The RIC Report
Investment Strategy
Global
12 September 2006
Local vs. Global
ML RIC Group
MLPF&S
local” as the global profits cycle slows
„ “Think
Investors tend to focus on the economic cycle, but the way in which assets
perform is much more sensitive to profits cycles than it is to economic cycles.
The profits cycle is considerably more volatile than the economic cycle, and it
historically has had a greater influence on global and regional sector, style, and
asset class rotations.
Global profits cycles tend to be highly correlated. With that in mind, it should be
disconcerting to investors everywhere that one of the most reliable profits
forecasting indicators in the U.S. has turned negative.
Chart 1: U.S. yield curve and S&P 500 EPS momentum
EPS Momentum
Slope of Yield
Yr/Yr % Chg
Curve (bps)
100%
500
60%
300
20%
100
-20%
-100
Y/Y % chg in S&P 500 Reported EPS
10-Year Treasury Bond Less 3-Month T-Bill (Lagged One Year)
-60%
-300
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
04
06
Source: Merrill Lynch Investment Strategy, FRB, Standard & Poor’s. Yield curve: three-month Treasury bills to 10-year Treasury bonds.
The U.S. yield curve has inverted. Every such inversion in the past four decades
has preceded a full-blown profits recession, which we define as a period in which
corporate profits growth is negative for at least two consecutive quarters. In
addition, quantitative strategist Nigel Tupper’s global profit indicators have been
negative for two months, and his “leadership” indicator has turned toward
defensive issues. That is in stark contrast to the conventional wisdom that global
profitability is strong and getting stronger.
The combination of those negative signals and the generally positive view of the
outlook for profits suggests that consensus 2007 earnings expectations are
probably too optimistic not only for the U.S., but possibly for many other markets.
Our “Investment Overview” (page 6) highlights some strategies that we think
would be appropriate for global investors if the global profits cycle slows. A central
idea in those strategies is that investors might find better opportunities by focusing
on regional or local factors rather than global macroeconomic factors.
Richard Bernstein
+1 212 449 0905
Chief Investment Strategist
MLPF&S
richard_bernstein@ml.com
See Team Page for Full List of Contributors
Table 1: Selected asset class total returns (%)
as of August 31, 2006
1 mo.
YTD
S&P 500
10-Year Treasury
2-Year Treasury
3-Month T-Bill
U.S. Dollar
CRB Index
Gold
Oil
CPI (July)*
2.4
2.2
0.7
0.4
0.0
-5.9
-1.5
-5.6
0.3
5.8
-0.2
2.3
3.1
-5.1
-0.8
21.3
15.1
3.4
Source: Standard & Poor's, Bloomberg, Factset.
* Unadjusted, 1 month lag on CPI.
New this month
Global Performance Matrix
U.S. economic, interest rate, and FX forecast
summaries
4
20
Table of contents
Financial markets recap
Actionable themes and investment ideas
Global Performance Matrix
Major market sector recommendations
Investment overview: Global markets and diversification
Guest Column: Energy Master Limited Partnerships
Asset allocations
Global equity weightings
U.S. client profile asset allocation
Fixed Income allocation models
Fixed Income barometers
U.S. economic, interest rate, and FX forecast
summaries
Stock recommended lists
Team page
2
3
4
5
6
10
15
16
17
18
19
20
21
30
Next issue
10 October 2006
Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.Customers of Merrill Lynch in the US can receive independent, third-party research on companies covered in this report, at no cost
to them, if such research is available. Customers can access this independent research at http://www.ml.com/independentresearch or can call 1-800-6377455 to request a copy of this research.
Refer to important disclosures on page 27 to 29. Analyst Certification on page 26. Price Objective Basis and Risk on page 26.
10547702
The RIC Report
1 2 Se ptembe r 20 06
Financial markets recap
August review
Risk-taking made a strong comeback in
August as the Federal Reserve paused in
its tightening cycle. High-beta stocks
immediately rallied, and were up by 10%
for the month.
Not surprisingly, technology stocks rallied
around the world. The hardware group
was among the best-performing industries
(see our new Global Performance Matrix
on page 4).
The renewed taste for risk-taking also was
evident in the fixed-income market, where
emerging market bonds led the way.
Commodities sold off during the month as
many global inflation measures came in at
levels that were more benign than many
investors expected. As inflation concerns
subsided, TIPS spreads narrowed sharply.
Table 2: Total return (%, U.S. dollar terms)
Asset Class
Equity Indices
S&P 500
NASDAQ Comp
FTSE 100
TOPIX
Hang Seng
DJ Euro Stoxx 50
MSCI EAFE
MSCI Emerging Markets
MSCI AC Asia Pac. Ex. Japan
2005
YTD
4.9
2.1
8.8
26.5
8.7
8.7
14.0
34.5
20.1
2.4
4.5
2.2
1.6
2.7
2.9
2.8
2.6
3.5
3.1
0.4
6.0
-0.9
9.8
5.5
3.8
3.9
3.4
8.9
2.1
22.0
22.3
20.7
21.5
24.8
31.0
25.5
5.8
-0.6
19.8
0.1
19.5
17.2
14.7
11.8
11.7
4.6
3.5
6.3
9.0
6.5
3.0
3.3
1.5
0.7
2.7
0.3
3.4
2.9
-3.3
-0.3
9.4
5.2
12.8
4.5
9.5
7.8
2.5
9.2
2.6
8.9
S&P 500 Sectors
Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Telecom Services
Utilities
-6.4
3.6
31.4
6.5
6.5
2.3
1.0
4.7
-5.3
16.8
2.0
3.7
-3.8
1.2
3.0
1.4
8.4
3.0
1.1
2.8
-1.7
7.3
3.2
3.0
8.7
-4.3
2.6
-0.3
11.3
10.5
-0.7
12.6
12.9
16.8
5.4
9.5
-0.4
19.2
19.0
10.8
1.0
10.5
14.9
6.9
4.5
2.8
-1.8
6.4
20.9
12.7
Merrill Lynch Bond Indices
10 Year Treasury
2 Year Treasury
TIPS
Municipals*
Corporate Bonds
High Yield Bonds
Emerging Markets
2.0
1.5
2.8
3.9
2.0
2.7
12.0
2.2
0.7
1.7
1.5
1.9
1.6
2.7
4.0
1.6
3.7
2.3
3.5
2.3
5.9
-2.1
2.7
1.6
3.2
0.7
5.5
10.0
-0.2
2.3
1.6
3.1
1.9
5.9
5.7
Foreign Exchange**
U.S. Dollar
British Pound
Euro
Yen
Swiss Franc
10.2
-11.6
-16.7
-20.1
-15.2
0.0
3.6
0.3
-5.5
-0.5
1.5
3.7
-0.1
-8.8
-2.4
-1.9
8.9
6.0
-12.6
0.5
-5.1
16.3
11.2
-2.8
6.2
Commodities**
CRB Index
Gold
Oil
16.9
17.9
40.5
-5.9
-1.5
-5.6
-4.6
-2.8
-1.4
-0.1
44.1
1.9
-0.8
21.3
15.1
Size & Style
Russell 2000
S&P 500 Citigroup Growth
S&P 500 Citigroup Value
S&P 600 Citigroup Growth
S&P 600 Citigroup Value
Source: Standard & Poor's, MSCI, Bloomberg, Factset, Merrill Lynch.
* Not tax adjusted. **Calculated by Bloomberg
2
As of August 31, 2006
1 month 3 months 12 months
The RIC Report
1 2 Se ptembe r 20 06
Actionable themes and investment ideas
Table 3: Actionable themes and investment ideas
Themes
Rationale
Short-Term/Tactical
Turnaround Industries „ Contrarian theme. Focuses on three very out-offavor industries within the U.S. market.
Investment ideas
Risks
„ Drugs, Media, and Diversified Telecom.
„ Fed eases and liquidity fuels speculative
investments.
„ Relative earnings deterioration may be attributable to
lack of cyclicality rather than secular causes.
„ Downward re-rating appears to have halted.
Cash/Equity Income
„ Central bank tightening.
„ Favor cash in Eurozone and Japan. Begin to
„ Central banks reverse course and ease.
extend maturities in U.S. and Canada.
„ Non-dollar equity income.
“Better Protected”
Emerging Markets
„ Central bank tightening draws liquidity away from
economies with weaker finances and current-account
deficits.
„ Overweight markets with current-account surpluses „ Central banks stop tightening.
and low P/Es such as Brazil, Russia, Korea, and
Indonesia.
„ Underweight markets that are expensive, have high
„ Global recession could mean that all
emerging markets underperform.
current-account deficits, or vulnerable earnings
outlooks; India, Central Europe, China, Chile.
Japanese Domestic
Demand
„ A budding credit cycle might make early-cycle
„ Housing stocks.
Japanese stocks attractive.
„ A return of deflation or a negative turn in
consumer sentiment.
„ Minimize exposure to consumer-oriented exporters.
Long-Term/Strategic
U.S. Exporters/NonU.S. Domestic
Demand
„ Weakening dollar, healthy global growth. Dollar
particularly vulnerable vs. the euro.
„ Gain exposure to other currencies. Non-U.S.
investors should continue to hedge their dollar
currency risk.
„ Higher interest rates, strengthening dollar,
and significant weakening of global
growth.
„ The trends that prevailed during the past five-to-10
years seem to be reversing.
„ Large cap U.S. exporters; smaller non-U.S., non-
export stocks.
Defense
„ A global arms race appears to be beginning.
„ U.S. and European defense stocks.
„ U.S. mid-term elections might be a short-
„ Large company stocks and stocks with S&P
„ Falling volatility.
„ Defense spending is increasing in the U.S., Asia, and
term risk, but could provide a longer-term
buying opportunity.
Latin America.
Large Cap/High
Quality
„ Undervalued relative to intrinsic value.
„ Provide hedge against rising global financial market
volatility.
Common Stock Ranks of B+ or better. Our High
Quality and Dividend Yield Screen is on page 23.
„ In the fixed income market, A-rated or insured
„ Central banks ease, spurring renewed
speculative activity.
municipals, mortgage-backed securities, and
selected bank preferreds.
Vaccines
„ The global vaccine business is beginning to expand
after years of weak demand and under-investment.
„ New markets related to the threats of a flu pandemic
and bioterror, a global push for higher inoculation
rates, and the promise of therapeutic vaccines.
„ Shares of companies with growing revenue streams „ Funding; competition and excess
related to the vaccine business (see August 7
Thematic Investing report, “Vaccines get a shot in
the arm”).
capacity; immaturity of individual
companies; legal liabilities associated with
vaccines; governments as single
customers.
Source: Merrill Lynch Investment Strategy.
3
The RIC Report
1 2 Se ptembe r 20 06
Global Performance Matrix
The Global Performance Matrix provides a quick, comprehensive way to compare
how 15 major market sectors and groups performed during the past month in 25
equity markets around the world. The returns, which are in U.S. dollar terms, are
price returns weighted by market capitalization. Blue/lighter shading indicates
that a sector or group posted a return that was more than 4% greater than that of
the MSCI World Index (2.4%); orange/darker shading indicates a return that was
more than 4% below that of the index.
Table 4: Global Performance Matrix
Cons.
Div.
