1. I N V E S T M E N T S T R A T E G Y G R O U P The Long-Term Investment Outlook for China February 2014

2. W W W. J A N N E Y. C O M2 Investors have taken a pessimistic view of Chinas economic fundamentals and long-term structural outlook. This has been driven by concerns over the banking system, overall debt levels in the economy, and slower economic growth rates. Meanwhile, Chinese stocks are now trading at a deep discount to global benchmarks, despite faster growth in the economy and corporate profits. The new lead- ership, under Premier Li Keqiang and President Xi Jinping, has also recently announced significant positive reform measures to emphasize free-market principles and reduce the governments role in the economy. In this paper, we examine major issues that China faces in continuing its extraordinarily rapid development, and we discuss potential investment opportunities that may result from economic reform. Historical Perspective of Chinas Rapid Development The growth of China is historically unprecedented and is happening at about 10 times the speed at which the United Kingdom improved average incomes during the Industrial Revolutionand on a much greater scale. Chinas GDP growth has averaged about 10% since the 1990s, per capita income has jumped 13-fold in the last three decades, and over 500 million people have been lifted out of poverty. Even with this extraordinary growth, China still needs to grow at an 8% per annum rate through 2030 in order to reach the per-capita GDP of South Korea, another emerging market country. Keys to Chinas Rapid Historical Growth 1) Rapid industrialization, aided by globalization, and structural movement of workers from low-productivity agricultural jobs to high-productivity urban manu- facturing and services jobs has led to a self-feeding, positive development cycle. 2) Massive domestic savings have enabled large-scale investment, without reliance on external funds, while incorporating foreign investors has brought in ad- vanced technology. Both of these factors have enhanced productivity. Resulting low-cost, efficient infrastructure and productivity gains created significant competitive advantages, facilitating rapid industrialization and rising income levels. 3) Chinese policymakers, while far from perfect, have been flexible and responsive in meeting challenges. The countrys economic reforms over the years have eliminated rigidities, improved efficiencies, and unleashed creativitywhile avoiding major policy blunders, as we discuss further. Chinas Importance to the Global Economy has Grown Enormously The Chinese economy expanded by about 8% in 2013, which represents a marked slowdown from the double-digit pace commonly seen before the Global Financial Crisis. Even so, five years after the Great Recession, Chinas GDP is currently 40% larger than in 2008, accounting for 12% of the global totalup from 7% in 2008 at the onset of the crisis. China has contributed to almost half of the net increase in global output over the past five years. Currently, China accounts for 19% of emerging market exports, compared with 14% five years ago. Similarly, China accounts for 16% of exports of some commodity-producing countries, more than double 2008 levels. China has emerged as the largest crude oil importer in the world. The global impact of the Chinese economy has grown enormously, and its marginal impact will likely contin- ue to grow. As such, getting China right has become all the more important in understanding the global macro picture. Chart A: Chinese GDP as a Share of Global Total (Source: Janney ISG, BCA Research) 0 2 4 6 8 10 12 0 5 10 15 20 25 30 35 4012 10 8 6 4 2 0 40 30 20 10 0 Chart B: Chinese Contribution to Global GDP Growth 2007 2013 2007 2013 6 12 40 20 Percent Percent 3. 3W W W. J A N N E Y. C O M While there is little doubt that China will play a leading role on the world stage in the 21st century, there is more uncertainty about how investors should seek to profit from this trend. Histori- cally, the most straightforward and lucrative way to play China has been through the commodity markets and commodity related countries and stocks. We think this has changed. China is at a Critical Turning Point Chinas double-digit growth rates over the last decade were significantly aided by the massive consumption boom in the developed world (China was the high-volume manufacturer of low-margin products for the world), which most likely ended with the Great Recession. Contribution to growth by net exports has recently turned negative, and slower global demand will be a formidable head- wind going