St. James Investment Company Updated: 11-Feb-14

BANK OF NEW YORK MEL LON (BK)

COMPANY DESCRIPTION

The of New York Mellon (BNY Mellon) is the result of the marriage of Bank of New York and 's Mellon Financial. The company is one of the largest securities servicing companies in the world as well as a leader in and corporate trust and treasury services. BNY Mellon has more than $26 trillion in assets under custody and administration, and some $1.4 trillion of assets under management. The bank’s Pershing unit is a leading securities clearing firm. Subsidiaries BNY Mellon Asset Management and Mellon Capital Management serve institutional , while the company's wealth management business courts high-net-worth individuals and families, endowments, and foundations.

INVESTMENT THESIS

BNY Mellon continues to struggle to increase revenue in a difficult operating environment. Fees generated by the bank’s Investment Services division rose just 5% year over year despite a 14% increase in assets under management, and net interest income rose 5% despite a 6% increase in average interest earning assets. Money market fee waivers continued to weigh on annual earnings by roughly 3%. Wall Street believes that these revenue challenges will continue until the interest-rate environment and client activity improve materially.

Perhaps so, but today BNY Mellon trades at 12x estimated 2014 earnings, 1x stated book value and 2x tangible book value versus a historical 15x P/E and 4–5x tangible book value.

P/B = 2 P/B = 4.7

P/B = 1

At the current valuation investors appear to be assuming a permanent near-zero interest rate environment and continued global financial deleveraging. While operating results could stay depressed for another year or so, we believe the company’s operating base contains

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St. James Investment Company Updated: 11-Feb-14

material upside to incremental earnings from even a partial recovery in interest margins, securities lending revenue, money market fees, and/or cost savings initiatives. Longer- term, BNY Mellon should be a prime beneficiary of increased financial regulatory burdens, back-office outsourcing, and international financial market growth—BNY Mellon currently generates 53% of pretax income from international operations, including 12% from the Asia-Pacific region. Although the company continues to face some regulatory and legal headwinds, the company has materially rebuilt its capital levels while significantly reducing risk within its balance sheet.

BNY Mellon holds dominant market positions in its Investment Services division (includes custody, clearing, securities lending, etc.) and Investment Management. The bank’s Investment Services (IS) segment represents 72% of revenue and pre-tax income with Investment Management (IM) representing the balance. In particular, we like the fact that 80% of the company’s revenue is fee-based whereas traditional generate the majority of their revenue from net interest income. At the end of 2013, BNY Mellon is well- capitalized in advance of the implementation of Basel III capital requirements despite the last three years of somewhat flattish financial results.

Many investors do not realize that Bank of New York Mellon is one of the nation's largest asset custodians, with almost $400 billion in assets. Over the past 10 years, Bank of New York Mellon remained disciplined in retaining profits and reinvesting capital into additional growth. In 2003, the company’s total stockholder equity was $8.4 billion. By 2013, that number had increased to $39.5 billion and continues to grow. BNY Mellon proved to be one of the most solid and fundamentally sound banks during the credit crisis and saw a large influx of assets in 2010 as a result—asset inflows represent an institutional validation of the bank.

The company’s return on invested capital (ROIC) remains understated because BNY Mellon is a custodial bank. As such, their total invested capital will increase if the bank continues to grow at a healthy rate. With total invested capital in the denominator, the ROIC is will be lower as the denominator increases. The true value of this company is free cash flow. In 2009, when the rest of Wall Street was in crisis mode, BNY Mellon generated a loss of only $600 million in cash from operations. Wall Street punished the stock that year, along with all banks of course. We currently model free cash flow of $3.4 billion in 2014. At current prices, we believe Bank of New York Mellon is worth approximately $42 per share.

COMPANY HISTORY

The Bank of New York was founded in 1784 by a series of documents drawn up by , but it was not until 1791 that the bank was able to procure a charter. In 1792, when the New York Stock Exchange first opened, The Bank of New York was the first company traded on the Exchange. The bank’s charter was renewed several times until 1852 when it was officially recognized under the Banking Law as a bank having a capital of US$2,000,000. Following the instigation of the National Banking Act, the Bank of New York in 1865 was once again chartered, this time as a National Bank via the act.

Through the early 1900s, the Bank of New York continued to expand. In July 1922, the Bank of New York and the New York Life Insurance and Trust Company merged. The bank survived the Great Depression and in 1948, the bank merged with the Fifth Avenue Bank, to be followed by a merger in 1966 with the Empire Trust Company. That same year, 1966, the Bank of New York opened offices in London which was instrumental in the establishment of the bank on the international level. The bank's holding company was created in 1969 and facilitated the company’s growth and expansion outside of New York City.