Health
Tech
Autos/Dur
Country /Services* Banks Staples Financials Energy Care Industrials Insurance Materials Media Retailing Software Hardware Telecom Utilities
Canada
USA
Belgium
Finland
France
Germany
Italy
Netherlands
Norway
Spain
Sweden
Switzerland
UK
Australia
Hong Kong
Japan
Singapore
China
India
Korea
Taiwan
Brazil
Mexico
Russia
South Africa
n/a 6.7%
2.8% 0.0%
1.1% 1.3%
16.9%
n/a
4.8% 6.6%
2.9% 4.6%
2.5% 7.8%
3.3% 3.0%
n/a 2.5%
1.8% 4.6%
6.8% 2.5%
6.3%
n/a
5.1% 2.3%
1.8% 3.6%
1.3% 3.8%
2.7% -1.0%
10.3% 0.5%
-3.3% -1.0%
8.4% 10.8%
10.0% -6.8%
-1.3% -5.6%
26.5% -0.9%
1.4% 6.2%
n/a 21.9%
6.2% -2.5%
7.1%
3.5%
0.5%
1.9%
3.0%
4.4%
n/a
0.6%
n/a
0.8%
2.4%
4.8%
3.2%
10.1%
n/a
-0.1%
n/a
3.8%
6.6%
-0.4%
-3.0%
4.9%
6.9%
n/a
-0.4%
7.0%
1.4%
6.7%
n/a
4.3%
0.4%
5.3%
5.1%
n/a
2.5%
-3.7%
2.2%
2.0%
2.9%
2.3%
6.3%
12.6%
14.7%
n/a
11.5%
-2.2%
n/a
n/a
n/a
-0.5%
-0.7% 9.6%
-4.0% 2.5%
4.6% -0.3%
-8.6% 8.4%
-0.4% -4.9%
n/a 6.9%
-0.2%
n/a
1.0%
n/a
-6.9%
n/a
2.3% -4.0%
-9.5% 5.4%
n/a 1.1%
-4.6% 3.6%
-3.5% -0.9%
n/a
n/a
-7.3% 1.8%
n/a -6.0%
2.1%
n/a
8.9% 9.7%
-5.7% 9.0%
n/a
n/a
-2.5% 10.4%
n/a
n/a
6.5%
n/a
-3.8% 5.1%
6.3%
1.1%
7.9%
2.8%
5.8%
4.6%
2.2%
2.5%
7.3%
1.3%
4.4%
2.4%
4.0%
1.6%
0.8%
0.1%
0.6%
0.9%
11.8%
1.3%
-2.2%
15.4%
5.5%
n/a
7.6%
5.2%
2.2%
n/a
9.7%
7.7%
8.4%
4.9%
5.2%
0.5%
1.9%
n/a
3.5%
5.5%
3.6%
n/a
-3.2%
n/a
1.5%
n/a
4.6%
-7.2%
n/a
n/a
n/a
-6.0%
3.5%
n/a
3.0% 2.0%
5.3%
n/a
4.7%
n/a
5.4% 2.3%
1.7% 4.1%
-0.7% 0.7%
2.8% 7.7%
-1.3% 8.7%
0.2% 2.8%
1.9% 3.9%
0.9%
n/a
1.6% 4.7%
-0.5% 3.9%
n/a -7.2%
2.1% 0.5%
n/a 2.3%
0.2%
n/a
5.9% 4.4%
4.4% 0.2%
-1.0%
n/a
-5.2%
n/a
1.0% 1.8%
-1.9%
n/a
1.1% -1.7%
12.5%
2.8%
2.5%
n/a
3.4%
-4.5%
n/a
n/a
n/a
3.8%
4.2%
n/a
1.6%
0.8%
10.9%
5.3%
5.9%
-2.1%
n/a
0.4%
n/a
15.1%
n/a
n/a
-2.0%
n/a
5.1%
n/a
20.7%
7.2%
4.4%
-6.0%
-32.4%
n/a
3.7%
7.9%
n/a
0.8%
-1.1%
n/a
-0.7%
n/a
3.5%
7.2%
-9.1%
n/a
n/a
n/a
n/a
n/a
n/a
9.5%
3.2%
5.6%
10.5%
9.5%
n/a
10.7%
4.3%
n/a
6.0%
6.8%
4.4%
n/a
10.3%
3.5%
15.0%
8.1%
n/a
7.0%
6.7%
n/a
n/a
n/a
4.5%
13.0%
1.4%
3.0%
2.0%
2.3%
-5.6%
2.9%
8.7%
-0.3%
1.5%
9.5%
1.5%
1.4%
-6.1%
0.9%
0.5%
-3.6%
4.3%
14.4%
-1.5%
-7.1%
8.9%
3.7%
10.8%
1.9%
8.5%
2.4%
n/a
-0.7%
3.6%
5.0%
1.3%
n/a
n/a
3.6%
n/a
n/a
4.5%
5.8%
3.3%
6.1%
n/a
3.4%
5.4%
2.2%
n/a
4.2%
n/a
0.5%
n/a
Price returns in U.S. dollars, weighted by market capitalization. MSCI World Index return for August was 2.4%. Blue/lighter shade: more than 4% above MSCI. Orange/darker shade: more than 4% below MSCI. N/A = not available. As of monthend August 31, 2006. * Autos/Dur/Services: dur is durables, services comprises hotels, restaurants, leisure, and diversified consumer services.
Source: Merrill Lynch Global Quantitative Strategy.
4
The RIC Report
1 2 Se ptembe r 20 06
Major market sector
recommendations
Table 5: Sector recommendations
Sector
Brian Belski, our U.S. sector strategist,
overweights industrials and telecom
services and underweights utilities. For a
detailed discussion of sector weightings,
please see his September 11th “Sector
Strategy Update.”
Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Industrials
Information Technology
Materials
Telecommunications Services
Utilities
U.S.
Europe
Japan
Asia ex-Japan
=
=
=
=
=
+
=
=
+
-
+
+
+
=
+
=
+/=
=
+
+
+
=
=
=
=
=
=
+/=
+
=/=
+/=
+/=
-
Source: U.S: Brian Belski, Europe: Khuram Chaaudhry, Japan: Masatoshi Kikuchi, Asia ex. Japan: RIC recommendations based on the work of
Spencer White and Nigel Tupper. + means Overweight, - means Underweight, and = means Equal weight.
Table 6: U.S. Sector Strategy Weightings
Sector Blended EPS
EPS
S&P 500
Val.
Growth
Revisions
Sector
Weight +/- MKT/LTA MKT/LTA MKT/LTA
Favored
Industries/Themes
Comments
Industrials
10.7%
+
P/P
-/+
+/+
Consistent deliverer of earnings growth intact; stuck between
growth and cyclical "tag" during current market transition
Conglomerates; Aerospace &
Defense
Telecom Services
3.4%
+
D/D
-/+
-/+
Valuation discounts persist despite price outperformance;
earnings growth trending above average again (L-T positive)
Integrated providers
Utilities
3.5%
-
D/P
-/+
-/+
Expensive on an historical basis and not defensive
Consistent dividend growers
Cons. Discretionary
9.7%
=
D/D
+/=
+/=
Everyone's sector to despise appears to be bottoming; theme
for retailers is "you get what you pay for." Avoid bottom fishing
Media becoming consensus play;
seek premium growth within retailers
Consumer Staples
9.9%
=
P/D
-/-
+/+
Defense wins championships, but likely source of cash when
the market rallies; premium valuation to market intact
Tobaccos for defense; drug retailers
for growth
Energy
9.9%
=
D/D
+/+
-/+
Hard to ignore earnings momentum, but supply/demand tugof-war likely to increase near term volatility; take some gains
Integrated oil & gas
Financials
21.7%
=
D/P
-/-
+/+
Earnings growth trending below the market; future Fed rate
cuts "should be" positive, but discounting mechanism risky
Asset managers, brokers, select
insurance and large banks
Health Care
12.9%
=
D/D
-/-
-/+
Second most defensive sector; prospects for premier growth
industries remain ambiguous and vulnerable to election risk
Specialty services; pharma recovery
increasingly selective
Info Technology
15.1%
=
P/D
+/-
-/-
Valuations bottoming, but no one wants to "make the call";
positive long-term, but vulnerable to seasonal correction
Telecom equipment; selected semis
selected software
Materials
2.9%
=
D/D
+/+
+/+
Another tug-of-war situation-- this one is inflation vs. global
growth; commodity price volatility hard to chase
Selected specialty chemicals
Source: Merrill Lynch Sector Strategy.
S&P 500 Weights as of August 31, 2006.
+/-/=: Current Merrill Lynch Sector Strategy Opinion; Overweight (+), Underweight (-) or Market Weight (=) relative to respective sector within S&P 500 Index.
P/D: (MKT/LTA): Current Premium (P) or Discount (D) relationship of Sector Valuation compared to the S&P 500 Index (MKT) and to that respective sector's long-term average (LTA).
+/-/=: (MKT/LTA): Stronger (+) or Weaker (-) or Equivalent (=) EPS Growth and EPS Revision readings sector relative to the S&P 500 Index (MKT) and to that respective sector's long-term average (LTA).
5
The RIC Report
1 2 Se ptembe r 20 06
Investment overview
Global Markets and Diversification
Investors take note: diversification can
work in unexpected ways.
History suggests that correlations between global economies and, more important
for investors, global stock markets tend to increase during economic downturns.
Every investor knows the importance of geographic diversification, but few seem
to realize that, in practice, diversification often works in unexpected ways —
sometimes exactly the opposite of how it is supposed to work. In fact, history
shows that correlations among markets seem to get weaker (diversification takes
hold) during bull markets, but get stronger (diversification does not work) during
bear markets.
The following table shows the correlations among major equity markets during up
and down markets. Markets do, in fact, have higher correlations during down
markets. That suggests that diversifying globally might not be as opportunistic as
one might think.
Table 7: Global market correlations with S&P 500
S&P 500 Negative
S&P 500 Positive
Return
Return
Germany DAX
France CAC 40
MSCI Emerging
Markets
KOSPI
Japan Nikkei Avg 225
Hang Seng
FTSE 100
Difference (Negative Positive)
0.70
0.70
0.30
0.33
0.39
0.38
0.58
0.34
0.40
0.39
0.66
0.26
0.07
0.17
0.17
0.47
0.32
0.27
0.24
0.22
0.20
Source: Merrill Lynch Investment Strategy, MSCI, Factset.
Sorted by highest to lowest correlation difference. Monthly data from August 1988 thru June 2006.
U.S slows. World to follow?
This time around, a slowdown in the U.S.
economy might have a muted effect
elsewhere in the world.
The U.S. economy seems to be poised for a slowdown. The “front end” or early
cycle sectors of the economy (those that are most sensitive to changes in shortterm interest rates) are now showing signs of weakness; housing and autos are
two examples. Overall, our economists are forecasting GDP growth of only 3.4%
for 2006 and a paltry 1.9% for 2007.
However, the U.S. slowdown might not spread to all parts of the world. We
expect global GDP growth to slow somewhat in 2007, but because the U.S.
accounts for such a large proportion of worldwide economic activity, much of the
expected slowdown can probably be attributed to a sluggish performance by
America.
That makes it more important than ever for investors to carefully look for
investment opportunities around the world. Clearly, some portions of the global
economy will suffer as the U.S. slows, but if our economists are correct, there will
be portions of the global economy that might continue to do well.
One word of warning: the profits cycles of countries around the world have
historically been highly correlated. Before every economic slowdown, analysts
argue that cyclical investments are no longer cyclical. We view such comments
with skepticism. However, there are some country-specific or region-specific
events that might counteract the global macro environment.
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No slowdown in China could be good for global bonds
China seems likely to continue expanding
its productive capacity come what may;
ultimately, that’s disinflationary.
Investors need to remember that China is not a traditional capitalistic economy; it
is a socialistic/government version of capitalism. Traditional capitalism focuses
on profit maximization; one could argue that the Chinese version of capitalism
focuses on employment maximization.
If Chinese capitalism really does focus on employment maximization rather than
profit maximization, it is likely that a slowdown in the global economy might not
impede China’s headlong rush to expand its productive capacity. Indeed, Michael
Hartnett, our chief emerging market strategist, has suggested that investors
underweight China because corporations there are already having trouble raising
prices. Investors focus on profits, and not employment.
