Northern Trust. March Donna Renaud, CFA Managing Director, Large Cap Value Management

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Norther Trust The Divided Advatage March 2010 Doa Reaud, CFA Maagig Director, Large Cap Value Maagemet Recet stock market volatility, coupled with geeral axiety about the ecoomy, has set may equity

1 Norther Trust The Divided Advatage March 2010 Doa Reaud, CFA Maagig Director, Large Cap Value Maagemet Recet stock market volatility, coupled with geeral axiety about the ecoomy, has set may equity ivestors ito a state of iertia. They wat to ivest, but do ot kow how or whe to do so. Ufortuately, whe it comes to the stock market, there is o bell that rigs to sigal the coast is clear. The oly prove way to realize solid returs i equities is to stay ivested log-term. Ad the coservative way to do that is with a ivestmet strategy that mitigates dowside moves. Oe such strategy is to ivest i large capitalizatio, high divided stocks. Combied with a value ivestmet methodology, this approach ca potetially be a wiig combiatio, as it provides ample opportuity for total retur, yet reduces dowside volatility. The advatage of this approach is twofold. First, the value style ivolves ivestig i compaies that are fudametally soud, but are sellig at a discout to their fair value as a result of some temporary problem, challege, or dislocatio. Dowside volatility is reduced, sice the compaies beig bought have already declied i price. Secod, the high cash divideds paid by each compay add to portfolio value ad led support to the stock price. The divideds also help offset possible stock price declies. While the wisdom of buyig stocks sellig at a discout to their fair value requires little explaatio, the beefits of divided ivestig are ofte overlooked. A review of recet research sheds light o the advatages of owig divided stocks. A 2008 study by Norther Trust 1 looked at divided yield ad overall performace of the largest 750 U.S. stocks over forty years. As show i Exhibit 1, stocks with above-average divided yields outperformed those with below-average yields by 2.0% over a 1-year holdig period, 6.3% over a 3-year holdig period, ad 9.8% over a 5-year holdig period; plus offered lower volatility. Whe utility compaies are excluded (give their tedecy for limited stock price appreciatio 2 ), the outcome is eve better, as higher-yieldig stocks outperformed by 2.5% i 1-year periods, 8.1% i 3-year periods, ad 13.5% i 5-year periods; agai with lower volatility. Exhibit 1 All Stocks holdig Period Excess Returs stadard Deviatio of Returs Oe Three Five Share of Year Years Years Observatios Mothly Aually With Above Media Divided Yields 1.0% 3.1% 4.7% 50.0% 4.4% 17.6% With Media or Below Divided Yields 1.0% 3.2% 5.1% 50.0% 6.1% 21.4% Spread 2.0% 6.3% 9.8% 1.7% 3.8% Excludig Utilities With Above Media Divided Yields 1.4% 4.6% 8.0% 50.0% 4.8% 18.5% With Media or Below Divided Yields 1.1% 3.5% 5.5% 50.0% 6.3% 21.7% Spread 2.5% 8.1% 13.5% 1.5% 3.2% 1 The Importace of Divideds, Norther Trust Value Ivestors (2008). This study was commissioed by Norther Trust from Empirical Research Parters. 2 Utilities may distort overall market results as these compaies typically offer very high yields, but lower share price appreciatio due to the profitability costraits of high govermet regulatio. cotiued

