EYE ON THE MARKET special edition

The & agThe ny ecst sy The Risks and Rewards of a Concentrated Stock Position The Agony and the Ecstasy is 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 Michelangelo’s 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 Ecstasy conveys the disparate outcomes facing concentrated holders of individual stocks in a world, like Michelangelo’s, that is beset with intrigue, unforeseen risks, intense competition and uncertainty.

Eye on the Market  J.P. MORGAN EYE ON THE MARKET • J.P. MORGAN

The Agony and the Ecstasy: The Risks and Rewards of a Concentrated Stock Position

Executive Summary

There are many Horatio Alger stories in the corporate world in which an entrepreneur or CEO has the right idea at the right time and executes brilliantly on a business plan. But history also shows that forces both within and outside management control led many of their businesses to suffer serious reversals of fortune. As a result, many individuals are known not just for the wealth they created through a concentrated position, but also for the decision they made to sell, hedge or otherwise take some chips off the table. In this paper, we take a look at the long history of individual stocks, and at the risks and rewards of concentration. I first analyzed this topic in detail around ten years ago; since that time, while some things have changed, the overall song remains the same.

Over the long run, some companies substantially outperform the broad market and maintain their value. However, the odds have been stacked against the average concentrated holder: • Risk of permanent impairment. Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value. For Technology, Biotech and Metals & Mining, the numbers were considerably higher.

• Negative lifetime returns vs. the broad market. The return on the median stock since its inception vs. an investment in the Russell 3000 Index was -54%. Two-thirds of all stocks underperformed vs. the Russell 3000 Index, and for 40% of all stocks, their absolute returns were negative.

• After incorporating the issue of single stock volatility, we find that 75% of all concentrated stockholders would have benefited from some amount of diversification.

Another sobering observation: since 1980, over 320 companies were deleted from the S&P 500 for business distress reasons, which implies a lot of turnover. This should not be a surprise: capitalism is based on competition, creative destruction and reinvention. While globalization (and in particular, China’s acceptance into the World Trade Organization in 2001) expanded the opportunities for individual companies, it also increased their competitive, regulatory and operational risks.

We start with some empirical analysis, and follow with case studies by sector. While the losses on the stocks in our case studies may seem obvious or inevitable with the benefit of hindsight, in all likelihood the company’s management, its board of directors, research analysts, credit rating agencies and its employees all firmly believed in its long-term success.

Michael Cembalest J.P. Morgan Asset Management

1 1 Eye on the Market  J.P. MORGAN 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 4 Success, 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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Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

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 do their 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 and deletions 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 of a problem, and reflect benign index removals because: they were acquired at a premium to their current 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 were a consequence of stocks that failed outright, were removed due to substantial declines in their market value, or were acquired after suffering such a decline. As shown below, there were over 320 of them since 1980. The pace of distress-based deletions rises during a market crisis or recession, but there is a steady pulse of business failure during the entire business cycle. Consumer Discretionary, Technology and Financials accounted for the majority of distress-based deletions.

Number of companies removed from the S&P 500 due Cumulative number of companies removed from the to distress by year, Number of companies S&P 500 due to distress, Number of companies 30 350

25 300 250 20 200 15 150 10 100

5 50

0 0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Source: FactSet, Bloomberg, Standard & Poor's, JPMAM. 2013. Source: FactSet, Bloomberg, Standard & Poor's, JPMAM. 2013.

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

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EyeEye on thethe Market market •J.P. J.P. MORGAN Morgan

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 of individual stocks is higher than the index deletion rate, since there are stocks that suffer substantial price declines from which they do not recover, irrespective of whether they remain in an index. And what 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 time from 1980 to 2014, a database of 13,000 large cap, mid cap and small cap stocks. We then defined what we believe a concentrated stock holder would see as a catastrophic loss: “a decline of 70% or more in the price of a stock from its peak, after which there was little recovery such that the eventual loss from the peak is 60% or more.” How often does this take place? As shown in the table, 40% of all stocks suffered such a permanent decline from their peak value. Remember, we are not 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 and Consumer Discretionary had the highest loss rates. In terms of subsectors, Biotech (part of Health Care) and Metals & Mining (part of Materials) had loss rates over 50%.

Total % of companies experiencing Around 40% of all stocks experienced "catastrophic loss", Sector 1980 - 2014 catastrophic declines, when defined as a All sectors 40% 70% decline from peak value with Consumer Discretionary 43% minimal recovery. This is a subjective Consumer Staples 26% cutoff point; many concentrated holders Energy 47% would see smaller permanent declines as Materials 34% equally unacceptable, and whose risk Industrials 35% should be mitigated. The outcomes Health Care 42% based on a variety of thresholds suggest Financials 25% that for many concentrated holders, Information Technology 57% diversification should be a central part of Telecommunication Services 51% wealth management planning. Utilities 13% Source: FactSet, J.P. Morgan Asset Management.

When do such catastrophic declines happen? The next chart shows the percentage of companies at any given time experiencing a catastrophic loss. These loss rates tend to rise during recessions and market corrections, but there’s a steady pace of distress even during economic expansions. I don’t think we should draw too many conclusions from the decline in loss rates in 2010-2013; they have been 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 a natural tailing off at the end of the chart, given that there is less time for companies to fail.

Catastrophic loss rates on Russell 3000 companies % of companies in the process of suffering a catastrophic, The Russell 3000 Index measures the unrecovered loss of 70% or more performance of the largest 3,000 US 20% companies representing approximately 98% of the investable US equity market. 15% It is reconstituted annually to ensure that new and growing companies are 10% reflected.

5%

0% 1980 1985 1990 1995 2000 2005 2010 Source: FactSet. J.P. Morgan Asset Management.

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Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

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 that are consistently above (Technology) or below (Staples and Utilities) market levels.

Information Technology: loss rates higher than the R3000 Cons. Staples & Utilities: loss rates lower than the R3000 Companies in the process of suffering a catastrophic, unrecovered loss Companies in the process of suffering a catastrophic, unrecovered loss 50% 30% Information Technology Consumer Staples 40% Russell 3000 Utilities 20% Russell 3000 30%

20% 10%

10%

0% 0% 1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010 Source: FactSet. J.P. Morgan Asset Management. Source: FactSet. J.P. Morgan Asset Management.

Loss rates in Energy, Telecommunications and Financials tell the story of their respective points of distress. For Energy, the oil price collapse of the early 1980’s and natural gas price collapse of 2008- 2011 were catalysts for rising business failures and falling stock prices, while the energy price rally of the mid 2000’s reduced loss rates. In the case of Telecommunications, loss rates were lower than the broad market in the 1980’s and early 1990’s. 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 study section). And finally, the last chart shows the spike in Financial sector distress beginning in 2008, and also during the 1991 recession; outside of these periods, Financial sector distress was lower.

Energy: catastrophic loss rates vs. the Russell 3000 Telecom: catastrophic loss rates vs. the Russell 3000 Companies in the process of suffering a catastrophic, unrecovered loss Companies in the process of suffering a catastrophic, unrecovered loss 50% 50% Energy Telecommunication Services 40% 40% Russell 3000 Russell 3000

30% 30%

20% 20%

10% 10%

0% 0% 1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010 Source: FactSet. J.P. Morgan Asset Management. Source: FactSet. J.P. Morgan Asset Management. Financials: catastrophic loss rates vs. the Russell 3000 Companies in the process of suffering a catastrophic, unrecovered loss 30% Financials A meaningful number of companies are always in the process of suffering sharp, Russell 3000 20% unrecovered price declines at any given time, even during an economic expansion.

10%

0% 1980 1985 1990 1995 2000 2005 2010 Source: FactSet. J.P. Morgan Asset Management.

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Eye on the Market  J.P. MORGAN

Success,EyeEYE onON theTHE failure Market MARKET and the•J.P. J.P. distributionMORGAN MORGAN of lifetime returns on Russell 3000 stocks

Success,Focusing onlyfailure on andthe risk the of distribution failure misses of half lifetime the picture: returns the on potential Russell rewards3000 stocks of a concentrated stock position. There are a number of ways to assess the risks and rewards involved. One approach is Ftoocus looking at only all stocks on the and risk compute of failure their misses respective half the “lifetime” picture: the price potential returns rewards vs. the ofRussell a concentrated 3000 (i.e., stockstarting position with the. There time arewhen a number the company of ways first to existsassess in the public risks form and rewardsand reports involved a stock. One price approach, and until is toits looklast reported at all stocks price and in 2014compute or until their th respectivee date at which“lifetime” it was price merged, returns acquired vs. the Russellor for some 3000 other (i.e., reasonstarting delisted with the1). time The whenchart belowthe company shows thefirst resultsexists ,in which public can form be andsummarized reports a as stock follows: price , and until its last reported price in 2014 or until the date at which it was merged, acquired or for some other • The median 1stock underperformed the market with an excess lifetime return of -54%. In other reason delisted ). The chart below shows the results, which can be summarized as follows: words, in most cases, a concentrated holder would have been better off invested in the market. • The median stock underperformed the market with an excess lifetime return of -54%. In other • Two-thirds of all excess returns vs. the Russell 3000 were negative, and for 40% of all words, in most cases, a concentrated holder would have been better off invested in the market. stocks, returns were negative in absolute terms. • Two-thirds of all excess returns vs. the Russell 3000 were negative, and for 40% of all • Historically, there were some extreme winners: the right tail is ~7% of the universe and includes stocks, returns were negative in absolute terms. companies that generated lifetime excess returns more than two standard deviations over the mean. • Historically, there were some extreme winners: the right tail is ~7% of the universe and includes Distributioncompanies that of excess generated lifetime lifetime returns excess on individualreturns more stocks than vs. two Russell standard 3000, deviation 1980-2014s over the mean. Number of stocks Distribution2,100 of excess lifetime returns on individual stocks vs. Russell 3000, 1980-2014 Median Number1,800 of stocks 2,100 Extreme winners 1,500 Median 1,800 Extreme winners 1,200 1,500 900 1,200 600 900 300 600 0 300 50% > 0% - 450% 400% 350% 300% 250% 200% 150% 100% ------> 50% > > 150% > 200% > 250% > 300% > 350% > 400% > 450% > 500% > 550% > 600% > 650% > 700% > 750% > 800% > 850% > 900% > 950% 0 > 100% > > > > > > > > > 1000% > 1050% > 1100% > 1150% > 1200% > 1250% > 1300% > 1350% > 1400% > 1450% > 1500% > 1550% > 1600% > 1650% > 1700% > 1750% > 1800% > 1850% > 1900% > 1950% > 2000% > 2050% Time-adjusted lifetime price return on each stock vs. the Russell 3000 Index 50% > 0% - 450% 400% 350% 300% 250% 200% 150% 100% ------> 50% > > 150% > 200% > 250% > 300% > 350% > 400% > 450% > 500% > 550% > 600% > 650% > 700% > 750% > 800% > 850% > 900% > 950% Source: FactSet, J.P. Morgan Asset Management.> 100% > > > > > > > >

> 1000% > 1050% > 1100% > 1150% > 1200% > 1250% > 1300% > 1350% > 1400% > 1450% > 1500% > 1550% > 1600% > 1650% > 1700% > 1750% > 1800% > 1850% > 1900% > 1950% > 2000% > 2050% Time-adjusted lifetime price return on each stock vs. the Russell 3000 Index The relative frequency of success and failure shown above is not sensitive to when companies were Source: FactSet, J.P. Morgan Asset Management. created. For example, in one scenario, we excluded all Technology, Biotech and other companies that wentThe relative public frequencybetween 1995 of success and 2000 and failurein order shown to test above whethe is notr the sensitive subsequent to when collapse companies in many were of them hadcreated. an outsized For example, impact in on one the scenario, results above we excluded. They do all not;Technology, even when Biotech excluding and otherthese companiescompanies, that the wentmedian public return between is still negative, 1995 and the 2000 percentage in order ofto companiestest whether underperformin the subsequentg thecollapse index in is manystill around of them hadtwo -anthirds, outsized and theimpact percentage on the resultsof winners above is. still They 7%. do not; even when excluding these companies, the median return is still negative, the percentage of companies underperforming the index is still around two-thirds, and the percentage of winners is still 7%.