Although the profitability of Chinese companies may be under pressure, China’s
expansion has helped Japan begin to solve its deflation problems. Japan is
among the most cyclical of the developed markets, but the boom in Asian growth
has allowed many of the Japanese banks to reliquify their balance sheets, and a
traditional lending cycle is budding. If that bud flowers, early-cycle stocks in
Japan could be attractive. On the flip side, investors might want to avoid the
shares of Japanese companies that depend to a large extent on exports to the
U.S. (auto or electronics companies, for example). Instead, it might be a good
idea to overweight Japanese stocks that are more closely tied to domestic
demand, such as homebuilding.
Global bonds stand to benefit as China
makes it difficult for secular inflation to
take hold.
Another point: if China continues to increase its productive capacity without
regard to global demand, global inflation expectations might fall. We have been
somewhat concerned about the late-cycle inflation pressures that are currently
evident in the U.S., but our opinion that the forces of disinflation (or deflation)
have the upper hand for the long term should remain intact as long as China’s
capacity continues to grow. Simply put, it is hard to see how secular inflation can
take hold when the world economy is undergoing the greatest capacity expansion
in our lifetimes. In such a climate, global bonds might become increasingly
attractive.
With that in mind, consider the next table (see Table 8 on the following page). Its
design is similar to that of Table 7, which deals with markets, but it shows the
correlations of 10 major asset classes in the S&P 500 during up and down
periods (for more information on these asset classes’ historical performance and
risk/return characteristics, see our July 17, 2006, U.S. Strategy Update, “A Simple
Risk Reduction Tool: Time”). Note that global equities’ (MSCI EAFE®) correlation
to the S&P 500 becomes stronger when the S&P 500 goes down (the correlation
increases from 0.31 to 0.53). However, the opposite is true for fixed-income: the
correlations between the S&P 500 and cash, long-term Treasuries, and corporate
bonds all fall when the S&P 500 goes down.
The consensus is that China’s unbridled growth would be bullish for commodities,
and that it might spur inflation fears. A contrarian point of view, which seems to
be supported by market history, is that China’s unbridled growth coupled with a
slowing U.S. economy might actually be bullish for bonds.
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Table 8: Asset class correlations with S&P 500
S&P 500 Negative Return S&P 500 Positive return
EAFE
REITS
CRB
Smalls
Gold
ART
Cash
LT Treasury
Corporates
0.53
0.42
0.01
0.61
0.00
-0.07
-0.06
0.00
0.02
0.31
0.30
-0.10
0.52
-0.05
-0.05
0.10
0.24
0.32
Difference (Neg-Pos)
0.22
0.12
0.11
0.09
0.05
-0.02
-0.16
-0.24
-0.30
Source: Merrill Lynch Investment Strategy, MSCI, Factset.
Bolded have higher correlations in down U.S. markets. Sorted by highest to lowest Correlation Difference, Monthly data Jan 1970 thru June 2006.
Even Europe is changing
The Old World may be changing its old
ways. As it does, investors should “think
local.”
European markets generally have higher correlations to the U.S. than others do,
and Europe might be the region that is most effected by slower U.S. growth. The
correlations between the S&P 500 and both the DAX and the CAC40 tend to rise
quite substantially during down markets (they more than double). That means
that, in general, a defensive posture toward Europe might be appropriate.
If the U.S. economy slows, investors interested in Europe might find better
opportunities by focusing on microeconomics instead of macroeconomics.
European corporations’ much criticized, sclerotic approach to corporate
restructuring seems to be changing; a new period of restructuring may be getting
under way, one that might even include the sale of public assets. If that proves to
be the case, investors ought to concentrate on individual opportunities rather than
make broad country allocations.
Central banks out of synch
Dollar-denominated assets could face
tough sledding if the Fed and other
central banks diverge.
If the U.S. economy does slow while economies elsewhere begin to or continue to
advance, global central banks are likely to become out of synch with each other.
GDP growth of 1.8% in the U.S. next year would mean that the Federal Reserve
would be more likely to ease; at the same time, healthy growth in Japan, Europe,
and Asia would mean that central banks in those areas might be in the earlier
stages of their tightening cycles.
Unsynchronized monetary policies might not bode well for assets denominated in
U.S. dollars. That’s because the dollar would be likely to weaken if non-U.S.
central banks were tightening while the Fed was easing. In last month’s RIC
Report “Investment Overview,” we commented that it was becoming increasingly
important for dollar-based investors to consider non-dollar sources of income.
We have repeatedly argued that investors pay too much attention to
diversification when it comes to potential capital appreciation and too little when
the subjects are income and overall total return.
Our foreign exchange strategy group recently revised its forecasts to reflect a
weaker-than-expected showing by the dollar. Their latest forecast is on page 20.
A sea change is taking place
The U.S. consumer may soon relinquish
the driver’s seat when it comes to global
growth and investment themes.
Taking a broad view, the economic backdrop seems to strongly support one of
our long-term investment themes: the trends that prevailed during the past five-to10 years are reversing themselves.
The strong growth of the U.S. consumer sector was a key variable in the global
economic equation in recent years, and investments that were tied to that growth
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tended to do quite well. In the U.S., the big winners included domestic demand
stories such as housing, retailing, and small capitalization stocks. Outside the
U.S., the growth stories were often exporters that provided goods (China) or
services (India) to the U.S. consumer. U.S. domestic demand stories
outperformed U.S. exporters, and non-U.S. exporters outperformed non-U.S.
domestic demand stories.
We think the next several years will see a complete reversal of that situation.
Taken together, a number of factors -- a weaker U.S. dollar, the reliquification of
U.S. consumers’ balance sheets as individuals boost their savings rate, and
selected pockets of counter-trend domestic demand growth such as the housing
sector in Japan -- could provide the impetus for a new secular investment theme
that favors U.S. exporters and non-U.S. domestic demand stories. It may be time
for global investors to “think local.”
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Guest column
Energy Master Limited Partnerships:
High yields, attractive total-return potential
In last month’s “RIC Report,” we emphasized the importance of income in a
diversified global portfolio and discussed potential income opportunities in U.S.
and non-U.S. equities, U.S. and non-U.S. preferreds, and several sections of the
fixed-income market. Our guest column this month highlights another incomeoriented idea: Gabe Moreen, our natural gas pipelines, utilities and master limited
partnership analyst, discusses the opportunities and risks in the energy MLP
sector. The average yield of the MLPs that he covers is 6.8%.
Energy MLPs offer high current yields and
attractive total-return potential.
Energy Master Limited Partnerships (MLPs) handily outperformed the market
during the past 10 years (the benchmark Alerian MLP Index [AMZX] posted a
gain of about 391% vs. an increase of 135% for the S&P 500). Even so, we think
that energy MLPs continue to offer investors the potential for annual double-digit
total returns.
Chart 2: Energized performance; MLPs have been doing much better than the S&P 500
450%
400%
Total Return (%)
350%
300%
250%
200%
150%
100%
50%
Se
p9
Ma 6
y-9
7
Ja
n9
Se 8
p9
Ma 8
y-9
Ja 9
n0
Se 0
p0
Ma 0
y-0
1
Ja
n0
Se 2
p0
Ma 2
y-0
3
Ja
n0
Se 4
p0
Ma 4
y-0
Ja 5
n06
0%
AMZX total return
S&P 500 total return
Source: Alerian MLP Index, Factset. Data as of 31 August 2006.
In particular, we consider the yield component of the MLP sector’s total return to
be both important and attractive, particularly in what our economists think will be
a declining interest rate environment. Even so, we think that a greater portion of
energy MLP’s total-return potential is tied to capital appreciation driven by robust
cash distribution (dividend) growth.
MLPs are meeting energy infrastructure needs
Increases in the cash distributions of energy MLPs are likely to be increasingly
driven by a focus on growth from attractive, high-return internal projects as MLPs
participate in the build-out of needed energy infrastructure projects related to
increasing crude oil imports to the U.S. and new sources of natural gas supplies
such as the Rocky Mountain region. We also expect growth to be supplemented
by other internal initiatives (fee increases, for example) and acquisition activity.
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Chart 3: Healthy growth in MLPs’ cash distributions
Aggregate YoY MLP cash distribution growth
10%
8%
6%
4%
2%
0%
2002
2003
2004
2005
2006E
2007E
Source: Merrill Lynch analysis and estimates. Note: figures and estimates are only for the MLPs covered by Merrill Lynch.
Energy MLPs are still an “under the radar” asset class
Energy MLPs are likely to attract more
attention in the years ahead.
Despite a decade of robust growth and strong returns, the energy MLP sector
remains something of a hidden gem, in our opinion. One reason is the structure
of MLPs, which we discuss on page 13. Another is their ownership profile, which
is heavily skewed toward individual rather than institutional investors. We think
that the visibility of MLPs will increase as institutional interest in the sector picks
up, growth continues, and more qualifying assets are placed into an MLP
structure. We would not be surprised to see the MLP sector’s current aggregate
market capitalization of about $85 billion double by the end of the decade.
Chart 4: The MLP sector’s market cap has been on the upswing
Energy MLP market capitalization ($bn)
90
80
70
60
32.4% CAGR
50
40
30
20
10
0
YE00
YE01
YE02
YE03
YE04
YE05
9/1/06
Source: Alerian MLP Index. As of 1 September 2006.
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A sector with low business risk….
A lower-risk link in the energy chain.
Most energy MLPs operate in what we consider to be the lower-business-risk
segment of the energy chain, by transporting or storing hydrocarbons (natural
gas, crude oil and refined products), usually subject to government regulation. In
general, the revenues of energy MLPs tend to be fee-based and not particularly
sensitive to commodity-price fluctuations (although investors should keep in mind
that each MLP has its own commodity exposure and asset mix).
…..and diversification benefits
Historically, the MLP sector has traded at low correlation levels to other fixedincome and equity asset classes. That means that MLPs give investors a way to
diversify their portfolios. Although the direction of interest rates does matter for
MLPs, the sector has shown an increasing tendency to decouple from interest
rate movements over time. That reflects a growing realization that MLPs are not
bonds (MLPs offer a growing, not static, coupon, in our view), and the fact that
many of the business that MLPs operate hold up relatively well during the
economic cycle (for example, the demand for refined products tends to slow, but
not decline, during a recession).
MLPs and commodity prices
On balance, energy MLPs stand to benefit
from higher commodity prices in the
energy sector.
The equity-market performance of the MLP sector and the movements of energy
commodity prices have shown little correlation over the long term. That makes
sense because most MLP revenues are derived from fee-based services that do
not fluctuate with commodity prices. However, commodity prices influence MLPs
in different ways; we would argue that MLPs that own refined-product pipelines
and terminals actually tend to be somewhat “short” commodity prices because
higher prices tend to induce conservation. However, in a larger sense, higher
commodity prices have been a boon for MLPs by fostering development in areas
that were considered uneconomic or too risky in a lower commodity price
environment (Canadian crude oil sands, unconventional natural gas drilling). On
balance, MLPs stand to be long-term beneficiaries of higher commodity prices
because they provide infrastructure that brings energy supplies to market.
Chart 5: Investing in the business
MLP capex ($bn)
7.0
6.0
5.0
38.9% CAGR
4.0
3.0
2.0
1.0
0.0
2003
2004
Source: Partnership reports, Merrill Lynch analysis. As of 31 August 2006.
12
2005
2006E
2007E
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What is an energy MLP?
How MLPs work.
A publicly-traded MLP is a limited partnership (LP) interest that is traded on a
public exchange and whose operations are managed by a general partner (GP).
An interest in an MLP is referred to a “unit” rather than a “share.” MLP units
generally trade on the NYSE and NASDAQ. An MLP typically pays out the bulk
of its operating cash flow on a quarterly basis as distributions (not dividends) to its
limited and general partners; as such MLPs are relatively high-yielding securities
whose main aim is to grow cash distributions over time.
To qualify for MLP status under the IRS code, partnerships must generate 90% or
more of their gross income from “qualifying income,” which includes “income and
gains derived from the exploration, development, mining or production,
processing, refining, transportation (including pipelines transporting gas, oil, or
products thereof), or the marketing of any mineral or natural resource (including
fertilizer, geothermal energy, and timber).” Most energy MLPs operate in the
“midstream” energy sector, transporting or storing different hydrocarbons.
