Beyond the usual suspects: Diversified sources of income

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1 J.P. Morgan Asset Management Research Summit 2011 Passport to opportunity Beyond the usual suspects: Diversified sources of income Mariana Connolly, CFA Client Portfolio Manager, U.S. Equity Group Anne Lester Senior Portfolio Manager, Global Multi-Asset Group Gerd Woort-Menker Portfolio Manager, Global Equities Team Strategies focused on income generation have been attracting a growing amount of investor attention. On the equity front, among the 30 large cap value funds experiencing the fastest inflows in 2010, half are focused on dividend-paying stocks. 1 A recent McKinsey study 2 finds the equity income niche to be among the strategies most ripe for growth. However, the interest among investors extends beyond equity and across asset classes. The good news is, we believe attractive incomegenerating investment opportunities can currently be found across industries, geographies and asset classes to meet these investor demands. 1 Morningstar, 2010 inflows. 2 McKinsey & Company, Winning the Defined Contribution Market of 2015: New Realities Reshape the Competitive Landscape, September FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY NOT FOR PUBLIC DISTRIBUTION

2 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 02 Key presentation takeaways Over the long term, dividends drive returns. Historically, dividends have accounted for a sizable proportion of total market returns. Don t just look for the highest yielding stocks. Look for high yielding stocks supported by strong and sustainable cash flows. These tend to perform well across economic cycles. Diversify across industries and geographies (stocks of some European countries have considerably higher dividend growth rates and yields than those in the U.S.). Taking a holistic, multi-asset class approach to building an incomeoriented portfolio can improve portfolio efficiency generating a targeted level of yield with less risk. What s the attraction? Why all the interest in these strategies? Institutions that have pared back equity allocations to lower their market beta risk are beginning to view income-generating strategies as a more conservative equity allocation. Baby boomers are also part of the story; approaching the end of their working years they are looking for incomeproducing investments but will also need growth opportunities to see them through several decades of retirement. In short, individuals and institutions alike are finding income-oriented strategies attractive, not just for their steady income streams, but also for their potential to generate above average returns with below average risk. The fact is, the characteristics we look for in identifying income producing stocks durable franchises, fortress balance sheets, steady earnings, sustainable business models and, critically, disciplined and effective use of capital are the same factors that can help in identifying stocks with the consistent performance many investors desire, even those not focused on income generation. Indeed, evidence suggests that dividend paying stocks outperform non-dividend payers over the long term (Exhibit 1). What s more, dividends drive total returns, so it follows that understanding what drives dividends is critical in evaluating dividendpaying stocks. Consider the dividend discount model in which a stock s fair value is derived by discounting a stream of projected dividends. While the 80 s and 90 s, when capital appreciation dwarfed dividends, may suggest otherwise, over the long term (1926 through 2009) dividends have actually accounted for a major proportion (43%) of total returns for the S&P EXHIBIT 1 Dividend paying stocks within the S&P 500 have outperformed non-dividend paying stocks by a large margin Equal-weighted geometric average of total returns for S&P 500 stocks, by dividend policy [1/31/72-12/31/10] 9.6% 7.4% 1.7% Source: Ned Davis Research, Inc. Data as of 12/31/ Dividend growers and initiators Dividend payers with no changes in dividend Dividend cutters or eliminators Non-dividend paying stocks 3 Standard & Poor s, FactSet, Ibbotson/Morningstar, J.P. Morgan Asset Management.

