for large parts of the UK public sector
well as demonstrating our sector picking decisions. In this and there are prospects of significant job losses to come. In
edition, we show how detailed analysis is required when the US, the number of workers in part-time employment for
picking consumer-facing stocks. There are considerable economic reasons rose from about 4 million at the end of
headwinds to household incomes in many countries, for 2007 to 9 million currently. This represents a significant
example from high current levels of unemployment, a change in those households, with less disposable income
growing tax burden, public sector spending cuts, the available for consumption. In general terms, real after-tax
adverse wealth effects from the bear market in stocks, and incomes are currently under pressure from a combination of
the high levels of debt built up in the previous cycle. higher inflation and tax increases.
Looking beyond these headwinds though, it is important to
look at micro level drivers of individual sub-sectors and The impact can vary significantly though. For example, lower-
groups within each country. Our analysis shows a number paid households usually spend a higher proportion of their
of consumer-related stock opportunities where the long- income on basics such as food and energy. Turning to access
term drivers are more positive. to credit, the availability of mortgages remains more difficult
for first time buyers, who need to raise a larger deposit, than
We examine the outlook for consumer-related stocks, for existing home owners with significant equity in their
examining five questions which form our Focus on Change house. There is a marked contrast between home owners and
philosophy: households who rent; the former have generally benefitted
• What are the key drivers? from the sharp reductions in interest rates as central banks
have eased policy, while rents have often lagged the cycle.
• What is changing?
UBS’ analysis suggested that UK household incomes post tax
• What expectations are priced into the markets? and interest income rose almost 10% in 2009, but the effect
• Why will the market change its mind? will fade significantly into 2011 even if interest rates remain
• What are the triggers? low. The recovery in stock markets, led by technology
spending, and also in house prices rising from their lows in
What are the drivers of consumer spending? 2009 has meant a positive wealth effect for certain
households. These include many of those based in London
These include: and the South East in the UK, or New England and parts of
• income growth – the tax burden is rising as the west coast, Marin County and Medina which are home to
governments tackle large public sector deficits, while technology-related wealth, in the USA.
employment growth is low on a historical basis;
A stock-specific beneficiary of these trends is Saks. We have
• credit growth – certain households are less able to
witnessed a close relationship between stock market
access credit due to their financial position or the
movements and sales at high-end retailers. As financial asset
weakness of the banking sector;
values recover, it appears that wealthier households resume
• debt servicing – certain households benefit more than their spending habits significantly faster than the average
others from the significant cuts in interest rates seen in consumer (chart 1). To the extent that the current stock
many countries; market weakness continues, such customers may become
• wealth effects – certain households benefit more than skittish but are typically the first to increase spending in the
others from the recovery in the housing and stock economic recovery phase. Similar trends have been seen
markets. across Europe, where a number of luxury goods providers,
such as LVMH and Swatch, have reported strong sales
growth, including high-end demand from parts of Asia, in
recent months.
6 Global Outlook

9. Chart 2 Chart 3
Percentage of total population represented by Contrasting fortunes in transport
the middle classes
110 110
Malaysia
100 100
China
90 90
Thailand
80 80
Asia ex-Jpn
70 70
Indonesia
60 60
Philippines
(%)
50 50
0 10 20 30 40 50 60 70 2009 2010
2014 2009 Share price performance relative to the UK Travel & Leisure sector for (01/01/09=100):
Stagecoach Group First Group
Source: CLSA Asia Pacific Markets Source: Thomson Datastream
The consumer staples sector provides further evidence. In As more Chinese households experience higher wages and
recent months, several food producers have noted salaries, this feeds through to increases in ‘life-style’ spending
increased promotional activity by some of the largest fast- from which we have identified winners amongst consumer-
moving consumer goods companies. Most recently, UK facing stocks. Anta Sports Products is a ‘branded’ sportswear
personal care company McBride, which sells its products company catering to the aspirations of increasingly affluent
mainly through private labels, has signalled weaker-than- consumers in second and third-tier cities in China. Wage
expected trading due in part to such heavy discounting. growth here has outpaced that in first-tier cities in recent
The economic downturn clearly made consumers more months but for these consumers global sportswear brands
price sensitive. In this environment, differentiating one's such as Nike and Adidas are still just out of reach. Another
product becomes more crucial than ever. One of our company with an expanding market is internet provider
favoured holdings in the consumer staples sector is high- Tencent, which benefits from rising internet penetration but
end food producer Cranswick, which has managed to also provides social networking opportunities.