In addition, MLPs are tax advantaged securities; no taxes are paid at the
corporate level, and cash distributions to LP unitholders are generally 80-to-90%
tax deferred. The non-deferred portion of distributions is taxed at ordinary income
rates, and the deferred portion of distributions is recaptured at ordinary rates
when units are sold. During tax season, investors in publicly-traded MLPs file a
Form K-1, an annual form replacing the 1099 investors use to report interest and
dividend income. K-1 forms provide the unitholder’s share of taxable income,
which is offset by deductions such as interest expense and DD&A.
Due to their tax-advantaged structure and emphasis on cash distributions, assets
within MLPs have tended to trade at higher valuations than those under a
traditional corporate structure. The higher valuations and their tax-advantaged
status have provided MLPs with a low cost of capital with which to drive growth.
MLP recommendations
Some Buy-rated, larger-cap, more-liquid
energy MLPs that we think are
particularly attractive.
Here are some of the larger-cap, more-liquid MLPs that we currently rate Buy:
Kinder Morgan Energy Partners, L.P. (NYSE: KMP: B-1-7: $42.08 on
September 8)/Kinder Morgan Management (NYSE: KMR: B-1-7: $44.04). In
our view, KMP is a good example of an MLP whose growth opportunities have
shifted from being acquisition-oriented to internally generated. Through its
extensive asset footprint, KMP should be able to participate in needed energy
infrastructure projects to bring increasing amounts of Rockies natural gas
production and liquefied natural gas (LNG) imports to market. The partnership
should also see growth opportunities related to the need to develop pipelines and
terminals to facilitate rising imports of Canadian crude oil to the lower-48 states.
Once several major projects are completed in 2008, we expect KMP’s cash
distribution growth rate to reaccelerate from 4-to-5% annually in 2006-07 to 8% or
more. KMP’s current yield of 7.4%; KMR’s is 7.7%. The pending $22-billion
buyout of KMP’s GP, Kinder Morgan Inc. (NYSE: KMI), should have little
fundamental impact on KMP, in our view.
KMR is economically equivalent to KMP, but is a paid-in-kind security and pays
dividends in additional shares. Unlike investing in a traditional MLP, KMR also
does not generate a form K-1 or unrelated business taxable income.
Our 12-month price objective of $50 per LP unit for KMP/KMR is based on an
analysis of discounted cash distributions per LP unit. We estimate the cost of
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equity at 10% and distributions per LP unit growth of 5% in 2006, 4% in 2007, 5to-8% in 2008-2011 with a terminal growth rate of 2%. Business risks to our rating
and price objective on KMP/KMR are a decrease in crude oil production at its
CO2 segment; an outright decline in demand for refined products or natural gas;
and supply chain disruptions (such as hurricanes).
Enterprise Products Partners, L.P. (NYSE; EPD; B-1-7; $26.25). As the
largest MLP, EPD’s diversified asset mix is likely to provide numerous organic
growth opportunities for energy infrastructure development to capture increases
in natural gas liquids (NGL) production in the Rockies, as well as Deepwater Gulfof-Mexico (GOM) crude oil and natural gas production. EPD’s current yield is
6.9%. We see the partnership’s organic growth profile allowing for annual
increases to its cash distributions of 7% in 2006 and another 7% in 2007. The
partnership’s operations are somewhat sensitive to end-user demand for natural
gas liquids (NGLs), which is itself a function of the overall economic environment.
Our 12-month price objective of $29 per LP unit for Enterprise is based on an
analysis of discounted cash distributions per LP unit. We estimate the cost of
equity at 9.5% and distributions per LP unit growth of 7% in 2006, 7% in 2007, 4to-6% in 2008-11 with a terminal growth rate of 2%. Business risks to our rating
and price objective are a decrease in natural gas and crude oil imports into the
Gulf Coast, an outright decline in demand for energy commodities due to higher
prices, an economic slowdown or other reasons, and supply chain disruptions.
Plains All American Pipeline, L.P. (NYSE; PAA; A-1-7; $45.01). A crude oil
logistics MLP, PAA’s model differs somewhat from the industry’s norm. About
half of its operating margin is derived from traditional fee-based crude oil pipeline
and terminal activities. In addition, PAA has a significant proprietary crude oil
logistics business which seeks to take advantage of physical and temporal
dislocations in the crude oil markets. The recent volatility in the crude oil markets,
which we expect to continue, has provided opportunities for that segment of
PAA’s business. Although the company’s business model entails higher risk than
those of most MLPs, the partnership has one of the highest cash distribution
coverage ratios in the sector (more than 1.5 for 2005). We project that PAA will
raise its cash distribution at an annual rate of 8-to-10% through the end of the
decade, aided by continued crude oil market volatility, a strong slate of organic
growth projects and its pending merger with Pacific Energy Partners, L.P. PAA’s
current yield is 6.4%.
Our 12-month price objective of $51 per LP unit for PAA is based on an analysis
of discounted cash distributions per LP unit. We estimate PAA’s cost of equity at
9.2% and distributions per LP unit growth of 10% in 2006, 9% in 2007, 6-to-9% in
2008-2011 with a terminal growth rate of 1%. Business risks to our rating and
price objective on PAA are a decrease in crude imports into the Gulf Coast and
from Canada, an outright decline in demand, and supply chain disruptions.
Risks to our MLP outlook
Watch for higher interest rates, changes
in energy consumption patterns, supply
disruptions, and regulatory changes.
14
Access to capital is all-important for the MLP sector because MLPs pay out the
bulk of their operating cash flow in the form of distributions and need to fund their
growth. Although the MLP sector has shown a declining sensitivity over time to
interest rate movements, a material rise in interest rates would likely present
headwinds to MLP sector performance. Other risks include significant changes in
energy consumption patterns, supply disruptions (hurricanes, for example), and
regulatory changes.
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Asset allocations
Table 9: Asset allocation guidelines as of 8/3/2006
Recommended
Equities
U.S. Stocks
Non-U.S. Stocks
Bonds
Policy Range
50%
35
15
30
40-100%
40-80
0-20
10-50
Cash
20
0-30
Alternative Investments
10*
0-20
Source: Merrill Lynch Investment Strategy.
* Alternative investments should be allocated via diversification from other asset categories, depending on an investor's risk tolerance.
Asset allocations for global investors
The Global Asset Allocation Models show target asset allocation guidelines as
well as ranges. The midpoint of the ranges is the long-term neutral benchmark
allocation for a particular investor profile.
Table 10: Global asset allocation guidelines with alternative investments*
Allocation Ranges
Capital
Income &
Preservation Income
Growth
Growth
Equities
Equity Range
Fixed Income
Fixed Income Range
Cash
Cash Range
Alternative Investments
AI Range
25%
10-30
50
45-65
20
10-30
5
0-10
35%
20-40
45
40-60
15
5-25
5
0-10
45%
30-50
35
30-50
5
0-20
15
0-20
55%
40-60
25
20-40
0
0-10
20
5-25
Aggressive
Growth
65%
50-70
10
5-25
0
0-10
25
10-30
Source: RIC.
*These percentage allocation recommendations are for the global investor in the major base currency regions including the US$, Euro, Yen, and
Sterling.
Table 11: Global asset allocation guidelines without alternative investments*
Rounded Allocation Ranges
Capital
Income &
Preservation Income
Growth
Growth
Equities
Equity Range
Fixed Income
Fixed Income Range
Cash
Cash Range
25%
10-30
55
50-70
20
10-30
40%
25-45
45
40-60
15
5-25
55%
40-60
35
30-50
10
0-20
65%
50-70
30
25-45
5
0-10
Aggressive
Growth
80%
65-85
15
10-30
5
0-10
Source: RIC.
*These percentage allocation recommendations are for the global investor in the major base currency regions including the US$, Euro, Yen, and
Sterling.
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Global equity weightings
The following table summarizes the RIC’s regional equity market and sector views:
Table 12: Regional equity view
MSCI
Equity
Region
Weight*^ Overweight**
U.S.
46%
Equity
Underweight**
The sector may be caught between “growth” and “cyclical” labels. Earnings growth has been
consistent and remains well above long-term average levels, yet Industrials are still inexpensive
compared to historical averages. We have become increasingly selective; the sector’s cycle is not
in its early stages. We favor conglomerates and aerospace/defense stocks.
Telecom Services
Despite its solid price performance so far this year, the sector trades near historic valuation lows
and offers high dividend yields. Its long-term relative price performance appears to have
bottomed, and we expect continued improvement, unless the economy slows significantly.
Utilities
Europe
29%
Materials
Financials
Energy
16%
5%
Utilities and Consumer Staples appear expensive, but EPS growth rates have improved. The
technology sector’s EPS growth and revisions have deteriorated, and it now ranks as the least
favored in the model. The Consumer Discretionary sector has “fallen from grace” as its earnings
and valuation measures have become less attractive.
Japan
Strategist Masatoshi Kikuchi thinks that portfolios should be oriented toward domestic demand
themes, and he has become more aggressive this month. The food industry has been
downgraded in favor of areas such as financials and retailing. He also suggests housing-related
stocks (rising household incomes should benefit this industry). Electronics remain underweight,
due to concerns over rising inventories and a weaker U.S. consumer sector.
Australia
Indonesia
Thailand
Regional strategist Spencer White believes that subdued risk appetites toward the region favor
core markets and larger-cap stocks. In Australia, the economy appears to be on firmer footing
ahead of income tax cuts and enhanced capital spending, and valuations are low. Indonesia
remains a domestic story as rate pressures and inflation ease; he suggests adding to holdings of
bank and discretionary stocks. Economic momentum in Thailand is improving and oil prices are
declining; that should fuel earnings.
Taiwan
Emerging Markets
The sector looks expensive by several measures. Stocks have moved up along with the market’s
defensive bias, but we don’t find Utilities to be defensive at all. Instead, they appear to be more
economically sensitive. That would be a negative if the U.S. economy slows, as expected.
According to quantitative strategist Khuram Chaudhry, sector valuations have diverged this year
compared to their very tight range in 2005. This is favorable for sector rotation, with Materials now
the most favored from a quantitative view. EPS estimate revisions have been especially strong for
Materials, Energy and Financials; Energy and Financials also appear to have good relative value.
Technology
Cons. Discretionary
Cons. Staples
Utilities
Asia
Comments
Industrials
Brazil
Russia
Indonesia
Turkey
In Taiwan, the dual challenges are technology and politics. The tech sector may see a fourthquarter rally (low valuations, seasonal demand), but we do not favor it for the longer term.
GEM strategist Michael Hartnett thinks that investors should focus on undervalued markets in
countries with current-account surpluses. Two of his favorites remain Brazil and Russia. Brazil’s
valuation is one of the lowest among the GEMs, and interest rate cuts should foster a recovery in
economic growth. Indonesia appears to be in a similar position. In Russia, growth and liquidity
appear ample. In Turkey, a currency recovery is easing inflation and interest rate fears.
India
China
Central Europe
India is the most expensive emerging market, and it has the largest current account deficit in Asia;
rising inflation is likely to pressure the exchange rate, and more monetary tightening is expected.
In China, the massive build-up in capacity is cutting into profit margins, and earnings growth is
declining sharply; we are concerned that tightening may be too aggressive. In Central Europe,
valuations remain expensive and vulnerable to higher rates and currency pressures.
Source: Merrill Lynch Research Investment Committee. * Weighting represents percentage of MSCI All Country Equity Index. ** Sector and country recommendation is versus local regional/country index weights. ^ Weights do not add to 100%
because Canada is excluded.
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U.S. client profile asset allocation
Our investor profiles are designed to serve as guidelines for a three-to-five-year
investment horizon. For the most part, they are strategic in nature, not tactical.