forward. Existing growth model flaws are also evidenced by excess capacity that has built up in nearly all sectors that the government had subsidized and interfered in, in the rising cost structure, declining global competitiveness, and shrinking corporate profitability of many Chinese companies and in the unprecedented environmental degradation. With its export markets increasingly saturated, the country has no choice but to shift its growth model from investment and exports to domestic con- sumption. This transition will offer investors many opportunities, while also posing risks. We View the Odds of a Debt-Driven Chinese Hard Landing as Remote A potential China hard landing is considered a top risk facing the global economy. This concern is driven by the amount of debt in the Chinese economy, which is causing the Chinese authorities to take precautionary measures. These measures include cooling off the housing sector, restricting local government borrowing, and tightening scru- tiny on shadow banking (shadow banking, which exists in every major economy, occurs when non- bank financial institutions provide services similar to traditional banksbut outside the system of regulated depository banking). Regulators have mandated banks to dramatically increase the provision coverage ratio of non- performing loans. The provision coverage ratio of banks has increased from a mere 40% in 2007 prior to the financial crisis to about 300% current- ly, a massive buffer to protect banks capital base. The overall leverage ratio in the Chinese economy is not exceptionally high compared with other countries. The total indebtedness of the economy, including the government, the corporate and household sectors, is about 150% of GDP, substan- tially lower than most other major countries in the world (the U.S. stands at 300% of GDP). Even tak- ing into consideration the shadow banking activity, Chinas overall leverage ratio, at 205% of GDP, does not stand out in a global comparison. Shadow Banking Analysis: The rapid expansion of shadow banking activity in the past few years is a risk factor that has weighed heavily on investors sentiment and on Chinese stocks. Despite growing rapidly, the shadow banking activity has not yet reached systemic significance (Charts C and D). While there are certainly some trust and wealth management products that have promised unrealistic returns for investors, the overall situation is less alarming than the individual cases that have grabbed the headlines. The average yield on wealth management products is currently 5.5%, higher than Treasury yields but lower than corporate bonds. Trust products on av- erage have higher yields, but historically have been more volatile and have not been too far off from the average lending rate of new bank loans. Finally, an overwhelming majority of Chinese financial institutions are state-owned or state-controlled, and all trust and wealth management products are issued in local currency terms. Barring major policy mistakes, the Chinese authorities have unlimited resources to back- stop any potential crisis scenario. We expect the shadow banking issue to remain un- resolved for an extended period. While we believe the risk of a credit event or financial crisis remains low, the risk of default on trust and wealth man- agement products will likely continue to surface, creating headline risk and uncertainty for investors. 4. W W W. J A N N E Y. C O M4 Importance of Urbanization Second, Chinas urbanization rate will likely reach 53% as of 2013, compared with 20% at the begin- ning of the countrys economic reforms in the late 1970s. Nonetheless, Chinas urbanization rate is still substantially lower than that of other countries at comparable income levels, let alone the developed world. Currently, Chinas average urban income is three times that of the rural sector, which generates strong incentive for rural workers to move to cities for more productive and better-paying jobs. If the experience of some newly industrialized countries offers a useful guide for Chinas future roadmap, it will take at least two more decades before Chinas urbanization rate reaches 80%still a relatively modest level compared with other major world economies. Urbanization also generates the need for infrastructure investment, especially in trans- portation, housing, power, water, sanitation, and social servicesproviding sources of demand as well as economic growth. Finally, the vast gap between Chinas relatively developed coastal region and the poorer inland provinces provides the potential for less devel- oped areas to catch up. The