continue growing throughout the economic downturn by
offering consumer-differentiated premium product at an In the UK the differing pace of recovery in consumer well-
affordable price. This is an example where consumers have being is evident from recent comments by bus and rail
shown themselves to be willing to trade up to the highest companies, including Stagecoach and FirstGroup, on the
price points. We feel the competitive advantage generated geographical trends which they are witnessing (chart 3).
by this differentiation is not properly reflected in the Whilst both companies are reporting a relatively robust
valuation of the stock. recovery in commuter traffic into London, they are also
reporting weaker conditions in provincial towns, especially
Another beneficiary of consumers trading up comes from the those in more deprived regions of the UK. This may reflect
Asia-Pacific region. CP All operates convenience store chains the different employment conditions across different
in Thailand and China, similar in concept to 7-11 stores. It is regions, as well as different levels of home ownership and
expanding its range and price points in response to an consequent exposure to cheap floating rate mortgages. A
increasingly health-conscious and growing middle-class similar pattern has also been observed by UK bus and rail
consumer base. Chart 2 shows how these trends are forecast companies with exposure to the US market, with commuter
to alter in coming years in various countries. traffic in the relatively affluent New York area recovering
most rapidly. Stagecoach is our favoured stock in the bus
What is in the price? and rail sector, as we consider that the improving volume
Given the well-known pressures on household incomes, the trends being seen across large parts of the business are not
share prices of many consumer-related stocks have been fully reflected in its valuation.
under pressure. Hence, the global consumer goods and
services sectors currently have P/E ratios of 18.6x and When US fuel prices were very high in 2008 and early 2009,
17.4x, which are not dramatically cheap but look lower-income shoppers in rural areas curtailed their trips to
favourable against 10 and 20-year average valuations. Wal-Mart to save on the cost of fuel. Following the reduction
in fuel costs, Wal-Mart has not recovered the number of trips
Why will the market change its mind? What are from these shoppers. It appears that price competition from
the triggers? dollar stores and grocery markets has intensified to the point
where the need to return to Wal-Mart is not present. This is
Our detailed analysis has concluded that it is necessary for
also helped by the fact that fewer retail stores are going out
investors to adopt a more granular approach rather than
of business, because banks are less willing to realise loan
simply examining the broad macro economic factors
losses and also the ability of retailers to raise funds. Therefore,
affecting consumer spending, such as analysing the impact
with the supply of retailers 'artificially higher than normal', the
of consumer tax increases in various countries, important as
retail environment is becoming a zero sum, market share
these may be. We expect the market to pay up for
game. Winners in this environment offer products with the
companies that can generate better revenue growth by
best value to the consumer, which does not always mean the
focusing on attractive trends across socio-economic groups
least expensive.
or regions even if the general backdrop is less favourable.