3 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 03 Rules of engagement In addition to focusing on stocks with the above fundamental characteristics, there are several important considerations to bear in mind when constructing income-producing portfolios: Buying the highest yielding stock is not a returnmaximizing strategy. The highest yielding stock may not prove to be the best performer. Its high yield may be the result of a depressed price or an overly generous and unsustainable dividend payout rate. It is the combination of a high dividend yield along with high dividend growth that can lead to strong performance. For example, an analysis of high yielding stocks within the MSCI ACWI equity index found that USD 1,000 invested in 1988 in stocks with a high dividend yield and a high dividend growth rate would have increased 16-fold by the end of 2009, while high yielding stocks not supported by high dividend growth would have increased only nine-fold over the same period. 4 Another important indicator of sustainable high dividends is free cash flow (operating cash flow less capital expenditures) the cash flow from which dividends are paid. Historically, among stocks with high yields, those with strong free cash flow have tended to outperform across market cycles. (See Exhibit 2). Diversification is key. As with portfolios generally, diversifying income-oriented portfolios can help improve risk management, enhance portfolio efficiency and support a more stable flow of income through various economic cycles. In the developed, we are seeing attractive cash flow yields across equity. As Exhibit 3: By country illustrates, current nominal free cash flow yields are above their historical (1986 through early January 2011) averages. In fact, in some European countries, stocks currently offer an attractive income-generating alternative to government bonds in terms of yield. In France, for example, current dividend yield for the CAC-40 is estimated at 4.2%, versus 3.6% for 10-year government bonds. 5 EXHIBIT 2 Among stocks that boast high dividend yields, those with strong free cash flow outperform those with low free cash flow Monthly excess returns of dividend and cashflow investing since 1987 [developed world, excluding U.S.] 1.08% 0.68% 1.28% 0.7 Top quintiles of dividend yield and free cash flow yield Top quintile of dividend yield and all other lower cash flow yields 0.32% During recessions 12-months following a recession All other periods Additionally, we are finding opportunities across a broad spectrum of industries, not just in the traditional dividendpaying utilities and telecom sectors, but also in industrials, retail and even technology stocks, where companies are generating current free cash flow yields above historical norms (Exhibit 3: By sector). Of course, these broad current and historical country and industry averages suggest fertile grounds for income-seeking investors, but identifying those specific stocks with sustainable yields requires extensive, bottom-up fundamental analysis % Source: Empirical Research Partners Analysis, as of 12/31/09. Developed world (ex-u.s.) average monthly USD-hedged relative returns to stocks in the top quintile of dividend yield sorted by quintile of free cash flow yield, 1987 through July Ranked across the universe. Equally-weighted returns relative to the universe. 4 Merrill Lynch Global Quantitative Strategy, MSCI, Worldscope, as of 12/31/09. MSCI ACWI is the MSCI All Country World Index, equal weighted. 5 Bloomberg. Data as of 5/5/11.

4 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 04 EXHIBIT 3 Free cash flow yields in the developed world are attractive By country: Developed Nominal free cash flow yield by region* Historical range, December 2009 and current level 1986 through early-january 2011 By sector: Developed [excludes U.S.] Nominal free cash flow yield by sector Historical range, average and current level 1986 through early-january % 6% 4% 2% 15% 1 5% -2% -4% -5% -6% -8% Developed U.K. Continental Europe Japan Asia [excl. Japan] U.S. -1 Consumer Industrial durables commodities Capital goods Technology Health care Retail & other consumer cyclicals Consumer staples Energy Telecom CYCLICALS GROWTH-ORIENTED OTHER Range Dec.2009 Current level Range Average Current level *Capitalization-weighted data, excluding financials. Source: Empirical Research Partners analysis from International Portfolio Strategy January Building multi-asset class income-oriented portfolios We believe that searching for income-generating opportunities, not just by industry and country within equity or within debt, but across asset classes, can further enhance the risk/return trade-off of income-oriented portfolios. From our perspective, investors often take too narrow a view in constructing these multi-asset class portfolios. Often, the universe of opportunities is confined to U.S. equity and U.S. fixed income and then, a few securities are selected from each category. In our view, the opportunity set should be much more broadly defined, incorporating asset classes from cash and developed market core fixed income (at the lower end of the risk/ return spectrum) to high yield fixed income and U.S. (somewhere in the middle) to emerging market (at the high risk/high return end). Determining portfolio composition should then involve a more dynamic asset allocation approach, choosing, not one from column A and one from column B, but rather assessing the most risk/yield efficient portfolio composition regardless of where the components lie in terms of asset class or market. Constructing a portfolio using a broader opportunity set can help to push the efficient frontier up and to the left (as illustrated theoretically in Exhibit 4). This expanded universe allows for the construction of portfolios that are capable of generating strong risk-adjusted yield. A holistic, multi-asset class approach gives an active manager the freedom to take advantage of market opportunities which may go unrecognized in a single asset class strategy. The rare circumstance previously mentioned, in which within a specific country are yielding more than that government s bonds is a perfect example.

