morgan stanley - the agony and the ecstasy

8/10/2019 Morgan Stanley - The Agony and the Ecstasy

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EYE ON THE MARKETS P E C I A L E D I T I O N

ag ny&ecst syTHE RISKS AND REWARDS OF A CONCENTRATED STOCK POSITION

THE

THE


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The Agony and the Ecstasyis a 1961 biographical novel by American author Irving Stone on the life of Michelangelo:

his passion, intensity and perseverance as he created some of the greatest works of the Renaissance period.

Like Michelangelos paintings and sculptures, successful businesses are the by-product of inspiration, hard work,

and no small amount of genius. And like the works of the Great Masters, only a small minority stand the test of

time and last over the long run. The Agony and the Ecstasyconveys the disparate outcomes facing concentrated

holders of individual stocks in a world, like Michelangelos, that is beset with intrigue, unforeseen risks, intense

competition and uncertainty.


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EyE on thE markEt J.P. morgan

Table of Contents Page

Empirical analysis

The steady drumbeat of creative destruction in the S&P 500 3

Falling from grace: catastrophic losses on Russell 3000 companies 4Success, failure and the distribution of returns on Russell 3000 stocks 6

Why volatility matters and its implications for optimal concentrated holdings 8

Sector case studies

Overview 10

Consumer Discretionary 12

Consumer Staples 14

Energy 15

Financials 16

Health Care 19

Industrials 20

Information Technology 21

Materials 25

Telecommunications 26

Utilities 28

Alternative Energy 30

A look at the winners (The Ecstasy) 32

Further considerations

The performance of IPOs vs. the broad market 34

What about taxes? 35

Final thoughts on managing concentrated stock positions 36

Appendix I: on Chinese government subsidies 37

Appendix II: Biotech and Life Sciences 38

Additional information

Sources 39

Acronyms 40

Biography 41

Disclaimer 42

Please note: the results of any particular investment strategy may be uncertain. Particular circumstances may vary,and other factors may need to be taken into account when deciding on any diversification plan and timing.


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The steady drumbeat of creative destruction in the S&P 500

A simple place to start when thinking about the risk of concentrated stock positions: how often dotheir circumstances change? Since 1957, the S&P 500 has served as a proxy for 500 of the largest,most successful US-domiciled companies. We have compiled a detailed history of its additions anddeletions since 1980, which forms the basis for this part of the analysis. To be clear, not every S&P 500

deletion was the result of a problem stock. Actually,most

deleted companies were not the result ofa problem, and reflect benign index removals because: they were acquired at a premium to theircurrent price; they merged with other companies in the index; or, they reincorporated outside the US.

After sorting through the benign deletions, we focused on the rest: the S&P 500 deletions that werea consequence of stocks that failed outright, were removed due to substantial declines intheir market value, or were acquired after suffering such a decline. As shown below, therewere over 320 of them since 1980. The pace of distress-based deletions rises during a market crisis orrecession, but there is a steady pulse of business failure during the entire business cycle. ConsumerDiscretionary, Technology and Financials accounted for the majority of distress-based deletions.

The spike in index removals during recessions is accurate in time, but misleading in terms of businessrisk. Many such companies were much riskier than they seemed during good times, and when the tidewent out with the economy, their operational, financial and competitive weaknesses were revealed.

0

5

10

15

20

25

30

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

Source: FactSet, Bloomberg, Standard & Poor's, JPMAM. 2013.

Number of companies removed from the S&P 500 dueto distress by year, Number of companies

0

50

100

150

200

250

300

350

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

Source: FactSet, Bloomberg, Standard & Poor's, JPMAM. 2013.

Cumulative number of companies r emoved f rom t heS&P 500 due to distr ess, Number of companies


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Falling from grace: catastrophic losses on Russell 3000 companies

The prior section looks at stocks that were deleted from the S&P 500. However, the distress rate ofindividual stocks is higher than the index deletion rate, since there are stocks that suffer substantialprice declines from which they do not recover, irrespective of whether they remain in an index. Andwhat about small and mid cap stocks which are not captured by the S&P 500?

To broaden our analysis, we analyzed all stocks that were members of the Russell 3000 at any timefrom 1980 to 2014, a database of 13,000 large cap, mid cap and small cap stocks. We then definedwhat we believe a concentrated stock holder would see as a catastrophic loss: a decline of 70% ormore in the price of a stock from its peak, after which there was little recovery such that theeventual loss from the peak is 60% or more. How often does this take place? As shown in thetable, 40% of all stocks suffered such a permanent decline from their peak value. Remember, we arenot talking about temporary declines during the tech boom-bust or during the financial crisis, but large,permanent declines that were not subsequently recovered. Technology, Telecom, Energy andConsumer Discretionary had the highest loss rates. In terms of subsectors, Biotech (part of HealthCare) and Metals & Mining (part of Materials) had loss rates over 50%.

When do such catastrophic declines happen? The next chart shows the percentage of companies atany given time experiencing a catastrophic loss. These loss rates tend to rise during recessions andmarket corrections, but theres a steady pace of distress even during economic expansions. I dontthink we should draw too many conclusions from the decline in loss rates in 2010-2013; they havebeen dampened by the longest and largest monetary experiment in the history of the Federal Reserve,during which time the real cost of money has been negative for more than 5 years. There is also anatural tailing off at the end of the chart, given that there is less time for companies to fail.

Total % of companies experiencing

"catastrophic loss",

Sector 1980 - 2014

All sectors 40%

Consumer Discretionary

Consumer Staples

Energy

Materials

43%

26%

47%

34%

Industrials 35%

Health Care 42%

Financials 25%

Information Technology

Telecommunication Services

57%

51%

Utilities 13%

Source: FactSet, J.P. Morgan Asset Management.

0%

5%

10%

15%

20%

1980 1985 1990 1995 2000 2005 2010

Source: FactSet. J.P. Morgan Asset Management.

Catastrophic loss rates on Russell 3000 companies% of com panies in the process of suf fering a catastrophic,unrecovered loss of 70% or more

Around 40% of all stocks experiencedcatastrophic declines, when defined as a70% decline from peak value withminimal recovery. This is a subjectivecutoff point; many concentrated holderswould see smaller permanent declines asequally unacceptable, and whose riskshould be mitigated. The outcomesbased on a variety of thresholds suggestthat for many concentrated holders,diversification should be a central part ofwealth management planning.

The Russell 3000 Index measures the

performance of the largest 3,000 UScompanies representing approximately98% of the investable US equity market.It is reconstituted annually to ensure thatnew and growing companies arereflected.


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When looking at the timing of catastrophic loss rates by sector, a few are similar to the overall market:Consumer Discretionary, Materials, Health Care and Industrials. Some sectors experience loss rates thatare consistently above (Technology) or below (Staples and Utilities) market levels.

Loss rates in Energy, Telecommunications and Financials tell the story of their respective points ofdistress. For Energy, the oil price collapse of the early 1980s and natural gas price collapse of 2008-2011 were catalysts for rising business failures and falling stock prices, while the energy price rally ofthe mid 2000s reduced loss rates. In the case of Telecommunications, loss rates were lower than thebroad market in the 1980s and early 1990s. After the passage of the 1996 Telecommunications Act,loss rates rose in a deregulated environment (see pages 26-27 for more details in our case studysection). And finally, the last chart shows the spike in Financial sector distress beginning in 2008, andalso during the 1991 recession; outside of these periods, Financial sector distress was lower.

0%

10%

20%

30%

40%

50%

1980 1985 1990 1995 2000 2005 2010


Russell 3000


Companies in the process of suff ering a catastrophic, unrecovered lossInformation Technology: l oss rates higher than the R3000

0%

10%

20%

30%

1980 1985 1990 1995 2000 2005 2010

Consumer Staples

Utilities

Russell 3000


Cons. Staples & Util it ies: loss rates lower than the R3000Companies in the process of suff ering a catastrophic, unrecovered loss

0%

10%

20%

30%

40%

50%

1980 1985 1990 1995 2000 2005 2010

Energy

Russell 3000


Companies in the process of suffering a catastrophic, unrecovered lossEnergy: catastrophic loss rates vs. the Russell 3000

0%

10%

20%

30%

40%

50%

1980 1985 1990 1995 2000 2005 2010


Russell 3000


Companies in the process of suffering a catastrophic, unrecovered lossTelecom: catastrophic loss rates vs. the Russell 3000

0%

10%

20%

30%

1980 1985 1990 1995 2000 2005 2010

Financials

Russell 3000


Companies in the process of suff ering a catastrophic, unrecovered lossFinancials: catastrophic loss rates vs. the Russell 3000

A meaningful number of companies arealways in the process of suffering sharp,unrecovered price declines at any giventime, even during an economic expansion.


