DJIA Price Return (January 1,1900-September 30, 2010)

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1 Strategy Insights First Quarter 2011 At Hawthorn, we believe the tax efficient growth of capital can best be achieved through a valuation-based, risk-aware diversified investment approach. A Golden Decade for the Golden Boomers The Baby Boom generation consists of those born from 1946 to In the United States there are roughly 78 million Baby Boomers, who began turning 65 on January 1, At a rate of 1 person every 8 seconds, 10,000 a day, or 4 million a year, Baby Boomers are entering their Golden Years life after retirement. According to the Congressional Budget Office, the post-wwii Baby Boom generation controls more than 50% of personal financial assets in the United States. Any effort to clearly understand this giant generation would be well served by focusing on a few similarities between the members rather than their myriad differences. Similarly, ensuring that the Boomers, as well as all investors, embark on a Golden Decade of investing will require an appreciation for a few key tenets of successful investing. In this quarter s edition of Strategy Insights, we ll begin to explore these tenets, focusing on the importance of valuation. In future editions, we plan to discuss additional investment pillars, such as portfolio integration, diversification, and tax-aware strategies, which are each critical to building profitable long-term portfolios. Chart 1 depicts Dow Jones Industrial Average SM price return since The four great secular market cycles that have occurred during the lifetime of the oldest Baby Boomers began in Two bull markets and two periods of sideways consolidation have taken place during a period defined by four wars, a man walking on the moon, runaway inflation, and incredible technological innovation. Chart 1 DJIA Price Return (January 1,1900-September 30, 2010) 10, /30/10 3,000 John S. Traynor Managing Director, Director of Investment Strategy & Alternative Investments john.traynor@hawthorn.pnc.com 1, Martyn S. Babitz, JD Senior Vice President, Senior Wealth Strategist martyn.babitz@hawthorn.pnc.com 10 Data shown in log scale to best illustrate long-term index patterns. Source: Bloomberg L.P. hawthorn.pnc.com

2 Stock prices over the entire period were driven by rising earnings and changing valuation levels. Each bull market began with low valuation levels _ a priceearnings ratio (P/E) below 10 times _ and ended at much higher levels (a P/E above 22 times). Each consolidation phase began with high P/E levels, which declined over time. That being said, it is important to remember that in either cycle, bull or consolidation, earnings increased. The primary determinant of market return was the change in valuation level. In each cycle, there were opportunities to generate positive returns in individual securities, but it was certainly much easier to profit when rising valuation levels lifted the majority of stock prices during the bull-market phase. For Boomers hoping to embark on a Golden Decade of investing within the current consolidation phase, we believe a careful analysis of appropriate valuation levels must be paired with an understanding of the drivers of earnings growth for any potential stock investment. Just as market valuation levels are important to earning good returns, understanding the valuation level for individual companies is also critical to successful investing. Investors have learned that a great company purchased at a high P/E level is not always a great investment. Overpaying for even the best asset can weigh on portfolio returns for future portfolio returns. When a Great Asset Is Also a Great Investment We believe strongly in understanding how an asset is valued and where in the normal cycle of valuation levels that asset is trading at any particular time. The following illustration takes a look at the trading history of Wal-Mart Stores, Inc., and the S&P 500. The period analyzed dates back to 1992 and encompasses three distinct valuation cycles for Wal-Mart. During the entire period it can be argued that Wal-Mart was a high-quality asset. Its dominance of the U.S. retail industry grew to unprecedented levels, while its global presence expanded dramatically. An investor who only read the financial reports on Wal-Mart could have assumed that a purchase of Wal-Mart stock at any point during the period should have resulted in a good return. Chart 2 depicts the P/Es for Wal-Mart and the S&P 500. It can be seen that Chart 2 P/E Convergence, Wal-Mart Versus S&P P/E Ratio (x) WMT S&P /24/1992 7/24/1993 7/24/1994 7/24/1995 7/24/1996 7/24/1997 7/24/1998 7/24/1999 7/24/2000 7/24/2001 7/24/2002 7/24/2003 7/24/2004 7/24/2005 7/24/2006 7/24/2007 7/24/2008 7/24/2009 7/24/2010 Source: Thompson ONE 2