Global Outlook 7

10. Global Sectors Chart 1
Beneficiaries from oil industry upheaval
Light at the end of the tunnel
190 190
180 180
The technology sector has emerged as one of the bright lights of the 170 170
global recovery with LEDs set to benefit. 160 160
150 150
140 140
130 130
120 120
110 110
100 100
90 90
80 80
2009 2010
Lancashire Holdings price performance relative to Global Non-Life Insurance sector (01/01/09=100)
Tullow Oil share price performance relative to Global Oil & Gas Producers sector (01/01/09=100)
BG Group price performance relative to Global Oil & Gas Producers sector (01/01/09=100)
Lance Phillips Source: Thomson Datastream
Head of Global Equities
LEDs the way ahead deepwater oil rigs. Approximately 80% of oil production in
The technology sector was one of the first to display signs the Gulf of Mexico comes from deepwater production and
of recovery following the recent global economic the sudden disruption in demand for such rigs is likely to
downturn. Although macroeconomic uncertainties continue result in an overhang of supply globally. This in turn will
to linger, the sector appears capable of sustaining its impose downward pressure on deepwater rig prices, which
upward momentum. Our analysis is particularly favourable generally make up nearly 50% of a well’s overall cost. Those
for the LED lighting sector which is benefiting from new standing to benefit from the cost reduction are companies
products and technological innovations. This has been operating in regions that are unaffected by the drilling
driven in part by the success of LED backlighting for TVs, moratorium. In particular, this has positive implications for
but is expected to be extended by the increasing use of oil firms BG Group and Tullow Oil, which have significant
LEDs in commercial lighting. exposure to deepwater operations in Brazil and Africa
respectively.
The upturn in the LED lighting cycle presents a compelling
opportunity for those firms that have maintained their R&D Another beneficiary of changes within the oil sector is the
investments through the crisis. Among these, we would insurance industry, which is expected to gain from upward
highlight Royal Philips Electronics and Aixtron as key pressure on insurance costs. Pricing in the specialised oil
beneficiaries of the LED upturn. Philips is one of the few insurance segment had previously been forecast to be flat-
companies with a presence across the whole value chain of to-down. However, a renewed focus on safety in the oil
LED lighting. However, a recent restructuring of its lighting sector is expected to push prices higher, with some analysts
business means that it is increasingly focusing on the predicting up to a 30% increase in pricing. Our research
development and design stage and is likely to emerge as a indicates that UK insurer, Lancashire Holdings, is well placed
leader in the lighting architecture and consulting business. to benefit from improving volumes and pricing in the
This is likely to generate strong revenue opportunities offshore energy insurance market.
particularly as companies shift commercial facilities to LED
lighting systems. Our strategy within global sectors
Macro headwinds continue to negatively impact global
Swiss firm Aixtron, a company that manufactures machines equities markets despite improving corporate fundamentals.
for the production of LEDs, is another set to benefit from However, there are still opportunities in high quality
the LED upturn. The firm has a dominant share of the LED companies in which we look to invest. We continue to gain
manufacturing machinery market and is well-protected exposure to the high-end consumer segment through
from the entry of low-cost rivals. The firm is particularly auction house operator Sotheby’s. Ongoing strength in art
exposed to the exponential growth in the use of LED auction pricing around the world has boosted expectations
lighting in LCD TVs. Robust demand for LCD TVs has been for a faster recovery in profitability. We have also continued
a key trend in the last 18 months and is likely to continue to build our holding in US technology giant Apple. The firm
as consumers maintain a stay-at-home approach to their has benefited from a robust product cycle with both iPhone
leisure time. and iPad product lines delivering strong revenues.
Opportunities in adversity Our bottom-up approach to stock selection is leading us to
The recent moratorium on drilling activity in the Gulf of companies that are likely to be market leaders and market
Mexico has halted oil exploration in the region. However, share gainers in the next phase of the economic cycle. Our
the impact on short-term oil supply is likely to be moderate, allocation combines pro-cyclical and defensive elements,
with the region accounting for less than 3% of world with Heavy weightings in consumer discretionary,
production. Even so, there are some important technology and industrial sectors coinciding with Light
consequences for the oil services industry. One key aspect is exposure to financials and materials, driven by individual
the change to global supply and demand dynamics for stock ideas.