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EYE ON THE MARKET J.P. MORGAN

Success, failure and the distribution of lifetime returns on Russell 3000 stocks

Focusing only on the risk of failure misses half the picture: the potential rewardsof a concentratedstock position. There are a number of ways to assess the risks and rewards involved. One approach isto look at all stocks and compute their respective lifetime price returns vs. the Russell 3000 (i.e.,starting with the time when the company first exists in public form and reports a stock price, and until

its last reported price in 2014 or until the date at which it was merged, acquired or for some otherreason delisted1). The chart below shows the results, which can be summarized as follows:

The median stockunderperformedthe marketwith an excess lifetime return of -54%. In otherwords, in most cases, a concentrated holder would have been better off invested in the market.

Two-thirds of all excess returns vs. the Russell 3000 were negative, and for 40% of allstocks, returns were negative in absoluteterms.

Historically, there were someextreme winners:the right tail is ~7% of the universe and includescompanies that generated lifetime excess returns more than two standard deviations over the mean.

The relative frequency of success and failure shown above is not sensitive to when companies werecreated. For example, in one scenario, we excluded all Technology, Biotech and other companies thatwent public between 1995 and 2000 in order to test whether the subsequent collapse in many of themhad an outsized impact on the results above. They do not; even when excluding these companies, themedian return is still negative, the percentage of companies underperforming the index is still aroundtwo-thirds, and the percentage of winners is still 7%.

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Distribution of excess l ifetime returns on individual stocks vs. Russell 3000, 1980-2014Number of stocks

Time-adjusted lifetime price return on each stock vs. the Russell 3000 Index

Extreme winnersMedian

1We compare stock price returns to Russell 3000 price returns. When including the impact of dividends on bothindividual stocks and the Russell 3000, the results do not change materially, even for the Utilities sector.


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7

The success/failure distribution is similar across most sectors. As shown below, excess returns onthe median stock were negative in each sector; 60%-70% of stocks in most sectors generated lifetimeexcess returns less than the Russell 3000

2; a third or more generated negative absolute returns; and

aside from Consumer Staples, the percentage of extreme winners was in single digits.

Heres a synthesis of what we have done so far.The first step measured the frequency of a stockprice suffering a catastrophic decline. This is apainful event; however, some concentrated holdersmight say, a decline from unsustainable marketvaluations was painful, but I still benefited

substantially from being concentrated in the stock.My original basis was very low, so things turned outfine in the long run. There are many examples ofthis paradigm, particularly in Technology. TakeCisco, whose business model survived the techcollapse. It suffered a huge price decline from itspeak and has only recaptured a portion since then,but still generated substantial excess returns vs. themarket over the long run for its original concentrated holders. Thats the purpose of the second step:life-cycle analyses of price returns, to look for stocks whose returns were positive over the long rundespite interim collapses and volatility. The negative skew of the distribution on the prior page showsthat while some stocks generated volatile but positive life-cycle returns (like Cisco), many more did not.

Analy sis of l ifet im e returns by sector , 1980-2014

All Sectors -54% 64% 40% 7%


Consumer Staples

Energy

Materials

-62%

-3%

-93%

-73%

65%

51%

72%

66%

44%

26%

48%

34%

7%

15%

6%

8%

Industrials -58% 64% 37% 7%

Health Care -39% 60% 42% 8%

Financials -21% 58% 30% 6%



-63%

-57%

71%

68%

53%

54%

6%

6%Utilities -141% 85% 14% 0%


Median excessreturn vs Russell

3000

Percentage of stockswith negative

EXCESS returns

Percentage of stockswith negative

ABSOLUTE returns

Percentage ofextreme winner

stocksSector

The frequency of catastrophic declines and the negative skew in the distribution ofindividual stock returns compound our perception of concentrated stock risk, and suggestthat diversification play an important role in wealth planning for most entrepreneurs.

$0

$10

$20$30

$40

$50

$60

$70

$80

1990 1994 1998 2002 2006 2010 2014

Source: Bloomberg, J.P. Morgan Asset Management. July 2014.

Cisco SystemsStock price

Eventual loss frompeak of: -67%

Max loss f rompeak of: -86%

Since inception stock

price return of 27%annually vs. marketreturns of 8%

2In the case of Utilities, the frequency of negative absolute returns is very low, while the frequency of negative

excess returns is high. This is a reflection of the lower returns on utility stocks, which are offset by their muchlower catastrophic loss rate. While utility stock risk is lower than the market, there have been more than a fewexamples of extreme utility distress, as explained in the case study section.


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Why volatility matters and its implications for optimal concentrated holdings

To many clients, stock price changes over the long run are all that matter, rather than anything thathappens in between. However, volatility can be an important signal since it tells us something aboutthe risk of a stock. Not everyone agrees that interim price movements are a good proxy for risk; insome cases, they arent. However, over the long run, returns and volatilities tend to track each

other pretty closely. For purposes of thisanalysis, we define risk as volatility ofnegative stock price movements; in otherwords, we look at volatility from falling stockprices rather than from falling and rising ones.I find that most investors prefer this definitionof risk (technically referred to as semi-deviation), since they are not worried aboutthe risk of rising prices. As shown, if thevolatility of your stock is rising sharply,chances are that its returns are falling.

Next, we factor risk into the equation ofbeing a concentrated stockholder. With 20-20 hindsight, we can compute the optimalcombination of any stock with the Russell3000. In other words, what combination of each stock and the Russell 3000 would havedelivered the best risk-adjusted return? Such an approach did not always hold a lot of a high-returning stock if its volatility was too high. Similarly, it heldmoreof a lower-returning stock if itexhibited attractive diversification benefits vs. the Russell 3000. The results tell us something about thefrequency with which concentrated holders would optimally choose to own different amounts of theirstock, if the issue of price volatility mattered to them.

The bar chart below shows the results. There were quite a few cases when the optimal course of actionfrom a risk-adjusted perspective was to own 100% in the concentrated stock: that happened around

6% of the time (500 observations in our data set). However, in the majority of cases, it made sense toown no more than 30% of the concentrated stock, and often none of it. This is not a surprise; as perpage 6, if two-thirds of stocks underperformed the Russell 3000, it is very unlikely that a risk-adjustedapproach would want to own many of them since it would prefer to own the Russell 3000 instead.

0

500

1,000

1,500

2,000

2,500

3,000

3,500

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%


Optimal mix of a concentrated stock posi tion with theRussell 3000, 1980-2014, number of observations

Optimal concentrated stock weight

-100%

-50%

0%

50%

100%

150%

200%

0% 20% 40% 60% 80% 100% 120% 140%


Higher volatility usually associated wit h lower stockprice returns, Universe: Russell 3000 stocks, min. 3 years ofreturns, 1980-2014

Downside volatility (semi-deviation)

Annualized

stock

pricereturn


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As a last step in our empirical analysis, we weave together each of the three risk factors wehave examined so far: the risk of catastrophic loss, the risk of underperforming the Russell3000 and finally, the risk of heightened volatility that subjected concentrated holders withinsufficient diversification to a very wild ride.

In the table below, we show the percentage of stocks in each sector that:

suffered a catastrophic loss; or generated negative absolutelifetime returns; or

generated negative excesslifetime returns vs. the Russell 3000; or

experienced high volatility such that the optimal portfolio process described on the prior pagechose to own no more than 20% in the stock.

In other words, all the cases in which some amount of diversification would have made sense. Withthe benefit of hindsight, in around three-quarters of all cases, diversification could have played animportant role in sustaining family wealth.

Percent of stocks whose concentrated holderswould have benefited fr om diversification, 1980-2014

SectorPercentAll sectors 74%


Consumer Staples

Energy

Materials

74%

58%

81%

75%

Industrials 75%

Health Care 72%

Financials 63%



82%

74%

Utilities 87%Source: FactSet, J.P. Morgan Asset Management.


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Sector case studies: some forensics on catastrophic loss

A deeper dive into catastrophic stock price loss reveals important realities of global business dynamics.There are hundreds of cases to choose from; the ones we selected illustrate different paradigms thatresulted in substantial and permanent impairment. We focus on large cap (and the upper end of midcap), since many were household names at the peak of their success. It is not always simple to

explain why a company suffered a decline, since a combination of fundamental factors and the whimsof investor sentiment are involved. The descriptions represent our perception of the primary factors;other explanations may be just as plausible. Note that these examples were chosen in the summer of2014; over time, many Lazarus stocks come back from the dead, so it is fair to assume that some ofthem may recover from their current levels.

