TheAdvisory

INVESTMENT PERSPECTIVES FROM BROWN ADVISORY 1 COVER STORY OPPORTUNISTIC INVESTMENTS BASED ON OUR OUTLOOK 5 A DEEPER LOOK FINDING COMPELLING STOCKS DESPITE LOW GROWTH 6 YIELD GUIDE THREE WAYS TO ADD INCOME TO YOUR PORTFOLIO

COVER STORY

DECEMBER 2011

An Orderly Descent
From recession in Europe to a hard landing in China, there is plenty to fear. Here are the potential pitfalls to avoid and the opportunities among the ominous.

s asset allocators, were for several years to come as these constantly comparing nations work off their debts, both and scrutinizing mar- public and private. Emerging markets to find tactical op- kets should help keep the global portunities for our client economy afloat, but the overhang of portfolios to exploitor to avoid. Europe, Japan and to a lesser extent With the recent pace of economic the U.S. will likely make the next and geopolitical developments five years a period of less-than-stellar around the world, weve had plenty capital market returns. In this sceof information to sort through. nario, navigating tactical opportuniFirst, the sobering news: Our ties should be critical to protecting base-case outlook is for growth in and growing portfolios. CONTINUED ON PAGE 2 developed economies to be muted

Back to Basics
The best long-term predictor of stock prices is corporate profits. Stock prices today suggest that earnings arent sustainableso companies that can keep ratcheting up profits should be rewarded.
BY PAUL CHEW, CFA

Head of Investments

S&P 500: Price versus Earnings 1.600 1,400 1,200 1,000 800 600 400 200 0
1997 1999 2001

COVER STORY CONTINUED

We see no reason to alter our belief that the main way to grow portfolios over time is to invest in equities. Further, we firmly believe that over the long term, the major driver of stock prices is earnings. (See the chart at right.) As we survey the investment landscapefrom stocks to fixed income to commodities and other asset classes we think that the most compelling opportunities (and the trouble spots to avoid) are primarily within equities and ultimately rest on the issue of earnings sustainability.
EUROZONE DEFENSE

Price

Earnings

90 80 70 60 50 40 30 20 10 0
2011

2003

2005

2007

2009

SOURCE: BLOOMBERG

At the time of this writing, events in Europe are moving quickly. A Greek default seems inevitable, Italian bonds are teetering, and both countries are forming new governments in an effort to confront economic reform. Greece is in the grip of a full-scale depression, with G.D.P. contracting in eight of the last 10 quarters and its economic problems as numerous as they are severe. Traditional solutions for the troubles facing Greece, Italy and Spainfiscal and monetary stimulus or currency depreciationare off the table due to their weak credit and their ties to European Union currency. The potential fallout of Greek default on the European economy could be severe. Most immediate is the proposal of the European Bank2 THE ADVISORY DECEMBER 2011

ing Authority to raise reserve requirements for banks, which would reduce INVESTMENT OPPORTUNITY the capital available for business investment. More important, however, We are de-emphasizing is the impact of austerity measures on developed international equities, the economy. Nearly 50% of Eurodespite their historically zone G.D.P. comes from government cheap valuations. spending, which is almost double that of the U.S. As country after country THE U.S. PROFIT MACHINE in the Eurozone cuts spending fur- Probably the most impressive developther, the odds of E.U. G.D.P. turning ment in the investment universe in the negative increase. last couple years has been the dramatic A European recession would clearly growth in U.S. corporate profits. Hishurt U.S. exports to Europe, as the E.U. torically, S&P 500 earnings have grown represents approximately 20% of the twice as fast as G.D.P. In 2011, S&P 500 total U.S. export market. On the other earnings have risen a remarkable 15% hand, demand growth in the emerging while G.D.P. has expanded just 1.4% markets should help to counteract any annualized. U.S. corporations have gendownturn in Europe. Moreover, we erally delivered exceptional numbers by believe that the strength of corporate squeezing every dollar of profit they can balance sheets in the U.S. should help out of sluggish sales through tight cost to alleviate the potential impact of any controls. Of course, the focus on profits tightening of global credit caused by a has kept a lid on new hiring, leaving the more restrictive lending environment unemployment rate around 9%. in Europe. CONTINUED ON PAGE 4