8 Global Outlook

11. European ex-UK Equities Chart 1
Banking franchises with solid fundamentals
Broadening horizons
240 240
220 220
Congested capital markets pose a challenge for many European
200 200
banks. We are finding the winning contenders, alongside firms
exploiting worldwide economic growth. 180 180
160 160
140 140
120 120
100 100
80 80
2009 2010
Share price performance relative to the European Banking sector for (01/01/09=100):
DnB NOR Credit Suisse
Will James Source: Thomson Datastream
Investment Director, Europe
Squeezing out value in European banks Europe. We are identifying stocks that offer exposure to
The sovereign debt issues that have dominated market such global growth prospects at an attractive price (72% of
movements for the last few months are now triggering the sectors in Europe are on a discount to their US peers).
specific problems for the European banking sector. The Alongside these relative valuation opportunities comes the
issuance needs of European banks are estimated to be additional advantage of European exporters gaining directly
around €700 billion per annum over the next three years. from the currently depressed euro. Given how volatile the
However, as governments rush to refinance their own currency is, we do not expect European businesses to alter
balance sheets, liquidity is becoming limited within the pricing in order to drive market share. Instead, we think
interbank markets, ‘crowding out’ the banks which need to they will take the currency benefit to the bottom line,
obtain term funding. expanding margins and profitability.
We are Light in peripheral European banks; we reduced One of our holdings that exploits these global growth
BBVA in April, anticipating that Spain would have to take prospects is Prysmian, a worldwide leader in underground
even more stringent fiscal austerity measures that would electric cable. We foresee growth opportunities in the US,
decrease loan demand and hurt credit quality. Instead, we as upgrades of the electricity grid get underway, in China,
remain focused on finding regional banking franchises built as investment of electrical and telecommunications
on sustainable models, where funding headwinds are less infrastructure continues, and in Brazil as the firm develops
likely to have a detrimental effect. Norway’s largest bank, flexible pipes for offshore oil extraction. However, the
DnBNOR, falls into this camp. Norway has the lowest market rates the stock as if revenues will grow at a very
default risk in the world and its economy is thriving, with pedestrian rate. Elsewhere, we are invested in Danish
low government debt, house prices above previous peaks diabetes drug company Novo Nordisk, whose biggest
and low unemployment. Increased access to capital via market is China, and aero engine maker Safran, given its
securitised mortgages following recent regulatory change exposure to US customer Boeing. We also hold several
enables DnBNOR to benefit from a far more favourable exporters, such as Daimler, which is set to profit from the
outlook than its peers elsewhere in Europe. recovery in the US truck market and better-than-expected
demand for Mercedes cars in China.
Staying in Scandinavia, we also continue to prefer Sweden’s
Svenska Handelsbanken, whose differentiated business Our strategy within European equities
model appears underappreciated. The bank is accelerating Europe offers the opportunity to invest in companies which
its organic growth drive outside of Sweden, and these have not only world-class technology, but have also
growth opportunities, alongside its focus on customer maintained their R&D investments through the crisis, in
profitability, should lead to a loan portfolio with lower credit contrast to many of their global peers. ASML, a world
losses. Svenska has not raised capital or joined the Swedish leader in lithography equipment for the semiconductor
government’s scheme, and its relative strength signals industry, is one such example. The firm’s top line is
ongoing margin health. Finally, we are still invested in benefiting from a catch-up in spend following a period of
Credit Suisse, which is the most over-capitalised bank in significant underinvestment by its Asian customer base,
Europe. The bank is employing its capital to facilitate client which we think will continue for longer than the market
activity, rather than using it to buy and hold assets for anticipates. Meanwhile, we have added Dutch-based
trading gains. dredging services group Royal Boskalis Westminster to our
Winners List. In our view, the market underappreciates the
Masters of the universe prospects for Boskalis’ earnings recovery, which is supported
We continue to believe that in times of macroeconomic by a growing project pipeline from both port operators and
uncertainty the market overlooks European companies’ oil companies. Finally, we have been reducing our funds’
exposure to global growth. In fact, around 40% of weighting in Portugal Telecom; taking some profits post a
European firms’ sales are derived from outside western period of strong performance.
Global Outlook 9

12. US Equities Chart 1
Sector outperformance
The price is right
225 225
200 200
Pricing resilience stands several transport-related companies in
good stead, while life insurers are poised to profit from attractively 175 175
priced prospects.