2 A secod study, coducted by Norther Trust i 2009, aalyzed divided yield 3 usig market data from 1984 to This study aalyzed stock returs usig a beta adjustmet to remove the effect of geeral ad relative market risk i order to isolate alpha. The results show that divided yield, after adjustig for market volatility (risk), added value over the log ru, with stocks i the top tertile (top 33%) of beta-adjusted yield, typically providig returs i excess of the bechmark ad outperformig lower-yieldig stocks. From a sector perspective, this study showed that stocks i the top tertile teded to outperform i eight out of eleve idustry sectors: cosumer discretioary, staples, eergy, healthcare, idustrials, materials, telecommuicatios, ad utilities. Stocks i the secod tertile teded to outperform i the other three sectors: fiacials, techology, ad REITs. Both of the Norther Trust studies cofirm that divided-payig stocks add to returs. However, these studies are ot uique i their fidigs. There are umerous other studies that show similar results. The followig provides brief descriptios of recet work. A Jauary 2010 Societe Geerale 4 report o global icome ivestig foud that divided yield ad divided growth determie equity returs. This comprehesive aalysis of the MSCI World Idex 5 data sice 1970 foud that, over the log term, high divided yield beats the market by a wide margi. I additio, based o actual divided ad buyback data sice 1995, divideds reivested back ito the equity market retured about 14% almost three times more tha the 5% retur provided o share buybacks. Accordig to this report, share buybacks provide lower returs compared to regular reivestmet of divideds, as compaies ted to buy back the most shares at the top of the earigs cycle, whe operatig cash flows are at their highest ad shares prices are at a premium level. Divided reivestmet, o the other had, occurs at regular quarterly itervals i both up ad dow markets, takig advatage of dollar cost averagig. A 2009 study by Merrill Lych 6 aalyzed divided yield-based strategies usig global data sice This study foud that high reported divided yield was the strategy with the best risk/retur trade-off, providig a relative aualized retur of 4.9% per year ad uderperformig the idex oly 30% of the time. I up-markets, the best performig divided strategies were high 5-year divided growth, which provided a 6.2% relative aualized retur; high reported divided yield, which provided a 5.8% relative aualized retur; ad high 3-year divided growth, which provided a 5.7% relative aualized retur. I dow-markets, the best performig strategies were high 1-year ad high 5-year divided payouts, with both providig relative aualized returs of over 8%. However, these same two strategies were the worst performers durig up-markets, with the high 5-year divided payout strategy losig -7.7% ad high 1-year divided payout strategy losig -8.4% ad both uderperformig the bechmark about 55% of the time. A 2009 British study, coducted by UBS 7, aalyzed divided yield-based strategies over the last 20 years, ad showed a portfolio comprised of stocks with the highest quitile (top 20%) of divided yield achieved a aualized performace of 11.0%, compared to 8.7% for the market, 8.1% for a portfolio comprised of stocks with the lowest quitile yield, ad -1.4% for the portfolio composed of compaies that did ot pay divideds. This study also showed that the best performace would have bee obtaied by buyig compaies with high or very high divided yields ad high or very high divided growth rates. 3 Beta-Adjusted Yield, Norther Trust Active Maagemet (2009). 4 The Global Icome Ivestor, Cross Asset Research, Societe Geerale (Jauary, 2010). 5 The MSCI World Idex is comprised of 1500 global stocks ad is commoly used as a bechmark for global stock fuds. 6 Nigel Tupper, Carrie Zhao, ad Girish Nair, Optimal Divided Strategies, Global Focus Poit, Merrill Lych (September 1, 2009). Returs are relative to the MSCI AC World Idex. 7 Divided based Ivestig i the UK, Global Quatitative Research, UBS (February, 2009). 2