Trailing 12-Month EPS

S&P 500 Price Index

Asset Allocation at Brown Advisory

Traditional asset allocationthat is, how investment advisors typically select a mixture of assets for client portfoliosrests on a critical assumption: Global financial markets do not move up and down in unison so declines in one asset class are buffered by gains in other asset classes. We think that this premise is flawed in both its logic and its implementation. Globalization has linked economies around the globe together, and technology now allows for the easy transfer of investment capital from market to market. This has led to a material increase in correlations among asset classes. As a result, the belief that diversification alone will protect investors in market declines is both faulty and dangerous, since it can lead to investors taking on more risk than they realize. We build portfolios entirely differently, using our Three-Bucket Approach. First, we work with our clients to separate their capital into three buckets: an operating account that provides for liquidity and cash needs; a core portfolio for creating growth and income; and opportunistic investments that allow for tactical and/or higher-risk investments. Then, for each bucket, we create an asset allocation to meet those objectives. The most important decision for a portfolio is the proportion of growth assets (stocks, private equity, real estate) from stability assets (fixed income and cash). Once we establish that mix, we then select those asset typescore and opportunisticthat we feel have the best chances of meeting the clients needs for principal preservation, income, liquidity, capital appreciation and so on. Our identification of opportunistic investments is key; we do not simply sprinkle capital among commonly used assets. For a quick take on what opportunistic investments were employing in client portfolios now, see the table below.

ASSET CLASS

OUR PERSPECTIVE

INVESTMENT OPPORTUNITY

FIXED INCOME

Yields are currently unattractive and the Fed intends to keep it that way, an environment that calls for a tactical approach. Overall valuations are highly attractive and earnings strong, but the low-growth environment is likely to persist. The Eurozone could easily slide into recession, worsening the growth prospects in the U.S. and Japan. Emerging markets should keep the global economy growing, as Asian domestic consumption rises. The Feds current policy provides a good risk/ reward backdrop for commodities but prices are fairly valued. Risks include a hard landing in China and Eurozone recession. Low interest rates and reasonable prices make for a buyers market. Real estate should provide income diversification and low correlation to other assets.

U.S. dollar-denominated emergingmarket corporate bonds Low-beta, income-oriented stocks Higher-beta, small-cap stocks De-emphasize developed international Favor small-cap emergingmarkets stocks Maintain a small allocation as an inflation hedge against easy monetary policies Cash-flowing developed properties below replacement costs Multifamily with strong rental income growth

U.S. EQUITIES

INTERNATIONAL EQUITIES

COMMODITIES

REAL ESTATE

COVER STORY CONTINUED FROM PAGE 2

The question is whether these record profits are sustainable. The pretax margin for S&P 500 companies has gone from 4.4% during the recession in 2008 to 12% today. The farther Europes issues spread into the U.S. and the longer unemployment levels remain high, the harder it will be for companies to continue expanding marginsa prospect that appears to be built into earnings expectations for 2012. That said, we believe that equity valuations are relatively compelling, even if corporate-profit growth moderates, as we expect. Today, the S&P 500 is trading well below its 5-, 10- and 20year price/earnings averages. We believe that the fundamental backdrop for corporate profits will become more challenging as we progress into 2012. That perspective leads us to favor two distinct types of companies.
INVESTMENT OPPORTUNITY The first are firms that have strong cash flows that benefit shareholders in the form of dividends. High-dividend-paying companies tend to be noncyclical businesses with the financial strength to weather economic downturns. Equity-income stocks should also garner attention as investors search for yield given todays low interest rates. (For more on equity income, please see the story on page 6.) The second opportunity we see is small U.S. companies that can grow earnings even if the economy doesnt expand
4 THE ADVISORY DECEMBER 2011