government has been pouring capital into the inland provinces to improve transportation infrastructure, and private sectors have also been moving in to take advantage of cheaper costs. As a result, the inland provinces have been growing at a notably faster pace than the coastal region in recent years. The inland region can benefit from the experiences, expertise, and capital of the more developed parts Drivers of Future Growth Catch-up Potential A key driver to Chinas future growth potential is the gap between China and other advanced economies. Using the U.S. as a benchmark for the advanced frontier, Chinas current per capita GDP is slightly over 30% of the U.S. level, com- parable to Japan in the 1960s and Korea in the mid-1970s. This comparison highlights that despite the tremendous progress China has made in the past several decades, it still significantly lags other advanced economies. This catching-up enables China to achieve much faster productivity gains by learning from technology know-how, institutional infrastructure, and business best practices in the developed world. This should not change funda- mentally for at least the next 10 years. Chart E: Per Capita GDP (Source: Janney ISG, World Bank) 0 10000 20000 30000 40000 50000 60000 In $U.S. 8 7 6 5 4 3 2 1 0 China Mexico Korea Japan U.S. $6,091 $9,749 $22,590 $46,720 $51,749Chart C: Trust Assets as a % of Total Bank Assets (Source: Janney ISG, BCA Research) 0 1 2 3 4 5 6 7 8 Percent 8 7 6 5 4 3 2 1 0 2010 2011 2012 2013 (thru Q3 2013) 3 4.2 5.5 6.75 Chart D: Wealth Management Products as a % of Total Bank Deposits (Source: Janney ISG, BCA Research) 0 2 4 6 8 10 Percent 2010 2011 2012 2013 (thru Q3 2013) 10 8 6 4 2 0 3.3 5 8 9.5 Shadow Banking is not yet Systemically Significant 5. 5W W W. J A N N E Y. C O M of the country. Infrastructure density and social development levels in the inland regions are still far inferior compared with the national average, which suggests that the catch-up process has much further to run. Importance of Growing Middle Class As China shifts its economy from an investment and export-centric model to a consumer-centric one, this will generate tremendous opportunities for companies that are able to tap into the rising incomes of Chinas expanding middle class. Defining the middle class as those who earn be- tween $6,000 and $30,000 (this range is roughly between the average income of Brazil and Italy), China now has about 335 million people whose incomes fall in that rangethe current size of the entire U.S. population. By 2020, over 75% of Chi- nese income-earners will belong to this middle class, up from 25% today. To put this in some perspective, approximately 740 million Chinese people will join the middle class club over the next decade, which is more than Europes entire current population. McKinsey research suggests that the upper middle class is poised to become the principal engine of consumer spending over the next decade. China is already the worlds largest auto market and the second largest luxury goods market. McKinsey research also indicates that by 2015, more than one-third of the money spent around the world on high-end bags, shoes, watches, jewelry, and ready-to-wear clothing will come from Chinese consumers. There is also strong secular demand for healthcare and insurance products. Importance of Recent Policy Meetings In November of 2013, the Chinese government released its reform blueprint, following the third Plenum (a major Communist Party policy meet- ing), which will guide the countrys development in the coming decade. This policy meeting and associated reform blueprint are notable because they coincide with the early-days of the Xi Jinping- Li Keqiang leadership decade, and because of the historical record of prior third Plenums: the 1978 third Plenum launched what was to become the economic reforms that transformed China from a moribund, self-sufficient economy into a global powerhouse, and the 1993 third Plenum estab- lished the market reform agenda that was later to be essential to the modernization of Chinas economy under Premier Zhu Rongjiboth major thresholds of policy change that were fundamental to catalyzing Chinas development progress. The proposed reform measures seek to rearrange the relationship between market forces and the government in regulating economic affairs. The Chinese leadership stated that market forces will be granted the determining role, which infers that the government will recede to a supportive position. Role of the Market The top leadership believes there are some ma- jor problems in the economy where