1 We compare stock price returns to Russell 3000 price returns. When including the impact of dividends on both individual stocks and the Russell 3000, the results do not change materially, even for the Utilities sector. 1 We compare stock price returns to Russell 3000 price returns. When including the impact of dividends on both 6 6individual stocks and the Russell 3000, the results do not change materially, even for the Utilities sector. 6

Eye on the Market  J.P. MORGAN

EyeThe onsuccess/failure the Market distribution J.P. MORGAN is similar across most sectors. As shownEye on below, the returnsmarke ont • theJ.P. Morgan

median stock were negative in each sector; 60%-70% of stocks in most sectors generated lifetime Theexcess success/failure returns less than distribution the Russell is3000 similar2; a third across or moremost generatedsectors. A negatives shown absolute below, excess returns; returns and on theaside median from Consumer stock were Staples, negative the in percentageeach sector of; 60% extreme-70% winners of stocks was in inmost single sectors digits generate. d lifetime excess returns less than the Russell 30002; a third or more generated negative absolute returns; and asideAnalysis from ofConsumer lifetime returns Staples, by the sector, percentage 1980-2014 of extreme winners was in single digits. Median excess Percentage of stocks Percentage of stocks Percentage of Analysis of lifetime returnsreturn by sector, vs Russell 1980-2014 with negative with negative extreme winner Sector Median3000 excess PercentageEXCESS returnsof stocks PercentageABSOLUTE of returns stocks Percentagestocks of All Sectors return -54%vs Russell with negative64% with negative40% extreme7% winner SectorConsumer Discretionary 3000-62% EXCESS65% returns ABSOLUTE44% returns stocks7% AllConsumer Sectors Staples -54%-3% 64%51% 40%26% 15%7% ConsumerEnergy Discretionary -62%-93% 65%72% 44%48% 7%6% ConsumerMaterials Staples -73%-3% 51%66% 26%34% 15%8% EnergyIndustrials -93%-58% 72%64% 48%37% 6%7% MaterialsHealth Care -73%-39% 66%60% 34%42% 8% IndustrialsFinancials -58%-21% 64%58% 37%30% 7%6% HealthInformation Care Technology -39%-63% 60%71% 42%53% 8%6% FinancialsTelecommunication Services -21%-57% 58%68% 30%54% 6% InformationUtilities Technology -141%-63% 71%85% 53%14% 6%0% Source:Telecommunication FactSet. J.P. MorganServices Asset Management.-57% 68% 54% 6%

Utilities -141% 85% 14% 0% Here’sSource: FactSet.a synthesis J.P. Morgan of whatAsset Management. we have done so far. Cisco Systems Stock price The first step measured the frequency of a stock $80 Here’sprice suffering a synthesis a catastrophic of what decline.we have This done is a so far. Cisco Systems $70 Eventual loss from Thepainful first event step ;measured however, thesome frequency concentrated of a stock holders Stock price $60 peak of: -67% pricemight suffering say, “a d aecline catastrophic from unsustainable decline. This market is a $80 $70$50 painfulvaluation events was; however, painful, but some I still concentrated benefited holders Max loss fromEventual loss from $60$40 peak of: -86%peak of: -67% mightsubstantially say, “a from decline being from concentrated unsustainable in themarket stock . Since inception stock valuationMy originals was basis painful, was very but low, I still so benefi thingsted turned out $50$30 price return of 27% annually vs. market Max loss from substantiallyfine in the long from run. being” There concentrated are many inexamples the stock of. $40$20 peak of: -86% Sincereturns inception of 8% stock Mythis originalparadigm basis, particularly was very low,in Tech so nology.things turned Take out $30$10 price return of 27% annually vs. market fineCisco, in whosethe long business run.” Theremodel are survived many theexamples tech of $20$0 thiscollapse. paradigm It suffered, particularly a huge in priceTech nology.decline from Take its 1990returns 1994of 8% 1998 2002 2006 2010 2014 $10 Cisco,peak and whose has businessonly recaptured model surviveda small amountthe tech since Source: Bloomberg, J.P. Morgan Asset Management. July 2014. $0 collapse.then, but Itstill suffered generated a huge substantial price decline excess from returns its 1990 1994 1998 2002 2006 2010 2014 peakvs. the and market has only over recaptured the long run a portion for its original since then, concentrated Source: holders. Bloomberg, That’s J.P. Morgan the Assetpurpose Management. of the July second 2014. butstep: still life generated-cycle analyses substantial of stock excess price returns returns, vs to. the look for stocks whose returns were positive over the marketlong run over despite the longinterim run collapses for its original and volatility. concentrated The negative holders. skew That’s of the the purpose distribution of the on second the prior step: lifepage-cycle shows analyses that while of price some returns, stocks to generated look for stocks volatile whose but positive returns life were-cycle positive returns over (like the Cisco) long, runmany despitemore did interim not. collapses and volatility. The negative skew of the distribution on the prior page shows that while some stocks generated volatile but positive life-cycle returns (like Cisco), many more did not.

The frequency of catastrophic declines and the negative skew in the distribution of Theindividual frequency stock of returns catastrophic compound declines our andperception the negative of concentrated skew in the stock distribution risk, and of suggest individualthat diversification stock returns play compoundan important our role perception in wealth of planning concentrated for most stock entrepreneurs. risk, and suggest that diversification play an important role in wealth planning for most entrepreneurs.

2 In 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 much 2lower In the catastrophic case of Utilities, loss ratethe .frequency While utility of negativestock risk absolute is lower returns than the is marketvery low,, there while have the frequencybeen more of than negative a few excessexamples returns of extreme is high. utility This distressis a reflection, as explained of the lower in the returns case study on utility section. stocks, which are offset by their much lower catastrophic loss rates. While utility stock risk is lower than the market, there have been more than a few 7 examples of extreme utility distress, as explained in the case study section. 7 7

EyeEye on thethe Market market •J.P. J.P. MORGAN Morgan

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 that happens in between. However, volatility can be an important signal since it tells us something about the risk of a stock. Not everyone agrees that interim price movements are a good proxy for “risk”; in some cases, they aren’t. However, over the long run, returns and volatilities tend to track each other pretty closely. For purposes of this analysis, we define risk as “volatility of Higher volatility usually associated with lower stock price returns, Universe: Russell 3000 stocks, min. 3 years of negative stock price movements”; in other returns, 1980-2014 words, we look at volatility from falling stock 200% prices rather than from falling and rising ones. 150% I find that most investors prefer this definition of risk (technically referred to as semi- 100% deviation), since they are not worried about 50% the risk of rising prices. As shown, if the volatility of your stock is rising sharply, 0% chances are that its returns are falling. -50%

-100%

Next, we factor risk into the equation of Annualized stock price return 0% 20% 40% 60% 80% 100% 120% 140% being a concentrated stockholder. With 20- Downside volatility (semi-deviation) 20 hindsight, we can compute the “optimal” Source: FactSet, J.P. Morgan Asset Management. combination of any stock with the Russell 3000. In other words, what combination of each stock and the Russell 3000 would have delivered 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 held more of a lower-returning stock if it exhibited attractive diversification benefits vs. the Russell 3000. The results tell us something about the frequency with which concentrated holders would optimally choose to own different amounts of their stock, 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 action from 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 to own no more than 30% of the concentrated stock, and often none of it. This is not a surprise; as per page 6, if two-thirds of stocks underperformed the Russell 3000, it is very unlikely that a risk-adjusted approach would want to own many of them since it would prefer to own the Russell 3000 instead.

Optimal mix of a concentrated stock position with the Russell 3000, 1980-2014, number of observations 3,500 3,000 2,500 2,000 1,500 1,000 500 0 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Optimal concentrated stock weight Source: FactSet, J.P. Morgan Asset Management.

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Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

As a last step in our empirical analysis, we weave together each of the three risk factors we have examined so far: the risk of catastrophic loss, the risk of underperforming the Russell 3000 and finally, the risk of heightened volatility that subjected concentrated holders with insufficient 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 absolute lifetime returns; or • generated negative excess lifetime returns vs. the Russell 3000; or • experienced high volatility such that the optimal portfolio process described on the prior page chose 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. With the benefit of hindsight, in around three-quarters of all cases, diversification could have played an important role in sustaining family wealth.

Percent of stocks whose concentrated holders would have benefited from diversification, 1980-2014 Sector Percent All sectors 74% Consumer Discretionary 74% Consumer Staples 58% Energy 81% Materials 75% Industrials 75% Health Care 72% Financials 63% Information Technology 82% Telecommunication Services 74% Utilities 87% Source: FactSet, J.P. Morgan Asset Management.

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SEyeEyectore on case thethe Market studymark eforensicst •J.P. J.P. MORGAN M organ

ASector deeper case dive studies: into catastrophic some forensics stock price on catastrophicloss reveals important loss realities of global business dynamics. There are hundreds of cases to choose from; the ones selected illustrate different paradigms and factorsA deeper affecting dive into stocks catastrophic that suffer stocked substantialprice loss reveals and permanent important impai realitiesrment. of global We focus business on large dynamics cap . There(and the are upper hundreds end of midcases cap), to choose since many from; were the ones “household we selected names” illustrate at the different peak of paradigmstheir success. that It is resultednot always in substantialsimple to explain and permanent why a company impairment. suffered W ae focusdecline, on since large a cap combination (and the upper of fundamental end of mid cap),factors since and many the whims were “householdof investor sentiment names” at are the involved. peak of theirThe descriptions success. It isrepresent not always our simple perceptio to n of explainthe primary why factors;a company other suffered explanations a decline, may since be just a combination as plausible. of Note fundam thatental these factors examples and were the whims chosen ofin theinvestor summer sentiment of 2014; are over involved. time, manyThe descriptions “Lazarus” stocksrepresent come our back perceptio from then of dead the ,primary so it is fairfactors; to otherassume explanations that some ofmay them be justmay as recover plausible. from Note their thatcurrent these levels. examples were chosen in the summer of

In2014; the caseover studies,time, many there “Lazarus” are instances stocks of come leveraged back overfrom- expansionthe dead,, soparticularly it is fair to towards assume the that end some of aof them may recover from their current levels. business cycle, and examples of management misreading rapidly-changing industry dynamics and Incompetitive the case studies, factors. t hereThere are were instances also examples of leveraged of companies over-expansion that mismanaged, particularly atowards large acquisition; the end of we a businesswere not cycle surprised, and toexamples find these of managementinstances, since misreading most studies rapidly we- changinghave seen industry estimate dynamics M&A failure and rates 3 atcompetitive 50% to 80% factors. of all There transactions are also. examplesHowever, of many companies of the companiesthat mismanaged suffered a duelarge to acquisition; factors largely we outsidewere not management surprised by’s this control., since Wemost list studies some ofwe these have exogenousseen estimate factors M&A in failure the box rates on theat 50 facing% to 80% page.of all transactions After reviewing3. However, the companies many companies affected sufferedby them, due it is tonot factors clear that largely even outside the best management management teamscontrol in. the We world list some could of havethese done exogenous much tofactors alter thein the ultimate box on outcome the facing. page. In these cases, it is

Whilenot clear some that catastrophiceven the best lossesmanagement on the teamsfollowing in the pages world maycould seem have obviousdone much or toinevitable alter the with ultimate outcome. the benefit of perfect hindsight, in all likelihood the company’s management, its board of Whiledirectors, some research catastrophic analysts losses, credit on ratingthe following agencies pages and its may employees seem obvious all firmly or inevitable believed inwith its longthe benefit-term success. of perfect hindsight, in all likelihood the company’s management, its board of directors, research analysts, credit rating agencies and its employees all firmly believed in its Noteslong- termabout success. the charts Some examples show pre-Chapter 11 prices of companies that have since emerged from bankruptcy andNotes are about now thethriving charts with sound operating businesses (e.g., Charter Communications and Calpine), in whichSome examplescase the primary show pre problem-Chapter was 11 often prices the of firm’companiess prior thatcapital have structure. since emerged All stocks from are bankruptcy shown andthrough are nowtheir thrivingfinal reported operating pricing businesses date, which (e.g., isCharter either JulyCommunications 31, 2014, or anand earlier Calpine date). whenAll stocks the are showncompany through was acquired, their final merged reported or delistedpricing date, and whichwhich isis notedeither belowJuly 31, the 2014, chart. or Pricean earlier histories date on when themany company stocks reflect was acqu splitired, adjustments merged or that delisted took placeand which over time, is noted such below that historicalthe chart. prices Price appear histories lower on manythan the stocks levels reflect at which split theyadjustments were once that quoted. took place over time, such that historical prices appear lower than the levels at which they were once quoted.

3 The earliest analyses performed in the US and Europe in the 1970’s found merger and acquisition failure rates of 40%-50%. More recent estimates are higher. Wharton’s “Why Do So Many Mergers Fail” cites professor Robert3 The earliest Holthausen, analyses whose performed failure inrate the estimates US and Europ rangee fromin the 50% 1970’s-80%. found A 2010merger study and from acquisition McKinsey failure estimates rates failureof 40% rates-50%. of More66%- recent75%. estimatesAnd in a 2010 are higher. book from Wharton’s Mitchel “Whyl Lee MarksDo So (SanMany Francisco Mergers State Fail” University,cites professor and an advisorRobert Holthausen,in 100 mergers whose and failure business rate transitions), estimates rangefailure from rates 50% are estimated-80%. A 2010at 75%. study from McKinsey estimates failure rates of 66%-75%. And in a 2010 book from Mitchell Lee Marks (San Francisco State University, and an 10 10advisor in 100 mergers and business transitions), failure rates are estimated at 75%. 10

Eye on the market • J.P. Morgan Eye on the Market  J.P. MORGAN

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

• commodity price risks that 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 scope of competition, changing subsidies for renewable energy, changes in carbon tax regimes and fracking rules, government-sponsored enterprises with a lower cost of funds crowding out private sector activity, changes in the interpretation of anti-trust rules, shifts from capacity pricing 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 boom–bust cycles in telecommunications, utilities and broker- dealers • foreign competitors whose market share is magnified by government subsidies and exchange rate manipulation  China’s exchange rate management and subsidies to its auto, steel, solar, paper and glass companies are primary examples (see Appendix I for more details) • intellectual property infringement by 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 1997-2007 accounted for ~30% of all instances; or fraud by employees or management in companies that you acquire, or which acquire you • technological innovation that 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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EyeEye on thethe Market market •J.P. J.P. MORGAN Morgan

Consumer Discretionary

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

Once the pioneer of discount retailing, management Overleveraged cable television acquisition spree paid outflanked by Walmart and Target, and underinvested for with inflated stock price; accounting issues in merchandise, key locations and supply chain $25 $30 Kmart Corporation $25 $20 Charter Communications $20 $15 $15 $10 $10 $5 $5

$0 $0 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: Bloomberg. May 2003. Source: Bloomberg. November 2009.