3 for almost the entire period, investors perception of the proper valuation of Wal-Mart varied much more dramatically than for the market as a whole, represented by the S&P 500. During 1992 investors were willing to pay more than $40 for every dollar Wal-Mart earned. By 1996 their ardor cooled and they saw Wal-Mart s earnings as no more valuable than the market in general. In 1999, at the height of the dot.com bubble, investors again were willing to pay a significant premium for the perceived quality of Wal-Mart s earnings. To an investor, this P/E rollercoaster represents the normal ebb and flow of market sentiment, or investor opinion, toward every asset. Chart 2 (page 2) illustrates that, in addition to analyzing the fundamental underpinnings of an investment, investors need to understand how others perceive those fundamentals. The effect those other investors can have on the success of an investment is shown in Chart 3. $ 80 $ 70 Chart 3 Wal-Mart Stock Price Falling P/E Rising P/E Falling P/E intrinsic value: The actual value of an asset based on both tangible and intangible factors affecting its potential earning power. $ 60 $ 50 $ 40 7/24/1992 7/24/1993 7/24/1994 7/24/1995 7/24/1996 7/24/1997 7/24/1998 7/24/1999 7/24/2000 7/24/2001 7/24/2002 7/24/2003 7/24/2004 7/24/2005 7/24/2006 Price 7/24/2007 7/24/2008 7/24/2009 7/24/2010 $ 30 $ 20 $ 10 $ 0 Price Change P/E Range EPS Range 7/24/92-12/31/96 WMT S&P /31/96-12/31/99 WMT S&P /31/99-11/30/10 WMT S&P % 102.5% 518.1% 107.5% -10.6% -1.9% (-53%) (+36%) (+222%) (+60%) (-76%) (-45%) (+91%) (+111%) (+91%) (+27%) (+213%) (+55%) Source: Thompson ONE In Chart 3, we have divided the price history of Wal-Mart into three distinct periods defined by either a rising or falling P/E ratio that we saw on Chart 2. For both Wal-Mart and the S&P 500, in the table that 3

4 accompanies Chart 3 we have calculated the price change during the period, along with the beginning and ending earnings per share and P/E. As was stated earlier, we view Wal-Mart as a quality asset during this entire period and point to its strong earnings growth during each of the three periods as a reasonable justification for this assessment. The importance of changing valuation levels during the three periods has an overwhelming impact on the ultimate return earned by an investor. In the first period, strong earnings growth combined with a declining P/E led to a disappointing -14.7% total return. In the second period, earnings growth was met with an expanding P/E to generate an exceptional gain of 518.1%. In the current consolidation phase, exceptional earnings growth met a declining P/E to deliver a return of -10.6%. By combining an understanding of the value of Wal-Mart stock along with an analysis of corporate earnings growth, an investor could have a tremendous effect on the ultimate results of an investment. We believe this understanding of the importance of valuation to the success of an investment in the stock market can be expanded to every other asset class considered for inclusion in a portfolio. Investment Implications We began this note describing the enormity of the Baby Boom generation. By focusing on a few key tenets to successful investing, such as the importance of valuation, rather than the innumerable differences between individual investments, we can begin the process of building successful portfolios. By focusing on a few common traits of investment success, a generation of investors that includes members as different as Bill Clinton (born in 1946) and Sarah Palin (born in 1964), can build its own golden portfolios. In a consolidation phase, within which the markets are currently mired, we believe adopting an active management strategy capable of tactically allocating to assets through a valuation-based model will be very important for continued success. Our investment recommendations remain virtually the same as they were last quarter. The trends we anticipated came to pass and remain intact today. Maintain Equity Exposure We believe the combination of attractive valuation, generous dividend yields, and a growing economy will position equity portfolios for further growth. We therefore reaffirm our current guidance to fully invest the equity portion of your portfolio. Two themes that we believe will be positive contributors to performance next year are as follows. Emphasize revenue growth. Those companies able to increase revenue at a rate higher than their peers in a low-growth economic environment should be attractive investments. 4

5 Emphasize dividend growth. Companies can communicate confidence in their expectations for future results by increasing dividends. This return of cash to shareholders has been shown to be especially attractive once the initial rally of a bear market low (March 2009) has run its course, which is usually 12 months from the low. Tread Carefully in the Bond Market Last quarter we wrote: The premium investors are paying for the perceived safety of Treasury securities has manifested itself in today s low interest rates. Ned Davis research estimates that the yield on the 10-year Treasury bond is 90-basis-points lower than normal due to strong investor demand. Since early October, the yield on the 10-year Treasury has risen more than 1% (100 basis points) to a yield of 3.53% as of December 15, Prices on a variety of bonds have declined as their yields rose. We continue to recommend building bond portfolios comprising primarily higher-quality/shorter-maturity issues to limit exposure to rising interest rates. Conclusion The change in market psychology since the 2010 elections and the passage of year- end legislation to renew the Bush administration tax cuts should continue setting a positive tone for financial markets in We expect an expanding domestic economy, coupled with continued dynamism in the developing world, to set equity markets up for continued gains in the coming year. 5