In the case studies, there are instances of leveraged over-expansion, particularly towards the end of abusiness cycle, and examples of management misreading rapidly-changing industry dynamics andcompetitive factors. There are also examples of companies that mismanaged a large acquisition; wewere not surprised by this, since most studies we have seen estimate M&A failure rates at 50% to 80%of all transactions

3. However, many companies suffered due to factors largely outside management

control. We list some of these exogenous factors in the box on the facing page. In these cases, it isnot clear that even the best management teams in the world could have done much to alter theultimate outcome.

While some catastrophic losses on the following pages may seem obvious or inevitable withthe benefit of perfect hindsight, in all likelihood the companys management, its board ofdirectors, research analysts, credit rating agencies and its employees all firmly believed in itslong-term success.

Notes about the chartsSome examples show pre-Chapter 11 prices of companies that have since emerged from bankruptcyand are now thriving operating businesses (e.g., Charter Communications and Calpine). All stocks areshown through their final reported pricing date, which is either July 31, 2014, or an earlier date whenthe company was acquired, merged or delisted and which is noted below the chart. Price histories on

many stocks reflect split adjustments that took place over time, such that historical prices appear lowerthan the levels at which they were once quoted.

3The earliest analyses performed in the US and Europe in the 1970s found merger and acquisition failure ratesof 40%-50%. More recent estimates are higher. Whartons Why Do So Many Mergers Fail cites professorRobert Holthausen, whose failure rate estimates range from 50%-80%. A 2010 study from McKinsey estimatesfailure rates of 66%-75%. And in a 2010 book from Mitchell Lee Marks (San Francisco State University, and anadvisor in 100 mergers and business transitions), failure rates are estimated at 75%.


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Force Majeure: a partial list of exogenous factors that can put companies at risk andwhich are outside management control

commodity price risksthat cannot be hedged away

government policy examples: changes in service reimbursement rates, a slowdown in FDA

approval patterns, bandwidth and other public domain privatizations which increase the scopeof competition, changing subsidies for renewable energy, changes in carbon tax regimes andfracking rules, government-sponsored enterprises with a lower cost of funds crowding outprivate sector activity, changes in the interpretation of anti-trust rules, shifts from capacitypricing to merchant pricing (natural gas), etc.

on government action, deregulation has proven to be just as disruptive as re-regulation,particularly as it relates to boombust cycles in telecommunications, utilities and broker-dealers

foreign competitors whose market share is magnified by government subsidies andexchange rate manipulation

Chinas exchange rate management and subsidies to its auto, steel, solar, paper and glasscompanies are primary examples (see Appendix I for more details)

intellectual property infringementby domestic or foreign firms (see Appendix I)

the impact of patent trolls, estimated to cost US businesses upwards of $20 billion per year

changes in US or foreign government tariff or trade policy

fraud by non-executive employees, which according to SEC investigations from 1997-2007accounted for ~30% of all instances; or fraud by employees or management in companies thatyou acquire, or which acquire you

technological innovationthat effectively provides consumers with enough information to

bypass intermediaries and distributors a shift in buying power to the firms customers resulting from consolidation

unconstrained expansion by competitors, leading to a collapse in pricing power


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Consumer Discretionary has seen its fair share of catastrophic declines (see list on following page). Bigbox multi-line retailing, online retailers, auto parts, print media, publishers, music, faddish apparel andrestaurant chains make up most of the list. One factor perhaps underappreciated by concentratedholders: according to Nielsen surveys, US consumers are less brand-loyal than their counterpartsin Europe, Asia, the Middle East and Latin America when it comes to mobile phones, personalelectronics, electronic appliances, beauty products, health/medical products, in-store retail andcable/internet service. Theyre also more likely to switch brands for a better price. Many brandsenjoyed success during their initial expansion phase, but faced challenges when organic new storegrowth slowed, and when consumer tastes changed. Radio, music and print media struggled withshifting technology, which put a lot of pressure on ad revenues (e.g., a 57% drop in newspaper adrevenue from 2000 to 2009).

$0

$5

$10

$15

$20

$25

$30

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Source: Blo omberg. May 2003.

Kmart Corporation

Once the pioneer of discount retailing, managementoutflanked by Walmart and Target, and underinvestedin merchandise, key locations and supply chain

$0

$5

$10

$15

$20

$25

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Bloomberg. November 2009.

Charter Communications

Overleveraged cable television acquisition spree paidfor with i nflated stock price; accounting issues

$0

$10

$20

$30

$40

$50

$60$70

$80

$90

2002 2004 2006 2008 2010 2012 2014

Source: Blo omberg. July 2014.

Weight Watchers International Inc.

Surpassed by di gital competitors; low barriers of entry

$0

$5

$10

$15

$20

$25

$30

$35

$40

1996 1998 2000 2002 2004 2006 2008 2010

Source: Blo omberg. May 2010.

Bad timing: leveraged theme park acquisitions headinginto a recession

Premier Park s Inc. (Six Flags)

$0

$20

$40

$60

$80

$100

$120

$140

$160

$180

1988 1989 1990 1991 1992 1993 1994 1995

Source: Bloomberg. October 1995.

Carter Haw ley HaleStores (Broadway Stores )

Scorched earth strategy works too well: fending off TheLimited (via spinoff of Neiman Marcus and massive debt)

doomed the company's future

$0

$5

$10

$15

$20

$25

$30

$35

1994 1995 1996 1997 1998 1999 2000 2001

Source: Blo omberg. April 2001.

Sunglass Hut International Inc.

Organic sales growth hits a wall at 2,000 stores,acquisition of a key but fading rival compounds the

problem


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There are dozens of other cases we could have chosen to illustrate examples of distress in theConsumer Discretionary sector. The table below shows some of the more recognizable names. Somedate back to the 1980s, while others are more recent.

Select Consumer Discretionary stocks in the Russell 3000 suffering unrecovered, catastrophiclosses (see page 4 for definition) by industry, 1980 to 2014

Auto Components Household Durables (continued) Media (continued)

Dana Corp.

Delphi Corporat ion

Federal-Mogul Corp.

Goodyear T ire & Rubber Company

Lear Corporation

Visteon Corp.

Kaufman & Broad Home Corp. RH Donnelly Corp.

Maytag Corporation Savoy Pictures Entertainment, Inc.

Pillowtex Corp. Warner Music Group Corp.

Sealy Corp. Westwood One Inc.

Standard Pacific Corp. XM Satellite Radio Holdings

Sunbeam Corporation

Zenith Electronics Corporation Multiline Retail

Department Stores Ames Department Stores Inc.

Federated Department Stores Inc. Internet & Catalog Retail Bradlees Discount Store Inc.

Macy's, Inc. barnesandnoble.com inc. Caldor Corp.

Buy.com Inc. Circle K Corp.

Distributors Drugstore.Com Inc. Filene's Basement Corp.

GNC Energy Corp. eToys, Inc. J. C. Penney Company, Inc.

Subaru of America Inc. Home Shopping Network, Inc.

Lillian Vernon Corporation Specialty Retail

Diversified Consumer Services Nutrisystem, Inc. Aeropostale, Inc.

Apollo Educat ion Group Inc. Spiegel Inc. bebe stores, Inc.

Corinthian Colleges Inc. Webvan Group, Inc. Blockbuster Inc.

Education Holdings 1 Inc. Boise Cascade Corporation

ITT Educational Services Inc. Leisure Products Borders Group Inc.

Learning Tree International Inc. Baldwin Piano & Organ Company Chico's FAS, Inc.

Callaway Golf Company Circuit City Stores, Inc.

Hotels Restaurants & Leisure LeapFrog Enterprises, Inc. Coldwater Creek Inc.

Bally Total Fitness Holding Corp. Polaroid Corporation CompUSA Inc.Boston Chicken, Inc. Worlds of Wonder, Inc. Design Within Reach, Inc.

Boyd Gaming Corporation Eddie Bauer Holdings Inc.

Checkers Drive-In Restaurants, Inc. Media FAO Schwarz, Inc.

Chi-Chi's Inc. Adelphia Communications Corporation Heileg-Myers Furniture Co.

Churchs Fried Chicken, Inc. Cablevision Systems Corporation Jennifer Convertibles Inc.

Coleco Industries, Inc. Carolco Pictures Inc. Just For Feet, Inc.

Cosi, Inc. Clear Channel Outdoor Holdings Inc. Lechter's Inc.

Krispy Kreme Doughnuts, Inc. Crown Media Holdings Inc. Office Depot, Inc.

Luby's, Inc. Emmis Communications Corporation RadioShack Corp.

Monaco Coach Corporation Gannett Co., Inc. Restoration Hardware Inc.

Morton's Restaurant Group Inc. Harcourt Brace Jovanovich Inc. Sharper Image Corp.

Patriot American Hospitality Inc. Harte-Hanks Inc. Talbots Inc.