Surpassed by digital competitors; low barriers of entry Bad timing: leveraged theme park acquisitions heading $90 into a recession $80 $40 Weight Watchers International Inc. $70 $35 $60 $30 $50 $25 Premier Parks Inc. (Six Flags) $40 $20 $30 $15 $20 $10 $10 $5 $0 $0 2002 2004 2006 2008 2010 2012 2014 1996 1998 2000 2002 2004 2006 2008 2010 Source: Bloomberg. July 2014. Source: Bloomberg. May 2010.

Scorched earth strategy works too well: fending off The Organic sales growth hits a wall at 2,000 stores, Limited (via spinoff of Neiman Marcus and massive debt) acquisition of a key but fading rival compounds the doomed the company's future problem $180 $35 $160 $30 $140 $120 Carter Hawley Hale $25 Stores (Broadway Stores) Sunglass Hut International Inc. $100 $20 $80 $15 $60 $10 $40 $20 $5 $0 $0 1988 1989 1990 1991 1992 1993 1994 1995 1994 1995 1996 1997 1998 1999 2000 2001 Source: Bloomberg. October 1995. Source: Bloomberg. April 2001.

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

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

Auto Components Household Durables (continued) Media (continued) Dana Corp. Kaufman & Broad Home Corp. RH Donnelly Corp. Delphi Corporation Maytag Corporation Savoy Pictures Entertainment, Inc. Federal-Mogul Corp. Pillowtex Corp. Warner Music Group Corp. Goodyear Tire & Rubber Company Sealy Corp. Westwood One Inc. Lear Corporation Standard Pacific Corp. XM Satellite Radio Holdings Visteon Corp. 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 Education 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. Cent ex Corp. Orion Pictures Corporation L.A. Gear, Inc. Hovnanian Enterprises, Inc. Readers Digest Association Inc. North Face, Inc.

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EyEyee onon ththee Marketmarket •J.P. J.P. MORGANMorgan

Consumer Staples

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

Chiquita expanded during trade talks to open European Competition in low-margin supermarkets from Walmart banana market, suffers when Europe opts to maintain and Publix too much for “America’s Supermarket” imports from former colonies; 2001 Chapter 11 filing $60 $60 United Brands Company (Chiquita) $50 $50 $40 $40 Winn-Dixie Stores Inc. $30 $30 $20 $20

$10 $10

$0 $0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 1981 1984 1987 1990 1993 1996 1999 2002 2005 Source: FactSet. March 2002. Source: Bloomberg. November 2006.

Sometimes there’s no room for #3 (behind Duracell and Over-leveraged Revlon runs into deep-pocketed Energizer); non-core acquisitions (pet supply) outside competitors (J&J, P&G), and loses company core competence $500 $45 $40 $400 $35 Rayovac Corporation $30 $300 $25 Revlon Inc. $20 $200 $15 $10 $100 $5 $0 $0 1998 2000 2002 2004 2006 2008 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Bloomberg. August 2009. Source: Bloomberg. July 2014.

Doing business in China involves under-regulated supply Chapter 22? Hostess first went bankrupt in 2004, citing chains and the lack of consumer safeguards reduced demand for high-carb snacks and rising $50 labor/energy costs $40 $40 Synutra International Inc. $30 $30

$20 $20

$10 $10 Hostess Brands (Interstate Bakeries) $0 $0 2006 2007 2008 2009 2010 2011 2012 2013 2014 1992 1994 1996 1998 2000 2002 2004 2006 2008 Source: Bloomberg. July 2014. Source: Bloomberg. February 2009.

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Energy

Energy rivals Technology as the sector most ideally suited to discussions about concentration risk. The nature of exploration and production, commodity prices, business cycle risks, environmental accident risks and regulatory issues create a volatile backdrop for many oil and gas stocks. Event risk in E&P spiked during the oil price decline in the early 1980’s, and almost every time since when a commodity price falls unexpectedly, such as during the natural gas price decline of 2009. Energy stock price volatility is not just an issue for E&P: out of 27 S&P 500 industries with at least 8 stocks, Energy Equipment & Services exhibited the highest volatility from 2002 to 2012, even higher than Metals & Mining, Software and Semiconductors (recent equipment/services catastrophic loss examples include McDermott, Willbros and Hercules). Business risk in the Energy sector is not confined to oil/gas and related services: despite the world’s voracious use of coal (up 50% since 2000, with 2013 as the highest year of global coal consumption as a % of primary energy since 1970), coal companies face plenty of challenges as well.

Largest coal company in the world; global expansion Texas-based natural gas company suffers from designed to reduce impact of US regulations and nat collapse in natural gas prices, and leverage (45% of gas boom ended up damaging margins revenue in Q1 2014 used to pay interest expense) $100 $45 Peabody Energy Corporation $40 Quicksilver Resources Inc. Similar stock price $80 Similar stock price declines: $35 Arch Coal, Alpha Natural declines: Chesapeake, Resources, Consol, James $30 SandRidge, Comstock, $60 River, Patriot Coal $25 Exco, Ultra Petroleum, Penn Virginia $20 $40 $15 $20 $10 $5 $0 $0 2002 2004 2006 2008 2010 2012 2014 2000 2002 2004 2006 2008 2010 2012 2014 Source: Bloomberg. July 2014. Source: Bloomberg. July 2014. When core competence is in shallow water, deepwater Owners of Deepwater Horizon, the semisubmersible operations can be high risk for companies providing drilling rig which caught fire, exploded and then sank in construction equipment and services the Gulf of Mexico $35 $175 $30 $150 Transocean $25 $125 McDermott International Inc. $20 $100 $15 $75 $10 $50 $5 $25 $0 $0 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Bloomberg. July 2014. Source: Bloomberg. July 2014. Early 1980's: OPEC over-supply and lower oil demand What happens to the largest operator of oil tankers due to recession hurts E&P and equipment/servicers when tanker rates decline by 40%-50%; leverage and $3,500 some aging vessels compound the problem Western Company of North America $80 $3,000 $70 Similar stock price declines: Frontline Ltd. $2,500 Dome Petroleum, Edisto Resources, $60 Southland Royalty, Apache, Parker Drilling $2,000 $50 $40 $1,500 $30 $1,000 $20 $500 $10 $0 $0 2000 2002 2004 2006 2008 2010 2012 2014 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 Source: FactSet. March 1989. Source: Bloomberg. July 2014. 15 15

EyEyee on on th thee markMarketet • J.P.J.P. MMORGANorgan

Financials

There’s a long list of banks, brokerage firms, mortgage insurers, REITs and specialty finance companies that suffered permanent price declines during the financial crisis of 2008-2009. What’s interesting for purposes of understanding concentration risk in Financials: the role that government policy can play in altering or influencing the behavior of private sector firms. As described in a November 2013 Eye on the Market (“Course of Empire”), US government-sponsored enterprises took a lot of the oxygen out of the room: the green and red lines in the chart show the increase in high-risk lending undertaken by the GSEs which predated the massive increase in subprime and Alt A lending by the private sector (black line). The GSE increases move roughly in tandem with lending standards which required the GSEs to make more low and moderate income loans (blue line). This timeline is not meant to absolve the private sector, which made some horrendous and well-documented underwriting decisions; the point is to understand what government actions and policies preceded them. The Course of Empire: Prelude to Destruction Percent of annual underwriting (except Fannie/Freddie share based on total outstanding balances) 60% Freddie Mac/Fannie 55% Fannie/Freddie share of GSE Mae underwriting 50% + Private sector FHA LTV >=97% that exceeded 45% 1 traditional standards 2 in selectively 40% disclosed portfolio GSE Low & Moderate 35% 3 Income lending target 1. Non-traditional Freddie Mac 30% 4 2. Freddie cash out CLTV > 75% 25% 5 3. Fannie/Freddie DTI > 38% 4. Fannie purchase loan CLTV > 90% 20% 5. Fannie/Freddie DTI >= 42% 15% 10% Private sector subprime and Alt A % of 5% total origination 0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: American Enterprise Institute. J.P. Morgan Asset Management. November 2013.

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 on single family mortgages: the vast majority had debt-to-income ratios below 38%, loan-to-values below 90% on purchase loans, or loan-to-values on cash-out refinancing loans below 75%. The GSEs had a one-third share of outstanding mortgages. Private sector subprime had existed for decades, but was limited in size at ~10% of annual residential mortgage origination. Home ownership rates and home prices relative to income and replacement cost were stable at post-war averages.

The era of sound GSE lending did not last. The 1992 “Federal Housing Enterprises Financial Safety and Soundness Act” enabled the Department of Housing and Urban Development to set formalized minimum affordable lending standards for the GSEs. HUD first set Low & Moderate Income standards at 30% of annual GSE acquisitions, and raised them to 50% in the week before the November 2000 election. Home ownership rates 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 market rose by 2.5x vs. 1990. Freddie Mac’s non-traditional loans were ~45% of their annual acquisitions and guarantees, and more than 40% of Fannie Mae’s Alt A (low documentation) loans qualified for the HUD- determined affordable housing goals. Note that the GSE revolution took place before the explosion in private sector subprime and Alt A loans.

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

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Another large part of the financial crisis Growth in assets and major financial sector legislation resulted from under-capitalized risk-taking Index, 12/31/1992 = 100 1,000 at the 5 large broker-dealers. As background, $4.2 Trillion 900 Broker-dealers in the mid 1970’s, broker-dealers like Merrill 5 institutions Lynch, DLJ and A.G. Edwards were leveraged 800 700 SEC Uniform Net from 5-to-1 to 8-to-1. Most of their activities Capital Rule Change 600 were “brokering” (acting as agent), not 500 “dealing” (acting as principal). Commission Gramm-Leach- 400 $10 Trillion Bliley Act deregulation then reduced their core profitability 300 513 institutions (commissions declined from 61% of industry 200 Commercialbanks revenues in 1965, to 40% in 1976, to 16% in 100 >$1billion in assets 1990), leading many firms to push for ways to 0 take on higher leverage and higher risk. In 2004, Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Dec-07 the SEC eliminated the Net Capital Rule that had Source: FDIC, Bloomberg. limited broker-dealer leverage at 12-1 since 1975. 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 $4.2 trillion 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 the largest S&P 500 banks and capital markets firms recovered relative to June 2007 levels. Surviving firms are now adhering to stricter capital standards not only via higher minimum requirements, but also in improved quality of capital (more reliance on loss-bearing capital like tangible common equity and the exclusion of trust preferreds from Tier 1 capital altogether). Furthermore, US banks have made a substantial transition away from wholesale (interbank) liquidity, which has fallen from 47% to 27% of all 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 monetary policy; substantial risks of concentrated ownership remain.

S&P 500 Banks, Brokers and Consumer Finance firms: changes in stock price vs. June 2007 Current index level, 6/30/2007=100 150 140 Higher than June 2007 stock price 130 Below June 2007 stock price 120 Delisted or acquired* 110 100 90 80 70 60 50 40 30 20 10 0 WaMu Schwab Regions Synovus Lehman KeyCorp Citigroup SunTrust Comerica Wachovia E*TRADE SLM Corp M&T Bank CIT Group Huntington BB&T Corp BB&T WellsFargo US Bancorp Countrywide CapitalOne First Horizon Merrill Lynch NationalCity Bear Stearns PNC Financial ZionsBancorp Amer. Express Amer. Morgan Stanley Fifth Third Bank Goldman Sachs Marshall & Ilsley Bank of America Commerce Banc. JPMorgan Chase

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

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As for Financial concentration risk before 2008, there was a spike in distress in banks and thrifts during the consumer-led recession of the late 1980’s. What’s more interesting as part of a discussion on concentration risk are the Financial sector business models that are presumably more stable: insurance companies, companies acting as fee-based transaction agents, REITS and asset managers. History provides quite a few examples of how overly aggressive insurance companies, without access to the Fed’s 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 through syndicated bank loans. As a result (and given their cash flow distribution requirements), equity and mortgage REITs implicitly assume that credit and equity markets will remain open, even during a recession. The REIT stresses during 2008-2009 were in some ways the first big test for the sector, since they were much less prevalent during the prior commercial real estate recession in 1990-1991.

There are a million flavors of derivatives, and some of Sometimes short-sellers are right: a leveraged, them taste terrible acquisition-based insurance company makes little $1,750 sense, and became the 3rd largest bankruptcy in history $60 $1,500 $50 $1,250 American International Group, Inc. $40 Conseco Inc. $1,000

$750 $30

$500 $20

$250 $10

$0 $0 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 1987 1989 1991 1993 1995 1997 1999 2001 2003 Source: Bloomberg. July 2014. Source: Bloomberg. September 2003.