3 A 2005 study by Empirical Research Parters 8 showed that large cap, high-yieldig stocks outperformed, while stocks payig o divideds uderperformed, i every decade sice 1964 except the 1990s, as show i Exhibit 2. Exhibit 2 Large Capitalizatio Stocks Relative Returs by Divided Yield Decile by Decade Measured Over a Holdig Period of Oe Year 1964 through mid-april 2005 Relative Retur By Decade Deciles of Yield Etire Period Highest Decile Yield 1.5% 1.8% 1.2% 2.3% % Secod Decile Yield 0.7% 0.2% 1.2% 2.6% 1.7% 6.2% No Divided 2.2% 2.1% 3.8% 5.5& 6.0% 7.8% Source: Empirical Research Parters Aalysis This same study further showed that high-yieldig stocks outperform durig bear market periods, with the best quitiles of large cap divided-payig stocks providig mothly returs that are.9% better tha the market early twice the excess returs provided by stocks selected based o free cash flow yield, price-to-book, ad price-to-earigs i the same bear market periods. The dowside protectio offered by high-yieldig stocks, as suggested by both the Empirical ad the Merrill Lych studies just described, is critical give that ot losig ca be more importat tha gaiig upside i geeratig log-term stock performace. 9 It is also especially pertiet i poor ecoomic eviromets, or whe there is cocer that the market may pull back or eter periods of weakess. A 2005 study by Uiversity of Pesylvaia professor, Jeremy Siegel, cofirms the efficacy of divided yield i providig solid stock returs. His study of S&P 500 Idex stocks from foud that higher divided yields directly correlated with higher returs with the highest-yieldig quitile (top 20%) of stocks producig a aualized retur of 14.3%, versus a 11.2% aualized retur for the Idex itself. This study echoed a 1994 study by Siegel o S&P 500 Idex stocks from which showed that low divided yields appear to be followed by periods of low retur, while higher divided yields appear to be followed by periods of higher returs. Lookig at 30-year returs, the 1994 study showed stocks that started the period i the lowest decile (bottom 10%) of divided yield provided a 4.8% compoud aual retur, while stocks startig i the highest decile (top 10%) provided a 7.5% retur. Aalysis of 5-year returs showed a similar outcome, with stocks startig the period i the lowest decile (bottom 10%) of divided yield producig a 1.0% compoud aual retur, versus a 15.7% compoud aual retur for the stocks startig i the highest decile (top 10%). 8 The Big D: Divided Yield, Empirical Research Parters (April, 2005). 9 Charles D. Ellis, Ivestig Success i Two Easy Lessos, Fiacial Aalysts Joural (2005). 10 Jeremy Siegel, The Future for Ivestors (Crow Busiess, 2005). 11 Jeremy Siegel, Stocks for the Log Ru, (Richard D. Irwi, Ic., 1994). 3

4 Other market data observatios are cosistet with these studies. As show i Exhibit 3 from Stadard ad Poors, divideds ad their reivestmet accouted for 35% of total S&P 500 Idex returs from 1926 to 2008, cotributig from 14% to 53% of mothly total returs i every decade from the 1940s through the 1990s. Exhibit 4 shows that a hypothetical $10,000 ivestmet i S&P 500 divided-payig stocks from 1985 to 2008 would have eared 76% more tha o-divided-payig stocks. Exhibit 3 Divided Icome as a % of the Mothly Total Retur of the S&P % 50% 53% 50% 40% 39% 35% 30% 28% 26% 20% 10% 14% 0% 1940 s 1950 s 1960 s 1970 s 1980 s 1990 s 1926 to Nov Source: Stadard & Poor s Exhibit 4 Divided-Payig stocks of the S&P 500 Vs. No-Divided-Payig stocks 1985 to 2008 $400,000 $350,000 Growth of $10,000 $300,000 $250,000 $200,000 $150,000 $100,000 Divided Payers No-Divided Payers $194,678 $110,623 $50,000 $ Source: ChartSource, Stadard & Poor s Fiacial Commuicatios. For the period from Jauary 1, 1985, through December 31, Based o total retur of equally weighted portfolios of the divided- ad o-divided-payig compaies i Stadard & Poor s Composite Idex of 500 Stocks, a umaaged idex that is geerally cosidered represetative of the U.S. stock market. Past performace is ot a guaratee of future results. (CS000181) Similarly, divided stocks outperform durig bear market periods. Accordig to S&P 500 Idex data from 1926 to 2008, equities declie a average of -13.6% i dow markets. However, as show i Exhibit 5, durig these same time periods, divideds retur a average of +4.5% offsettig about oe third of bear market equity losses. 4