150 150
125 125
100 100
75 75
50 50
2009 2010
Apple share price performance relative to US Technology sector (01/01/09=100)
Intercontinental Exchange share price performance relative to US Financial sector (01/01/09=100)
Euan Sanderson Source: Thomson Datasteam
Senior Vice President, US Equities
Tightening transport market on track for course to complete by late 2010. With AIG trying to raise
pricing gains capital to repay its substantial government bailout, MetLife
We are positioning our US equities portfolios to take was able to secure the overseas business for what appears a
advantage of transport firms’ improving pricing power. In reasonable price. Alico is attractive to MetLife for several
the railroad sector, where Winners List stock CSX features, reasons. Firstly, the acquisition offers MetLife direct access
and the logistics sector, where we like package delivery firm to Japan, which represents the second-largest life insurance
FedEx, we see signs that rising volumes, pricing gains and market in the world. MetLife’s position in Europe will also
solid cost controls are generating strong operating leverage. be enhanced, while various emerging market regions will
This, in turn, should lead to share price appreciation. become more accessible, offering a wealth of new
distribution opportunities. We believe the market is
After years of pricing pressure, railroads finally began to underestimating the future earnings potential of the
establish pricing power in 2004 as demand started to combined company as a result of this deal.
outstrip supply. Following several years of pricing gains,
investors became concerned that pricing discipline would We also hold a position in life insurer Prudential Financial
fade as the industry faced serious volume declines in 2009. (no relation to the UK insurer). Like MetLife, Prudential is
However, industry players remained disciplined in the taking significant market share, benefiting from the ‘flight
downturn and retained their focus on generating earnings to quality’ trend being seen across the industry. The firm
from capital invested. With volumes now recovering, we has a fair amount of excess capital at its disposal, and we
believe pricing gains should accelerate from here. CSX, anticipate that this will be used to make an acquisition over
which operates the largest rail network in the eastern the next few years. With many financial firms likely to be
United States, should be a prime beneficiary. The reviewing their non-core insurance holdings, there should
company’s excellent cost control throughout the downturn be no shortage of potential opportunities available.
now sets the stage for significant operating leverage as
volumes continue to rise. We are also encouraged by robust Our strategy within US equities
pricing for transporting metallurgical coal, while pricing in Customers’ growing preference for smaller, more portable
CSX’s intermodal business should be boosted by a mobile devices is a trend that shows no sign of abating.
tightening in the truckload market. Aiming to capitalise on this, we continue to hold a Heavy
position in Apple. The firm has established a market-leading
Our investment in FedEx, the world’s largest express position in anticipating and responding to consumer
transportation provider, reflects our belief that pricing in the preferences, and is seeing initial impressive sales for its iPad
small package market will also get better. We believe the tablet computer. We also own chip maker Qualcomm,
market is underestimating the potential for FedEx to whose products are used in wireless devices. Qualcomm is
expand its operating margins, and think these will return to making strides in the higher end of the cell phones market
peak levels faster than expected on the back of volume with its Snapdragon platform. We believe the winners in a
growth and better pricing. The company’s management new world of greater device portability are likely to be
cites improving pricing as a key priority and its most recent companies such as Qualcomm as opposed to current PC
quarterly report provided early evidence of this chip incumbents like Intel. Elsewhere, futures exchange
commitment. IntercontinentalExchange (ICE) still looks attractive. The firm
has witnessed record volumes in the midst of recent market
Acquisitive insurance companies offer volatility. In the longer-term, it should also gain from
opportunities financial reform as the government and regulators aim to
A further theme emerging across our US equities portfolios increase transparency. The push towards increased over-
is that of companies benefiting from M&A activity. For the-counter (OTC) clearing and ultimately some OTC
example, MetLife, the largest US life insurer, was added to derivatives becoming exchange traded also bodes well for
our Winners List in April of this year. The company’s the firm.
purchase of AIG’s foreign insurance operation Alico is on
10 Global Outlook

13. Japanese Equities Chart 1
Efficient use of balance sheets
Investing for growth
115 115
110 110
Consolidation in Japan’s non-life insurance sector allows for better
pricing, while takeover activity among pharmaceutical firms should 105 105
deliver greater balance sheet efficiency.