An overly aggressive investment strategy (i.e., 45% of Diversifying a low-margin business (discount Executive Life's assets in HY bonds) can attract brokerage) with a cyclical one (home equity lending) attention of regulators and scare policyholders can be hazardous to your wealth $20 $600 $500 $16 First Executive Corporation $400 $12 E*TRADE Financial Corporation $300 $8 $200

$4 $100

$0 $0 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1997 1999 2001 2003 2005 2007 2009 2011 2013 Source: FactSet. April 1991. Source: Bloomberg. July 2014.

Asset managers who are concentrated by style (Janus) Most REITs came back from 2009 lows, but are still or with a handful of star managers (like Legg Mason in exposed to credit crises given 90% income 2006-08) can suffer radical changes of fortune distribution, no access to Fed discount window and $50 preference for bonds > more easily negotiable syndicated bank loans $40 Janus Capital Group Inc. $70 $60 Developers Diversified Realty Corp. $30 $50 Similar REIT declines and recoveries: General $20 $40 Growth Properties, $30 Duke, Maguire, Cousins $10 $20 $10 $0 Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Jun-14 $0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Source: Bloomberg. July 2014. Source: Bloomberg. July 2014. 18 18

Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

Health Care

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

Device companies heavily reliant on one product (drug- Note to CEOs selling a company for stock in a roll-up: coated stents, in this case) are like concentrated stock due diligence on buyers is important; largest outpatient portfolios themselves rehab roll-up was fueled in part by accounting fraud $50 $160 $45 Boston Scientific $140 $40 HealthSouth Corporation $120 $35 Corporation $30 $100 $25 $80 $20 $60 $15 $40 $10 $5 $20 $0 $0 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 Source: Bloomberg. July 2014. Source: Bloomberg. July 2014.

Prostate cancer wonder drug? Sometimes FDA Unanticipated sharp declines in Medicare reimbursements approval is not enough, customer demand has to render GHV (nursing home) capital structure inoperable; materialize as well contagion spreads to other providers $60 $40 Dendreon Corporation Company Genesis Health $35 $50 withdrew Ventures Inc. FDA approval guidance $30 $40 received $25 $30 Successful $20 test results $15 $20 announced $10 $10 $5 $0 $0 Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Jun-14 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Source: Bloomberg. July 2014. Source: Bloomberg. October 2001.

FDA approval tolerance can shift over time, particularly if Advanced scientific breakthroughs (even mapping approved competitors (Lunesta, Ambien) show signs of human DNA sequences) do not necessarily translate negative side effects immediately into profitable business models $70 $120 Neurocrine Human Genome Sciences Inc. $60 FDA denies Biosciences, Inc. approval for $100 Largest Biotech companies with $50 larger dose $80 catastrophic price declines, 2000-02: $40 Indiplon Millennium, Celera, Abgenix, Protein insomnia drug $60 Design Labs, Medarex, Maxygen, $30 Curagen, Enzon, Cell Therapeutics $40 $20 $10 $20 $0 $0 1997 1999 2001 2003 2005 2007 2009 2011 2013 1996 1998 2000 2002 2004 2006 2008 2010 2012 Source: Bloomberg. July 2014. Source: Bloomberg. August 2012. 19 19

EyeEye on thethe Market market •J.P. J.P. MORGAN Morgan

Industrials

Most Industrial failures that people remember are airlines, which is understandable since there have been so many (162 airline bankruptcies from 1978 to 2005 as per the US GAO). There have been other Industrial distress cases as well. Many thrived for a long period of time, sometimes multiple decades, perhaps convincing concentrated holders that event risk was minimal. Then, something changed: Asian growth, asbestos litigation, competitive forces resulting from China’s entry into the World 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 decommissioning funds (EnergySolutions), a state government terminating alternative energy subsidies (Foster Wheeler), etc. Regarding the latter company, there’s a broader paradigm of business risk for industrial companies involved with the various aspects of renewable energy (photovoltaic equipment, wind turbines, fuel cells and related services). See A123 Systems below, and pages 30-31 for more details.

Slow responses to low-fare competition and high salary Debt-fueled expansion and reliance on overseas workers, coupled with a spike in jet fuel costs, forced consumption can be risky: reduction in orders from the airline to file for bankruptcy Indonesia in 1998 when its GDP fell 17% $80 $50 Other catastrophic airline stock price $45 $70 declines: American, Braniff, Frontier, JetBlue, $40 $60 KLM, Mesa, Midway, Northwest, PanAm, SkyWest, Texas Air, TWA, United, $35 $50 US Airways, ValuJet $30 Harnischfeger Industries Inc. $40 $25 $30 $20 $15 $20 Delta Air Lines Inc. $10 $10 $5 $0 $0 1981 1984 1987 1990 1993 1996 1999 2002 2005 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 Source: Bloomberg. April 2007. Source: Bloomberg. July 2001.

In 90 AD, Pliny the Younger wrote of medical problems Preeminent civil engineering and heavy construction associated with asbestos mining; 2,000 years later, firm overextends itself financially while aggressively nearly 100 asbestos producers filed Chapter 11 expanding into non-core areas like mass transit $50 $60 Owens-Corning $50 $40 Fiberglass Corporation $40 $30 $30 $20 Morrison Knudsen Corp. $20

$10 $10

$0 $0 1981 1984 1987 1990 1993 1996 1999 2002 2005 1981 1983 1985 1987 1989 1991 1993 1995 1997 Source: Bloomberg. October 2006. Source: Bloomberg. August 1997.

One of the world's largest machine tool manufacturers The government can sponsor the idea of electric cars, struggled to compete with cheaper foreign competition but cannot make people buy them, or the lithium ion and the slowdown in US manufacturing batteries that A123 made $400 $25 $350 CincinnatiCincinna tiMilacron Milacron Inc. Inc. China joins WTWTOO $20 $300

$250 $15 $200 A123 Systems, Inc. $150 $10 $100 $5 $50 $0 $0 1980 1983 19861986 19891989 19921992 19951995 19981998 20012001 20042004 2007200720102010 Sep-09 Sep-10 Sep-11 Sep-12 Source: Bloomberg. February 2013. Source: Bloomberg. July 2013.

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Eye on the Market  J.P. MORGAN Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

Information Technology Information Technology The tech sector has generated some of the most spectacular gains in the history of US equity markets. 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 most Google, Apple, Qualcomm, salesforce.com, eBay, Adobe Systems, Oracle, etc. are some of the most successful public companies in the world. As shown on page 7, however, only 6% of all tech successful public companies in the world. As shown on page 7, however, only 6% of all tech companies turned out to be extreme winners; the median tech company substantially underperformed companies turned out to be extreme winners; the median tech company substantially underperformed the market; 70% underperformed the Russell 3000; and over 50% generated negative absolute the market; 70% underperformed the Russell 3000; and over 50% generated negative absolute returns. Furthermore, almost 60% of all technology companies in the history of the Russell 3000 Index returns. Furthermore, almost 60% of all technology companies in the history of the Russell 3000 Index fell by 70% from their peak price and did not recover. fell 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 themselves The story of the tech sector is a long narrative about disruptive technologies which are themselves4 disrupted by changes that follow. Wang Labs, Silicon Graphics, Digital Equipment Corporation4 and disrupted by changes that follow. Wang Labs, Silicon Graphics, Digital Equipment Corporation and Commodore are some of the earlier casualties, unable to adapt to the shift away from dedicated word Commodore are some of the earlier casualties, unable to adapt to the shift away from dedicated word processors and 3D graphics servers and towards PC platforms based on Microsoft’s Operating System. processors and 3D graphics servers and towards PC platforms based on Microsoft’s Operating System. Similar fates were eventually in store for Cray Supercomputer, Prime Computer, Data General, Atari, Similar fates were eventually in store for Cray Supercomputer, Prime Computer, Data General, Atari, Maxtor, DEC, Borland International and other tech stalwarts of the 1980’s and 1990’s. They were all Maxtor, DEC, Borland International and other tech stalwarts of the 1980’s and 1990’s. They were all industry leaders at their peak, run by some of the smartest individuals in the business world whom industry leaders at their peak, run by some of the smartest teams in the business world that would would presumably be able to adapt to changing technologies and circumstances. presumably adapt to changing technologies and circumstances. Most of them, however, did not.

Dedicated word processing equipment Dedicated 3D graphics servers Dedicated word processing equipment Dedicated 3D graphics servers $45 $16 $45 $16 $40 $14 $40 $14 $35 Silicon Graphics Inc. $12 Silicon Graphics Inc. $35 $12 $30 Wang Labs, Inc. $30 Wang Labs, Inc. $10 $25 $10 $25 $8 $20 $8 $20 $6 $15 $6 $15 $10 $4 $10 $4 $5 $2 $5 $2 $0 $0 $0 $0 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 Source: FactSet. August 1993. Source: FactSet. September 1993. Source: Bloomberg. September 2006. Source: Bloomberg. October 2006. The next phase in the tech sector came in the late 1990’s, when internet use began to rise sharply. The The next phase in the tech sector came in the late 1990’s, when internet use began to rise sharply. The dot-com era was fueled by this enthusiasm, as well as by opportunities in the business-to-business dot-com era was fueled by this enthusiasm, as well as by opportunities in the business-to-business space. As global internet users rose ten-fold from 32 million in 1995 to 320 million by 2000, markets space. As global internet users rose ten-fold from 32 million in 1995 to 320 million by 2000, markets assumed that profitable business models would emerge around it. However, while global internet use assumed that profitable business models would emerge around it. However, while global internet use did keep growing at a rapid clip, many technology companies weren’t making enough money to did keep growing at a rapid clip, many technology companies weren’t making enough money to survive what turned out to be a mild recession in 2001, and required even more exponential survive what turned out to be a mild recession in 2001, and required even more exponential internet/ internet/broadband uptake than what was occurring in order to be profitable. broa dband uptake than what was occurring in order to be profitable.

Data center provider cannot survive collapse of its tech Provider of optical equipment to the high-tech food Data center provider cannot survive collapse of its tech JDS' customer base for optical equipment (Alcatel, customer base and the eventual migration from co- chain (Alcatel, Ciena, Cisco, Corning, Juniper, Lucent, customer base and the eventual migration from simple Ciena, Cisco, Corning, Juniper, Lucent, Marconi, location to managed hosting Marconi, Motorola, Nortel, Scientific Atlanta, Siemens, co-location to full-service managed hosting Motorola, Nortel, Scientific Atlanta, Siemens, Sycamore) $80 Sycamore), much of which collapsed at the same time $80 all suffered a collapse in demand at the same time $70 Exodus $1,200 $70 ExodusCommunications Inc. $1,200 $60 Communications Inc. $1,000 $60 $1,000 $50 JDS Uniphase $50 $800 JDS Uniphase $40 $800 $40 $600 $30 $600 $30 $400 $20 $400 $20 $10 $200 $10 $200 $0 $0 $0 $0 1998 1999 2000 2001 2002 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1998 1999 2000 2001 2002 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Bloomberg. May 2002. Source: Bloomberg. July 2014. Source: Bloomberg. June 2002. Source: Bloomberg. July 2014.

4 “The personal computer will fall flat on its face in business”, Ken Olsen, CEO Digital Equipment 4 “The personal computer will fall flat on its face in business”, Ken Olsen, CEO Digital Equipment Corporation, who was proclaimed “America’s most successful entrepreneur” by Fortune magazine in 1986. Corporation, who was proclaimed “America’s most successful entrepreneur” by Fortune magazine in 1986. 21 21 21 Eye on the Market  J.P. MORGAN

EyeEye on thethe Market market •J.P. J.P. MORGAN Morgan As the tech bust rolled on through 2001 and 2002, dozens of technology companies ended up seeing Astheir the highest tech buststock rolled prices on in through the rear 2001view mirrorand 2002,(for example,dozens ofo technologyf 212 Internet companies& Software endedService up seeing theircompanies highest with stock stock prices prices in the in February rearview 2000,mirror only(for 17example, ever saw of 212higher Internetstock &prices Software at any Service time betweencompanies March with stock2000 andprices February in February 2014 2000,). Some onlyof 17 the ever largest saw declinehigher sstock apppear prices below at any; the time first three each had a peak market cap over $100 billion. While some companies survived (EMC, Intel, Cisco, between March 2000 and February 2014). Some of the largest declines appear below; the first three5 eachBroadcom), had a peakothers market did not cap adapt over to$100 industry billio nchanges,. While some adapted companies temporarily, surviveor ddid (EMC, not adapt Intel, Ciscoin time, . Broadcom), others did not adapt to industry changes, adapted temporarily, or did not adapt in time5. The world’s largest telecom equipment company in Lucent's Canadian competitor, drowning in a sea of 1999 with $38 billion in sales; relied excessively on its overpriced, ill-chosen, poorly integrated acquisitions; Theincumbent world’s position largest telecom and did notequipment adapt company in Lucent'ssuffered fromCanadian a "culture competitor, of arrogance drowning and in hubris"* a sea of $601999 with $38 billion in sales; relied excessively on its $900overpriced, ill-chosen, poorly integrated acquisitions; incumbent position and did not adapt $800sufferedNortel from Networks a "culture Corporation of arrogance and hubris"* $50$60 Lucent Technologies Inc. $900 $700 $800 Nortel* according Networks to a study Corporation $40$50 Lucent Technologies Inc. $600 $700 released in 2014 by the $500 *University according of to Ottawa a study $30$40 $600 $400 releasedDepartmentsin 2014 of Law, by the $500 University of Ottawa $20$30 $300 Electrical Engineering and $400 Departments of Law, $200 Management $10$20 $300 Electrical Engineering and $100 $200 Management $10$0 $0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 $1001981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 $0 $0 Source: Bloomberg. November 2006. Source: Bloomberg. July 2014. 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 Source:Industry Bloomberg. shifted November away from 2006. Sun on hardware (to x86 Source:Supply Bloomberg. chain management July 2014. software leader runs into processor machines), and on software (away from Germany's SAP, which decides to compete and abandon Industryproprietary shifted licensing) away from Sun on hardware (to x86 SupplyJV; 2008 chain IP judgment management against software SAP wasleader too runslittle, into too late processor machines), and on software (away from $2,500Germany's SAP, which decides to compete and abandon $250proprietary licensing); see footnote #5 JV; 2008 IP judgment against SAP was too little, too late Sun Microsystems $2,500 I2 Technologies Inc $200$250 $2,000 I2 Technologies Inc Sun Microsystems $2,000 $150$200 $1,500 $1,500 $100$150 $1,000

$1,000 $100$50 $500

$500 $50$0 $0 1987 1990 1993 1996 1999 2002 2005 2008 1997 1999 2001 2003 2005 2007 2009 $0 $0 Source: Bloomberg. December 2009. Source: Bloomberg. January 2010. 1987 1990 1993 1996 1999 2002 2005 2008 1997 1999 2001 2003 2005 2007 2009 Source: Bloomberg. January 2010. Source: Bloomberg. January 2010.