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St. James Investment Company Updated: 11-Feb-14

"T. Mellon & Sons' Bank", as Mellon Financial was originally called, was founded in Pittsburgh, . The bank was established in 1869 by the retired Judge Thomas Mellon and his sons, Andrew W. Mellon and Richard B. Mellon. , Westinghouse, and Bethlehem Steel were a few of the companies T. Mellon & Sons' financed. In 1902, T. Mellon & Sons' name was changed to that of the Mellon National Bank. The firm merged with the Union Trust Company in 1946, a business founded by . The name of the newly formed organization was the Mellon National Bank and Trust Company, Pittsburgh's first US$1 billion bank. In 1946, Mellon National and the Union Trust Company merged to form Mellon National Bank and Trust Company. A reorganization in 1972 brought about a name change to Mellon Bank, N.A. and the formation of a holding company, Mellon National Corporation.

On December 4, 2006, Bank of New York and Mellon Financial Corporation announced they would merge to create the world's largest securities servicing and asset management firm. Under terms of the deal, Bank of New York's shareholders received 0.9434 shares in the new company for each share of Bank of New York that they owned, and Mellon shareholders received one share in the new company for each Mellon share they owned. Bank of New York and Mellon entered into mutual stock option agreements for 19.9% of the issuer's outstanding common stock.

BUSINESS OVERVIEW

BNY Mellon is a 228 year old bank focused on managing and servicing investments. The company is a dominant global player in this field with $27.1 trillion worth of assets under custody or administration and $1.5 trillion under management. BNY Mellon works with customers - private and public - to create, trade, hold, manage, distribute and restructure investments. The business model is fee-based with more than three quarters of revenue generated by recurring fees. This leaves them with less credit risk than most of their peers, and helps them generate capital rapidly - $3 billion worth of it in 2012. The company continues to use that capital to issue dividends and complete share buybacks, with acquisitions a lower priority for the time being.

As illustrated, asset servicing, issuing, clearing and investment management and performance fees are the bank's main source of revenue. This recurring revenue underpins

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the company’s business model during the current period of low interest rates and net interest margins. Revenue on a geographical basis:

BNY Mellon is still very much a U.S. company, although international operations now account for a larger piece of the company’s current and future growth. The investments industry is an intrinsically global business as capital flows regardless of boundaries. BNY Mellon is in an attractive position to grow as they have an extremely long history and a relatively clean track record in a field where customers are understandably conscious of reputation.

It is important for investors to understand that despite having the word “bank” in its name, Bank of New York Mellon is not a bank in the traditional sense but instead primarily provides a range of processing, custody and investment management services to corporations, governments and financial institutions. While absolutely essential, these services are not easily understood by the average . To use an analogy, Bank of New York Mellon is more akin to a local electric utility, a necessary but unglamorous element of any city’s infrastructure. The two largest segments (comprising approximately 55% of total company earnings) are asset custody (where it holds $27 trillion in assets on behalf of customers) and issuer services (where it acts as trustee for approximately $11 trillion of debt securities and more than 1,300 depository receipt programs). Each of these businesses is an oligopoly in which Bank of New York has a leading position with sustainable competitive advantages derived from economies of scale coupled with the costs of switching and customer loyalty.

In addition to the base fee income earned in its investment services business, the bank generates ancillary revenue from foreign exchange trading, securities lending and the interest rate spread on approximately $280 billion of low cost deposits on which the bank currently pays an average interest rate of less than 0.1%. The competitive advantage around the investment services businesses is seen in the high returns on tangible equity that Bank of New York earns—currently in the mid-20’s and historically in the mid-30’s. Bank of New York also has a more traditional investment management business that represents approximately 30% of total company’s earnings. This business is made up of a diverse collection of equity, fixed income, alternative asset, and money market management services with an aggregate of $1.5 trillion of assets under management. The investment management business also offers an inherently high return on capital, though the competitive advantage surrounding this business tends lower than for the investment

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services business. Bank of New York’s diversity of asset classes offers some protection from the ebbs and flows of investor sentiment.

In general, each of the bank’s major businesses should grow in conjunction with the continued increase in the amount and value of debt and equity outstanding globally, with only modest incremental capital needed to support that growth.