rapidly. These companies tend to generate the bulk of their revenue from the U.S., shielding them from the international developed-market turmoil, and they typically focus on niche markets that may be insulated from the overall economy. (For more on how to identify such small companies, see the story on the next page.) LANDING IN ASIA

economy will transition from infrastructure- and export-driven growth to consumption-led expansion. China and India are on course to become, respectively, the third and sixth largest consumer markets in the world by 2020, a massive shift from even a decade ago.
INVESTMENT OPPORTUNITY We are attracted to emerging market small-cap equities that play into the growth of the rising consumer class without being exposed to infrastructure and export slowdowns, as larger companies tend to be. In addition, we think that investors looking for yield should consider U.S. dollar-denominated, emerging-market corporate debt. (For more on that topic, see the story on page 6).

Over the last few months, several indicators from emerging market economies have alarmed investors. Growth rates for many Asian countries have fallen. In October, inflation in China fell to 5.5% from Septembers 6.1%, a sign of economic slowing. Another concern is residential housing in China, which has seen sales volumes collapse in the last few months. Nonetheless, the government has not altered its plan to build 20 million units a year. By comparison, at the peak of the housing bubble in the U.S., developers were starting two million units a year. However, as frothy as the Chinese property market seems, its much different from the real estate market in the U.S. For starters, Chinese consumers are not leveraged nearly as much as their American counterparts, banks arent as exposed to real estate, and the Chinese government has expressed no compunction about interfering in the economy to stabilize asset prices. In short, we think that while a hard landing in China would indeed be devastating, the odds are low, even if property prices decline substantially. Looking ahead, whats most important, in our view, is that Chinas

This Inaugural Issue

of The Advisory should give you a good sense of the opportunities were finding in the markets today. Please email us at brownadvisory@brownadvisory.com and tell us what you think of this new publication and what topics youd like us to address in upcoming issues.

A Deeper Look
Finding the exciting companies in a slow-growth environment

BY DAV I D S C H U ST E R

s discussed in this issues cover story, the U.S. seems to be in for an extended period of slow economic portant issue facing the U.S. today. Some forward-thinking companies growth. But this outlook obviously does not mean that every are taking advantage of governmenU.S. company will perform the same. tal belt-tightening. Take Maximus, a In a period like this when investors can Virginia-based company that boasts no longer rely on a rising tide to lift all the tagline Helping Government boats, equity performance depends on Serve the People. Maximus is a marfinding companies that have a greater ket-leader in the administration of opportunity to generate strong earn- public health, child support, employings irrespective of macroeconomic ment counseling and other services. The firm provides much more than conditions. At Brown Advisory, our equity strat- cost takeout; it also offers higher qualegies are based on bottom-up, funda- ity and consistency in these programs mental research. Between our equity than the government can achieve. As analysts, portfolio managers and other states and municipalities hack away at investment professionals, we follow inefficiencies, Maximus stands to benhundreds of stocks. Again, we invest efit nicely. company by company, but when I look at some of the most exciting firms we FIND THE TOLL TAKERS follow, I see several themes for how to Youre probably familiar with the fact that the true wealth of the California invest in tough times like these. gold rush went not to the prospectors but to those who supplied the miners CAPITALIZE ON GOVERNMENT with picks and shovels. A modern-day INEFFICIENCY While the budget issues in Washington example of that is a firm like Broadremain front and center, it is easy to ridge Financial Solutions, a technolooverlook the pressure that state and gy-based outsourcing and operationallocal governments are under. Slow eco- support solution to financial-services nomic growth amplifies the financial firms. For a fee, Broadridge helps firms pressure on state and municipal coffers handle mission-critical services such since sales and income taxes account as securities processing, clearing and for a large slice of government rev- investor communication. In the wake enues. In addition, lower home prices of the financial crisis, changes to mean lower property-tax receipts. This regulation and reporting requirements leads many to conclude that the shape should increase demand for a variety of of government finances is the most im- Broadridges services.