100 100
95 95
90 90
85 85
80 80
2009 2010
Share price performance relative to the Japanese
Healthcare sector for (01/01/09=100): Astellas Daiichi-Sankyo
Matthew Williams Source: Thomson Datastream
Investment Director, Asia Pacific
Improved pricing potential for insurers acquired OSI Pharmaceuticals, which provides it with a
With a large number of firms competing for limited foothold in the US as well as access to an oncology drug
business, Japan’s mature non-life insurance market has portfolio. We believe this takeover is a positive move as it
suffered from a slow decline in premiums and dwindling should deliver an investment yield well in excess of the
margins. However, we have started to see some return Astellas was receiving on its cash hoard and should
consolidation in the industry, with the forthcoming union prove earnings-accretive over time. Importantly, the
between Mitsui Sumitomo, Aioi and Nissay Dowa set to prospective drug pipeline on offer should put the company
create a new industry leader. Fewer industry participants back on a growth path.
should result in a better pricing environment for those who
remain, including our preferred holding Tokio Marine. We also hold Daiichi-Sankyo, which does not have the same
patent issues but has sought acquisitions to make more
Meanwhile, better regulation in the sector also creates an efficient use of its balance sheet and grow at a faster pace.
opportunity for companies to differentiate their offering and It bought a majority stake in Indian drugs firm Ranbaxy,
charge at a more reasonable pricing point. For example, which specialises in generic drugs, in 2008. Since then, the
semi-independent industry body Non-Life Insurance Rating integration has not gone to plan, as two of Ranbaxy’s
Organization (NLIRO) currently produces only two production facilities were subject to a US import ban
reference rates for auto insurance premiums – one for because of irregularities in drug storage implementation.
drivers under 21 and one for those over 21. Therefore, a Daiichi-Sankyo has taken action to resolve this, engaging
22-year old driver would pay the same premium as a 45- directly with the FDA and overhauling Ranbaxy’s
year old with the same accident history. However, from management team. As a result, we are starting to see
2011 NILRO will produce eight rate levels covering a range evidence of a resolution to the situation, which should
of ages. Although there will continue to be no hopefully be completed by the year end. This would leave
differentiation between men and women, the new pricing Daiichi-Sankyo with some good products and a decent
levels will at least allow Tokio Marine to charge according to drug pipeline, which we consider deserves more
individual customer risk profiles and target more profitable recognition in the share price.
areas. While the pace of change in the non-life insurance
sector is unlikely to be rapid, these improvements represent Our strategy within Japanese equities
a big shift within the industry which we believe has not yet We recently reduced our holding in LCD TV glass maker
been priced in by investors. Asahi Glass. We had previously been optimistic on the
pricing outlook for the industry, with an oligopolistic market
Pharmas put balance sheets to better use making for better pricing cohesion. However, we now think
Pharmaceutical companies are looking to offset threats to this has played out, with two new credible competitors
profitability as well as increase balance sheet efficiency by entering the industry and companies starting to jostle for
using surplus capital to make acquisitions and fuel growth market share. We believe the cohesive environment will not
(chart 1). We own Astellas, Japan’s second-largest last, with pricing already coming off more aggressively than
pharmaceutical company by market capitalisation. It has the seasonal average reductions. Elsewhere, we have added
several key drug patents ending, which could lead to to Denso, a car parts maker affiliated to Toyota, across some
margin erosion. This has already been discounted by of our funds. The share price has been weak following
investors, along with low growth and an idle balance sheet. Toyota’s recent recall problems but we have used this
However, with net cash of around US$2 billion and capacity opportunity to raise our position, taking the view that an
to raise more debt finance, Astellas has the firepower extremely competitive product portfolio will enable Denso
required to counter these patent cliffs. It has already to win share outside of the group in the near future.
Global Outlook 11

14. Emerging Market Equities Chart 1
Building on infrastructure
India enjoys prevailing winds
200 200
180 180
Strong Indian growth has propelled domestically orientated stocks
higher, whilst investors are also increasingly focused on income 160 160
opportunities across Asia.