5 Exhibit 5 Divideds support returs i dow markets 1926 to % 20% 15% 12.36% 21.77% Average Total Retur Average Retur From Divideds 10% 5% 4.23% 4.12% 4.52% 0% 5% 10% 15% 13.60% All Markets Up Markets Dow Markets Source: ChartSource, Stadard & Poor s Fiacial Commuicatios. Based i rollig 12-moth periods from Jauary 1, 1926 through December 31, Based o the price appreciatio ad divided yield of Stadard & Poor s Composite Idex of 500 stocks, a umaaged idex that is geerally cosidered represetative of the U.S. stock market. Past Performace is ot a guaratee of future results. This is ot meat to represet the performace of ay Norther Trust product. Based o these studies, the divided advatage appears clear. But why does it occur? There are five key reasos: 1) Divided yield is a importat metric for idetifyig udervalued compaies that are high-quality ad offer strog potetial for share price out-performace. Accordig to Bejami Graham, the father of securities aalysis ad value ivestig, A log record of payig divideds, as log as 20 years, shows that a compay has substace ad is a limited risk. 12 While other valuatio metrics, such as free cash flow yield, price-to-book, ad price-to-earigs measures are all importat metrics for stock selectio, their usefuless may be ehaced whe combied with divided yield, as divideds ca help idetify higher quality, udervalued securities i the followig ways: As there is a iverse relatioship betwee divided yield ad share price, a above average divided yield may idicate a low share price ad a potetially udervalued security. Compaies that commit to payig divideds typically have strog, cosistet cash flows. Studies show that the combiatio of high divided yield ad high free cash flow yield is a strog idicator of future stock outperformace. Divideds are tagible evidece of fiacial well-beig ad stregth. Not oly are dividedpayig compaies typically larger, more mature, stable, ad fiacially soud; substatial divided paymets idicate high predictability ad sustaiability of compay cash flows. Divided paymets are also hard evidece that suggest maagemet s cofidece i future performace ad the credibility of past earigs reports. Oly stable, well-maaged, fiacially soud compaies that cosistetly have excess cash will typically make such a commitmet. Compaies payig higher divideds ted to have higher earigs. 13 This is believed to occur as divided paymets impose maagemet disciplie ad ecourage prudece i capital allocatio decisios. 14 With a portio of profits earmarked for divideds, maagemet may be less likely to udertake foolhardy or risky projects. 12 Jaet Lowe, Bejami Graham o Value Ivestig (Pegui, 1994). 13 Pig Zhou ad William Rulad, Divided Payout ad Future Earigs Growth, Fiacial Aalysts Joural (May/Jue, 2006). 14 Robert Arott ad Clifford Asess, Surprise! Higher Divideds = Higher Earigs Growth, Fiacial Aalysts Joural (Jauary/February, 2003). 5

6 2) Divideds are a source of absolute retur ito the portfolio. Divideds are cash paymets made to the ivestor that cotribute directly to the portfolio performace, plus provide for o-goig portfolio reewal, reivestmet, ad the positive effects of compoudig. Ulike earigs ad cash flow, divideds are hard cash paymets that are kow i advace ad ot subject to maagemet estimatio, fiacial statemet maipulatio, or differig accoutig defiitios. 15 Also, ulike stock buy-backs which deped o the share price ad ofte ever happe after beig declared, divideds are paid as declared. Because divideds are a sigal to the market about how a compay is farig, compaies frequetly raise their divideds o a regular basis ad go to great legths to avoid lowerig or suspedig their divideds oce iitiated. As a result, divideds are half as volatile as earigs ad vary a fifth as much as free cash flow. 16 As divideds provide a cosistet ad steady stream of cash ito the portfolio over time, they have cotributed sigificatly to the total retur offered by U.S. equities for over 200 years. 17 3) Divideds are a source of growth. Ulike bod coupos, divided paymets ca icrease over time, as may compaies regularly raise their divideds as their earigs grow. A divided raise ot oly icreases cash flows ito the portfolio, it ca drive the share price higher. Ad as divideds are typically paid quarterly, regular paymet schedules provide for disciplied reivestmet ad compouded growth. 4) The iclusio of high-divided stocks i a portfolio ca bolster returs ad reduce volatility. With prices held costat, higher yieldig stocks by defiitio produce greater returs. Whe the effects of compoudig are icluded through divided reivestmet, the effects o total retur ca be sigificat. Divideds also provide dowside price support, as buyig for yield may boost share demad. As show i Exhibit 6, as Microsoft s share price moved lower i 2008, its divided yield moved higher because its cash divided paymet remaied the same. This caused Microsoft s divided yield to exceed the yield o the 2-year Treasury potetially makig the stock attractive to ivestors based o yield aloe. This buyig for yield creates demad ad helps to push the share price up. Exhibit 6 Example: Microsoft Date 8/12/08 10/10/08 1/28/10 Microsoft Share Price $28.12 $22.35 $29.22 Microsoft Aual Divided Paymet $0.52 $0.52 $0.52 Divided Yield 1.85% 2.33% 1.78% 2 Year Treasury Yield 2.42% 1.63% 0.88% 5) Besides addig directly to portfolio value, divideds cotribute to portfolio stability by providig icetive for ivestors to be patiet, log-term holders. As divided collectio occurs over time, divided ivestors are paid while they wait for share price upside. The Divided Ivestor Newsletter, states that Because divideds take time to collect, they virtually force the ivestor to take a log term view. Over a good stretch of years, the day-to-day volatility of prices stads to cacel out Juliet Estridge ad Barbara Lougee, Measurig Free Cash Flow for Equity Valuatio: Pitfalls ad Possible Solutios, Joural of Applied Corporate Fiace (Sprig, 2007). 16 The Big D: Divided Yield, Empirical Research Parters (April, 2005). 17 Robert D. Arott, Divideds ad the Three Dwarfs, Fiacial Aalysts Joural, AIMR (2003). 18 Is Divided Ivestig Broke?, The Divided Ivestor Newsletter (September 3, 2008). 6