6 Wealth Strategy: New Planning Opportunities in a New Tax World We believe the end-of-year tax legislation enacted as a result of a compromise agreement between President Obama and congressional Republicans, combined with historically low interest rates, has created a unique opportunity for wealth transfer in 2011 and Increased Gift Exemption The lifetime federal gift exemption has been increased from $1 million to $5 million per person or $10 million for a married couple, as part of the reunification of the estate tax and gift tax systems, which increased both exemptions to this level. Furthermore, the historically low 35% gift tax rate for lifetime transfers in excess of this lifetime exemption has been extended for 2011 and Combined with annual exclusion ($13,000 per person, per donee) gifting, these higher exemptions and lower rates provide an unprecedented opportunity for additional transfers of assets (along with future appreciation) out of individuals taxable estates and to descendants, or trusts for them. Furthermore, these gifting opportunities can be combined with the increased $5 million generation skipping tax exemption to create long-term family trusts to bypass transfer tax liability for several generations. Low-Interest-Rate Environment The low-interest-rate environment makes certain wealth transfer tools far more attractive as well. Chief among these is the grantor retained annuity trust (GRAT), specifically, the so-called zeroed out GRAT, which allows for the gift-tax-free transfer of asset appreciation beyond a hurdle rate to children or other beneficiaries. This hurdle rate is 2.8% for February A GRAT holds assets for a period of years, returning the value of the asset annuitized at the hurdle rate over a transferor-selected period of two or more years. Should the transferor die during this period, then the entire assets of the GRAT are included in the transferor s estate. Further, should the return on investment be less than the hurdle rate, all assets will be returned to the transferor. If, however, the GRAT fails due to sub-hurdle-rate return on investment or death of the transferor during the annuity term, there is no penalty other than the cost of establishing and administering the GRAT. President Obama and leading Democrats had attempted, on several occasions to restrict the effectiveness of GRATs by imposing a minimum 10-year annuity term and requiring that at least some taxable gift result. Such efforts have been readily defeated in the Senate thus far, and are more likely to fail in light of the additional Republican representation in Congress this year. 6

7 Conclusion We believe affluent investors should seek to combine their asset allocation strategy with these wealth transfer opportunities through transfer of high-growth potential assets to GRATs, family trusts, and other estate planning vehicles. 7

8 Asset Class Strategy How do current conditions affect our asset class strategy? For each asset class on the following pages we have delineated our: strategy (the why of our plan); and tactics (the how of our plan). Naturally, each investor and each portfolio is unique. Investors should review the strategies and tactics we discuss here with their Portfolio Manager for appropriateness to their portfolios. Equity Strategy We expect accelerating economic growth to provide the fuel for upside earnings surprises in early Positive news on the employment front should increase consumer confidence. All eyes will be on retail sales momentum once holiday season results are tabulated. We believe the stock market is continuing to transition from the early-cycle beta phase to the latercycle alpha phase of market returns. Therefore the choice of investment strategy and manager should be very important to investment success. Selecting equities with strong earnings growth in the moderategrowth economic environment should, we anticipate, provide profitable returns. Tactics We recommend that investors in all capitalization ranges begin to bias incremental additions to existing equity portfolios to those companies best able to generate earnings growth through increasing revenues rather than continued cost cutting. We expect that growth in the developed economies of Europe will remain muted in 2011 relative to the United States and many emerging markets. We believe the emerging markets will continue to grow more rapidly than the developed markets, but they are not immune to the vicissitudes of the larger global economy. We therefore recommend the inclusion of a hedged position in emerging market portfolios. This should be discussed with your Portfolio Manager for appropriateness. We believe the economy is transitioning between the early cycle, higher-return, beta phase of the market to the later-cycle, moderate-return, alpha phase of market returns. Therefore, the choice of investment manager and strategy is very important to investment success. 8