the role of markets is insufficient, and the latest reform push implies major changes in the pricing mechanism in three areas where the government still main- tains strong administrative controls: 1. Allowing free-market pricing of moneythe backbone of Chinas financial reform. The proposed reforms involve freer cross-border capital flows, and ultimately the movement to a market-driven floating exchange-rate system. Furthermore, interest rates are to be liberal- ized, allowing market participants to price capital based on demand and supply, as well as risk assessment. Liberalization measures also include allowing private banks, setting up deposit insurance programs, and changing initial public offering (IPOs) procedures in the equity marketall of which are designed to encourage more efficient allocation of capital. 2. Allowing market forces and competition to take control of resourcesincluding utility prices of water, petroleum, natural gas, electric- ity, transportation, and telecom. 3. Allowing free-market pricing of land, particu- larly in rural areas. This has the potential to enable the rural population to monetize the rising value of rural residential land, further enhancing urbanization. 6. W W W. J A N N E Y. C O M6 The reforms look to restrict the governments role in the economy to improving market supervision, enhancing public services, and safeguarding over- all macro stability. They are looking to improve efficiency as well as reduce corruption. For state-owned enterprises (the champions of leg- acy economic policy and a source of many of the economys inefficiencies), more attention will be paid to improving return on capital through state asset-holding companiesrather than engaging in competing business activity with private firms. The reform roadmap outlines fiscal reforms to promote more efficient use of fiscal resources, and the Chinese leadership maintains the strategic judgment that growth is key to solving all of the countrys ailsthe government plans to maintain relatively strong economic growth, and will not tolerate major growth slowdowns. These and other reform measures represent an aggressive push on supply-side policies, and are consistent with many of the recommendations pro- vided by the World Bank, International Monetary Fund, and OECD, which lends additional credibil- ity to the plan. Early Implementation and Potential Investment Opportunities Chinese stocks reacted favorably to the reform news, and early indications are that the gov- ernment is moving rapidly to implement the measures. They hold the promise of improving overall economic efficiency and lifting the econo- mys long-term growth potential. Chinese stocks have seen significant valuation com pression in the past few years, and are trading at substantial discounts to their global and emerging market peers (Chart F). While there may be some market volatility as China transitions its economy, we view the reforms as a significant catalyst for Chinese stocks, and think the time is right for long-term investors. Table 1 represents several investment vehicles to access the Chinese equity market. Table 1: Chinese Funds and ETFs Fund Name Tickers Description The ING Greater China Fund A IFCAX C IFCCX Wrap IFCWX Invests predominantly in equity securities in China, Taiwan and Hong Kong. Managed by one of the largest investment managers in Asia. The Templeton China World Fund A TCWAX C TCWCX Wrap TACWX Seeks long-term capital appreciation by investing 80% of its net assets in China companies. These are companies that are organized under the laws of, or with a principal office in the PRC. iShares FTSE China 25 ETF FXI The fund is designed to represent the performance of the 25 largest and most liquid companies in the China equity market that are available to international investors. iShares MSCI China ETF MCHI The fund is designed to measure the performance of the top 85% of equity securities by market capitalization in the Chinese equity markets. SPDR S&P China ETF GXC The fund is designed to track the S&P BMI Index which is a market capitalization weighted index that defines and measures the investable universe of publicly traded companies domiciled in China, but legally available to foreign investors. (Source: Janney ISG) Multinational companies with the strongest brands will enjoy the greatest opportunities in China and are listed in Table 2. Chart F: Chinese Stocks Offer Compelling Value (Source: BCA Research 2014) 7. 