7 Coclusio: There are may ways to ivest i stocks. Oe strategy, ivestig i high divided yieldig stocks, provides upside potetial ad mitigates dowside volatility by brigig cash ito the portfolio o a predictable basis. With divided yields curretly at record levels compared to Treasuries, 19 ivestmet i high divided-yieldig stocks offers a potetially compellig strategy that should be cosidered as a essetial part of a coservative ivestmet portfolio. Norther Trust s Large Cap Value Team has bee maagig ivestor moey sice 1987, usig a value approach that ivests i large capitalizatio compaies payig above average divided yields. Based o over 20 years of ivestmet experiece ad out-performace, Norther Trust s Large Cap Value strategy provides real time evidece of the divided advatage. At 3/22/10, the divided yield o the Norther Trust Large Cap Value Maagemet portfolio was 2.4% versus 1.8% for the overall market ad 2.4% for the 5-year Treasury bod. 19 At 3/22/10, the divided yield o the S&P 500 Idex was 1.8% versus 1.0% for the 2 year Treasury, 1.5% for the 3 year Treasury ad 2.4% for the 5 year Treasury. IRS Circular 230 Notice: To the extet that this message or ay attachmet cocers tax matters, it is ot iteded to be used ad caot be used by a taxpayer for the purpose of avoidig pealties that may be imposed by law. For more iformatio about this otice, see The opiios expressed i this ewsletter are those of the author ad do ot ecessarily reflect those of the Norther Trust Corporatio or its subsidiaries. Performace is historical ad does ot guaratee future results. Idex returs do ot reflect ay fees or expeses. It is ot possible to ivest directly i a idex. The iformatio provided should ot be cosidered ivestmet advice or a recommedatio to purchase or sell ay security. There is o assurace that ay of the securities discussed herei will remai i a portfolio at the time you receive this report or that securities sold have ot bee repurchased. The securities discussed herei do ot represet a etire portfolio ad i the aggregate may represet oly a small percetage of a portfolio s total holdigs. It should ot be assumed that ay of the securities trasactios or holdigs discussed were or will be profitable, or that the ivestmet recommedatios or decisios we make i the future will be profitable or will equal the ivestmet performace of the securities discussed herei. I additio, your fiacial cosultat should be cotacted if there have bee ay chages i your fiacial situatio or ivestmet objectives, or if you wish to impose or modify ay accout restrictios. NOT FDIC INSURED May lose value/no bak guaratee orthertrust.com

CHAPTER 2 PRICING OF BONDS

CHAPTER 2 PRICING OF BONDS CHAPTER SUARY This chapter will focus o the time value of moey ad how to calculate the price of a bod. Whe pricig a bod it is ecessary to estimate the expected cash flows ad