Table 13: Asset allocation by investor with alternative investments
US Stocks
US Range
Non-US Stocks
Non-US Range
Bonds
Bonds Range
Cash
Cash Range
Alternatives
Alternative Range
TOTALS
Capital
Preservation
Income
Income &
Growth
Growth
Aggressive
Growth
20%
10-20
5
0-5
45
45-60
25
10-25
5
0-10
100
35%
30-40
5
0-10
40
40-55
15
0-15
5
0-10
100
40%
40-55
5
0-10
35
30-45
10
0-15
10
10-15
100
50%
40-60
10
5-15
25
20-35
5
0-15
10
10-20
100
60%
50-70
15
10-25
10
10-20
5
0-15
10
10-25
100
Source: Merrill Lynch.
Table 14: Traditional asset allocation by investor profile
US Stocks
US Stocks Range
Non-US Stocks
Non-US Stocks Range
Bonds
Bonds Range
Cash
Cash Range
TOTALS
Capital
Preservation
Income
Income &
Growth
Growth
Aggressive
Growth
20%
10-20
5
0-5
50
45-65
25
15-30
100
35%
30-40
5
0-10
45
40-60
15
0-20
100
45%
40-60
5
0-10
40
35-45
10
0-15
100
55%
50-65
10
0-15
25
20-30
10
0-15
100
65%
50-70
15
10-25
10
10-25
10
0-15
100
Source: Merrill Lynch.
Table 15: Equity allocation by investor profile using size & style
Large Cap Growth
Large Cap Value
Small Cap Growth
Small Cap Value
Non-U.S.
TOTALS
Capital
Preservation
Income
Income &
Growth
Growth
Aggressive
Growth
10%
15
0
0
0
25
10%
20
0
5
5
40
20%
15
5
5
5
50
25%
20
5
5
10
65
25%
20
10
10
15
80
Source: Merrill Lynch.
Table 16: Sector weights across investor profile — August 2006
% Weight* in
Capital
Income &
Aggressive
S&P 500 Index Preservation Income Growth Growth Growth
Technology
HealthCare
Consumer Staples
Consumer Discretionary
Industrials
Materials
Telecomm. Services
Financials
Utilities
Energy
TOTALS
15.1%
12.9
9.9
9.8
10.8
3.0
3.4
21.8
3.5
9.9
100
3%
17
22
8
14
0
3
15
6
12
100
0%
8
19
4
12
0
7
22
12
16
100
10%
11
16
8
16
0
3
18
8
10
100
23%
21
6
12
18
0
2
7
0
11
100
24%
23
3
10
23
0
3
4
0
10
100
Source: Merrill Lynch. * S&P 500 Weights are as of August 31, 2006.
17
The RIC Report
1 2 Se ptembe r 20 06
Fixed income allocation models
If we are right that the Federal Reserve
will be cutting rates next year, yields on
money market funds will decline in 2007.
We expect intermediate- and long-term
yields to decline by then as well. That’s
why we recommend locking in the yields
that are currently available on
intermediate and longer-term issues.
„
For income, growth, and income and growth investors, we emphasize the
five-to-15 year maturity range in both the taxable and municipal markets.
„
We suggest high-quality securities, Treasuries, mortgage-backed, and
selected preferreds in the taxable market, and higher quality munis.
Table 17: Fixed-income allocation by investor profile
Capital
Income &
Preservation
Income
Growth
TAXABLE-Maturity
1-4.99 years
5-14.99 years
15+ years
TOTALS
TAXABLE-Sector
Nominal Treasuries
TIPS
Certificates Of Deposit
Agencies
Corporates
Mortgage-backed
Asset-backed
Preferreds
High Yield
Cash
TOTALS
TAX EXEMPT-Maturity
1-4.99 years
5-9.99 years
10-14.99 years
15+ years
TOTALS
100%
Growth
Aggressive
Growth
100
30%
55
15
100
30%
55
15
100
30%
55
15
100
43%
42
15
100
17
3
25
35
20
0
0
0
0
0
100
11
5
5
9
32
21
0
12
5
0
100
11
5
5
9
32
21
0
12
5
0
100
11
5
5
9
32
21
0
12
5
0
100
30
5
0
8
16
28
3
6
4
0
100
100
20
30
35
15
100
20
30
35
15
100
20
30
35
15
100
15
20
30
35
100
100
Source: Merrill Lynch.
Table 18: Taxable vs. tax-exempt: suggested allocations by profile and tax rate
Aggressive
Federal Marginal
Capital
Income &
Tax Rate
Market
Preservation Income Growth Growth
Growth
35%
33%
28%
25%
0% (e.g., IRA)
Source: Merrill Lynch.
18
Munis
Treasuries
Munis
Treasuries
Munis
Treasuries
Munis
Treasuries
Munis
Treasuries
97%
3
89
11
79
21
69
31
0
100
99%
1
97
3
94
6
91
9
0
100
99%
1
97
3
94
6
91
9
0
100
99%
1
97
3
94
6
91
9
0
100
98%
2
96
4
93
7
89
11
0
100
The RIC Report
1 2 Se ptembe r 20 06
Fixed income barometers
Chart 6: Short-term rates decline after the Fed stops
Chart 7: Individuals moving to money funds
3-Month Treasury Bill Yields
10.0
Assets in money market funds
800
9.0
780
760
7.0
$ Billions
Percent
8.0
6.0
5.0
740
720
4.0
700
3.0
1
2
3
4
5
6
7
8
9
10
11
12
680
Months after fed stops raising rates
1989
1995
Jan-04
2000
Aug-04
Apr-05
Dec-05
Aug-06
Source: Federal Reserve Board, Merrill Lynch.
Source: Federal Reserve Board
Short-term yields typically decline in the months after the last
Fed tightening because the Fed soon shifts gears to cutting
rates.
Individuals are flocking to money market funds, but if we are
right that the Fed will be cutting rates next year, yields on
these funds will start declining. We recommend locking in
intermediate- and long-term yields.
Chart 8: What’s your marginal tax rate?
Table 19: Summary of tax strategies
Effective Marginal Tax Rate, Married Couple, Two Children
40%
„
Emphasize munis in taxable accounts
„
Tax-favored assets in taxable accounts, fully-taxable
assets in tax-deferred accounts
„
High-yielding bonds in tax-deferred accounts
„
Be aware of tax treatment of market discount/premium
bonds
„
Avoid Alternative Minimum Tax (AMT) munis
Effective Marginal Tax Rate, %
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
0
100
200
300
400
500
Source: Merrill Lynch.
Income, Thousands $
Source: Merrill Lynch bond indices
The tax system has become mind-numbingly complex, and it’s
hard for many individuals to determine their marginal tax rate.
Still, intermediate- and longer-term munis provide better
income than Treasuries in the 28% Federal tax bracket and
higher, which applies to most higher-income individuals.
Despite the complexity of the current tax system and the
uncertainty about future changes, the recommendations in the
table above should be appropriate for most individuals.
19
The RIC Report
1 2 Se ptembe r 20 06
U.S. economic, interest rate, and FX forecast summaries
Table 20: U.S. Economic forecast summary (as of 8 September 2006)
Real Economic Activity, % SAAR
4Q05 1Q06 2Q06
Real GDP
Domestic Demand
Consumer Spending
Residential Investment
Nonresidential Investment
Structures
Equipment and Software
Government
Net Exports (billions of $)
Key Indicators
Industrial Production, FRB, % SAAR
Capacity Utilization (percent)
Civilian Unemployment Rate (%)
Productivity, % SAAR
Personal Savings Rate (%)
Housing Starts (Thousands SAAR)
Corporate Profits and Earnings
S&P 500 Earnings Per Share ($)*
% Change, Year Ago
Inflation
GDP Price Index, % SAAR
CPI, Consumer Prices, % SAAR
CPI Ex Food & Energy, % SAAR
3Q06
4Q06
1Q07
2Q07
3Q07
4Q07
2005
2006
2007
1.8
0.7
0.8
-1.0
5.2
12.0
2.8
-1.1
-636.6
5.6
5.4
4.8
-0.3
13.7
8.8
15.6
4.9
-636.6
2.9
1.7
2.6
-9.8
4.7
22.1
-1.6
0.9
-623.6
2.3
2.6
3.7
-18.5
8.4
12.5
7.5
1.7
-622.5
2.0
1.9
2.0
-6.8
5.7
5.8
6.0
2.0
-608.6
1.7
1.1
1.2
-10.3
5.2
5.5
5.3
2.2
-590.9
1.5
0.4
0.5
-13.0
4.8
5.0
5.0
2.0
-567.0
2.0
1.4
1.7
-12.3
5.6
5.5
6.0
2.2
-544.4
2.5
2.0
2.0
-7.5
6.3
6.0
6.7
2.5
-525.9
3.2
3.6
3.5
8.6
6.8
1.1
8.9
0.9
-619.2
3.4
3.0
3.2
-3.1
7.7
9.2
7.1
2.0
-622.8
1.9
1.4
1.7
-11.3
5.7
7.3
5.4
2.0
-557.0
5.2
80.5
4.9
-0.1
-0.3
2060
5.0
81.1
4.7
4.3
-0.3
2123
6.4
81.9
4.6
1.6
-0.7
1875
3.5
82.3
4.8
1.3
-0.7
1770
2.9
82.4
5.0
1.7
-0.5
1700
0.8
82.2
5.2
2.3
-0.1
1610
0.1
81.8
5.5
2.4
0.2
1500
2.5
81.9
5.7
2.7
0.2
1450
2.6
82.0
6.0
3.6
0.0
1420
3.2
80.1
5.1
2.3
-0.4
2073
4.3
81.9
4.8
2.3
-0.6
1867
2.0
82.0
5.6
2.2
0.0
1495
17.3
24.1
19.7
16.2
20.3
10.8
19.2
10.6
18.4
6.6
20.4
3.6
20.5
1.2
20.1
4.5
19.0
3.0
69.9
19.4
77.6
11.0
80.0
3.0
3.3
3.2
2.4
3.3
2.2
2.4
3.3
5.0
3.5
3.0
3.2
2.9
2.4
1.5
2.3
2.2
1.7
1.8
1.8
1.2
1.7
1.6
1.5
1.7
1.4
1.9
1.6
3.0
3.4
2.1
3.1
3.6
2.5
2.2
1.7
2.0
Source: Merrill Lynch Economics. Shaded regions represent Merrill Lynch forecast.
Table 21: U.S. Interest rate forecast summary
(% End of Period, as of 25 August 2006) 1Q06
Fed Funds
3-Month T-Bill
2-Year T-Note
10-Year T-Note
4.75
4.63
4.82
4.85
2Q06
3Q06
4Q06
1Q07
2Q07
3Q07
4Q07
2005
2006
2007
5.25
5.01
5.16
5.15
5.25
4.95
4.90
4.85
5.25
4.80
4.70
4.70
4.75
4.65
4.45
4.45
4.50
4.20
4.00
4.45
4.25
3.95
3.80
4.35
4.00
3.70
3.60
4.25
4.25
4.10
4.40
4.39
5.25
4.80
4.70
4.70
4.00
3.70
3.60
4.25
Source: Merrill Lynch Interest Rate Committee. Shaded regions represent Merrill Lynch forecast.
Table 22: Currency rate forecast summary
As of September 6, 2006
Euroland Euro
Japanese Yen
British Pound
Swiss Franc
US$/Euro
¥/US$
¥/Euro
US$/£
£/Euro
SF/US$
SF/Euro
Source: Merrill Lynch FX Strategy. Spot rate exchange at previous London close.
20
Spot
Dec-06
Mar-07
Jun-07
Sep 07
Dec-07
1.28
116
149
1.89
0.68
1.23
1.58
1.34
107
143
1.94
0.69
1.16
1.55
1.26
110
139
1.77
0.71
1.21
1.52
1.26
103
130
1.75
0.72
1.19
1.50
1.27
100
127
1.74
0.73
1.19
1.51
1.30
96
125
1.75
0.74
1.19
1.53
The RIC Report
1 2 Se ptembe r 20 06
Stock recommended lists
The following are stock recommended lists and are not designed to constitute a
portfolio. Based on investor profile and risk tolerance, investors may choose to
buy securities from the lists.