Rainforest Cafe, Inc. Idearc Inc. Today's Man Inc.Shoney's Inc. Intelsat Corporation

Sizzler Restaurants International Inc. Interpublic Group of Companies, Inc. Textiles Apparel & Luxury Goods

TCBY Enterprises, Inc. Loews Cineplex Entertainment Corp. Burlington Industries Inc.

Trump Hotels & Casino Resorts, Inc. Martha Stewart Living Omnimedia, Inc. Crocs, Inc.

McClatchy Company Fruit of the Loom Ltd.

Household Durables New York Times Company Jones Apparel Group Inc.

Centex Corp. Orion Pictures Corporation L.A. Gear, Inc.

Hovnanian Enterprises, Inc. Readers Digest Association Inc. North Face, Inc.


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Consumer Staples

As noted on page 5, Consumer Staples have a lower rate of catastrophic price decline than the marketas a whole. The Staples that did suffer such declines were often low-margin supermarket, drug storeand convenience store chains that struggled to compete with the rise of Walmart (Brunos, DrugEmporium, Food Lion, A&P, SuperValu, Pantry Inc. and Winn-Dixie); we only review one of them belowsince the narratives are similar. According to a 2009 study from Dartmouth, when a Walmart opens ina new market, median sales drop 40% at similar high-volume stores, 17% at supermarkets and 6% atdrug stores. There are some other episodes worth discussing, which we review as well. The first onebelow refers to the 15-year US-European banana war, an illustrative example of risks around trade andtariffs. Eventually, Europe reached a deal under which it planned to provide equal treatment to allimporters. Unfortunately, this came too late for companies like Chiquita Brands.

$0

$10

$20

$30

$40

$50

$60

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

Source: Fac tSet. March 2002.

United Brands Company (Chiquita)

Chiquita expanded during trade talks to open Europeanbanana market, suffers when Europe opts to maintainimports from former coloni es; 2001 Chapter 11 fil ing

$0

$10

$20

$30

$40

$50

$60

1981 1984 1987 1990 1993 1996 1999 2002 2005

Source: Bloomberg. November 2006.

Winn-Dixie Stores Inc.

Competition i n low-margin supermarkets from Walmartand Publix too much for Americas Supermarket

$0

$5

$10

$15

$20

$25

$30$35

$40

$45

1998 2000 2002 2004 2006 2008

Source: Bloomberg. August 2009.

Rayovac Corporation

Sometimes theres no room for #3 (behind Duracell andEnergizer); non-core acquisitions (pet supply) outsidecompany core competence

$0

$100

$200

$300

$400

$500

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014


Revlon Inc.

Over-leveraged Revlon runs into deep-pocketedcompetitors (J&J, P&G), and loses

$0

$10

$20

$30

$40

$50

2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: Bloomberg. July 2014.

Synutra International Inc.

Doing business in China invo lves under-regul ated suppl ychains and the lack of consumer safeguards

$0

$10

$20

$30

$40

1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: Bloomberg. February 2009.

Hostess Brands(Interstate Bakeries )

Chapter 22? Hostess first went bankrupt in 2004, citi ngreduced demand for high-carb snacks and risinglabor/energy costs


17/46


18/4616


Financials

Theres a long list of banks, brokerage firms, mortgage insurers, REITs and specialty finance companiesthat suffered permanent price declines during the financial crisis of 2008-2009. Whats interesting forpurposes of understanding concentration risk in Financials: the role that government policy canplay in altering or influencing the behavior of private sector firms.As described in a November2013 Eye on the Market (Course of Empire), US government-sponsored enterprises took a lot of theoxygen out of the room: the green and red lines in the chart show the increase in high-risk lendingundertaken by the GSEs which predated the massive increase in subprime and Alt A lending by theprivate sector (black line). The GSE increases move roughly in tandem with lending standards whichrequired the GSEs to make more low and moderate income loans (blue line). This timeline is not meantto absolve the private sector, which made some horrendous and well-documented underwritingdecisions; the point is to understand what government actions and policies preceded them.

0%

5%

10%

15%

20%

25%

30%

35%

40%45%

50%

55%

60%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

The Course of Empire: Prelude to Destructi onPercent of annual underwriting (except Fannie/Freddie share based on total outstanding balances)

Source: American Enterprise Institute. J.P. Morgan Asset Management. November 2013.

Freddie Mac/FannieMae underwri tingthat exceededtraditional standardsin selectivelydisclosed portfolio

Private sector subprime and Alt A % oftotal origination

GSE Low & ModerateIncome lending target

Fannie/Freddie share of GSE+ Private sector FHA LTV >=97%

2

3

4

5

1. Non-traditional Freddie Mac2. Freddie cash out CLTV > 75%

3. Fannie/Freddie DTI > 38%4. Fannie purchase loan CLTV > 90%

5. Fannie/Freddie DTI >= 42%

1

A brief summary of the timeline (see November 18, 2013 Eye on the Market for more details)In 1990, Fannie Mae and Freddie Mac (government-sponsored enterprises) adhered to prudent underwriting onsingle family mortgages: the vast majority had debt-to-income ratios below 38%, loan-to-values below 90% onpurchase loans, or loan-to-values on cash-out refinancing loans below 75%. The GSEs had a one-third share ofoutstanding mortgages. Private sector subprime had existed for decades, but was limited in size at ~10% ofannual residential mortgage origination. Home ownership rates and home prices relative to income andreplacement cost were stable at post-war averages.

The era of sound GSE lending did not last. The 1992 Federal Housing Enterprises Financial Safety andSoundness Act enabled the Department of Housing and Urban Development to set formalized minimumaffordable lending standards for the GSEs. HUD first set Low & Moderate Income standards at 30% of annualGSE acquisitions, and raised them to 50% in the week before the November 2000 election. Home ownershiprates jumped, and home prices relative to replacement cost, rent and household income began to rise above

historically stable levels.

By 2002, the GSEs had increased their market share from one-third to 60% as the size of the mortgage marketrose by 2.5x vs. 1990. Freddie Macs non-traditional loans were ~45% of their annual acquisitions andguarantees, and more than 40% of Fannie Maes Alt A (low documentation) loans qualified for the HUD-determined affordable housing goals. Note that the GSE revolution took place before the explosion in privatesector subprime and Alt A loans.

In 2003, the private sector found a way to compete: the deepening of private mortgage backed securitiesmarkets. Home prices surged further, and the mortgage market doubled in size vs. 2002. The private sectorregained market share, mostly through subprime and Alt A loans which rose to 40% of annual origination. Tobe clear, private sector defaults and losses per dollar on subprime were much worse than on GSE loans,particularly when related to malignant derivative offshoots.


19/4617


Another large part of the financial crisisresulted from under-capitalized risk-takingat the 5 large broker-dealers. As background,in the mid 1970s, broker-dealers like MerrillLynch, DLJ and A.G. Edwards were leveragedfrom 5-to-1 to 8-to-1. Most of their activities

were brokering (acting as agent), notdealing (acting as principal). Commissionderegulation then reduced their core profitability(commissions declined from 61% of industryrevenues in 1965, to 40% in 1976, to 16% in1990), leading many firms to push for ways totake on higher leverage and higher risk. In 2004,the SEC eliminated the Net Capital Rule that hadlimited broker-dealer leverage at 12-1 since1975. As shown in the chart, broker-dealer balance sheets soared after this took place. By 2006,broker-dealers were leveraged around 30/35-1, with the 5 largest balance sheets comprising $4.2trillion in assets, and the rest is history.

In terms of what has happened since, the chart below shows the degree to which stock prices of thelargest S&P 500 banks and capital markets firms recovered relative to June 2007 levels. Surviving firmsare now adhering to stricter capital standards not only via higher minimum requirements, but also inimproved quality of capital (more reliance on loss-bearing capital like tangible common equity and theexclusion of trust preferreds from Tier 1 capital altogether). Furthermore, US banks have made asubstantial transition away from wholesale (interbank) liquidity, which has fallen from 47% to 27% ofall funding. All things being equal, these steps should reduce event risk in the financial system.However, banks are still highly exposed to the business cycle, credit losses and changes in monetarypolicy; substantial risks of concentrated ownership remain.

0

1020

30

40

50

60

70

80

90

100

110

120

130

140150

WellsFargo

Amer.Express

Schwab

USBancorp

JPMorganChase

PNCFinancial

M&TBank

CapitalOne

CommerceBanc.