VALUATION

As for price, Bank of New York Mellon is valued today at about 12x times this year’s estimated earnings according to Value Line. The majority of these earnings are distributable to shareholders as the company is extremely well capitalized and can grow with relatively small amounts of retained capital. Further, we consider these earnings somewhat understated because today’s low interest rates have forced the bank to waive money market fees and have depressed interest margins. We estimate an increase of 100 basis points in interest rates could increase earnings by about 15% and reduce the valuation multiple to only 11 times earnings.

Our fair value estimate builds on summing-up the values of individual businesses in a sum- of-the parts analysis. The value of each business is calculated using a discounted cash flow methodology. We forecast fundamental drivers like pricing, market share, and profit margins for different businesses in estimating each business’ value within our valuation framework. The analysis primarily focuses on those forecasts that drive our share price and value estimate.

The Bank of New York Mellon Corp. 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Terminal Free Cash Flow Asset Servicing ($ Mil) 757 794 756 662 891 1,003 1,117 1,214 1,314 1,417 1,531 25,514 Asset & Wealth Management ($ Mil) 633 592 601 544 746 852 958 1,051 1,138 1,221 1,320 21,998 Interest Income ($ Mil) 547 512 560 451 630 745 865 932 990 1,089 1,155 19,254 Issuer Services ($ Mil) 244 273 301 324 347 372 397 6,617 Treasury Services & Others ($ Mil) 245 269 293 312 330 349 369 6,150 Clearing Services ($ Mil) 211 236 259 279 300 321 343 5,717 Free Cash Flow ($ Mil) 2,967 3,378 3,794 4,113 4,419 4,769 5,115 85,249 Dividend Payout Ratio (%) 19.3% 59.1% 73.9% 98.8% 90.0% 85.0% 80.0% 75.0% 75.0% 75.0% 75.0% 75.0%

Discounted Cash Flows ($ Mil) 2,427 2,373 2,280 2,107 2,058 2,019 1,969 32,810 Discount Rate (%) 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%

Sum of Discounted Cash Flows ($ Bil) 48.04 Shares Outstanding (Bil) 1.14 Estimate of Fair Value per Share $ 42.1

Our fair value estimate of $42 per share sums each business unit which in turn was valued using a discounted cash flow methodology. The most important drivers for the Asset Servicing business, the largest contributor in our model to the company’s valuation, are serving fees as a percentage of assets under custody (AUC), and growth in AUC. As global economic conditions gradually improve, we expect the bank's assets under custody to exhibit reasonable growth in the short-term on account of improving valuation of financial securities and the increasing role played by emerging markets. As the fixed costs incurred on infrastructure and technology setup become diluted over a larger asset pool and investor base, we expect the servicing fees as a percentage of assets under custody to decline since custodians compete for assets for custody on the basis of price. After the decline we expect fees to remain constant.

The custody industry essentially involves processing and dissemination of information on customers’ securities holdings and transactions along with value-added services that provide liquidity and financing to clients, all of which require large investments in information technology. Once the technology investment has been made, processing additional volumes requires minimal incremental costs. Accordingly as assets under custody increase,

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profitability will increase materially and the company should be able to lower fees while maintaining margins. Because the custody of assets is essentially the physical and electronic safekeeping of financial securities, on behalf of a third-party, in exchange for a servicing fee, value to the company increases as the net inflows of assets to be held under custody increase, and the appreciation of valuation of the financial assets in custody. Because BNY Mellon is a leader in asset servicing, the company’s global scale enables it to offer competitive fees to clients. These competitive fees, coupled with its strong reputation, attract clients and should continue to drive inflows going forward.

Asset & Wealth Management constitutes the second largest contributor to our company estimate of fair value. The most important value drivers for the company’s Asset & Wealth Management business are management fees as a percentage of assets under management and obviously the growth in assets under management. BNY Mellon assists institutions by managing the growth of their money through investments in equity securities, fixed income securities and cash and money market instruments. In return for managing its clients' money, BNY Mellon charges a fee based on the amount of money under management which is represented by management fee as a percentage of assets under management. Since many active investment strategies have been unable to outperform the benchmark index consistently over the long term, there is a trend in favor of lower investment advisory fees compensated by higher performance fee, which is charged for returns over and above a predetermined contractual threshold. Therefore, managers will be compensated more for performance. Although active investing charges significantly higher investment advisory fees than passive investing, many investors have shifted to passive investing—an area that BNY Mellon needs to address.