7W W W. J A N N E Y. C O M Table 2: Multinational Companies With Significant Chinese Opportunities Company Name Ticker Forward P/E Earnings Growth Dividend Yield Credit Rating Notes Coverage CONSUMER DISCRETIONARY Improving internal consumption is at the center of Chinas long-term economic plans. Upper middle class is growing rapidly and demanding luxury brands. BAYERISCHE MOTOREN WERKE AG BMW GR 10.11 4.15 - A+ German car brands are in big demand in China. S&P LAS VEGAS SANDS CORP LVS 19.64 16.50 1.87 BBB- Major casino operator in Macau, the adult playground of China. S&P/CS/J WYNN RESORTS LTD WYNN 25.80 11.00 3.33 BB+ Major casino operator in Macau, the adult playground of China. S&P/CS/J SWATCH GROUP AG/THE-BR UHR VX 16.95 11.26 - - Watches, jewelry, and accessories are coveted by affluent Chinese. CS LVMH MOET HENNESSY LOUIS VUI MC FP 16.57 11.22 2.38 A+ Portfolio of luxury brands in high demand for affluent Chinese. CS NIKE INC -CL B NKE 23.63 12.76 1.23 AA- Nike Swoosh is a strong brand in China. S&P/CS/J YUM! BRANDS INC YUM 20.04 11.61 2.48 BBB More revenue and profit comes from China than the U.S. S&P/CS/J CONSUMER STAPLES These companies are providing the Chinese economy with new must have staple items. COLGATE-PALMOLIVE CO CL 19.65 9.50 2.20 AA- Leading market share in China for Oral Care. S&P/CS Procter & Gamble PG 17.86 9.18 3.10 AA- Growing middle class provides opportunity for PGs brands. S&P/CS ENERGY China is now the largest oil importer in the world and big oil will benefit from this demand. EXXON MOBIL CORP XOM 11.80 16.91 2.72 AAA Worlds largest publicly-owned integrated oil company. Low risk energy play. S&P/CS SCHLUMBERGER LTD SLB 15.16 15.20 1.45 AA- Bellweather oil service firm benefits from Chinese energy demand S&P/CS INDUSTRIALS China needs lots of industrial and machinery equipment for its urbanization and infrastructure build.Air travel is also growing rapidly. BOEING CO/THE BA 16.69 10.83 1.60 A Large demand for aircraft as China develops. S&P/CS CATERPILLAR INC CAT 15.80 9.00 2.52 A Worlds largest producer of earthmoving equipment. A credit rating. S&P/CS GENERAL ELECTRIC CO GE 14.49 9.00 3.21 AA+ Leader in Power & Water, Oil & Gas,Aviation, Transportation and Energy Management. S&P/CS AMETEK AME 20.53 15.00 0.50 BBB Well positioned in China for many advanced manufacturing processes. J/S&P HEALTH CARE A growing middle class and aging population demand more and better health care. JOHNSON & JOHNSON JNJ 14.90 6.93 2.98 AAA AAA rated blue chip selling Pharmaceuticals and Medical Devices in China. S&P/CS MEDTRONIC INC MDT 14.21 7.94 1.99 AA- Very diverse product line, strong cash flow, valuation and dividend support. S&P/CS TECHNOLOGY Technology and communication play key roles in modernizing an economy. APPLE INC AAPL 11.77 18.37 2.34 AA+ Products are in big demand with growing middle class. J/S&P/CS BAIDU INC - SPON ADR BIDU 29.78 25.25 - - The Google of China has tremendous opportunity as Internet becomes Ubiquitous. S&P/CS INTEL CORP INTC 12.54 7.68 3.78 A+ Worlds largest microprocessor manufacturer has majority of sales to Asia and Pacific. S&P/CS QUALCOMM INC QCOM 14.26 14.45 1.78 NR QCOM technology in high demand for Chinas wireless telecommunications needs. S&P/CS MATERIALS Infrastructure requires lots of materials. Diversified metals and mining firms are finding, mining and processing the metals and minerals needed to create Chinas infrastructure. RIO TINTO PLC-SPON ADR RIO 10.13 7.00 - A- One of worlds largest miners of iron ore, industrial minerals, aluminum and copper. S&P/CS ISHARES MSCI GLOBAL METALS & PICK - - - - ETF provides broad exposure to global metal & mining companies. Definitions: Forward P/E - Current stock price divided by EPS consensus estimate for the next four quarters. Earnings Growth Estimate - Mean broker estimate of the compounded annual growth rate of the operating eps over the companys next full business cycle (typically 3-5 years). Dividend Yield - Trailing 12 month dividend per share divided by share price Credit Rating - Rating assigned by Standard & Poors to the long term obligations of the issuer if repaid in the local currency of the issuer. 8. JANNEY MONTGOMERY SCOTT LLC www.janney.com The Highest Standard of Success in Financial Relationships 2014, Janney Montgomery Scott LLC Member: NYSE, FINRA, SIPC This is for informative purposes only and in no event should be construed as a recommendation by us or as an offer to sell, or solicitation of an offer to buy any securities. The information given herein is taken from sources that we believe to be reliable, but is not guaranteed by us as to accuracy or completeness. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. 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