5 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 05 EXHIBIT 4 Diversification can decrease risk for a targeted level of yield YIELD Global yields U.S. only yields Target RISK Non-diversified portfolio Source: J.P. Morgan Asset Management. For illustrative purposes only. Exhibit 5 shows estimated current yields and historical return ranges for three-month rolling returns (as an indicator of risk) across asset classes. The analysis suggests additional opportunities which can come to light under a multi-asset class approach. For example, on the left side (lower volatility), we see why our current allocations are tilted toward high yield (a position we are watching carefully for further spread tightening). Here, in comparison to EM fixed income, U.S. high yield bonds have roughly the same 3-month return range, but an additional 1.5% in current yield. These specific risk versus yield measures are only one example of the type of analysis used in building portfolios to maximize risk/yield tradeoffs; there are clearly others. The point is, when building diversified, multi-asset class portfolios careful consideration must be given to the role that each asset class plays in the portfolio and the price (in terms of risk) you are willing to pay for yields across, sectors and asset classes. EXHIBIT 5 A broad, multi-asset class perspective can highlight yield opportunities J.P. Morgan estimated current yields and three-month return ranges for the 10-year period ending March 31, month % return range % 8% 6.1% 6.2% 5.7% 6% 4.6% 4.8% 4% 3.4% 2% -2% -4% -6% -8% J.P. Morgan estimated current yield -8 Core fixed income TIPS Emerging fixed income High yield U.S. large cap Int l developed Global Commodities U.S. REITs Emerging small cap -1 Source: FactSet, J.P. Morgan Asset Management. For illustrative purposes only. The performance quoted is past performance and is not a guarantee of future results. Note: Data as of 3/31/11. Asset class 3-month return ranges are representative of market indexes for the 10-year period ending 3/31/11. Indexes are, from right to left: MSCI EM, MSCI U.S. REIT, Russell 2000, S&P GSCI, MSCI World, MSCI EAFE, S&P 500, Barclay s Capital U.S. Corporate High Yield 2% Issuer Capped, J.P. Morgan Emerging Market Bond Global, Barclays Capital U.S. Treasury Inflation-Protected (TIPS) and Barclays Capital U.S. Aggregate Indexes.

6 RESEARCH SUMMIT 2011 PASSPORT TO OPPORTUNITY :: 06 Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Indices do not include fees or operating expenses and are not available for actual investment. The information contained herein employs proprietary projections of expected returns as well as estimates of their future volatility. The relative relationships and forecasts contained herein are based upon proprietary research and are developed through analysis of historical data and capital theory. These estimates have certain inherent limitations, and unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees or other costs. References to future net returns are not promises or even estimates of actual returns a client portfolio may achieve. The forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Bonds are subject to interest rate risks. Bond prices generally fall when interest rates rise. Securities rated below investment grade are called high-yield bonds, noninvestment-grade bonds, below investment-grade bonds or junk bonds. They generally are rated in the fifth or lower rating categories of Standard & Poor s and Moody s Investors Service. Although these securities tend to provide higher yields than higher rated securities, there is a greater risk that the investment will decline. The price of equity securities may rise, or fall because of changes in the broad market or changes in a company s financial condition, sometimes rapidly or unpredictably. Equity securities are subject to stock market risk meaning that stock prices in general may decline over short or extended periods of time. International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas may not be as politically and economically stable as the United States and other nations. Investments in emerging can be more volatile. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited which is regulated by the Financial Services Authority; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l., Issued in Switzerland by J.P. Morgan (Suisse) SA, which is regulated by the Swiss Financial Market Supervisory Authority FINMA; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited, all of which are regulated by the Securities and Futures Commission; in Singapore by JPMorgan Asset Management (Singapore) Limited which is regulated by the Monetary Authority of Singapore; in Japan by JPMorgan Securities Japan Limited which is regulated by the Financial Services Agency, in Australia by JPMorgan Asset Management (Australia) Limited which is regulated by the Australian Securities and Investments Commission and in the United States by J.P. Morgan Investment Management Inc. which is regulated by the Securities and Exchange Commission. Accordingly this document should not be circulated or presented to persons other than to professional, institutional or wholesale investors as defined in the relevant local regulations. The value of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. 270 Park Avenue, New York, NY JPMorgan Chase & Co. INST-RS-DIV INC-GLOBAL