9 Fixed Income Strategy The sharp rise in interest rates since early October across varied maturity ranges and issuer types has resulted in widespread price declines for bond investors. This increase in yields accompanied by our moderated growth expectations for the U.S. economy has raised the attractiveness of bonds, in our opinion, since our fourth-quarter 2010 Strategy Insight. Rising interest rates have helped support the value of the dollar, making U.S. fixed-income investments relatively more attractive to foreign investors. An improving economy should continue to strengthen corporate balance sheets, thereby improving the credit quality of corporate borrowers. We anticipate further shrinking of the spread between Treasuries and Corporates. Tactics Municipal bonds remain very attractive for investors in the middle to upper tax brackets. Recent news about the difficulty several municipalities are having meeting budget and debt financing obligations have highlighted the need for a thorough understanding of the resources supporting each bond in a portfolio. Our focus remains on higher-quality holdings. We believe investors should bias their taxable bond holdings to emphasize spread product over Treasuries. Incremental yield can be gained through corporate and high-yield securities. The appropriateness of these securities for any individual client should be discussed with your Portfolio Manager. 9

10 Private Equity Strategy Activity in the developing world is increasing for many U.S.-based private equity firms. Whether the U.S. private equity model of aggressive cost cutting and majority ownership stakes travels well to these new markets has yet to be seen. Capital controls, fungible legal protections, and currency controls all combine to raise hurdles in these attractive markets. In 2005, private equity invested $47 billion in the Asia Pacific region compared with $73 billion in 2010 according to Capital IQ. The investment in all of Latin America this year is only about $10 billion. Clearly funds are flowing to the emerging markets but the higher risks and hurdles will require greater returns for investors. Tactics The secondary private equity market remains attractive, in our opinion, as transaction multiples rise to induce sellers to part with limited partnership units. Difficulties in the municipal finance arena have increased the opportunities for infrastructure funds to either buy and maintain existing facilities or build new projects for cash strapped states and localities. General partners have shown an increasing interest in global opportunities as they structure funds that are in concert with Hawthorn s positive view on increasing international exposure within portfolios. Deal activity in the United States has increased as ample capital and low interest rates have combined to elevate purchase multiples. We believe buoyant equity markets have created a positive backdrop for increased initial public offering activity. 10

11 Hedge Funds Strategy Returns posted by many hedge fund managers in 2010 will most likely disappoint investors when compared with traditional U.S. and emerging market returns. The average equity long/short fund has risen 6.2% and the average fund of funds is up 3.2% for the year through November 30, 2010, as reported by EDHEC-Risk Institute. The average manager in the distressed debt and emerging markets performed marginally better, perhaps 4-5% over the equity long/short managers. The primary culprit for the lower hedge fund return in 2010 is the extremely high correlation between individual securities and the overall market. This high correlation reduces the arbitrage opportunities for managers and therefore lowers their return potential. Tactics We believe emerging market long/short funds offer an attractive way to access these dynamic markets. We expect the growth of mutual funds and exchange-traded funds that use hedging techniques promises to broaden the investor base for this type of hedged investing. We believe this evolution of the hedged investing industry is helpful for investors because it addresses one of the big drawbacks of the hedge fund industry illiquidity. We believe the high correlation levels seen in 2010 will decline and therefore create a larger opportunity set for managers leading to more attractive returns. Opportunities in fixed-income arbitrage should remain plentiful as the dislocations caused by the credit crisis slowly wend their way through the system. 11

12 Balanced Portfolio Asset Allocation Baseline Stocks 50% Tactical Stocks 50% Bonds 25% Bonds 25% Cash 5% Alternative 20% Cash 5% Alternative 20% Equity Allocation Baseline Tactical U.S. 70% U.S. 74% Developed International 20% Emerging Market 10% Developed International 16% Emerging Market 10% Alternative Assets Baseline Private Equity 35% Tactical Private Equity 35% Real Estate 20% Hedge Funds 25% Commodities/ Real Assets 20% Real Estate 20% Hedge Funds 25% Commodities/ Real Assets 20% Hawthorn is a registered service mark of The PNC Financial Services Group, Inc. ( PNC ). Hawthorn provides investment consulting, wealth management and fiduciary services, certain FDIC-insured banking products and services and lending of funds through the PNC subsidiary, PNC Bank, National Association, which is a Member FDIC, and provides certain fiduciary and agency services through PNC Delaware Trust Company. Hawthorn and PNC do not provide legal or accounting advice and neither provides tax advice in the absence of a specific written engagement for Hawthorn to do so. This report is furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation or particular needs of any specific person. Use of this report is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading this report should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in this report was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in this report and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, the Federal Reserve Board, or any government agency. Securities involve investment risks, including possible loss of principal. Investments: Not FDIC Insured. No Bank or Federal Government Guarantee. May Lose Value The PNC Financial Services Group, Inc. All rights reserved.