BB&TCorp

Comerica

GoldmanSachs

FifthThirdBank

MorganStanley

SunTrust

Huntington

SLMCorp

KeyCorp

ZionsBancorp

FirstHorizon

BankofAmerica

Regions

Synovus

Marshall&Ilsley

MerrillLynch

Countrywide

Wachovia

Citigroup

E*TRADE

BearStearns

NationalCity

CITGroup

Lehman

WaMu

Higher than June 2007 stock price

Below June 2007 stock price

Delisted or acquired*

S&P 500 Banks, Brokers and Consumer Finance firms: changes in stock pri ce vs. June 2007Current index level, 6/30/2007=100

Source: Bloomberg. J.P. Morgan Asset Management. July 31, 2014. *Delisted or acquired stocks shown as of last reported price b efore delisting or acquisition.

0

100

200

300

400

500

600

700

800

900

1,000

Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Dec-07

Source: FDIC, Blo omberg.

Growth in assets and major financial sector legislationIndex, 12/31/1992 = 100

Broker-dealers

Gramm-Leach-Bliley Act

SEC Uniform NetCapital Rule Change

Commercial banks>$1billion in assets

$4.2 Tril lion

$10 Trillion

5 inst itutions

513 instit utions


20/4618


As for Financial concentration risk before 2008, there was a spike in distress in banks and thrifts duringthe consumer-led recession of the late 1980s. Whats more interesting as part of a discussion onconcentration risk are the Financial sector business models that are presumably more stable: insurancecompanies, companies acting as fee-based transaction agents, REITS and asset managers. Historyprovides quite a few examples of how overly aggressive insurance companies, without access to theFeds Discount Window, can experience substantial distress when the business cycle turns. While many

financial institutions have made substantial changes to their approach to leverage since the credit crisis,REIT capital structures look pretty similar, with most leveraging via bond markets instead of throughsyndicated bank loans. As a result (and given their cash flow distribution requirements), equity andmortgage REITs implicitly assume that credit and equity markets will remain open, even during arecession. The REIT stresses during 2008-2009 were in some ways the first big test for the sector, sincethey were much less prevalent during the prior commercial real estate recession in 1990-1991.

$0

$250

$500

$750

$1,000

$1,250

$1,500

$1,750

1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

Source: Bloomb erg. July 2014.

Amer ican International

Group, Inc.

There are a mill ion flavors of derivatives, and some ofthem taste terri ble

$0

$4

$8

$12

$16

$20

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

Source: FactSet. April 1991.

First ExecutiveCorporation

An overl y aggressi ve investment strategy (i.e., 45% ofExecutive Life's assets in HY bonds) can attractattention of regulators and scare policyholders

$0

$100

$200

$300

$400

$500

$600

1997 1999 2001 2003 2005 2007 2009 2011 2013


E*TRADE Financial Corporation

Diversifying a low-margin business (discountbrokerage) with a cyclical one (home equity lending)can be hazardous to your wealth

$0

$10

$20

$30

$40

$50

Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Jun-14


Janus Capital Group Inc.

Asset managers who are concentrated by sty le (Janus)or with a handful of star managers (like Legg Mason in2006-08) can suffer radical changes of fortune

$0

$10

$20

$30

$40

$50

$60

$70

1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013Source: Bloomberg. July 2014.

Developers Diversified Realty Corp.

Most REITs came back from 2009 low s, but are st il lexposed to credit cri ses given 90% incomedistr ibut ion, no access to Fed discount wi ndow andpreference for bonds > more easily negoti ablesyndicated bank loans

Similar REIT declinesand recoveries: GeneralGrowth Properties,Duke, Maguire, Cousins

$0

$10

$20

$30

$40

$50

$60

1987 1989 1991 1993 1995 1997 1999 2001 2003

Source: Bloomberg. September 2003.

Conseco Inc.

Sometimes short-sellers are right: a leveraged,

acquisition-based insurance company makes littlesense, and became the 3rd largest bankrup tcy in hi story


21/4619


Health Care

Health Care includes pharmaceutical companies, biotech, medical devices, hospitals and assortedservice providers. As you might expect, relative business risks differ. On large-cap pharma, genericdrugs took their toll: from 2003 to 2012, generic drug consumption generated $1.2 trillion in savingsfor the US health care system, much of which represented lost revenue for branded pharmaceuticalcompanies. The highest event risk in the sector is of course related to Biotechnology. According toHarvards Gary Pisano, even when a drug finally gets to Phase 3 trials, the probability of failure can stillbe as high as 50%. Pisano also found that the R&D process at biotech firms has been no better than atbig pharma companies; a study in the Journal of Health Economics actually found that larger firms hadbetterperformance in drug discovery. One irony about the biotech boom-bust of 2000: part of it wasbased on the promise of mapping the human genome, which is now finally paying dividends (timing iseverything). While 2000-2001 was the peak in biotech distress, there have been over 100 catastrophicfailures of Russell 3000 biotech/life sciences companies since 2002 (see Appendix II).

$0

$5

$10

$15

$20

$25

$30

$35

$40

$45

$50

1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013


Boston ScientificCorporation

Device companies heavily reliant on one product (drug-coated stents, in this case) are like concentrated stockportfoli os themselves

$0

$20

$40

$60

$80

$100

$120$140

$160

1987 1990 1993 1996 1999 2002 2005 2008 2011 2014


HealthSouthCorporation

Note to CEOs selling a company for stock in a roll-up:due dil igence on buyers is im portant; largest outpatientrehab roll -up was fueled i n part by accounting fraud

$0

$10

$20

$30

$40

$50

$60

Jun -00 Jun -02 Jun -04 Jun -06 Jun -08 Jun -10 Jun -12 Jun -14


Dendreon Corporation

Prostate cancer wonder drug? Sometimes FDAapproval is not enough, customer demand has tomaterialize as well

FDA approvalreceived

Companywithdrewguidance

Successfultest resultsannounced

$0

$5

$10

$15

$20

$25

$30

$35

$40

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001


Genesis HealthVentures Inc.

Unanticipated sharp declines in Medicare reimbursementsrender GHV (nursing home) capital structure inoperable;contagion spreads to other providers

$0

$10

$20

$30

$40

$50

$60

$70

1997 1999 2001 2003 2005 2007 2009 2011 2013

Source: Bloomberg. Ju ly 2014.

NeurocrineBiosciences, Inc.

FDA approval tol erance can shift over time, particularly if

approved competitors (Lunesta, Ambien) show signs ofnegative si de effects

FDA deniesapproval forlargerdoseIndiploninsomnia drug

$0

$20

$40

$60

$80

$100

$120

1996 1998 2000 2002 2004 2006 2008 2010 2012


Human Genome Sciences Inc.

Advanced sci enti fi c breakthroughs (even mapping

human DNA sequences) do not necessarily translateimm ediately into profitable business models

Largest Biotech companies withcatastrophic price declines, 2000-02:Mill ennium, Celera, Abgenix, ProteinDesign Labs, Medarex, Maxygen,Curagen, Enzon, Cell Therapeutics


22/4620


Industrials

Most Industrial failures that people remember are airlines, which is understandable since there havebeen so many (162 airline bankruptcies from 1978 to 2005 as per the US GAO). There have beenother Industrial distress cases as well. Many thrived for a long period of time, sometimes multipledecades, perhaps convincing concentrated holders that event risk was minimal. Then, somethingchanged: Asian growth, asbestos litigation, competitive forces resulting from Chinas entry into theWorld Trade Organization, declining demand for postage equipment in the internet era (Pitney Bowes),an unfavorable ruling by the Nuclear Regulatory Commission regarding the use of decommissioningfunds (EnergySolutions), a state government terminating alternative energy subsidies (Foster Wheeler),etc. Regarding the latter company, theres a broader paradigm of business risk for industrial companiesinvolved with the various aspects of renewable energy (photovoltaic equipment, wind turbines, fuelcells and related services). See A123 Systems below, and pages 30-31 for more details.

$0

$10

$20

$30

$40

$50$60

$70

$80

1981 1984 1987 1990 1993 1996 1999 2002 2005

Source: Bloomberg. April 2007.

Delta Air Lines Inc.

Slow responses to low -fare competit ion and high salarywor kers, coupled wi th a spike in jet fuel costs, forcedthe airl ine to fil e for bankruptcy

Other catastrophic airline stock pricedeclines: American, Braniff , Frontier, JetBlue,

KLM, Mesa, Midway, Northwest, PanAm,SkyWest, Texas Air, TWA, United,US Airways, ValuJet

$0

$5

$10

$15

$20

$25

$30

$35

$40

$45

$50

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001


Harnischfeger Industr ies Inc.

Debt-fueled expansion and rel iance on overseasconsumption can be ri sky: reduction in orders fromIndonesia in 1998 when its GDP fell 17%

$0

$10

$20

$30

$40

$50

1981 1984 1987 1990 1993 1996 1999 2002 2005


Owens-CorningFiberglass Corpor ation

In 90 AD, Pliny the Younger wr ote of medical problemsassociated w ith asbestos mining; 2,000 years later,nearly 100 asbestos producers filed Chapter 11

$0

$10

$20

$30

$40

$50

$60

1981 1983 1985 1987 1989 1991 1993 1995 1997


Morrison Knudsen Corp.