U.S. Focus 1
„
Table 23: U.S. Focus 1 List as of 9/7/2006
Company
Price as of 9/11/2006
3M Co.
Adobe Systems
Aflac
American
International Group
CVS Corp
Duke Energy
Ecolab
Edison International
Embraer
Freescale
Semiconductor
Goodrich
Hershey
JPMorgan Chase
Motorola
Newfield Exploration
News Corp
Qualcomm
SkyWest
Transocean
Merrill Lynch Research selects certain stocks to highlight for the Focus 1 list.
These recommendations reflect either Merrill Lynch’s current economic and
investment outlook or an unusual fundamental and/or investment development.
A selected stock remains on our Focus 1 stock list for a period of 12 months
unless the Focus 1 committee, at its discretion, removes the stock in
connection with an analyst downgrade or otherwise. The table below shows
the Focus 1 selections currently on our actively managed Focus 1 list.
Symbol
Opinion
Country
Date Added
Price When Added
Footnotes*
70.59
31.50
44.70
MMM
ADBE
AFL
A-1-7
C-1-9
B-1-7
US
US
US
3/29/06
4/27/06
8/1/06
BLbijoprsvx
BLbvx
bBxLjopv
63.90
35.11
29.88
41.73
42.54
40.19
AIG
CVS
DUK
ECL
EIX
ERJ
B-1-7
B-1-7
B-1-7
A-1-7
B-1-7
C-1-7
US
US
US
US
US
Brazil
3/14/06
11/9/05
3/13/06
7/11/06
8/9/06
6/8/06
76.30
38.15
44.14
68.07
30.32
39.54
51.53
45.20
23.04
41.90
19.38
36.97
23.84
73.28
FSL
GR
HSY
JPM
MOT
NFX
NWS
QCOM
SKYW
RIG
C-1-9
B-1-7
B-1-7
B-1-7
C-1-7
B-1-9
B-1-7
C-1-7
C-1-7
B-1-9
US
US
US
US
US
US
US
US
US
US
8/28/06
11/16/05
4/26/06
2/15/06
7/21/06
8/25/06
12/8/05
8/16/06
5/10/06
11/22/05
26.96
28.11
40.02
41.77
33.19
29.21
36.14
52.29
40.10
20.60
43.02
16.04
35.45
23.54
62.26
jopsvbBixLgOw
BLbjopwx
BLbijopsvx
BbxLjo
BLObijopsvx
bBxLv
BLbvx
ijsbBxpLwv
bBxLsivjopg
ijopsvbBx#LwOsg
BLObijpsvwx
bBxwLO
#BLObjovx
BLbjopvx
BLObisvx
bwBxLv
Source: Merrill Lynch Research.
(American International Group, Embraer, Goodrich Corp., JP Morgan, Motorola, and News Corp.) One or more analysts responsible for selecting the securities held in the Focus 1 List owns such securities. Investors should review the most recent
report on a company prior to making an investment decision.
Please refer to Footnote Key on page 25.
21
The RIC Report
1 2 Se ptembe r 20 06
Preferred Securities Recommendations
The following are preferred stock recommendations and are not designed to constitute a portfolio. Based on investor profile and risk
tolerance, investors may choose to buy securities from this list. Note that only the securities that pay Qualified Dividend Income are
those listed in the bottom two sections (the foreign preference and the DRDs).
Table 24: Preferred securities recommendations for individual investors
Issuer1
ML Sec. #
/CUSIP # Dividend
As of Sept. 8, 2006
Spread to
Ratings Call Date Price2 CY/YTM3 YTC3
Worst4
U.S Trust Preferreds and other deferrable hybrids (maturities generally about 30 years) — Do not pay Qualified dividend income
C Pr O
Citigroup Capital
52GX1
6.88%
Aa2/A 6/30/2011
25.38
6.77
USB Pr I
USB Capital
52GW4
6.50%
Aa3/A 4/12/2011
24.57
6.62
MSJ
Morgan Stanley
49D09
6.60%
A1/A- 2/1/2011
24.77
6.66
WNA
Wachovia Preferred Funding7
8Y0S1
7.25%
A2/A- /*+ 12/31/2022
27.67
6.55
LNC Pr G
Lincoln National
52GW5
6.75%
Baa2/A- 4/20/2011
24.83
6.80
U.S. Senior Debt Securities (maturities generally about 30 years) — Do not pay Qualified dividend income
GER
General Electric Capital
31XF0
6.45%
Aaa/AAA 6/15/2011
25.25
6.39
ABA
Alabama Power
03JE8
6.38%
Aaa/AAA 6/14/2011
25.25
6.31
CCT
Comcast Corp.
52GW6
7.00%
Baa2/BBB+ 5/15/2011
25.25
6.93
PL Pr D
Protective Life
52GX2
7.25%
Baa2/BBB 6/30/2011
25.09
7.23
PHA
Pulte Homes
59GN0
7.38%
Baa3/BBB 6/1/2011
24.94
7.39
U.S. REIT Preferred Securities (Perpetual securities.) Not appropriate for NRA investors. Do not pay Qualified dividend income
PSA Pr I
Public Storage
59GM0
7.25%
Baa1/BBB+ 5/3/2011
25.31
7.16
DRE Pr N
Duke Realty Corp.
21AE4
7.25%
Baa2/BBB 6/30/2011
25.40
7.14
Foreign Shares (Perpetual securities.) Dividend income taxation varies
RBS Pr Q
Royal Bank of Scotland8
67DA4
6.75%
A1/A 6/30/2011
25.46
6.63
RBS Pr M
Royal Bank of Scotland 8
661R8
6.40%
A1/A 9/30/2009
25.00
6.40
STD Pr I
Banco Santander8
08RJ9
6.41%
A2/A- 3/11/2009
25.12
6.38
AED
Aegon NV8
03N70
6.50%
A3/A- 12/15/2010
24.93
6.52
AXS Pr A
Axis Capital8
03HY6
7.25%
Baa3/BBB- 10/15/2010
24.93
7.27
DRD Preferred Shares (Perpetual securities.) Pay qualified dividend income6
HBA Pr H
HSBC USA
31YD8
6.50%
A2/A 7/1/2011
25.95
6.26
HFC Pr B
HSBC Finance
31YB6
6.36%
A2/A 6/24/2010
25.43
6.25
GS Pr B
Goldman Sachs
31XA2
6.20%
A2/A- 10/31/2010
25.37
6.11
Footnotes
6.51
6.94
6.84
6.21
6.92
176
166
170
124
184
svgbBijoxLOpsw
ijogsvbBxLps
jopbBwxLvOgsi
ijopsvgbBxLO
ijosbBxLvpOg
6.21
6.14
6.75
7.16
7.44
146
139
201
242
244
sgvbBijopxLO
BLbijosvwx
ijo#vsbBxLOg
i#sbBvxLjopg
bBxLsiOg
6.95
6.86
220
211
bBxLsigv
BLObisvx
6.31
6.39
6.21
6.57
7.33
156
162
144
157
232
5.61
5.86
5.81
TECY5
8.67
jopisvNgqwLs
8.37
jopisvNgqwLs
8.34
ijopvgbBsxLO
8.52
svbBijopxLg
9.51
ibBsxLvg
TECY5
87 8.19 svwbBijopxLOg
111 8.18 svwbBijopxLOg
106 7.99 ijopbsBvxLOwg
1 For hybrid preferred securities, name of security can vary from issuer name.
2 Prices are stated “clean”, without the accrued coupon. NYSE quotes are used for pricing. YTC and CY indicate yield-to-call and current yield, respectively. YTC is calculated based upon the strip price and call date.
3 The numbers that are bolded are the yield to worst. Yield to worst is the lower of the yield to call or yield to maturity. If the security is priced above its call price, the yield to worst is the yield to call. If the price is below the call price, the yield to
worst is the yield to maturity.
4 Spread to worst is the spread that applies to the yield to worst. If the price of the security is above the call price, the spread to worst is the spread of the yield to call vs. the Treasury security that matures closet to the call date. If the price is below
the call price, the spread is the yield to maturity vs. the 30-year Treasury.
5 TECY is the taxable equivalent current yield for an investor facing a 35% tax on ordinary income, and 15% on dividend income.
6 None of these issues are appropriate for NRA accounts.
7 This issue is a non-trust hybrid and is not a REIT
8 Company stated in prospectus that issue pays QDI.
Note that the favorable tax treatment for the preferreds that pay Qualified Dividend Income is due to expire at the end of 2010.
Criteria Used For Recommendations: 1) Issues with at least two years of call protection. 2) No sinkers, adjustables, or partnerships. 3) Issues with investment grade ratings (Baa3/BBB-, or better). 4) NYSE listing. 5) Outstanding par amount of at
least $100 million 6) Average daily trading volume of at least 5,000 shares during the past 30 day.
*/* On watch for a change in credit rating. NRA = Non-Resident Alien.
N.A. = Not Available or Not Applicable. For information on accessing these securities call 1-866-99-Market.
Please refer to Footnote Key on page 25.
22
The RIC Report
1 2 Se ptembe r 20 06
U.S. High quality & dividend yield screen
This month’s High Quality & Dividend Yield screen generated 16 companies on
which investors might focus.
Screening criteria are:
„
S&P Common Stock Rank of A+, A or A-. The S&P Common Stock rankings
are our main measure of quality. These rankings are based primarily on the
growth and stability of earnings and dividends over a 10-year period.
„
Return on Equity (ROE) greater than the average S&P 500 ROE.
„
Debt/Equity lower than the S&P 500.
„
Dividend Yield greater than the S&P 500.
„
Merrill Lynch Investment Opinion indicates the likelihood that the dividend will
remain the same or be increased (i.e., a dividend rating of “7”).
„
The ratio of the last 12 months’ free cash flow to dividends must be greater
than 10.
For additional information please refer to the “Monthly U.S. Strategy Update” by
Richard Bernstein and team titled “High Quality & Dividend Yield Screen.” The
latest report is dated September 5, 2006.
Table 25: High quality & dividend yield screen
Ticker Name
Sector
MO
MRK
PII
VFC
KMB
DHI
MMM
AVP
ABT
KBH
JNJ
EMR
PG
MKC
ITW
Consumer Staples
Health Care
Consumer Discretionary
Consumer Discretionary
Consumer Staples
Consumer Discretionary
Industrials
Consumer Staples
Health Care
Consumer Discretionary
Health Care
Industrials
Consumer Staples
Consumer Staples
Industrials
ALTRIA GROUP INC
MERCK & CO
POLARIS IND
VF CORP
KIMBERLY-CLARK C
D R HORTON INC
3M CO
AVON PRODUCTS
ABBOTT LABORATOR
KB HOME
JOHNSON & JOHNSO
EMERSON ELECTRIC
PROCTER & GAMBLE
MCCORMICK & COMP
ILLINOIS TOOL WO
Return
on Equity
31.09
30.31
38.06
19.21
22.19
27.54
31.73
50.8
21.2
34.29
28.8
22.55
21.61
24.72
20.49
Debt to
Equity
0.54
0.33
0.26
0.33
0.62
1
0.24
1.74
0.69
1.2
0.06
0.51
0.61
0.67
0.12
Dividend
Market Value
yield as of S&P common (in mlns) as of Prices as of
9/5/2006 stock ranking 9/5/2006
9/5/2006
4.12
3.75
3.25
3.15
3.09
2.74
2.57
2.44
2.42
2.34
2.32
2.17
2
1.98
1.91
A+
A
AAA
A+
A
A
A
A
A+
A
A
A+
A+
166987
87890
1550
7444
27979
6701
53028
12978
72907
3883
185212
32394
184419
4142
25944
83.53
40.55
38.1
69.89
63.5
21.93
71.7
28.71
48.7
42.76
64.66
82.15
61.9
36.42
43.9
Free Cash
Flow to
QRQ Dividends
B-1-7
B-1-7
B-1-7
B-2-7
A-2-7
B-2-7
A-1-7
B-2-7
B-1-7
B-2-7
A-1-7
A-1-7
A-1-7
A-1-7
A-2-7
1.5
1.9
2.5
2.2
1.6
7.9
2.5
1.6
1.8
11.2
2.3
2.5
2.3
2.2
3.7
Source: Merrill Lynch U.S. Strategy, Factset, S&P. Note: LTM stands for Last 12-Months. Financials stocks are excluded because they typically have very high Debt/Equity ratios that have nothing to do with their capital structure
23
The RIC Report
1 2 Se ptembe r 20 06
International high quality & dividend yield screen
This screen selects high quality and high dividend yield stocks from the MSCI AC
World ex-USA index which are covered by Merrill Lynch. The screen uses the
following criteria to uncover higher quality companies that offer relatively secure
dividend yield.