Portfolio Manager, Brown Advisory Small-Cap Value Strategy

DONT OVERLOOK THE UNGLAMOROUS

In 1959, Donald Lamberti struck a deal with his father to lease a service station in Des Moines, Iowa. After transforming that old country depot into a modern-day convenience store, Don took the advice of his gasoline supplier and friend, Kurvin C. (K.C.) Fish, and purchased a second location an hours drive north in the town of Boone, Iowa. He renamed his business Caseys after Fish and proceeded to replicate his success by building a chain of more than 1,600 convenience stores throughout the Midwest. Since a majority of Caseys stores are located in areas with populations of fewer than 5,000 people, they serve a market largely overlooked by nationalchain competition. In turn, their business model is often ignored by the broader market. Caseys isnt glamorous, but it is a good business model. As portfolio managers, we focus less on forecasting G.D.P. numbers and instead try to find businesses that can generate sustainable free cash flow and profits. Our strategy is to invest in stable companies that can thrive and provide returns no matter what the economic indicators say.

THE ADVISORY

DECEMBER 2011

Yield Guide
Its not easy, but you can find compelling portfolio income in todays ultra-low interest-rate environment.

BY TAYLOR GRAFF, CFA

or nearly three years, the Fed- currently yield 63%. This illustrates eral Reserve has held short- that income cannot be the only considterm interest rates near zero, eration for any investments. As the table causing yields throughout below shows, there are a number of opmost of the traditional fixed tions to pursue income yields well in EQUITY-INCOME STRATEGY income universe to hover near histori- excess of traditional high-grade bonds. During the third quarter of 2011, the cal lows. This environment has caused But, to separate the opportunities from dividend yield of the S&P 500 exceedtremendous frustration for investors the traps, the critical questions you have ed that of the 10-year Treasury bond for who use the income generated by to ask are: Do these strategies have solid only the second time in the last 40 years. their investments to meet their annual fundamentals? Do they fit well with the Indeed, there are many solid companies financial needs. But investors should other investments in your portfolio? Is with compelling dividend yields that not simply accept anemic income as an the yield worth it in terms of principal trade at inexpensive valuations. Howinexorable reality. Alternatives exist that risk, income risk, volatility, illiquidity, ever, other stocks are classic income can provide relief. However, you have blowup risk as well as many others? We traps, companies that will struggle to to exercise caution, as the landscape is have sorted through the options and maintain their dividendand, unlike replete with income traps set to ensnare are employing three strategies in client bonds, they have no obligation to do so. the imprudent. portfolios in an effort to boost portfolio Additionally, income-trap stocks may Yield certainly can be found in the yield: equity-income strategies; income- well be in danger of severe price depremarketplace. For example, Greek gov- producing real estate; and emerging- ciation. In other words, equity-income ernment bonds that mature in 2013 market debt. investors face both income risk (will the dividend be cut?) and principal risk (will the stock price fall?). Avoiding income traps is where funCommon Income Strategies damental stock analysis comes in. It is essential to analyze a companys balance sheet and earnings trajectory to ensure investment income yield considerations that it can maintain or, even better, grow the dividend. We look for compaU.S. High-Grade Bonds 2.4% nies with attractive upside price potenPrincipal Risk, tial and limited downside risk that also Equity-Income Strategy 3-4% Income Risk have the ability to grow their earnings and their dividend-payout ratiocreIncome-Producing Income Risk, 4-8% ating a solid outlook for an increasing Real Estate Illiquidity dividend and appreciating stock price. These companies provide attractive Principal Risk, Emerging-Market Debt 6-8% Elevated Volatility income with a lower risk profile than the general stock market, generally Notes: The yield for high-grade bonds is from Barclays Capital U.S. Aggregate Bond Index. offering some downside protection Other yields shown are indicative of the strategies Brown Advisory uses. Data as of Nov. 16. while capturing most of the upside in
6 THE ADVISORY DECEMBER 2011

Senior Analyst, Asset Allocation

Rent vs. Own

With home-ownership rates dropping, rental properties are becoming scarce.