Preeminent civil engineering and heavy constructionfi rm overextends itself fi nancially whi le aggressivelyexpanding int o non-core areas like mass transit

$0

$50

$100

$150

$200

$250

$300

$350

$400

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

Source: Blo omberg. February 2013.

Cincinnati Milacron Inc.

One of the world's largest machine tool manufacturersstruggled to compete with cheaper foreign competition

and the slowdown in US manufacturing

China jo ins WTO

$0

$5

$10

$15

$20

$25

Sep-09 Sep-10 Sep-11 Sep-12


A123 Systems, Inc.

The government can sponsor the idea of electric cars,but cannot make people buy them, or the li thium ion

batteries that A123 made

China joins WTOCincinnati Milacron Inc.


23/4621



The tech sector has generated some of the most spectacular gains in the history of US equity markets.Google, Apple, Qualcomm, salesforce.com, eBay, Adobe Systems, Oracle, etc. are some of the mostsuccessful public companies in the world. As shown on page 7, however, only 6% of all techcompanies turned out to be extreme winners; the median tech company substantially underperformedthe market; 70% underperformed the Russell 3000; and over 50% generated negative absolutereturns. Furthermore, almost 60% of all technology companies in the history of the Russell 3000 Indexfell by 70% from their peak price and did not recover.

The story of the tech sector is a long narrative about disruptive technologies which are themselvesdisrupted by changes that follow. Wang Labs, Silicon Graphics, Digital Equipment Corporation

4and

Commodore are some of the earlier casualties, unable to adapt to the shift away from dedicated wordprocessors and 3D graphics servers and towards PC platforms based on Microsofts Operating System.Similar fates were eventually in store for Cray Supercomputer, Prime Computer, Data General, Atari,Maxtor, DEC, Borland International and other tech stalwarts of the 1980s and 1990s. They were allindustry leaders at their peak, run by some of the smartest teams in the business world that wouldpresumably adapt to changing technologies and circumstances. Most of them, however, did not.

The next phase in the tech sector came in the late 1990s, when internet use began to rise sharply. Thedot-com era was fueled by this enthusiasm, as well as by opportunities in the business-to-businessspace. As global internet users rose ten-fold from 32 million in 1995 to 320 million by 2000, marketsassumed that profitable business models would emerge around it. However, while global internet usedid keep growing at a rapid clip, many technology companies werent making enough money tosurvive what turned out to be a mild recession in 2001, and required even more exponential internet/broadband uptake than what was occurring in order to be profitable.

$0

$5

$10

$15

$20

$25

$30

$35

$40

$45

1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Source: FactSet. September 1993.

Wang Labs, Inc.

Dedicated word processing equipment

$0

$2

$4

$6

$8

$10

$12

$14

$16

1987 1989 1991 1993 1995 1997 1999 2001 2003 2005


Silicon Graphics Inc.

Dedicated 3D graphics servers

$0

$10

$20

$30

$40

$50

$60

$70

$80

1998 1999 2000 2001 2002

Source: Blo omberg. June 2002.

ExodusCommunications Inc.

Data center provider cannot survive collapse of its techcustomer base and the eventual migration from simpleco-location to full-service managed hosting

$0

$200

$400

$600

$800

$1,000

$1,200

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014


JDS Uniphase

JDS' customer base for optical equipment (Alcatel,Ciena, Cisco, Corning, Juniper, Lucent, Marconi,Motorola, Nortel, Scientific Atlanta, Siemens, Sycamore)all suffered a collapse in demand at the same time

4The personal computer will fall flat on its face in business, Ken Olsen, CEO Digital Equipment

Corporation, who was proclaimed Americas most successful entrepreneur by Fortune magazine in 1986 .


24/4622


As the tech bust rolled on through 2001 and 2002, dozens of technology companies ended up seeingtheir highest stock prices in the rearview mirror (for example, of 212 Internet & Software Servicecompanies with stock prices in February 2000, only 17 ever saw higher stock prices at any timebetween March 2000 and February 2014). Some of the largest declines appear below; the first threeeach had a peak market cap over $100 billion. While some companies survived (EMC, Intel, Cisco,Broadcom), others did not adapt to industry changes, adapted temporarily, or did not adapt in time

5.

As for computer hardware,cheaper component parts and migration to smartphones and tabletseventually pulled down several manufacturers stocks.

$0

$10

$20

$30

$40

$50

$60

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006Source: Bloomberg. November 2006.

Lucent Technologies Inc.

The world s largest telecom equipment company in1999 with $38 bil li on in sales; reli ed excessively on itsincumbent position and did not adapt

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014Source: Blo omberg. July 2014.

Nortel Networks Corporation

Lucent's Canadian competitor, drowning in a sea ofoverpriced, i ll-chosen, poorly integrated acquisiti ons;suffered from a "cul ture of arrogance and hubris" *

* according to a studyreleased in 2014 by theUniversity of OttawaDepartments of Law,Electrical Engineering andManagement

$0

$50

$100

$150

$200

$250

1987 1990 1993 1996 1999 2002 2005 2008

Source: Bloomberg. January 2010.

Sun Microsystems

Industry shifted away from Sun on hardware (to x86processor machines), and on software (away fromproprietary licensing); see footnote #5

$0

$500

$1,000

$1,500

$2,000

$2,500

1997 1999 2001 2003 2005 2007 2009

Source: Blo omberg. January 2010.

I2 Technologies Inc

Supply chain management software leader runs intoGermany's SAP, which decides to compete and abandonJV; 2008 IP judgment against SAP was too little, too late

$0

$10

$20

$30

$40

$50

$60

$70

$80

1994 1996 1998 2000 2002 2004 2006


Gateway 2000

Too slow moving into portable computers, and fromretail to enterprise customers

$0

$10

$20

$30$40

$50

$60

1989 1992 1995 1998 2001 2004 2007 2010 2013


Dell Computer

Corporation

World's #1 computer system provider experiencesdeclining need for customized hardware and a bruisingprice war, difficulty executing on transition to mobile

5Sun Microsystems CEO Scott McNealy in 2011, on the conundrum of proprietary vs open-source code: "Themistake we made was putting it on our own hardware. If we hadn't metal-wrapped it, it would have been morewidely adopted. If we had put Solaris early on an Intel box, Linux never would have never happened. We wouldhave been the operating system for all those startups." [Information Week, February 25, 2011].


25/4623


After the dust cleared, the steady drumbeat of substantial tech stock price declines continued over thenext few years, even on stocks linked to rapidly growing wireless and video communications (eachexample shows the company; the date of its peak price before the decline; and the magnitude of thestock price decline through July 31, 2014 or the last quoted price, according to Bloomberg):

Travelzoo (largest publisher of travel, entertainment and local deals): December 2004, -82%

Avid Technology (commercial audio and video production software): February 2005, -89%

Intermec (automated identification and data capture, barcode scanners): September 2005, -71%

Sirf Technologies (GPS for consumer applications): February 2006, -89%

Trident Microsystems (digital processors for LCD TVs): March 2006, -99%

Brightpoint (distributor of mobile phones and other wireless products): April 2006, -68%

Digital River (e-commerce sites for software and other tech companies): November 2006, -76%

Imation Corp. (DVDs, flash drives and magnetic tapes): December 2006, -93%

THQ (video games such as Dawn of Warand Company of Heroes): March 2007, -100%

Fast forward to today. Some people view the Technology sector as changed, and believe thatcompanies brought to market via initial public offerings are more robust. Can this be substantiated?It depends how you define your parameters. As shown in the next chart, the median age of tech IPOs

has been rising since the height of the dot.com era;the median age has risen from 4 to 10 years. Thisdoes suggest a maturation of tech companies goingpublic, perhaps a result of deeper pre-IPO financingcapital pools which allow companies to stay privatelonger. As for valuations, nothing will probably evermatch the pricing of tech IPOs in 1999 and 2000when average price/sales ratios were 27x and 32x,respectively. More recent valuations have beencreeping up again, however, and are roughly wherethey were before the onset of the financial crisis.

Theres one area showing clear signs of rising investor

risk appetite: the falling percentage of tech IPOs thatare profitable at issuance. In the last couple ofyears, this measure has declined almost back to where it was during the dot.com era . Fromthis perspective, theres a lot of business risk being brought to market via companies whose profitabilityhas not yet been established. All things considered, the business risk of todays tech IPO may be onlymoderately lower than it was 15 years ago. For more on IPOs and their performance relative to adiversified basket of stocks, see page 34.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

Source: "Initial Public Offerings: Technology Stock IPOs". Ritter (University o f Florida). July 2014.