To check our discounted cash flow valuation model, we conduct a simple exercise and value the company based on two broad divisions of the company’s business, Investment Service and Investment Management, rather than on each separate reporting business line. We use several simple historic valuation metrics and growth assumptions. We assume Investment Services continues to grow revenues at 2% per year through 2015 while expanding margins. The interest rate turns more favorable (steeper yield curve) and net interest margins improve by 10%. Using BNY Mellon’s ten year price-to-earnings ratio of 13.5, and our profit estimates two years out, we believe Investment Services is worth $29 per share. We value Investment Management using a simple multiple of fee revenue as this eliminates the discrepancy between fees charged on different asset classes. Most asset managers trade between 2x and 5x fee revenue, with the majority trading around a multiple of 3.5x to 4x fee revenue. If we use a multiple of 3.75x on estimated fee revenue in 2015, we value Investment Management at $14 per share. Together, our estimate of fair value equals $43 per share.

RISK TO INVESTMENT

When presenting the rationale for an investment, it is common to hear all the reasons the investment will be successful. As a part of any realistic investment process, the investor should examine all the reasons an investment could fail. For any company, the most dire risks might be called “existential risks.” These are the risks of some event or series of events entirely wiping out existing stockholder value. In recent years, existential risks have tended to be caused by either leverage or obsolescence, usually resulting from technological innovation). Although Bank of New York Mellon is certainly leveraged in that assets significantly exceed equity, these assets are predominately government securities and deposits rather than loans or securities subject to credit risk. In fact, in the stress test laid out by regulators, which assumes a 5% decline in GDP over two years, an unemployment rate of 12%, a stock market decline of 50%, and residential and commercial real estate declines of 20%, Bank of New York Mellon would actually make more than $5 billion before

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taxes. As for technological obsolescence, the very fact the bank is well into its third century of existence would seem to indicate a relative low risk of obsolescence, which is true. As with an electric utility, the services provided by the bank are essential and irreplaceable.

Although such existential risk is low at Bank of New York Mellon, there are other important risks that could hurt our investment. The largest of these may well be a matter of national security. Although the bank maintains outstanding computer systems and other safeguards, a significant disruption, most likely in the form of a cyber-attack, of the bank’s computer operations could result in substantial losses given the sheer number of transactions processed every hour. At a less esoteric level, the bank is regulated as one of the world’s most significant financial institutions. As such, missteps with the regulators or inappropriate conduct toward customers (as happened several years ago when the bank was accused of pricing foreign exchange trades in a misleading manner) could result in significant fines, legal liability or higher capital requirements. Although the bank operates in an oligopoly in most of its businesses, another risk is that participants in an oligopoly do not always behave rationally. Certainly, in recent years a tendency toward undisciplined pricing has permeated this industry, though we hope this trend is diminishing. Finally, we must consider the possibility of the bank making a large, dilutive acquisition. Despite overwhelming data indicating that such acquisitions rarely create value, we are continually surprised by how often companies are tempted by the siren song of investment bankers. Fortunately, we consider this risk a remote one under current management.

SUMMARY

BNY Mellon is in excellent financial condition. The company remains one of the highest- rated U.S. bank and one of the highest rated financial institutions in the world. This financial strength is mostly a result of its business model which generates recurrent fee- income from services rather than interests from loans and trading activity. The company continues to maintain certain competitive advantages. First, the bank enjoys a significant cost advantage thanks to its economies of scale. This cannot be overstated, particularly because manpower, information technology and marketing expenses do not increase proportionally with the amount of assets under management. Second, a collection of clients find it more convenient to use BNY Mellon as a one-stop shop for most services. Clients generally look for companies that can operate in multiple countries. This is beneficial for an international player like BNY Mellon. Third, customer relationships tend to last for decades as powerful forces do not make clients switch providers very frequently.

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St. James Investment Company Updated: 11-Feb-14

ST. JAMES INVESTMENT COMPANY

We founded St. James Investment Company in 1999, managing wealth from our family and friends in the hamlet of St. James. We are privileged that our neighbors and friends have trusted us for over a decade to invest alongside our own capital.

The St. James Investment Company is an independent, fee-only, SEC- Registered Investment Advisory firm, providing customized portfolio management to individuals, retirement plans and private companies.

I M P O R T A N T D ISCLAIMER

Information contained herein has been obtained from sources believed reliable but is not necessarily complete and accuracy is not guaranteed. Any securities that are mentioned in this issue are not to be construed as investment or trading recommendations specifically for you. You must consult your advisor for investment or trading advice. The publisher of this report and one or more of its affiliated persons and entities may have positions in the securities or sectors recommended in this report and may therefore have a conflict of interest in making the recommendation herein. 4834-9369-8309, v. 1

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