As for computer hardware, cheaper component parts and migration to smartphones and tablets Aseventually for computer pulled hardware,down several cheaper manufacturers’ component stocks. parts and migration to smartphones and tablets eventuallyToo slow movingpulled down into portable several computers,manufacturers’ and from stocks. World's #1 computer system provider experiences Tooretail slow to enterprise moving into customers portable computers, and from decliningWorld's #1 need computer for customized system provider hardware experiences and a bruising $80retail to enterprise customers pricedeclining war, needcan't for execute customized on transition hardware to mobile and a bruising $70$80 $60price war, difficulty executing on transition to mobile Gateway 2000 $60$70 $50$60 Gateway 2000 $50$60 $50 Dell Computer $40 Corporation $40$50 Dell Computer $30$40 Corporation $30$40 $20$30 $20$30 $20 $10$20 $10 $10$0 $10$0 1994 1996 1998 2000 2002 2004 2006 1989 1992 1995 1998 2001 2004 2007 2010 2013 $0 $0 Source:1994 Bloomberg.1996 October1998 2007.2000 2002 2004 2006 Source:1989 Bloomberg.1992 1995 October1998 2013. 2001 2004 2007 2010 2013 Source: Bloomberg. October 2007. Source: Bloomberg. October 2013.

5 Sun Microsystems CEO Scott McNealy in 2011, on the conundrum of proprietary vs open-source code: "The mistake5 we made was putting it on our own hardware. If we hadn't metal-wrapped it, it would have been more Sun Microsystems CEO Scott McNealy in 2011, on the conundrum of proprietary vs open-source code: "The widely adopted. If we had put Solaris early on an Intel box, Linux never would have never happened. We would mistake we made was putting it on our own hardware. If we hadn't metal-wrapped it, it would have been more have been the operating system for all those startups." [Information Week, February 25, 2011]. widely adopted. If we had put Solaris early on an Intel box, Linux never would have never happened. We would 22have been the operating system for all those startups." [Information Week, February 25, 2011]. 22 22

Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

After the dust cleared, the steady drumbeat of substantial tech stock price declines continued over the next few years, even on stocks linked to rapidly growing wireless and video communications (each example shows the company; the date of its peak price before the decline; and the magnitude of the stock 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 War and Company of Heroes): March 2007, -100%

Fast forward to today. Some people view the Technology sector as changed, and believe that companies 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. This Technology IPO trends: firm age and valuation at IPO does suggest a maturation of tech companies going Median price/sales Median firm age in years public, perhaps a result of deeper pre-IPO financing 15x 15 capital pools which allow companies to stay private 12x 1999: 26.5 13 2000: 31.7 longer. As for valuations, nothing will probably ever 11 match the pricing of tech IPOs in 1999 and 2000 9x Median firm age when average price/sales ratios were 27x and 32x, 9 6x respectively. More recent valuations have been 7 creeping up again, however, and are roughly where 3x 5 they were before the onset of the financial crisis. Median price/sales 0x 3 There’s one area showing clear signs of rising investor 1980 1984 1988 1992 1996 2000 2004 2008 2012 risk appetite: the falling percentage of tech IPOs that Source: "Initial Public Offerings: Technology Stock IPOs". Ritter (Univ. of Florida). July 2014. are profitable at issuance. In the last couple of years, this measure has declined almost back to where it was during the dot.com era. From this perspective, there’s a lot of business risk being brought to market via companies whose profitability has not yet been established. All things considered, the business risk of today’s tech IPO may be only moderately lower than it was 15 years ago. For more on IPOs and their performance relative to a diversified basket of stocks, see page 34.

Remembrance of things past: low percentage of technology company IPOs with profits Percent of technology companies with positive net income at IPO 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Source: "Initial Public Offerings: Technology Stock IPOs". Ritter (University of Florida). July 2014.

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EyeEye on thethe Market market •J.P. J.P. MORGAN Morgan

To complete the tech sector review, we conclude with a few recent cases where there have been substantial reversals of fortune. To reiterate a theme, the fact that a certain segment of the industry is skyrocketing (e.g., the 220% growth in mobile search and display advertising since 2012) does not lift all boats. On gaming, many mobile game developers have struggled to establish the kind of brand loyalty that exists in traditional gaming (Madden NFL, World of Warcraft, Call of Duty) which keeps players coming back for more. There’s 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 can have very large impacts on the former. We conclude with BlackBerry. Innovation in handheld devices and mobile phones garners a lot of interest, but these companies can be rapidly eclipsed by competitors and changing technology. Palm, the company that pioneered personal digital assistants and first popularized the smartphone, collapsed in 2001; then Motorola could not maintain the advantage it had in 2006 with its revolutionary Razr phone; BlackBerry is just the latest casualty.

Google finally gets wise to "content farms" like Demand Big data flash storage leader's customer base too Media, and changes algorithms to avoid them concentrated (loss in pricing power); low barriers to $50 entry invite intense competition $45 $40 $40 Fusion-io, Inc. Demand Media, Inc. $35 $30 $30 $25 $20 $20 $15 $10 $10 $5 $0 $0 Jan-11 Jan-12 Jan-13 Jan-14 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Source: Bloomberg. July 2014. Source: Bloomberg. July 2014.

Buying the next big hit proves to be much harder than Pioneer of mobile advertising gets squeezed out once developing it; acquisition writeoffs, falling subscribers, the mega-platforms (Google, Facebook) compete with bloated management and lots of competition them; not every little fish gets bought $14 $25 $12 Millennial Media, Inc. Zynga Inc. $20 $10 $8 $15

$6 $10 $4 $5 $2 $0 $0 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Source: Bloomberg. July 2014. Source: Bloomberg. July 2014. Extreme revenue concentration for smaller technology Stale technology (no touch screen), operating system companies (in this case, software-defined networking) problems, worldwide outages, too much focus on corp causes problems when big customers cut back customers; mine is constantly re-booting for no reason $16 $150 $14 Cyan, Inc. $125 $12 BlackBerry Ltd. $10 $100 $8 $75 $6 $50 $4 $25 $2 $0 $0 May-13 Aug-13 Nov-13 Feb-14 May-14 1999 2001 2003 2005 2007 2009 2011 2013 Source: Bloomberg. July 2014. Source: Bloomberg. July 2014.

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Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

Materials

The Deng reforms in China and the Rao reforms in India are among the most momentous shifts in relative economic power in centuries. In both countries, capital and energy-intensive industries like iron and steel benefited from very generous government subsidies (see Appendix I). As these state-sponsored companies became more profitable, their earnings were reinvested, creating expansion of capacity and production well beyond their domestic markets’ ability to absorb. This resulted in a structural change in global export markets, and intense competition for US firms. Other secular, permanent shifts: the decline in US newspaper readership from 62 million daily (1990) to 52 million (2006), a problem for newspaper 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 which took place in 2009, the largest decline in 50 years (e.g., Alcoa, US Steel, AK Steel, Intrepid Potash all suffered sharp declines and have not yet substantially recovered).

Deng reforms in China reshape steel export market, Low margin packaging business with too much management did not reduce labor costs or increase leverage suffers from a collapse in trade during the plant productivity in time global recession $35 $25 BethlehemBethlehem SteSteelel CoCorp.rp. AnnualAnnual ChChineseinese ir ironon $30 and ststeeleel exexportsports $20 $25 jumpjump frfromom $1 $1.6B.6B to to $5.2B $20 $5.2B $15

$15 $10 $10 Smurfit-Stone Container Corp. $5 $5$5 $0$0 $0 1981 19831983 1985 1987 1989 19911991 19931993 19951995 19971997 19991999 20012001 20032003 1995 1997 1999 2001 2003 2005 2007 2009 Source:Source: Bl Bloomberg.oomberg. J Januaryanuary 2004 2004.. Source: Bloomberg. June 2010.

No statute of limitations: environmental misdeeds, even "Rare earth demand is insatiable since the entire 2-3 decades after they take place, can threaten a electronics and renewable energy industry depends on company's solvency them!!" That is, until workarounds are found $35 $80 $70 $30 $60 $25 Solutia $50 $20 Molycorp, Inc. $40 $15 $30 $10 $20 $5 $10 $0 $0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2011 2012 2013 2014 Source: Bloomberg. February 2008. Source: Bloomberg. July 2014.

An indirect internet casualty: declining newspaper Alcoa's fortunes hurt by global over-expansion of demand leads to collapse in the demand for newsprint capacity which drags down producer profits; a leveraged $20 reflection of global growth and capex $18 $45 Aluminum Company of America $16 $40 $14 $35 Similar profiles in metals/ mining due to collapse in global $12 $30 trade: US Steel, AK Steel, $10 $25 Walter Energy, Intrepid Potash, $8 $20 Century Aluminum, Thompson Abitibi-Consolidated Inc. Creek $6 $15 $4 $10 $2 $5 $0 $0 1990 1992 1994 1996 1998 2000 2002 2004 2006 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Source: Bloomberg. October 2007. Source: Bloomberg. July 2014.

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EyEyee onon ththee Marketmarket •J.P. J.P. MORGANMorgan

Telecommunications

While the period from 1999-2001 is often referred to as the dot-com bust, the telecommunications industry 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 the Telecommunications 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 allowed incumbent local carriers to compete in long distance markets). The combination of deregulation and advances in fiber optic technology resulted in the belief that a single firm could provide all of a given household’s or company’s 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 was constantly tied up in the courts since the FCC left many of the Act’s clauses open to interpretation or dispute (in particular, disputes over the FCC’s jurisdiction regarding forced co-location and other rules requiring incumbents to make room for new competitors).

A gold rush of investment followed: at the peak of the cycle, telecom capital spending was skyrocketing and industry profitability was negative. In hindsight, a buoyant IPO market and the willingness of telecom equipment sellers (Lucent, Nortel, Motorola, Alcatel and Cisco) to provide vendor financing were signs of industry weakness. In the early 2000’s, end-user demand for long-haul fiber 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 of bankruptcies (see box, below). Video streaming and other data-heavy trends that the telecom giants expected eventually appeared, several years later; however, leveraged capital structures could not wait that 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.

Private fixed investment in communications Communication industry after-tax profits Billions of 2009 USD (both axes) USD, billions $90 $30 $30 Communications $25 $80 structures $20 $70 $25 $15 $10 $60 Communications $5 $50 equipment $20 $0 -$5 $40 -$10 $30 $15 -$15 1995 1997 1999 2001 2003 1995 1996 1997 1998 1999 2000 2001 Source: Bureau of Economic Analysis. December 2003. Source: Bureau of Economic Analysis, J.P. Morgan Asset Management. 2001.

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, Rhythms Net, Telcove, XO (After FCC rulings that originally favored the new competitive local exchange carriers, an FCC ruling in 2000 on pricing methodology went against them)

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

Diversified/Other: Excite@Home

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Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

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 (in the case of Sprint, it was acquired in July 2013 by Japan’s SoftBank). Other examples of partial stock price recoveries include Qwest, US Cellular, Level 3 and Arch Wireless. Only a handful of telecom survivors look like Bell South, Alltel and SBA Communications, whose stock prices declined during the telecom crash and then rebounded substantially, reaching or surpassing prior stock price peaks.

Third largest wireless and wireline company barely Examples of recovering telecom stocks survived telecom boom-bust and a failed 2004 $36 Index = 100 at February 2000 billion merger with Nextel 250 $70

$60 200 SBA Communications $50 Bell South Sprint Communications 150 Alltel (acquired) $40 (acquired) $30 100 $20 50 $10 $0 0 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 1996 1997 1999 2001 2003 2005 2007 2009 2011 2013 Source: Bloomberg. July 2014. Source: Bloomberg. July 2013.