„
S&P Common Stock Rank (quality rank) of A+, A, or A- for our global ex-USA
model. Our Asia Pacific screen includes stocks with B+ or better rankings.
The S&P Common Stock rankings are our main measure of quality. These
rankings are based on the stability and growth in earnings and dividends
over a seven-year period for non-US companies.
„
Return on Equity (ROE) greater than the MSCI index.
„
Debt/Equity lower than the MSCI index.
„
Dividend yield greater than the MSCI index.
„
Merrill Lynch Investment Opinion indicates the likelihood that the dividend will
remain the same or be increased (i.e., a dividend rating of “7”).
„
The ratio of the past 12 months’ free cash flow to dividends is greater than
1.0.
Table 26: Merrill Lynch Global Quantitative Strategy—Global non-U.S. high quality and high dividend yield screen
Symbol
Company
Country
Sector
WOSLF
ETINF
WEBNF
NSRGF
TTFNF
EIPAF
PSMMF
GEWIF
NXGPF
AANAF
SCTBF
SAGKF
VCISF
BLWYF
TVPKF
TWODF
ISMAF
NHYKF
WOLSELEY
ENTERPRISE INNS
WESTPAC BANKING
NESTLE
TOTAL
ENI
PERSIMMON
WIMPEY (GEORGE)
NEXT
ALTANA
SECURITAS B
STAGECOACH GROUP
VINCI
BELLWAY
TRAVIS PERKINS
TAYLOR WOODROW
INDRA SISTEMAS A
NORSK HYDRO
United Kingdom
United Kingdom
Australia
Switzerland
France
Italy
United Kingdom
United Kingdom
United Kingdom
Germany
Sweden
United Kingdom
France
United Kingdom
United Kingdom
United Kingdom
Spain
Norway
Industrials
Autos, Durables, Services
Banks
Consumer Staples
Energy
Energy
Autos, Durables, Services
Autos, Durables, Services
Retailing
Health Care
Industrials
Industrials
Industrials
Autos, Durables, Services
Retailing
Autos, Durables, Services
Software & Services
Energy
Source: Merrill Lynch Global Quantitative Strategy, MSCI, IBES, S&P.
24
MCAP
12,963
6,449
32,683
138,521
165,662
122,537
6,974
3,769
7,713
8,285
6,133
2,385
24,310
2,617
3,876
3,749
3,008
33,474
Quality
A+
A
AAAAA+
A+
A
A
AAAA+
A+
AA
A-
Dividend Yield
2.4%
2.1%
4.6%
2.1%
3.1%
2.7%
2.6%
3.6%
2.6%
2.4%
2.7%
3.2%
2.4%
2.7%
2.1%
4.1%
2.4%
2.7%
Full QRQ
31-Aug-06
Price (USD)
A-1-7
A-1-7
A-1-7
A-1-7
A-1-7
A-2-7
B-1-7
B-1-7
B-1-7
B-1-7
B-1-7
B-1-7
B-1-7
B-2-7
B-2-7
B-2-7
B-2-7
B-2-7
21.78
19.48
17.85
343.28
67.46
30.59
23.68
9.53
31.71
59.01
17.63
2.21
108.16
23.11
32.07
6.52
20.78
25.85
The RIC Report
1 2 Se ptembe r 20 06
Europe 1 List
„
Table 27: Europe 1 Focus list as of August 14, 2006
„
Europe 1 represents a collection of stock recommendations from the Merrill
Lynch European research analysts and is designed to offer investors access
to some of our best research ideas. Each stock is chosen by a Research
committee whose aim is to construct a list of European stocks that it believes
will deliver significant positive price appreciation and reflect the general
themes being promoted by Merrill Lynch’s Research department.
Company
Symbol
Rating
Date Added
Currency
Current Local Price
as of 9/11/2006
Price When Added
Footnotes
Wienerberger
Stada Arzneimittel
Mediobanca
Nokia
Cadbury Schweppes
Cosmote Mobile
Man Group plc
Neste Oil
Red Electrica de Espana
Michelin
Peter Hambro Mining
Lanxess AG
Novartis (Reg.)
Fresenius
Akzo Nobel
Aker Kvaerner
Vedanta Resources PLC
Elisa
MOL
STMicroelectronics
Dana Petroleum
ABB Ltd
British Land
USG People
3i Group
Groupe Danone (BSN)
Punch Taverns
Scottish Power
Zurich Financial Services
BBVA
Xstrata Plc
Barclays
WBRBF
STDAF
MDIBF
NOKBF
CSGWF
CZMTF
MNGPF
NTOIF
RDEIF
MGDDF
PTHBF
LNXSF
NVSEF
FSNPF
AKZOF
AKKVF
VDNRF
ELMUF
MMGYF
STMEF
DNPXF
ABLZF
BRLAF
UQUEF
TIGRF
GPDNF
PCTVF
SCPWF
ZFSVF
BBVXF
XSRAF
BCLYF
B-1-7
B-1-7
B-1-7
B-1-7
A-1-7
C-1-8
B-1-7
C-2-7
B-1-7
B-1-7
C-1-9
C-1-9
A-1-7
B-1-7
B-1-7
C-1-7
C-1-7
B-1-7
C-1-7
B-1-7
B-1-9
B-1-7
A-1-7
C-1-7
B-1-7
B-1-7
B-1-7
A-1-7
B-1-7
B-1-7
B-1-7
B-1-7
5-Sep-05
5-Sep-05
6-Sep-05
6-Oct-05
10-Oct-05
11-Oct-05
14-Oct-05
21-Nov-05
16-Dec-05
5-Jan-06
10-Jan-06
23-Jan-06
23-Jan-06
25-Jan-06
17-Feb-06
23-Feb-06
1-Mar-06
7-Mar-06
16-Mar-06
17-Mar-06
27-Mar-06
7-Apr-06
18-Apr-06
18-Apr-06
5-May-06
25-May-06
30-May-06
1-Jun-06
16-Jun-06
21-Jun-06
31-Jul-06
14-Aug-06
EUR
EUR
EUR
EUR
GBP
EUR
GBP
EUR
EUR
EUR
GBP
EUR
CHF
EUR
EUR
NOK
GBP
EUR
HUF
EUR
GBP
CHF
GBP
EUR
GBP
EUR
GBP
GBP
CHF
EUR
GBP
GBP
37.15
38.12
16.67
15.17
560.00
18.92
432.00
22.84
29.56
51.25
1287.00
31.76
69.50
134.95
45.07
607.50
1362.00
16.10
21155.00
12.40
1193.50
16.50
1337.00
57.40
946.00
105.70
910.00
626.50
276.50
17.71
2353.00
656.50
34.00
28.48
16.33
13.93
556.50
16.88
1541.00
25.18
25.13
48.70
990.50
25.76
70.50
126.31
43.30
540.00
1099.00
18.15
21000.00
14.60
1009.50
16.85
1277.00
68.20
936.56
95.65
877.00
570.00
260.25
15.39
2297.00
*
qLv
qLwv
jopqLOgsiv
qLxvw
qvwjoxL
qLsiv
ijopsvNqwLg
qL
qLvNw
qL
qLw
qL
joqxLv
qL
qxLv
qLv
qLw
qLOw
qLwvO
qxLjpwgsiv
qLvsigw
qxLv
qwLjo
qLw
jpovqLNOsi
qLvx
qNLvwsi
ijpqsxLbBv
pjoqvwL
ijopvqsLxsw
qLwv
ijop#gsqwvxL
Source: Merrill Lynch Research. Solicitation of Commission Orders is prohibited. Please refer to Footnote Key.
Footnote Key
/b/ MLPF&S or one or more of its affiliates acts as a market maker for the recommended securities to the extent that MLPF&S or such affiliate is willing to buy and sell such securities for its own account on a
regular and continuous basis.
/B/ MLPF&S or one of its affiliates is willing to sell to, or buy from, clients the common equity of the company on a principal basis.
/g/ MLPF&S or an affiliate was a manager of a public offering of securities of this company within the last 12 months.
/i/ The company is or was, within the last 12 months, an investment banking client of MLPF&S and/or one or more of its affiliates.
/j/ MLPF&S or one of its affiliates is willing to sell to, or buy from, clients the common equity of the company on a principal basis.
/M/ Additional information pursuant to Section 34b of the German Securities Trading Act: Merrill Lynch and/or its affiliates was an underwriter in an offering of securities of the issuer in the last five years.
/N/ The company is a corporate broking client of Merrill Lynch International in the United Kingdom.
/o/ The company is or was, within the last 12 months, a securities business client (non-investment banking) of MLPF&S and/or one or more of its affiliates.
/p/ The company is or was, within the last 12 months, a non-securities business client of MLPF&S and/or one or more of its affiliates.
/q/ In the US, retail sales and/or distribution of this report may be made only in states where these securities are exempt from registration or have been qualified for sale.
/r/ An officer, director or employee of MLPF&S or one of its affiliates is an officer or director of this company.
/s/ MLPF&S or an affiliate has received compensation for investment banking services from this company within the past 12 months.
/v/ MLPF&S or an affiliate expects to receive or intends to seek compensation for investment banking services from this company within the next three months.
/w/ MLPF&S together with its affiliates beneficially owns one percent or more of the common stock of this company calculated in accordance with Section 13(d) of the Securities Exchange Act of 1934.
/x/ Customers of Merrill Lynch in the US can receive independent, third-party research on companies covered in this report, at no cost to them, if such research is available. Customers can access this independent
research at http://www.ml.com/independentresearch or can call 1-800-637-7455 to request a copy of this research.
/y/ One or more of the analysts responsible for covering the securities in this report has participated in a solicitation within the past 12 months to provide investment banking services in connection with a
transaction underwritten by MLPF&S or an affiliate.
/z/ The country in which this company is organized has certain laws or regulations that limit or restrict ownership of the company's shares by nationals of other countries.
/O/ MLPF&S or one of its affiliates has a significant financial interest in the fixed income instruments of the issuer. If this report was issued on or after the 10th day of a month, it reflects a significant financial
interest on the last day of the previous month. Reports issued before the 10th day of a month reflect a significant financial interest at the end of the second month preceding the date of the report:
/L/ The analyst(s) responsible for covering the securities in this report receive compensation based upon, among other factors, the overall profitability of Merrill Lynch, including profits derived from investment
banking revenues.
/#/ One or more analysts responsible for covering the securities in this report owns such securities. Rstr - RESTRICTED. SOLICITATION OF COMMISSION ORDERS IS PROHIBITED
25
The RIC Report
1 2 Se ptembe r 20 06
Price Objective Basis and Risk
Kinder Morgan
Our 12-month price objective of $50 per LP unit for KMP/KMR is based on an
analysis of discounted cash distributions per LP unit. We estimate the cost of
equity at 10% and distributions per LP unit growth of 5% in 2006, 4% in 2007, 5to-8% in 2008-2011 with a terminal growth rate of 2%. Business risks to our rating
and price objective on KMP/KMR are a decrease in crude oil production at its
CO2 segment; an outright decline in demand for refined products or natural gas;
and supply chain disruptions (such as hurricanes).