140 140
120 120
100 100
80 80
60 60
2009 2010
Share price performance relative to the Global Emerging Markets industrial
goods & services sector for (01/01/09=100):
Crompton Greaves C&C Constructions
Ronnie Petrie Source: Thomson Datastream
Head of Asia Pacific Equities
Global equity markets have been buffeted by macro corporate management teams and the rapid development
headwinds for much of 2010. However, in India, prudent of some of the region’s leading businesses has resulted in a
macroeconomic policymaking and buoyant infrastructure heightened focus on dividend income. In particular, we are
investment have remained key drivers of the economy. This seeing increasing evidence of Asian firms that are displaying
strength was evidenced recently, by impressive first-quarter the capacity to pay out more in dividends while
GDP growth of 8.6% per annum. Meanwhile, in nominal maintaining strong growth trajectories.
terms, GDP growth neared an all-time high of 20% a year.
This is an attractive combination for investors, in a region
In this environment, it is the firms that are focused that has emerged from the financial crisis with surprisingly
domestically that are offering the most attractive healthy corporate balance sheets. Indeed, recent estimates
opportunities (chart1). For example, Crompton Greaves, showed that the average debt to equity ratio in Asia was as
which manufactures a range of infrastructure-related low as 27%. Clearly, healthy balance sheets are
equipment, is well-placed to benefit from government encouraging management teams to take a closer look at
spending on roads, railways and other infrastructure the best ways in which to distribute their profits.
projects. Another beneficiary of this trend is C&C
Constructions. The firm has exposure to a wide range of One firm that appears to be a positive example of this trend
infrastructure construction services offering good growth. is Taiwanese chipmaker MediaTek. The firm has steadily
increased its dividend every year since 2003. Prior to that
The strength of the domestic economy is also proving date the firm had never issued a dividend. We believe that
favourable to the nation’s automakers which look set to this points to a changing mindset among Asian corporate
benefit from both rising incomes and government spending management teams, which have previously always been
on new roads. Tata Motors has emerged as a winner in the keen to maintain a war-chest as part of a ‘just-in-case’
Indian auto sector, which is one of the few which has been mentality. Instead, firms appear increasingly able to
able to sustain demand without the need for the ‘cash for distribute cash to investors, whilst still maintaining good
clunkers’ style incentives common in Europe, the US and growth prospects.
China. For Tata’s domestic operations, total volumes in the
first quarter of 2010 have risen by 55% year-on-year to Our strategy within emerging markets
216,646 vehicles. The firm’s market share is around 60% in Chinese economic growth remains a key driver in the region.
commercial vehicles, 15% in passenger cars; with the latter Market participants are currently digesting the possibility that
having been helped by the launch of the low-cost Nano. Chinese growth in late 2010 into 2011 could be somewhat
slower than previously anticipated following a series of
In addition, the firm has successfully turned round its Jaguar tightening measures by policymakers. As China switches from
Land Rover unit which announced a profit after tax of an export-oriented growth model to a more domestic
£113m in the January to March quarter, ‘several times demand-led approach, helped by RMB revaluation, spending
higher than analysts' forecasts. Tata has been able to make should continue to bolster corporate profitability.
big savings in the UK-based unit’s cost of production and
depreciation. Land Rover sales have been particularly strong Elsewhere in the region, inflationary pressures remain
in China and the UK. There is optimism that new product relatively contained, and central banks are unlikely to
launches, an example being the compact Range Rover, will radically alter their monetary policy. Asian equity markets
help boost volume growth further. are also supported by the relatively low levels of
indebtedness of both companies and individuals, while
Growing attractiveness of dividend yields in many Asian countries have further scope to stimulate
Asia domestic consumption, given generally strong government
Investing in Asia has traditionally been premised on the balance sheets. Asian businesses are, hence, underpinned
impressive growth-style opportunities available in the by resilient domestic demand and also by their low
region. However, a growing sophistication among inventory levels.
12 Global Outlook

15. UK Equities Chart 1
Valuation gap
Differentials within defensives
20 20
18 18
Several positive catalysts have prompted us to view the telecoms
industry more positively than other defensive sectors. Meanwhile, 16 16
some favoured stocks are reaping the rewards of internal change.