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

Differentiated product (unlimited minutes for low-end Not all wireless service created equal: higher frequency customers) attracts competition from proxies funded by spectrum has shorter coverage areas and weaker large wireless companies using superior 4G technology penetration strength; eventually surpassed by broadband $90 $30 $80 $25 $70 Clearwire Corporation $60 Leap Wireless International Inc. $20 $50 $15 $40 $30 $10 $20 $5 $10 $0 $0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2007 2008 2009 2010 2011 2012 2013 Source: Bloomberg. March 2014. Source: Bloomberg. July 2013. VOIP*: revolutionary idea gets old fast when Skype Iridium failure ten years prior was the template for offers basic service for free, cable companies compete satellite phone technology that did not live up to and wireless companies file patent infringement suits expectations $14 $30 *VOIP = Voice Over Internet Protocol $12 $25 TerreStar Corp. $10 Vonage Holdings Corp. $20 $8 $15 $6 $10 $4 $2 $5 $0 $0 May-06 May-08 May-10 May-12 May-14 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Bloomberg. July 2014. Source: Bloomberg. March 2013.

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EyeEye on thethe Market market •J.P. J.P. MORGAN Morgan

Utilities (power generation, transmission and distribution)

Utility catastrophic stock price declines are less frequent than in other sectors (there were no private sector utility defaults between the Great Depression and a New Hampshire utility failure in 1988). However, when they happen, they tend to be large. The largest was of course Enron, the catalyst for Sarbanes-Oxley and other regulations that followed. The distraction of Enron in a concentrated stock discussion is that accounting fraud is generally not the biggest risk for utilities. Instead, there are parallels with telecommunications: (a) deregulation led to a variety of unanticipated market outcomes and business failures, and (b) there was a poorly timed capacity glut financed with leverage. At times, mismatches between reimbursement mechanisms and changing commodity prices and electricity demand were the cause of severe declines (e.g., PG&E bankruptcy in 2001, when the state of California required the company to sell power at fixed prices regardless of its rising out-of-state electricity acquisition costs). The separation of generation from transmission in many states also took away a degree of income stability from formerly diversified utilities.

The first chart shows the increase in natural gas capacity at the end of the 1990’s. Much of it was fueled by the view that coal plant de-commissioning would accelerate, either due to voluntary decisions by utilities that owned them, or due to EPA regulations. However, when natural gas prices rose from their lows in 2001, utilities did not de-commission coal plants that quickly. Furthermore, electricity price spikes in the year 2000 led many companies to make massive additions to future natural gas capacity, financed with debt; this was a mis-read of underlying supply/demand conditions, as electricity prices soon corrected, particularly in California. The glut of unused plants and a sharp decline in electricity prices in the summer of 2001 (due to increased capacity, mild weather and weaker demand) led to sharply declining utility stock prices. The subsequent rise in natural gas input costs from 2001 to 2006 eventually pushed some companies into bankruptcy (Calpine, NRG, Mirant, NEGT) and heavily damaged others (Dynegy) when their contracts did not adjust sufficiently for rising gas input prices. Natural gas powered capacity additions Spike in California wholesale spot electricity prices Gigawatts of electricity generating capacity additions was not a reflection of a permanent supply shortage 60 Dollars per MWh $1,000 50 $900 $800 40 $700 $600 30 $500 $400 20 $300 10 $200 $100 0 $0 1990 1993 1996 1999 2002 2005 2008 2011 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Source: Energy Information Administration. 2013. Source: Western Price Survey, Energy NewsData Corporation. October 2001. US natural gas prices Dollars per MMbtu, generic front month US natural gas price $16 $14 $12 Rising prices, a problem for unhedged buyers $10 $8 $6 $4 $2 $0 2000 2001 2002 2003 2004 2005 2006 Source: Bloomberg. December 2006.

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Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

In the charts below, Calpine and Reliant are proxies for utility distress that took place as a result of the 1999-2003 capacity expansion in natural gas plants. There were other reasons for utility distress outside 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-heavy generation portfolio is in less demand since the natural gas boom and renewable energy production tax credits 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 the Financials section given its January 2007 launch of an energy trading business that created huge problems: the company had to arrange a fire sale when a pending downgrade could have required a collateral posting of $4 billion. This was not the first time that utilities suffered from outsized energy trading operations: problems earlier in the decade at Dynegy, Williams, Aquila and El Paso were similar.

Over-reliance on leverage (85%) despite a transition First leg: rising fuel input costs combined with $5bn debt from fixed price contracts to merchant pricing; at one increase from 2002 to 2003; Second leg: asset sales not point, 115% of capacity under construction completed fast enough before recession/liquidity crisis $60 $40 $35 $50 $30 $40 $25 $30 $20 $15 $20 Reliant Energy Inc. Calpine Corp. $10 $10 $5 $0 $0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Bloomberg. February 2008. Source: Bloomberg. December 2012.

Massive overseas expansion (esp. Latin America) Exelon portfolio: 55% nuclear at a time of rising nuclear backfires after 65%-75% currency declines, adverse maintenance costs, and falling prices of natural gas regulatory rulings in Brazil and falling global demand and wind-powered electricity $70 $100 $60 $90 $80 $50 $70 $40 $60 $50 $30 AES Corporation $40 Exelon $20 $30 $20 $10 $10 $0 $0 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 Source: Bloomberg. July 2014. Source: Bloomberg. July 2014.

Consequence of energy trading becoming a primary Wholesale ownership and distribution of water was an strategic focus, rather than the generation of wholesale immature market, limited ability to recapture capital power spending outlays $120 $25

$100 $20 $80 $15 Constellation Energy $60 $10 $40 Western Water $5 $20 Company

$0 $0 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 1993 1995 1997 1999 2001 2003 2005 Source: Bloomberg. March 2012. Source: Bloomberg. February 2006.

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EyeEye on thethe Market market •J.P. J.P. MORGAN Morgan

Subsector focus on alternative energy stocks

In our 2014 annual energy paper, we write about the practical certainty of the world’s eventual transition to renewable energy. This transition will be the fourth of the last few hundred years, with the first three being coal (early 1800’s), oil (early 1900’s) and natural gas (mid 1900’s). However, the journey to a renewable energy world will be long, and subject to fits and starts regarding what works and what doesn’t. The next chart is one way of visualizing the risks and opportunities for concentrated holders. It shows how the returns on two diversified clean energy indexes have usually underperformed the S&P Small Cap Index. The peaks and valleys are huge, with more valleys than peaks; new ideas often generate tremendous excitement, but only a few work out in the long run. Renewable energy stocks fall in and out of favor Rolling 1-year excess return of clean energy vs. S&P small cap 70%

50% NYSE Bloomberg AME Clean minus S&P Small 30% Cap Index

10%

-10%

-30%

-50% Wilderhill Clean Energy Index minus S&P Small Cap Index -70% 2002 2004 2006 2008 2010 2012 Source: Bloomberg. July 31, 2014.

The table below shows a few more comparisons. Clean energy stocks have struggled versus both the broad 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 when using different clean/alternative energy indices.

The underperformance of alternative energy stocks

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.

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Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

There may be no sector whose stocks have more true believers than alternative energy and related services/products. This category includes companies developing wind and solar equipment, fuel cells and biofuel processes. It also includes companies in search of superconductor materials, which would save the world enormous amounts of energy by reducing the 6%-10% of electricity that is lost on alternating current transmission lines and across other synapses. Unfortunately, while each of the ideas below 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 lack thereof), capacity factors/efficiency and the practical limits of science that can get in the way. We chose some of the better known examples below; each was seen in its day as a “magic bullet”, only to see dramatic reversals of fortune.

Wind turbine manufacturing and services Manufacturer of thin film photovoltaic solar panels, $300 provider of PV power plants/services $300 $250 Broadwind Energy, Inc. $250 $200 First Solar, Inc. $200 $150 $150

$100 $100

$50 $50

$0 $0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2007 2008 2009 2010 2011 2012 2013 2014 Source: Bloomberg. July 2014. Source: Bloomberg. July 2014.

Hydrogen fuel cells Superconductors $120 $80 American Superconductor Corporation $70 $100 Ballard Power Systems Inc. $60 $80 $50 $60 $40 $30 $40 $20 $20 $10

$0 $0 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Bloomberg. July 2014. Source: Bloomberg. July 2014.

Next generation renewable biofuels Environmentally friendly fast-food containers $20 $180 $160 KiOR Inc. $140 $15 Earthshell Corp. $120 $100 $10 $80 $60 $5 $40 $20 $0 $0 Jul-11 Jul-12 Jul-13 Jul-14 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Bloomberg. July 2014. Source: Bloomberg. August 2007.

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EyeEye on thethe Market market •J.P. J.P. MORGAN Morgan

A look at the winners (The Ecstasy)

We include an exhibit on the following page that shows the historical extreme winners. As explained earlier, we defined these winners as having generated more than a two standard deviation return over the Russell 3000 Index since their inception. There are several hundred of them in our database, which is too many to list here. Instead, we show a subset: stocks that generated the highest excess lifetime returns over the Russell 3000 Index, which are currently active (i.e., excluding inactive stocks that generated outsized returns before being acquired, merged etc.), and which have a current market capitalization over $5 billion.

This is a very heterogeneous list of companies. Some have been quite volatile; many technology companies suffered substantial declines during the tech bust, and have been on a tear since then (eBay, Qualcomm, Amazon). Some took decades to generate substantial wealth, while others accomplished it in a few short years. Some have not generated substantial returns to holders in many years, and instead experienced rapid appreciation during the 1990’s. Despite their differences, over the long haul, all of them generated substantial excess returns relative to their initial reported public stock price (excluding any pre-IPO wealth creation). Consumer Discretionary and Technology show a large number of success stories; these are the survivors, since both sectors also generated the largest number of catastrophic declines.

We prepared this list at the time this document was drafted, in the summer of 2014. If history is any guide, the drumbeat of business distress outlined on pages 3-5 will eventually ensnare some of them.

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EyeEye on on the the Market Market J.P. J.P. MORGAN MORGAN Eye on the market • J.P. Morgan