Home-Ownership Rate (%)

INCOME-PRODUCING REAL ESTATE

After the housing bubble burst in 2008, Rental Vacancy Rate 8 many investors shunned real estate as 7 an asset class, while others expected the distress in the market to create attractive 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 opportunistic investments. Certain U.S. real estate markets remained healthy on SOURCE: U.S. CENSUS BUREAU the back of favorable jobs trends; one example is Washington, D.C., which has benefited from stable government employment. Now, with banks healthier and more in occupancy rates, and illiquidity, so currency denominated bonds come willing to write down properties in you must be certain that the principal with far higher risks. Since the dollar their portfolios, the combination of dedicated to real estate will not be need- value of cash flows and market valdistressed sellers and historically low ed in the interim. Given these consider- ues depends on future exchange rates, interest rates has created opportuni- ations, we rarely recommend exposure these bonds bring income risk and adties. One attractive area: multifamily to income-producing real estate beyond ditional principal risk (from the curresidential property. After the financial 10% of a portfolio. rency translation of coupon and princrisis in the U.S., the percentage of cipal repayment). According to Merrill homeowners (as opposed to renters) has EMERGING-MARKET DEBT Lynch, in the dollar-denominated been falling (see chart). Given that it Emerging-market debt is a sector of market, emerging-market corporate takes significant lead time to bring new the market that has matured signifi- bonds currently offer yields of 7.6%, apartment buildings to market, supply cantly over the last decade and is now nearly 2.0% higher than emerginghas been limited, putting upward pres- larger than the U.S. high-yield market. market sovereign bonds while having sure on rental rates. These factors, along Since going through severe crises in the the same average credit-quality rating. with real estate prices that have fallen mid- to late-90s, many countries in the Emerging-market corporate bonds also to more reasonable levels, create a solid emerging world have built substantial provide higher income than similarly investment with rental income flowing reserves and lowered their debt burden rated U.S. corporate bonds, which while the developed world has become yield 6.8%. to investors. Income yields can vary widely increasingly indebted. Additionally, We typically take a position in dollardepending on the risk profile of the corporate balance sheets in developing denominated, emerging-market corpospecific investment. Generally, the nations are generally strong, and the rate bonds of up to 5% of portfolios. more conservative types of deals that economic growth outlook is far bright- No matter which strategy you choose to we feel are appropriate for most clients er than in developed markets. try to boost your income, you need to There are three major segments of understand how it works with the other produce yields of 4-8%. Furthermore, with the notable aberration of 2008, the emerging-market debt universe: parts of your portfolio. real estate has often provided portfolios local-currency denominated soverlow correlation to both the bond and eign bonds, U.S. dollar-denominated stock markets. The risks are income sovereign bonds, and U.S. dollaruncertainty, due mostly to fluctuations denominated corporate bonds. LocalTHE ADVISORY DECEMBER 2011 7

70 69 68 67 66 65

12 Home-Ownership Rate 11 10 9

Rolling Four-Quarter Rental Vacancy Rate (%)

stock market rallies. For many clients, were swapping out higher-risk stock holdings for equity-income positions.

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The views expressed are those of the authors and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospects and is for informational purposes only. It should not be construed as a research report. The S&P 500 Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include market capitalization, financial viability, liquidity, public float, sector representation, and corporate structure. An index constituent must also be considered a U.S. company. The Barclays Capital U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, Including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS. An investor cannot invest directly in an index. Brown Advisory is the marketing name for Brown Investment Advisory & Trust Company, Brown Investment Advisory Incorporated, Brown Advisory Securities, LLC, Brown Advisory, LLC, Brown Advisory Cavanaugh, LLC, Brown Advisory Ltd., Alex. Brown Investment Management, LLC, and Brown Advisory Trust Company of Delaware, LLC.