14 14
12 12
10 10
8 8
6 6
2009 2010
Price-to-earnings ratio comparison of selected UK sectors:
Telecoms Food & Beverages
David Cumming Source: Reuters
Head of UK Equities
Ringing a change in telecoms International. Both stocks are on our Winners List and we
Widespread scepticism over the sustainability of the have taken advantage of recent weakness to increase our
economic recovery in the UK has been reflected in the exposure to them.
recent underperformance of cyclical stocks. Investors
currently appear to prefer the perceived safety of those After seeing volumes dry up at the height of the financial
companies with more defensive earnings streams such as crisis, Inchcape successfully addressed balance sheet issues,
telecoms, a sector where we have upgraded our view from undertaking a rights issue and cutting costs, increasing
Neutral to Heavy. operational gearing into the recovery. Subsequently, car
sales volumes have recovered faster than expected. We
Telecom companies have demonstrated resilience in the believe forecasts from Inchcape’s management are too
face of the economic slowdown and as growth resumes, conservative, especially on UK margins. Inchcape has a
mobile spending in particular has the potential to bounce good diversified business model, with a premium focus in
back stronger than expected. This is good news for the UK and good exposure to the strongly recovering Hong
companies like Vodafone. The regulatory environment, Kong market. However, the wider market appears to be
meanwhile, appears to have shifted from favouring focusing on concerns around the Toyota recall
unbundled providers like Carphone Warehouse and BSkyB, (approximately 50% of Inchcape’s new and used car
towards the incumbent fixed line operator BT, our favoured business comes from Toyota), the impact of the end of
telecom company. BT previously suffered from price scrappage incentive schemes, and the company’s exposure
regulation issues, as OFCOM fought to achieve the lowest to southern European economies, fears we believe are
fixed-line prices in Europe. However, new regulatory overdone.
proposals could see fixed-line pricing linked to RPI, as well
as unregulated pricing on fibre optics aimed at encouraging Following a £300 million capital raising, DSG International,
investment in this area. which includes the Dixons, Currys and PC World brands,
has implemented a transformation plan, which is delivering
Telecom stocks are massively cash generative and offer the tangible results. Store refits have delivered on average a
highest free cashflow yields in the market. Most of the 20% uplift in sales, while a greater focus on customer
major UK players have solid balance sheets. BT’s free cash- service at non-refitted stores has also supported sales. The
flow yield is around 13% and we believe this could turnaround efforts by DSG’s management are credible and
strengthen further over the next few years, given scope for clearly working, helped by a slightly more favourable
cost cutting and flexibility around capex. Within the background for electricals. Competition in this space
telecoms sector there is also potential for M&A activity. This remains fierce, especially from online retailers, but we
benefits both potential bid targets and will also be believe DSG is managing this well.
supportive of remaining companies in a more consolidated
industry, something Vodafone has already acknowledged. Our strategy within UK equities
Despite these positive drivers, telecom stocks remain While the UK government focuses on debt reduction,
attractively valued. There is a significant valuation gap corporate sector balance sheets are in good shape with
between telecoms and other defensives such as food & significant flexibility over how prodigious cash flows are
beverage companies where opportunities for used. Many of our favoured stocks are in industrial and
outperformance appear limited. consumer sectors of the market which we expect to benefit
most from growth. We also selectively favour some
Healthier from the inside out defensive stocks like telecoms, which may have been
Successful balance sheet repair and cost cutting during overlooked by the market. However, we are less positive on
distressed times have put many UK companies in a much defensives such as food & beverages, where companies are
stronger position now that economic prospects are on relatively high ratings. We expect only anaemic revenue
improving. Two companies where we are seeing the fruits growth for some time to come from food and drinks
of positive internal change, which we consider is not yet companies, and firms are still dealing with the impact of
priced in, are global motor vehicle distributor and importer, consumers de-stocking and trading down to cheaper
Inchcape, and consumer electronics retailer, DSG brands.
Global Outlook 13