HistoricalHistorical Winner Winners lists list (see (see prior prior page page for for details); details); sector sector designations designations as peras perFactS FactSet et Consumer Discretionary Energy Industrials Amazon.com,Consumer DiscretionaryInc. CheniereEnergy Energy, Inc. CintasIndustrials Corporation Materials AutoZone,Amazon.com, Inc. Inc. CoreCheniere Laboratories Energy, NV Inc. DanaherCintas Corporation Airgas, Inc. BedAutoZone, Bath & Beyond Inc. Inc. EnergenCore LaboratoriesCorporation NV DonaldsonDanaher CorporationCompany, Inc. Ball Corporation BestBed Buy Bath Co., & Inc.Beyond Inc. EOGEnergen Resources Corporation EquifaxDonaldson Inc. Company, Inc. CF Industries Holdings, Inc. ComcastBest Buy Corporation Co., Inc. EQTEOG Corp. Resources ExpeditorsEquifax Inc.International of Washington, Inc. Ecolab Inc. DillardComcast Inc. Corporation HollyFrontierEQT Corp. Corp. FastenalExpeditors Company International of Washington FMC Corporation DishDillard Network Inc. Corp. Patterson-UTIHollyFrontier Energy, Corp. Inc. GeneseeFastenal & CompanyWyoming, Inc. Sherwin-Williams Company DollarDish Tree Network Inc. Corp. Patterson-UTI Energy, Inc. IllinoisGenesee Tool &Works Wyoming, Inc. Inc. Sigma-Aldrich Corporation FamilyDollar Dollar Tree Stores, Inc. Inc. Financials JacobsIllinois Engineering Tool Works Group Inc. Inc. Valspar Corporation FossilFamily Inc. Dollar Stores, Inc. AFLACFinancials Inc. PrecisionJacobs EngineeringCastparts Corp. Group Inc. Gap,Fossil Inc. Inc. BerkshireAFLAC Hathaway Inc. Inc. RoperPrecision Industries, Castparts Inc. Corp. Harley-Davidson,Gap, Inc. Inc. BlackRock,Berkshire Inc. Hathaway Inc. SouthwestRoper Industries, Airlines Co. Inc. Hasbro,Harley-Davidson, Inc. Inc. CharlesBlackRock, Schwab Inc. Corporation Stericycle,Southwest Inc. Airlines Co. HomeHasbro, Depot, Inc. Inc. FranklinCharles Resources, Schwab Inc. Corporation Stericycle, Inc. L BrandsHome Depot,Inc. Inc. LeucadiaFranklin National Resources, Corporation Inc. Information Technology Lowe's Companies, Inc. M&T Bank Corp. Adobe Systems Incorporated L Brands Inc. Leucadia National Corporation Information Technology McDonald's Corporation Markel Corporation Alliance Data Systems Corporation Lowe's Companies, Inc. M&T Bank Corp. Adobe Systems Incorporated Netflix, Inc. Northern Trust Corporation Altera Corporation McDonald's Corporation Markel Corporation Alliance Data Systems Corporation NIKE, Inc. Progressive Corporation Amphenol Corporation Netflix, Inc. Northern Trust Corporation Altera Corporation Nordstrom, Inc. Raymond James Financial, Inc. Analog Devices, Inc. NIKE, Inc. Progressive Corporation Amphenol Corporation O'Reilly Automotive, Inc. SEI Investments Company ANSYS, Inc. PolarisNordstrom, Industries Inc. Inc. StateRaymond Street Boston James Corporation Financial, Inc. AppleAnalog Inc. Devices, Inc. PVHO'Reilly Corp. Automotive, Inc. SVBSEI Financial Investments Group Company AppliedANSYS, Materials, Inc. Inc. RossPolaris Stores, Industries Inc. Inc. T. RoweState PriceStreet Group Boston Inc. Corporation Autodesk,Apple Inc. Inc. StarbucksPVH Corp. Corporation TDSVB Ameritrade Financial Holding Group Corp. AutomaticApplied Materials, Data Processing, Inc. Inc. TargetRoss Corp.Stores, Inc. TorchmarkT. Rowe Corporation Price Group Inc. CAAutodesk, Inc. Inc. TiffanyStarbucks & Co. Corporation W.TD R. BerkleyAmeritrade Corporation Holding Corp. CiscoAutomatic Systems, Data Inc. Processing, Inc. TimeTarget Warner Corp. Inc. Torchmark Corporation CognizantCA Inc. Technology Solutions Corp. TJXTiffany Companies, & Co. Inc. HealthW. R. Care Berkley Corporation CreeCisco Inc. Systems, Inc. TollTime Brothers, Warner Inc. Inc. Actavis PLC eBayCognizant Inc. Technology Solutions Corp. TractorTJX Companies, Supply Company Inc. AlexionHealth Pharmaceuticals, Care Inc. ElectronicCree Inc. Arts Inc. V.F.Toll Corporation Brothers, Inc. AmgenActavis Inc. PLC EMCeBay Corporation Inc. WaltTractor Disney Supply Company Company BiogenAlexion IDEC Pharmaceuticals, Inc. Inc. FactSetElectronic Research Arts SystemsInc. Inc. Williams-Sonoma,V.F. Corporation Inc. C. AmgenR. Bard, Inc.Inc. FiservEMC Inc. Corporation WynnWalt Resorts, Disney LimitedCompany CardinalBiogen Distribution, IDEC Inc. Inc. IntelFactSet Corporation Research Systems Inc. Williams-Sonoma, Inc. CatamaranC. R. Bard, Corporation Inc. IntuitFiserv Inc. Inc. ConsumerWynn Resorts, Staples Limited CelgeneCardinal Corporation Distribution, Inc. LinearIntel TechnologyCorporation Corporation Brown-Forman Corporation CernerCatamaran Corporation Corporation MasterCardIntuit Inc. Incorporated ChurchConsumer & Dwight Staples Co., Inc. DENTSPLYCelgene International Corporation Inc. MaximLinear Integrated Technology Products, Corporation Inc. CloroxBrown-Forman Company Corporation ExpressCerner Scripts Corporation Holding Company MicrochipMasterCard Technology Incorporated Inc. Colgate-PalmoliveChurch & Dwight Company Co., Inc. ForestDENTSPLY Laboratories, International Inc. Inc. MICROSMaxim Systems, Integrated Inc. Products, Inc. Constellation Brands Gilead Sciences, Inc. Microsoft Corporation Clorox Company Express Scripts Holding Company Microchip Technology Inc. Hershey Company IDEXX Laboratories, Inc. Oracle Corporation Colgate-Palmolive Company Forest Laboratories, Inc. MICROS Systems, Inc. Hormel Foods Corporation Incyte Corporation Paychex, Inc. Constellation Brands Gilead Sciences, Inc. Microsoft Corporation J. M. Smucker Company Intuitive Surgical, Inc. QUALCOMM Incorporated Hershey Company IDEXX Laboratories, Inc. Oracle Corporation Keurig Green Mountain Inc. Medivation, Inc. salesforce.com inc. Hormel Foods Corporation Incyte Corporation Paychex, Inc. Monster Beverage Corp. Medtronic, Inc. Total System Services, Inc. SyscoJ. M. Corporation Smucker Company MylanIntuitive Inc. Surgical, Inc. Xilinx,QUALCOMM Inc. Incorporated TysonKeurig Foods, Green Inc. Mountain Inc. ResMedMedivation, Inc. Inc. Yahoo!salesforce.com Inc. inc. WalgreenMonster Co. Beverage Corp. SalixMedtronic, Pharmaceuticals, Inc. Ltd. Total System Services, Inc. Wal-MartSysco Corporation Stores, Inc. St. MylanJude Medical, Inc. Inc. MaterialsXilinx, Inc. WholeTyson Foods Foods, Market, Inc. Inc. StrykerResMed Corporation Inc. Airgas,Yahoo! Inc. Inc. Walgreen Co. UnitedSalix HealthCare Pharmaceuticals, Corporation Ltd. Ball Corporation Wal-Mart Stores, Inc. UniversalSt. Jude Health Medical, Services, Inc. Inc. CF Industries Holdings, Inc. Whole Foods Market, Inc. WatersStryker Corporation Corporation Ecolab Inc. United HealthCare Corporation FMC Corporation Universal Health Services, Inc. Sherwin-Williams Company Waters Corporation Sigma-Aldrich Corporation Valspar Corporation Important Note:Note: thesethese are are not not recommendations recommendations, and, and the the company company list list is purelyis purely based based on onhistorical historical analyses analyses and and information whichwhich isis nevernever a a guarantee guarantee of of future future results results or or success. success. 33 33 33

EyeEye onon thethe Market market J.P.• J.P. MORGAN Morgan

The performance of IPOs vs. the broad market

While results obviously vary by stock, there are some observations one can make regarding the aggregate performance of IPOs after they are issued. Using over 7,000 IPOs since 1980, one can evaluate post-IPO performance (i.e., after the first day’s close) for 3 years and compare it to the broad market, and also to a group of stocks with similar market cap and book-to-market ratios. The charts below show the results based on the year of the IPO. There are obviously large differences between individual stocks, but overall, the results do not point to consistently outsized post-IPO performance when compared to diversified equity market alternatives.

Post-IPO returns vs. the market Post-IPO returns vs. similar style firms Average 3-year buy and hold IPO return vs. the market Average 3-year buy and hold IPO return vs. the similar style firms 40% 40%

20% 20%

0% 0%

-20% -20%

-40% -40%

-60% -60% 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: "Initial Public Offerings: Updated Statistics on Long-run Performance". Ritter (Univ. of Florida). April 2014. Note: Returns for stocks within 3 years of IPO are through 12/31/2013. Ritter defines the broad market using an index from the Chicago Booth School (Center for Research in Security Prices) which incorporates all stocks on the Amex, Nasdaq and NYSE exchanges. A closer look at the results shows that small firm IPOs tend to perform worse than larger ones, with the cutoff for “small” being $50 million in sales (in 2011 dollars). This is particularly true in technology and biotech IPOs.

On being an insider, and other issues related to concentrated ownership Concentrated holders have some important decisions to make: the situs where the stock is held, and the entity in which the stock is held (for example, a grantor or non-grantor trust). There are also choices between lifetime gifting and a step-up in basis at death that impact family wealth differently. Non-insider holders seeking to reduce exposure may want to explore options-based strategies as alternatives to outright selling. When the latter course is chosen, there are a range of decisions that holders should be familiar with (exchange funds, issues related to charitable giving to family foundations, and how to structure a selling program in terms of volume, order type and primary/secondary offerings).

There are often restrictions on insiders selling their positions; however, there are means by which insiders can reduce exposure over time. For example, rule 10b5-1 allows for carefully planned trading programs that may protect the insider from a claim of having made an investment decision while in possession of material inside information. Such a program, once established, allows trades to be made at any time, thereby freeing insiders from the prohibitions on trading during “closed window periods” that normally apply. When executed properly, they have the potential to mitigate signaling issues generally associated with sales by insiders.

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What about taxes?

It usually does not make sense to let the tax tail wag the dog; in other words, good and bad investment ideas rarely distinguish themselves based on taxes. In the case of concentrated stock positions, this is usually (but not always true): taxes need to be considered given the treatment of low- basis stock upon death (it receives a step-up in basis). As a result, older owners of concentrated stock interested in reducing exposure have to take into account the potential tax freight involved with diversification. There are a lot of scenarios one can assume; based on our findings, in most of them, taxes do not have a large impact on the outcome.

Let’s assume the following. A concentrated holder wants to reduce exposure, has a basis that is 20% of the current stock price, and has no unrealized losses available to mitigate the gain. Including taxes related to the Affordable Care Act (Medicare surtax), the total Federal long-term capital gains rate would be 23.8%. The owner wants to maintain exposure to equity markets, just not in concentrated form, and intends to invest the sales proceeds in the Russell 3000 Index. To maximize the amount in the diversified portfolio, the owner sells the stock, invests in the Russell 3000 and borrows the proceeds to pay taxes due at an interest rate of 4%. The loan is repaid at the end of the holding period.

The grid below shows two variables that affect the outcome: how the stock performs relative to the Russell 3000 Index after the sale, and the time horizon, which reflects how long the owner would have held the stock otherwise (until a step-up in basis at death). As shown, the primary driver is how well the stock performs vs. the market. If the stock outperforms, then with 20-20 hindsight, selling is negative. On the other hand, if the stock underperforms the market after the sale, there would almost always be a benefit to selling. Only in a small number of cases (shown in red) would the impact of taxation on its own negate the benefits of selling, if in fact the stock underperforms the market. As a result, for most concentrated holders (excluding those at a very advanced age), we do not believe that the tax issue should drive the diversification discussion.

Annualized gain (loss) from disposition of concentrated stock and purchase of Russell 3000 Index Holding period until step-up in basis (years) 3 6 9 12 15 18 21 24 -15.0% -21.5% -17.9% -16.7% -16.2% -15.8% -15.6% -15.5% -15.4% -12.5% -19.0% -15.4% -14.2% -13.7% -13.3% -13.1% -13.0% -12.9% -10.0% -16.5% -12.9% -11.7% -11.2% -10.8% -10.6% -10.5% -10.4% -7.5% -14.0% -10.4% -9.2% -8.7% -8.3% -8.1% -8.0% -7.9% -5.0% -11.5% -7.9% -6.7% -6.2% -5.8% -5.6% -5.5% -5.4% -2.5% -9.0% -5.4% -4.2% -3.7% -3.3% -3.1% -3.0% -2.9% 0.0% -6.5% -2.9% -1.7% -1.2% -0.8% -0.6% -0.5% -0.4% 2.5% -4.0% -0.4% 0.8% 1.3% 1.7% 1.9% 2.0% 2.1%

return of Russell 3000 Index 5.0% -1.5% 2.1% 3.3% 3.8% 4.2% 4.4% 4.5% 4.6% 7.5% 1.0% 4.6% 5.8% 6.3% 6.7% 6.9% 7.0% 7.1% 10.0% 3.5% 7.1% 8.3% 8.8% 9.2% 9.4% 9.5% 9.6% over concentrated stock position concentrated over 12.5% 6.0% 9.6% 10.8% 11.3% 11.7% 11.9% 12.0% 12.1%

Excess annual 15.0% 8.5% 12.1% 13.3% 13.8% 14.2% 14.4% 14.5% 14.6% Note: assuming an annualized return on the Russell 3000 Index of 8%

The number of shaded red cells in the table above would not change much if we were to assume a lower annual return on the Russell 3000 Index; the inclusion of state capital gains taxes; or the absence of a loan (i.e., paying the tax on capital gains when due). Finally, there are strategies which involve diversification via charitable giving, derivatives and other security arrangements which do not entail the current recognition of taxable gains.

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Some final thoughts on managing concentrated stock positions

Great fortunes have been created by visionaries who seized a unique opportunity and work single- mindedly to realize their ambition. Concentration is an effective engine of wealth creation: it helped drive the success of all 10 of the top 10 on the Forbes magazine list of world billionaires in 2014. In the US, the top 10 of the “Forbes 400” also made their fortunes through concentration.

As difficult as it is to build a company and amass wealth, it is just as difficult to keep fortunes aloft. Our analysis (and others before it) demonstrates the hard reality that, all too often, continued concentration may ultimately destroy wealth. Since the early 1980’s, 40% of all companies experienced a severe loss and never recovered, with higher loss rates in Technology, Biotech and Consumer Discretionary. As this study lays out, no matter how well you know your industry and your company, no one is impervious to event risk and industry changes. The factors outside management control shown on page 11 are a formidable list, and have grown in complexity since we first drafted this report 10 years ago. This is perhaps the most important epiphany we gained from the study: that exogenous forces may overwhelm the things we can control.

Despite this, often the natural impulse is to leave well enough alone. After all, if concentration’s rewards have been so enormous, why not stay concentrated? Some may be concerned that “diversification” translates directly into “selling the business.” It does not. While you could sell all or part of your business, you might also consider taking some capital out of your business or use leverage to create a complementary portfolio. In doing so, a concentrated owner can take out some insurance against the unknown.

The process of addressing concentration starts with some personal choices about risk and the fate of future generations. While no plan is ever perfect, taking no action may be worse. The first step in the journey is to look at the overarching question of what you want to achieve in the long run, now that the wealth has been created. If you want your fortune to be enjoyed by your family for generations, you will need to create a plan that encourages guided consumption, as well as wealth preservation. A charitable legacy requires substantial planning as well.