Remembrance of things past: low percentage of t echnology company IPOs wi th profit sPercent of technology companies with positive net income at IPO

3

5

7

9

11

13

15

0x

3x

6x

9x

12x

15x

1980 1984 1988 1992 1996 2000 2004 2008 2012

Technology IPO trends: fir m age and valuation at IPOMedian price/sales Median firm age in years

1999: 26.52000: 31.7

Source: "Initial Public Offerings: Technology Stock IPOs". Ritter (Univ. ofFlorida). July 2014.

Median firm age

Median pri ce/sales


26/4624


To complete the tech sector review, we conclude with a few recent cases where there have beensubstantial reversals of fortune. To reiterate a theme, the fact that a certain segment of the industry isskyrocketing (e.g., the 220% growth in mobile search and display advertising since 2012) does not liftall boats. On gaming, many mobile game developers have struggled to establish the kind of brandloyalty that exists in traditional gaming (Madden NFL, World of Warcraft, Call of Duty) which keepsplayers coming back for more. Theres also piggy-backing risk: companies like Zynga and Demand

Media rely to a great extent on how Facebook and Google integrate them; changes in the latter canhave very large impacts on the former. We conclude with BlackBerry. Innovation in handheld devicesand mobile phones garners a lot of interest, but these companies can be rapidly eclipsed bycompetitors and changing technology. Palm, the company that pioneered personal digital assistantsand first popularized the smartphone, collapsed in 2001; then Motorola could not maintain theadvantage it had in 2006 with its revolutionary Razr phone; BlackBerry is just the latest casualty.

$0

$5

$10

$15

$20

$25$30

$35

$40

$45

$50

Jan-11 Jan-12 Jan-13 Jan-14


Demand Media, Inc.

Google finally gets wise to "content farms" like DemandMedia, and changes algorithms to avoid them

$0

$10

$20

$30

$40

Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14


Fusion-io, Inc.

Big data flash storage leader's customer base tooconcentrated (loss in pricing power); low barriers toentry invite intense competition

$0

$2

$4

$6

$8

$10

$12

$14

Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14


Zynga Inc.

Buying the next big hit proves to be much harder thandeveloping it; acquisition writeoffs, falling subscribers,bloated management and lots of com petition

$0

$5

$10

$15

$20

$25

Mar-12 Sep-12 Mar-13 Sep-13 Mar-14


Millennial Media, Inc.

Pioneer of mobile advertising gets squeezed out oncethe mega-platforms (Google, Facebook) compete withthem; not every little fish gets bought

$0

$2

$4

$6

$8

$10

$12

$14

$16

May-13 Aug-13 Nov-13 Feb-14 May-14


Cyan, Inc.

Extreme revenue concentration for smaller technologycompanies (in this case, software-defined networking)

causes problems when big customers cut back

$0

$25

$50

$75

$100

$125

$150

1999 2001 2003 2005 2007 2009 2011 2013


Stale technology (no touch screen), operating systemproblems, worldwide outages, too much focus on corp

customers; mi ne is constantly re-booti ng for no reason

BlackBerry Ltd.


27/4625


Materials

The Deng reforms in China and the Rao reforms in India are among the most momentous shifts inrelative economic power in centuries. In both countries, capital and energy-intensive industries like ironand steel benefited from very generous government subsidies (see Appendix I). As these state-sponsoredcompanies became more profitable, their earnings were reinvested, creating expansion of capacity andproduction well beyond their domestic markets ability to absorb. This resulted in a structural change inglobal export markets, and intense competition for US firms. Other secular, permanent shifts: thedecline in US newspaper readership from 62 million daily (1990) to 52 million (2006), a problem fornewspaper companies and the Materials companies that sell newsprint to them. As for cyclical risks,many Metals & Mining companies were not well positioned for the 20% collapse in global trade whichtook place in 2009, the largest decline in 50 years (e.g., Alcoa, US Steel, AK Steel, Intrepid Potash allsuffered sharp declines and have not yet substantially recovered).

$0

$5

$10

$15

$20$25

$30

$35

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Source: Bloomberg. January 2004.

Bethlehem Steel Corp.

Deng reforms in China reshape steel export market,management did not reduce labor costs or increaseplant productivity in time

Annual Chinese ironand steel exports

jump from $1.6B to$5.2B

$0

$5

$10

$15

$20

$25

1995 1997 1999 2001 2003 2005 2007 2009

Source: Bloomberg. June 2010.

Smurfit-Stone Container Corp.

Low margin packaging business with too muchleverage suffers from a collapse in trade during theglobal recession

$0

$5

$10

$15

$20

$25

$30

$35

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008


Solutia

No statute of l imi tations: environmental misdeeds, even2-3 decades after they take place, can threaten acompany's solvency

$0

$10

$20

$30

$40

$50

$60

$70

$80

2011 2012 2013 2014


Molycorp, Inc.

"Rare earth demand is insatiable since the entireelectronics and renewable energy industry depends onthem!!" That is, until workarounds are found

$0

$2

$4

$6

$8

$10

$12

$14

$16

$18$20

1990 1992 1994 1996 1998 2000 2002 2004 2006


Abitibi-Consolidated Inc.

An indirect in ternet casualty: decl in ing newspaperdemand leads to coll apse in the demand for newspri nt

$0

$5

$10

$15

$20

$25

$30

$35

$40

$45

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013


Aluminum Company of America

Alcoa's fortunes hur t by global over-expansion ofcapacity whi ch drags down producer profi ts; a leveraged

reflection of global growth and capex

Similar profiles in metals/mining due to collapse in globaltrade:US Steel, AK Steel,Walter Energy, Intrepid Potash,Century Aluminum, ThompsonCreek

$0

$5

$10

$15

$20

$25

$30

$35

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Bethlehem Steel Corp. Annual Chinese ironand steel exports

jump from $1.6B to$5.2B


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Telecommunications

While the period from 1999-2001 is often referred to as the dot-com bust, the telecommunicationsindustry accounted for much more equity market capitalization both gained and then lost. The lesson:regulatory shifts can make it difficult to forecast supply and demand. The catalyst for change was theTelecommunications Act of 1996, which was designed to bring competition to the local exchange level

(by 1996, long distance service was already subject to competition, although the Act also allowedincumbent local carriers to compete in long distance markets). The combination of deregulation andadvances in fiber optic technology resulted in the belief that a single firm could provide all of a givenhouseholds or companys telecom needs. Demand for bandwidth proliferated; from 1994 to 1996,internet traffic in the US increased from 16 to 1,500 terabytes per month. Meanwhile, the Act wasconstantly tied up in the courts since the FCC left many of the Acts clauses open to interpretation ordispute (in particular, disputes over the FCCs jurisdiction regarding forced co-location and other rulesrequiring incumbents to make room for new competitors).

A gold rush of investment followed: at the peak of the cycle, telecom capital spending wasskyrocketing and industry profitability was negative. In hindsight, a buoyant IPO market and thewillingness of telecom equipment sellers (Lucent, Nortel, Motorola, Alcatel and Cisco) to providevendor financing were signs of industry weakness. In the early 2000s, end-user demand for long-haulfiber did not rise as quickly as telecom companies projected. As a result, a glut of excess capacity,lower tolling rates and too much debt caused a collapse in telecom stock prices by 2003 and a wave ofbankruptcies (see box, below). Video streaming and other data-heavy trends that the telecom giantsexpected eventually appeared, several years later; however, leveraged capital structures could not waitthat long. The importance of this episode for concentrated stockholders is not that a telecom boom-bust will necessarily repeat itself, but that the paradigm might take place elsewhere.

$15

$20

$25

$30

$30

$40

$50

$60

$70

$80

$90

1995 1997 1999 2001 2003

Source: Bureau of Economic Analysis. December 2003.

Private fixed investment i n communi cationsBillions of 2009 USD (both axes)

Communicationsstructures

Communicationsequipment

-$15

-$10

-$5

$0

$5

$10

$15

$20

$25

$30

1995 1996 1997 1998 1999 2000 2001

Source: Bureau o f Economic Analysis, J.P. Morgan Asset Management. 2001.