Enterprise Products Partners
Our 12-month price objective of $29 per LP unit for Enterprise is based on an
analysis of discounted cash distributions per LP unit. We estimate the cost of
equity at 9.5% and distributions per LP unit growth of 7% in 2006, 7% in 2007, 4to-6% in 2008-11 with a terminal growth rate of 2%. Business risks to our rating
and price objective are a decrease in natural gas and crude oil imports into the
Gulf Coast, an outright decline in demand for energy commodities due to higher
prices, an economic slowdown or other reasons, and supply chain disruptions.
Plains All American Pipeline
Our 12-month price objective of $51 per LP unit for PAA is based on an analysis
of discounted cash distributions per LP unit. We estimate PAA’s cost of equity at
9.2% and distributions per LP unit growth of 10% in 2006, 9% in 2007, 6-to-9% in
2008-2011 with a terminal growth rate of 1%. Business risks to our rating and
price objective on PAA are a decrease in crude imports into the Gulf Coast and
from Canada, an outright decline in demand, and supply chain disruptions.
Analyst Certification
We, Richard Bernstein, Martin Mauro and Gabe Moreen, hereby certify that the
views each of us has expressed in this research report accurately reflect each of
our respective personal views about the subject securities and issuers. We also
certify that no part of our respective compensation was, is, or will be, directly or
indirectly, related to the specific recommendations or view expressed in this
research report.
26
The RIC Report
1 2 Se ptembe r 20 06
Merrill Lynch is currently acting as financial advisor to Kinder Morgan Inc. in connection with the sale of its natural-gas retail distribution unit to GE Energy Financial
Services, which was announced on August 14, 2006.
Merrill Lynch has been mandated to participate in the financing portion of Kinder Morgan Inc's proposed management buyout transaction.
Important Disclosures
KMP Price Chart
1-Sep:N
Brothwell
16-Jun:B
Moreen
PO:US$50
US$70
US$60
US$50
US$40
US$30
US$20
US$10
US$0
1-Jan-04
1-Jan-05
1-Jan-06
Restricted
Review
KMP
B : Buy, N : Neutral, S : Sell, PO : Price objective, NA : No longer valid
The Investment Opinion System is contained at the end of the report under the heading "Fundamental Equity Opinion Key". Dark Grey shading indicates the security is restricted with the opinion suspended. Light Grey shading indicates the security
is under review with the opinion withdrawn. Chart current as of August 31, 2006 or such later date as indicated.
EPD Price Chart
17-Feb:N
Brothwell
15-Jul:B
PO:US$23
13-Oct
PO:US$25
12-Jan
PO:US$27
3-Feb
PO:US$30
US$32
2-Sep
Laws
PO:US$29
20-Jul
Moreen
US$28
US$24
US$20
US$16
US$12
US$8
US$4
US$0
1-Jan-04
EPD
1-Jan-05
Review
1-Jan-06
Restricted
B : Buy, N : Neutral, S : Sell, PO : Price objective, NA : No longer valid
The Investment Opinion System is contained at the end of the report under the heading "Fundamental Equity Opinion Key". Dark Grey shading indicates the security is restricted with the opinion suspended. Light Grey shading indicates the security
is under review with the opinion withdrawn. Chart current as of August 31, 2006 or such later date as indicated.
27
The RIC Report
1 2 Se ptembe r 20 06
PAA Price Chart
2-Dec:N
Brothwell
28-Apr:B
Moreen
PO:US$48
25-May
PO:US$51
US$60
US$50
US$40
US$30
US$20
US$10
US$0
1-Jan-04
1-Jan-05
Review
PAA
1-Jan-06
Restricted
B : Buy, N : Neutral, S : Sell, PO : Price objective, NA : No longer valid
The Investment Opinion System is contained at the end of the report under the heading "Fundamental Equity Opinion Key". Dark Grey shading indicates the security is restricted with the opinion suspended. Light Grey shading indicates the security
is under review with the opinion withdrawn. Chart current as of August 31, 2006 or such later date as indicated.
Investment Rating Distribution: Energy Group (as of 30 Jun 2006)
Coverage Universe
Count
Percent
Inv. Banking Relationships*
Buy
Neutral
Sell
Buy
Neutral
Sell
80
82
8
47.06%
48.24%
4.71%
Investment Rating Distribution: Global Group (as of 30 Jun 2006)
Coverage Universe
Count
Percent
Inv. Banking Relationships*
Buy
Neutral
Sell
Buy
Neutral
Sell
1264
1398
203
44.12%
48.80%
7.09%
Count
Percent
32
24
0
40.00%
29.27%
0.00%
Count
Percent
430
404
45
34.02%
28.90%
22.17%
* Companies in respect of which MLPF&S or an affiliate has received compensation for investment banking services within the past 12 months.
FUNDAMENTAL EQUITY OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK
RATINGS, indicators of potential price fluctuation, are: A - Low, B - Medium, and C - High. INVESTMENT RATINGS, indicators of expected total return
(price appreciation plus yield) within the 12-month period from the date of the initial rating, are: 1 - Buy (10% or more for Low and Medium Volatility Risk
Securities - 20% or more for High Volatility Risk securities); 2 - Neutral (0-10% for Low and Medium Volatility Risk securities - 0-20% for High Volatility
Risk securities); 3 - Sell (negative return); and 6 - No Rating. INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher (dividend
considered to be secure); 8 - same/lower (dividend not considered to be secure); and 9 - pays no cash dividend.
LP.
LP.
MLPF&S or one of its affiliates acts as a market maker for the securities recommended in the report: Enterprise L.P., Kinder Morgan LP, Plains AA.
The company is or was, within the last 12 months, an investment banking client of MLPF&S and/or one or more of its affiliates: Enterprise L.P., Kinder Morgan
MLPF&S or an affiliate has received compensation from the company for non-investment banking services or products within the past 12 months: Kinder Morgan
The company is or was, within the last 12 months, a non-securities business client of MLPF&S and/or one or more of its affiliates: Kinder Morgan LP.
MLPF&S or an affiliate has received compensation for investment banking services from this company within the past 12 months: Enterprise L.P., Kinder
Morgan LP.
MLPF&S or an affiliate expects to receive or intends to seek compensation for investment banking services from this company within the next three months:
Enterprise L.P., Kinder Morgan LP.
MLPF&S or one of its affiliates is willing to sell to, or buy from, clients the common equity of the company on a principal basis: Enterprise L.P., Kinder Morgan
LP, Plains AA.
The company is or was, within the last 12 months, a securities business client (non-investment banking) of MLPF&S and/or one or more of its affiliates: Kinder
Morgan LP.
The analyst(s) responsible for covering the securities in this report receive compensation based upon, among other factors, the overall profitability of Merrill
Lynch, including profits derived from investment banking revenues.
28
The RIC Report
1 2 Se ptembe r 20 06
Other Important Disclosures
UK readers: MLPF&S or an affiliate is a liquidity provider for the securities discussed in this report.
Merrill Lynch fixed income analysts regularly interact with Merrill Lynch sales and trading desk personnel in connection with their research, including to ascertain
pricing and liquidity in the fixed income markets.
Information relating to Non-U.S. affiliates of Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S):
MLPF&S distributes research reports of the following non-US affiliates in the US (short name: legal name): Merrill Lynch (France): Merrill Lynch Capital Markets
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Ltd; Merrill Lynch (Milan): Merrill Lynch Capital Markets Bank Limited; MLPF&S (UK): Merrill Lynch, Pierce, Fenner & Smith Limited; Merrill Lynch (Australia): Merrill
Lynch Equities (Australia) Limited; Merrill Lynch (Hong Kong): Merrill Lynch (Asia Pacific) Limited; Merrill Lynch (Singapore): Merrill Lynch (Singapore) Pte Ltd;
Merrill Lynch (Canada): Merrill Lynch Canada Inc; Merrill Lynch (Mexico): Merrill Lynch Mexico, SA de CV, Casa de Bolsa; Merrill Lynch (Argentina): Merrill Lynch
Argentina SA; Merrill Lynch (Brazil): Banco Merrill Lynch de Investimentos SA; Merrill Lynch (Japan): Merrill Lynch Japan Securities Co, Ltd; Merrill Lynch (Seoul):
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This research report has been prepared and issued by MLPF&S and/or one or more of its non-U.S. affiliates. MLPF&S is the distributor of this research report in
the U.S. and accepts full responsibility for research reports of its non-U.S. affiliates distributed in the U.S. Any U.S. person receiving this research report and wishing
to effect any transaction in any security discussed in the report should do so through MLPF&S and not such foreign affiliates.
This research report has been approved for publication in the United Kingdom by Merrill Lynch, Pierce, Fenner & Smith Limited, which is authorized and
regulated by the Financial Services Authority; has been considered and distributed in Japan by Merrill Lynch Japan Securities Co, Ltd, a registered securities dealer
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Merrill Lynch Dublin is regulated by BaFin.
Copyright, User Agreement and other general information related to this report:
Copyright 2006 Merrill Lynch, Pierce, Fenner & Smith Incorporated. All rights reserved. This research report is prepared for the use of Merrill Lynch clients and
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representations or warranties whatsoever as to the data and information provided in any third party referenced website and shall have no liability or responsibility
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29
The RIC Report
1 2 Se ptembe r 20 06
Team Page
Research Investment Committee (RIC)
Richard Bernstein
+1 212 449 0905
Chief Investment Strategist
MLPF&S
richard_bernstein@ml.com
Mary Ann Bartels
+1 212 449 8038
+1 212 449-3620
+44 20 7996 4144
+1 212 449 0218
Research Analyst
MLPF&S
philip_fischer@ml.com
Michael Hartnett
+1 212 449 3600
Global EM Equity Strategist
MLPF&S
michael_hartnett@ml.com
Martin Mauro
+1 212 449 0927
Fixed Income Strategist
MLPF&S
martin_mauro@ml.com
Alex Patelis
+44 20 7996 5897
Global FX Strategist
MLPF&S (UK)
alex_patelis@ml.com
Kari Pinkernell
+1 212 449 7069
Investment Strategist
MLPF&S
kari_bayer@ml.com
Satya D. Pradhuman
+1 212 449 0913
Small Cap Strategist
MLPF&S
satya_pradhuman@ml.com
David A. Rosenberg
+1 212 449 4937
North American Economist
MLPF&S
david_rosenberg@ml.com
Nigel Tupper >>
+61 2 9226 5747
Quantitative Strategist
Merrill Lynch (Australia)
nigel_tupper@ml.com
David A. Wilson, CFA
+1 212 449 4500
Portfolio Strategist
MLPF&S
david_a_wilson@ml.com
The Global Private Client Research Investment Committee (RIC) is responsible for
articulating market views in a thematic context, and translating those themes to the
level of actionable ideas for GPC financial advisors and our private clients. In the
course of its work, the RIC is able to leverage the work of our entire global research
department. We will aim to communicate our most important macro ideas and
forecasts in a thoughtful, abbreviated format.
>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a
research analyst under NYSE/NASD rules.
30
Michele Chesnicka
Fixed Income Strategist
MLPF&S
michele_chesnicka@ml.com
Commodity Strategist
MLPF&S (UK)
francisco_blanch@ml.com
Philip J. Fischer
Lisa Kirschner
+1 212 449 0908
Investment Strategist
MLPF&S
lisa_kirschner@ml.com
US Sector Strategist
MLPF&S
brian_belski@ml.com
Francisco Blanch
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Editor
MLPF&S
steven_lauria@ml.com
Technical Research Analyst
MLPF&S
maryann_bartels@ml.com
Brian G. Belski
RIC Report
Steven Lauria
+1 212 449 2329