While each business and owner is unique, certain patterns and truths are universal. During the 170 years J.P. Morgan has been advising wealthy families around the world, we have had the privilege of assisting business owners in every phase of their operations and through all market conditions. At whatever stage you may be in the shift from wealth generation to wealth preservation, and whatever your hopes for your business, fortune and family, it would be our privilege to share the benefit of our experience with you.

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Eye on the Market  J.P. MORGAN Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan

Appendix I: Chinese government subsidies Appendix I: Chinese government subsidies G overnment subsidies are often an under-appreciated contributor to the challenges that businesses can Gface.overnment Sometimes, subsidies an industry are often leader an under in the-appreciated OECD ends contributor up facing stiff to thecompetition challenges from that government businesses - face. Sometimes, an industry leader in the OECD ends up facing stiff competition from government6 - supported firms in other countries. Here’s a look at the impact of Chinese subsidies6: supported firms in other countries. Here’s a look at the impact of Chinese subsidies : • At most Chinese solar, steel, glass, paper and auto parts companies, labor costs only make up 2% • Atto 7%most of Chinese total production solar, steel, costs. glass, Nevertheless, paper and auto intense parts c ompetitioncompanies, fromlabor China costs onlyoften make comes up from 2% smallto 7% Chinese of total firms production with limited costs. economies Nevertheless, of scale, intense and c ompetitionwhose products from sellChina in theoften international comes from smallmarket Chinese at 25% firms to 30% in these discounts sectors to with world limited prices. economies of scale, and whose products sell in • internationalHow can this marketbe explaineds at 25%? In to all 30% likelihood, discounts by subsidiesto world prices.received from the Chinese government. • How can this be explained? In all likelihood, by Subsidies take the form of free or low-cost loans; artificiallyGovernment cheap subsidies raw materials, to Chinese com firms,ponents, 1985-2005 energysubsidies or receivedland; support from thefor R&DChinese; and a heavily managedAnnual, (i.e., $ bn cheap) exchange rate. Land grantsCumulative, $ bn forgovernment office or .factory Subsidies construction take the formare particularly of free or valuable,$25 since companies can develop excess $350 parcelslow-cost and loans use; artificiallythe proceeds cheap to rawpay formaterials, R&D. As per a June 2013 article in The Wall Street Journal $300 components, energy or land; support for R&D; $20 Chinese government subsidies grew 23% y/y in 2012 (following on 24% y/y growth in 2011), $250 and a heavily managed (i.e., cheap) exchange benefiting 90% of all listed Chinese companies. $15 $200 • rate. Land grants for office or factory Example: in 2000, China was a net importer of steel. By 2007, China became the world’s largest $150 steelconstruction producer, are c onsumer,particularly and valuable, exporter. since Energy subsidies$10 to Chinese steel manufacturers were $27 companies can develop excess parcels and use $100 billion from 2000-2007. Even though its fragmented$5 steel industry has limited economies of scale andthe proceedsnot much to of pay a technological for R&D. The edge, bar chart Chinese steel sells for 25% less than US and European steel. $50 shows estimates of these subsidies through • A similar outcome is seen in the Chinese paper industry,$0 which received $33 billion in subsidies $0 2005 from the China Statistical Yearbook; the from 2002 to 2009. As solar PV, the 5 largest Chinese1985 companies1989 received1993 the equivalent1997 2001 of $31 2005 series was discontinued in 2006. Source: “Subsidies to Chinese Industry”, Usha Haley and George Haley, billion in low-interest loans from the state-owned ChinaOxford UniversityDevelopment Press, April Bank 2013., and other subsidies • fromAnother national data providerand provincial estimates government Chinese s. These amounts dwarf the amounts provided by the US government tosubsidies its solar to companies. public companies, and according to their findings, these subsidies are still growing rapidly. As per a June 2013 article in The Wall Street Journal citing this source, Chinese government subsidies grew 23% y/y in 2012 (following on 24% y/y growth in 2011), benefiting Estimated government subsidies to Chinese firms Annual,90% $of bn all listed Chinese companies. Cumulative, $ bn •$25 Example: in 2000, China was a net importer of steel.$350 By 2007, China became the world’s largest steel producer, consumer, and exporter. Energy subsidies to Chinese steel manufacturers were $27 $300 $20 billion from 2000-2007. Even though its fragmented steel industry has limited economies of scale and not much of a technological edge, Chinese steel$250 sells for 25% less than US and European steel. •$15 A similar outcome is seen in the Chinese paper industry,$200 which received $33 billion in subsidies from 2002 to 2009. As solar PV, the 5 largest Chinese$150 companies received the equivalent of $31 $10 billion in low-interest loans from the state-owned China Development Bank, and other subsidies $100 $5from national and provincial governments. These amounts dwarf the amounts provided by the US government to its solar companies. $50

China$0 is not the only country that provides subsidies to domestic$0 industry; the US does as well 1985 1989 1993 1997 2001 2005 (particularlySource: “Subsidies to its to Chineseauto industry) Industry”, ,Usha and Haley the andentire George OECD Haley, engages in substantial subsidies for agricultural 7 firmsOxford. University But in Press,our view, April 2013. the China case has no equal in terms of scope, breadth and impact.

AnotherChina is notaspect the ofonly the country China competitivethat provides story: subsidies copyright to domestic and IP industry; infringement the US. doesAccording as well to a 2011 report(particularly from theto its United auto industry)States International, and the entire Trade OECD Commission, engages USin substantial IP-intensive subsidies firms conducting for agricultural firmsbusiness7. But in China in our in view, 2009 the reported China lossescase has of $48.2 no equal billion in in terms lost global of scope, sales, breadth royalties andand impactlicense .fees due to intellectual property right infringement in China. Another aspect of the China competitive story: copyright and IP infringement. According to a 2011 report from the United States International Trade Commission, US IP-intensive firms conducting business in China in 2009 reported losses of $48.2 billion in lost global sales, royalties and license fees due to intellectual property right infringement in China.

6 6 From “How Chinese Subsidies Changed the World”, Usha Haley (West Virginia University) and George T. Haley, Harvard From “ HowBusiness Chinese Review, Subsidies April 2013 Changed. the World”, Usha Haley (West Virginia University) and George T. Haley,

7Harvard Business Review, April 2013.

7 According to an article in The Economist in September 2012, countries like Norway, Switzerland, Japan and South According Korea to provide an article subsidies in The to Economist their agricultural in September sectors 2012, equal countries to 45% -like 60% Norway, of gross Switzerland, farm receipts. Japan The and EU registersSouth Ko atrea 20% provide and subsidiesthe US at to 8%. their agricultural sectors equal to 45% - 60% of gross farm receipts. The EU registers at 20% and the US at 8%. 37 37 37

EyEyee on thethe Marketmarket •J.P. J.P. MORGAN Morgan

Appendix II: Biotech and Life Sciences

As mentioned in the Health Care section on page 19, while 2000-2001 was the peak distress period for biotech and life science companies, there has been a steady drumbeat since, with over 100 biotech and life science catastrophic loss events since 2002 (see bar chart). We referenced earlier research showing that even when a drug finally gets to Phase 3 trials, the probability of failure can still be as high as 50%. One possible emerging challenge for the biotech industry: patent trolls. For funding and other reasons, some universities are under pressure to monetize their patents by transferring rights to “assertion entities”. As per a 2014 paper from the University of California Hastings College of Law, as these patent sales take place, the risk to biotech and pharmaceutical companies with existing products on the market increases dramatically. Such patents can cover active ingredients of drugs, methods of treatment, screening methods to identify new drugs, manufacturing methods and dosage forms.

In the table, we show some of the more recent catastrophic losses (companies reaching the 70% decline threshold in 2012 or 2013). Biotech companies can experience periods of depressed stock prices as trials fail or have to be rerun, with some surging when/if success eventually occurs, or when they are bought by larger companies. As a result, the table below captures catastrophic loss at a point in time (Spring 2014), and does not represent a final assessment of each firm’s future prospects.

Health Care companies that reached the 70% loss threshold A Partial List of Russell 3000 Index Biotech and Life in a given year, 1980-2014, Number of stocks Science Companies reaching catastrophic loss thresholds 60 in 2012 and 2013 Pharmaceuticals Company Product / Treatment Disease / Condition 50 Life Sciences Tools & Services Health Care Equipment & Supplies Affymax Omontys Chronic kidney disease 40 Biotechnology Anthera Varesplaib, Blisibimod Heart disease, Lupus AVEO Tivozanib Kidney cancer 30 BG Medicine Galectin-3 Test Heart failure 20 Coronado TSO Crohn's disease Cytori Athena Coronary heart disease 10 Dynavax Heplisav Hepatitis B Infinity IPI-145 Blood cancer 0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Myrexis Azixa Brain cancer Source: JPMAM, FactSet. February 2014. Source: FactSet, J.P. Morgan Asset Management.

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Sources

Ailawadi K, Zhang J, Krishna A, and Kruger M, "When Walmart Enters: How Incumbent Retailers React and How This Affects Their Sales Outcomes," Journal of Marketing Research, June 2009.

“Agricultural subsidies”, The Economist, September 22, 2012.

“Boom and Bust in Telecommunications”, Couper, Hejkal and Wolman, Federal Reserve Bank of Richmond, 2003.

“Chinese Industrial Subsidies Grow 23%”, Wall Street Journal, June 23, 2013.

“Generic Drug Savings in the US”, Generic Pharmaceutical Association, 2013 Report

“The Growth of Chinese Exports: An Examination of the Detailed Trade Data”, Board of Governors of the Federal Reserve System International Finance Discussion Papers, November 2011, Berger and Martin

“How Loyal Are Your Customers? A View of Loyalty Sentiment Around the World”, The Nielsen Company, November 2013.

“The Impact of the Internet on Advertising Markets for News Media”, Athey, Calvano and Gans, University of Toronto and NBER, 2013.

“Patent Trolling: Why Bio and Pharmaceuticals are at Risk”, Feldman (University of California Hastings College of Law) and Price (Petrie-Flom Center for Health Law Policy at Harvard Law School), February 2014

Pisano, G. Science Business: The Promise, the Reality, and the Future of Biotech, Harvard Business School Press, Cambridge, MA; 2006.

United States International Trade Commission, Investigation No. 332-519, “China: Effects of Intellectual Property Infringement and Indigenous Innovation Policies on the US Economy”, May 2011.

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EyEyee onon thethe Marketmarket •J.P. J.P. MORGAN Morgan

Acronyms BEA: Bureau of Economic Analysis CLEC: Competitive local exchange carrier CLTV: Combined Loan to Value CRSP: Center for Research in Security Prices DTI: Debt-To-Income; E&P: Exploration and Production EIA: Energy Information Administration EPA: Environmental Protection Agency FCC: Federal Communications Commission FDA: Food and Drug Administration FDIC: Federal Deposit Insurance Corporation FHA: Federal Housing Administration GAO: Government Accountability Office GDP: Gross Domestic Product GICS: Global Industry Classification Standard GSE: Government-Sponsored Enterprise HUD: US Department of Housing and Urban Development IP: Intellectual Property IPO: Initial Public Offering JPMAM: J.P. Morgan Asset Management LCD: Liquid Crystal Display MMbtu: Million British Thermal Units MWh: Megawatt-hour OECD: Organisation for Economic Co-operation and Development OPEC: Organization of the Petroleum Exporting Countries PV: Photovoltaic R&D: Research and Development REIT: Real Estate Investment Trust S&P: Standard & Poor’s SEC: Securities and Exchange Commission

40 40 Eye on the market • J.P. Morgan

Michael Cembalest is Chairman of Market and Investment Strategy for J.P. Morgan Asset Management, a global leader in investment management and private banking with $1.6 trillion of client assets under management worldwide (as of December 31, 2013). He is responsible for leading the strategic market and investment insights across the firm’s Institutional, Funds and Private Banking businesses.

Mr. Cembalest is also a member of the J.P. Morgan Asset Management Investment Committee and a member of the Investment Committee for the J.P. Morgan Retirement Plan for the firm’s more than 250,000 employees.

Mr. Cembalest was most recently Chief Investment Officer for the firm’s Global Private Bank, a role he held for eight years. He was previously head of a fixed income division of Investment Management, with responsibility for high grade, high yield, emerging markets and municipal bonds.

Before joining Asset Management, Mr. Cembalest served as head strategist for Emerging Markets Fixed Income at J.P. Morgan Securities. Mr. Cembalest joined J.P. Morgan in 1987 as a member of the firm’s Corporate Finance division.

Mr. Cembalest earned an M.A. from the Columbia School of International and Public Affairs in 1986 and a B.A. from Tufts University in 1984.

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EyEyee on thethe Marketmarket •J.P. J.P. MORGAN Morgan

JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties. Each recipient of this material, and each agent thereof, may disclose to any person, without limitation, the US income and franchise tax treatment and tax structure of the transactions described herein and may disclose all materials of any kind (including opinions or other tax analyses) provided to each recipient insofar as the materials relate to a US income or franchise tax strategy provided to such recipient by JPMorgan Chase & Co. and its subsidiaries.

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