Communication industry after-tax profitsUSD, billions

2000-2003 Telecom bankruptcy wave (partial)

Long distance/wholesale fiber carriers: Global Crossing, GTS, 360Networks, Impsat, Network Plus, Star,Touch America, Viatel, WorldCom

Competitive local exchange carriers: Convergent, Covad, Focal, ICG, McLeod, Northpoint, NTL, RhythmsNet, Telcove, XO (After FCC rulings that originally favored the new competitive local exchange carriers, anFCC ruling in 2000 on pricing methodology went against them)

Wireless carriers: GlobalStar, Leap, Metricom, OmniSky, StarBand, Teligent, Winstar

Diversified/Other: Excite@Home


29/4627


The box on the prior page lists the companies that filed Chapter 11. Others survived the telecom bust,but their stock prices look like Sprint (below) which only recaptured a fraction of its lost market cap (inthe case of Sprint, it was acquired in July 2013 by Japans SoftBank). Other examples of partial stockprice recoveries include Qwest, US Cellular, Level 3 and Arch Wireless. Only a handful of telecomsurvivors look like Bell South, Alltel and SBA Communications, whose stock prices declined during thetelecom crash and then rebounded substantially, reaching or surpassing prior stock price peaks.

There were also telecom declines that took place after the telecom boom-bust that are worthreviewing. Like biotech and internet stocks, while the period of peakbusiness failure was 2000-2002,telecom companies are still subject to traditional business cycle and management risks.

$0

$10

$20

$30

$40

$50

$60

$70

1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011


Sprint Communications

Third largest wireless and wireline company barelysurvived telecom boom-bust and a failed 2004 $36bill ion merger with Nextel

0

50

100

150

200

250

1996 1997 1999 2001 2003 2005 2007 2009 2011 2013


Examples of recovering telecom stocksIndex = 100 at February 2000

Alltel(acquired)

SBA CommunicationsBell South(acquired)

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: Blo omberg. March 2014.

Leap Wireless International Inc.

Differentiated product (unlimited minutes for low-endcustomers) attracts competition from proxies funded bylarge wireless companies using superior 4G technology

$0

$5

$10

$15

$20

$25

$30

2007 2008 2009 2010 2011 2012 2013

Source: Bloomberg. Ju ly 2013.

Clearwire Corporation

Not all w ireless service created equal: higher f requencyspectrum has shorter coverage areas and weakerpenetration strength; eventually surpassed by broadband

$0

$2

$4

$6

$8

$10

$12

$14

May-06 May-08 May-10 May-12 May-14


Vonage Holdings Cor p.

VOIP*: revolutionary idea gets old fast when Skypeoffers basic service for free, cable companies competeand wireless companies file patent infringement suits

*VOIP = Voice Over Internet Protocol

$0

$5

$10

$15

$20

$25

$30

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: Blo omberg. March 2013.

TerreStar Corp.

Iridium failure ten years prior was the template forsatellite phone technology that did not li ve up toexpectations


30/46


31/4629


In the charts below, Calpine and Reliant are proxies for utility distress that took place as a result of the1999-2003 capacity expansion in natural gas plants. There were other reasons for utility distressoutside this period, such as under-appreciation of emerging market risks (AES). In the case of Exelon,changing energy policies and commodity supply created a formidable headwind: its nuclear-heavygeneration portfolio is in less demand since the natural gas boom and renewable energy production taxcredits make other forms of generation cheaper. In addition, renewable portfolio standards drive grid

operators towards more wind/solar. As for Constellation Energy, we might have included it in theFinancials section given its January 2007 launch of an energy trading business that created hugeproblems: the company had to arrange a fire sale when a pending downgrade could have required acollateral posting of $4 billion. This was not the first time that utilities suffered from outsized energytrading operations: problems earlier in the decade at Dynegy, Williams, Aquila and El Paso were similar.

$0

$10

$20

$30

$40

$50

$60

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008


Calpine Corp.

Over-reliance on leverage (85%) despite a transitionfrom fixed pri ce contracts to merchant prici ng; at onepoint, 115% of capacity under construction

$0

$5

$10

$15

$20

$25

$30

$35

$40

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: Bloomberg. December 2012.

Reliant Energy Inc.

First leg: rising fuel input costs combined with $5bn debtincrease from 2002 to 2003; Second leg: asset sales notcompleted fast enough before recession/liquidity crisis

$0

$10

$20

$30

$40

$50

$60

$70

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014


AES Corporation

Massive overseas expansion (esp. Latin America)backfires after 65%-75% currency declines, adverseregulatory ru lings in Brazil and falli ng global demand

$0

$10

$20

$30

$40

$50

$60

$70$80

$90

$100

1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014


Exelon

Exelon portfolio: 55% nuclear at a time of rising nuclearmaintenance costs, and falling prices of natural gasand wind-powered electricity

$0

$20

$40

$60

$80

$100

$120

1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011

Source: Bloomberg. March 2012.

Consequence of energy trading becoming a primarystrategic focus, rather than the generation of wholesalepower

Constellation Energy

$0

$5

$10

$15

$20

$25

1993 1995 1997 1999 2001 2003 2005


Western WaterCompany

Wholesale ownership and distribution of water was animm ature market, l imi ted abili ty to recapture capitalspending outlays


32/4630


Subsector focus on alternative energy stocks

In our 2014 annual energy paper, we write about the practical certainty of the worlds eventualtransition to renewable energy. This transition will be the fourth of the last few hundred years, withthe first three being coal (early 1800s), oil (early 1900s) and natural gas (mid 1900s). However, the

journey to a renewable energy world will be long, and subject to fits and starts regarding what works

and what doesnt. The next chart is one way of visualizing the risks and opportunities for concentratedholders. It shows how the returns on two diversified clean energy indexes have usually underperformedthe S&P Small Cap Index. The peaks and valleys are huge, with more valleys than peaks; new ideasoften generate tremendous excitement, but only a few work out in the long run.

The table below shows a few more comparisons. Clean energy stocks have struggled versus both thebroad market and versus the oil & gas stocks which make up the majority of energy-specific S&P sub-indices. The relative returns are similar when starting the analysis in 2002, 2005 or 2008, or whenusing different clean/alternative energy indices.

The underperformance of alternative energy stocks

-70%

-50%

-30%

-10%

10%

30%

50%

70%

2002 2004 2006 2008 2010 2012

Source: Bloomb erg. July 31, 2014.

Renewable energy stocks fall in and out of favorRolling 1-year excess return of clean energy vs. S&P small cap

Wilderhill Clean Energy Indexminus S&P Small Cap Index

NYSE Bloomberg AMEClean minus S&P SmallCap Index

Annualized Total Returns

Index Since 2002 Since 2005 Since 2008

Clean Energy Indices:

Wilderhill Clean Energy Index -3.04% -10.08% -4.11%

NYSE Bloomberg Americas Clean Energy Index ** 4.61% 11.82%

FTSE Environmental Opps. Renewable & Alternative Energy Index ** ** 1.90%

Benchmark Indices:

S&P Small Cap 12.01% 8.60% 18.39%

S&P Small Cap Energy 20.01% 12.49% 25.04%

S&P Mid Cap 12.04% 9.03% 19.98%

S&P Mid Cap Energy 12.19% 5.59% 18.41%

S&P 500 9.21% 7.47% 17.06%

S&P Large Cap Energy 14.64% 9.87% 13.71%

Source: Bloomberg. July 31, 2014. ** represents indexes prior to their inception.


33/4631


There may be no sector whose stocks have more true believers than alternative energy and relatedservices/products. This category includes companies developing wind and solar equipment, fuel cellsand biofuel processes. It also includes companies in search of superconductor materials, which wouldsave the world enormous amounts of energy by reducing the 6%-10% of electricity that is lost onalternating current transmission lines and across other synapses. Unfortunately, while each of the ideasbelow may one day become integral and indispensable, there are issues related to pricing, subsidies,

government regulations, overseas competition, raw materials costs, carbon emission taxes (or the lackthereof), capacity factors/efficiency and the practical limits of science that can get in the way. Wechose some of the better known examples below; each was seen in its day as a magic bullet, only tosee dramatic reversals of fortune.

$0

$50

$100

$150

$200

$250

$300

2006 2007 2008 2009 2010 2011 2012 2013 2014


Broadwind Energy, Inc.

Wind turbine manufacturing and services

$0

$50

$100

$150

$200

$250

$300

2007 2008 2009 2010 2011 2012 2013 2014


First Solar, Inc.

Manufacturer of thin fi lm photovoltaic solar panels,provider of PV power plants/services

$0

$20

$40

$60

$80

$100

$120

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014


Hydrogen fuel cells

Ballard Power Systems Inc.

$0

$10

$20

$30

$40

$50

$60

$70

$80

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014


Amer ican Superconduct or Cor por at ion

Superconductors

$0

$5

$10

$15

$20

Jul-11 Jul-12 Jul-13 Jul-14


Next generation renewable biofuels

KiOR Inc.

$0

$20

$40

$60

$80

$100

$120

$140

$160

$180

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007


Earthshell Corp .

Environment

morgan stanley - the agony and the ecstasy

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