TheAdvisory

INVESTMENT PERSPECTIVES FROM BROWN ADVISORY 1 OVER STORY C COMPELLING OPPORTUNITIES IN EMERGING MARKETS 5 ROM BORING TO BOOMING F THE BEAUTY OF DIVIDEND STOCKS 6 MBRACING THE IDIOSYNCRATIC E PRIVATE EQUITY AND YOUR PORTFOLIO

COVER STORY

MARCH 2012

Big Spenders
The rise of the middle class in emerging economies will drive growth for decades. Here are some interesting strategies to benefit from this trend.

he numbers are so large that its difficult to comprehend: According to the IMF, 800 million people in emerging market countries are expected to move from the lower class to the middle class over the next 10 years; 70% of global growth will come from emerging economies in that time; and G7 economies (the U.S., France, Germany, Italy, Japan, the U.K. and Canada) are estimated to slip from 65% of global GDP to-

day to 25% by 2034. The knee-jerk investment conclusion would be to over-allocate funds to emerging markets from developed markets, believing that such powerful economic growth will lead to strong investment returns over time. But our conclusion isnt quite so simple. Contemplating investments in emerging markets reminds me of my experience covering technology stocks during the dot-com frenzy
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Getting Cheaper
The collapse in emerging-markets stock prices in the last year has been largely the result of declining price/earnings ratios.

BY PAUL CHEW, CFA

23 21 19 17 15

Head of Investments

MSCI Emerging Markets Index Trailing P/E Ratio Long-Term Median

COVER STORY CONTINUED

in the late 1990s. Then, the markets 13 were mesmerized by the potential of the Internet to change our lives, which of 11 course it did. While there were many 9 casualties of the Internet bubble (re7 member Pets.com and their sock pup2001 2003 2005 2007 2009 2011 pet commercials?), other companies delivered on their potential. Amazon.com, SOURCE: BLOOMBERG for example, wowed investors with a business model that allows customers to shop from the comfort of their homes. Today, everyone knows that Amazon should have a meaningful allocation on emerging market consumers. Its has been a smashing success. What peo- that includes both large- and small-cap much more of a bet on the future price ple forget is that it took Amazon shares stocks, hedged exposure through long/ of oil, which is largely determined by 11 years to climb back to the heights short managers, and emerging-market economic activity in the U.S. and Euwhere they were trading at the end of corporate debt. Here are the details. rope rather than developing countries. 1999. The question in Amazons case In order to capitalize on the emergwas never growthit was valuation ATTENTION ASIAN SHOPPERS ing-market middle-class theme, we beand price. The rise of the emerging-markets con- lieve that it makes more sense to invest Just as the Internet brought trans- sumer is a well-known trend, yet ETFs, in smaller companies that offer a purer formational change to a variety of mar- index funds and many of the largest exposure to the high-growth consumer kets, the rise of the middle-class con- emerging-market mutual funds provide sectors and niche markets. These busisumer will reinvent emerging markets little actual exposure to the consumer. nesses tend to develop after the larger over the coming decades. This repre- The development of financial markets state-backed firms are established, and sents a great long-term opportunity, but in various emerging economies follows they are a more direct play on domestic we believe that taking advantage of it a familiar script, with the first public economies. As one indication of this will require a more thoughtful approach companies being government spin-outs potential, if consumption expenditures than just investing in an index fund or in industries such as financial services, continue growing at historical rates, throwing darts. That was clear in 2011, energy and materials. Thus, it is not developing-Asia consumers alone will when the MSCI Emerging Markets in- surprising that the MSCI Emerging account for 43% of worldwide condex fell more than 18%. The bright side: Markets Index is dominated by banks sumption by 2030, spending $32 trilThe price decline has caused valuations and export-focused energy and materi- lion annually, up from $4.3 trillion in to become quite attractive, as the chart als companies, as shown in the table on 2008. The consumer is therefore likely above shows. page 4. to be the engine of overall growth. Rather than a simple one size fits Take Petrobras. An investment in all approach, we believe that investors this Brazilian company is hardly a play CONTINUED ON PAGE 4
2 THE ADVISORY MARCH 2012

Finding Opportunities Across the Liquidity Spectrum

Timely, opportunistic additions to portfolios can make a significant difference in overall returns. Identifying ideas like the ones listed in the table below represents only the first half of our process for finding opportunistic investments. Identifying the correct vehicle to capitalize on that opportunity is just as important. We look for the right vehicle across the liquidity spectrum, which runs from money market funds to private equity with a 10-year lockup. Greater liquidity allows portfolios to be more nimble when entering and exiting the opportunistic investment, while less-liquid investment vehicles can offer a wider range of strategies to capitalize on the opportunity. For example, in early 2009, Brown Advisory identified smallcap growth companies as a compelling opportunity based on attractive valuations, the chance for rapid growth despite sluggish overall economic expansion, and the tendency of small-cap stocks generally to outperform coming out of a recession. In that case, the optimal vehicle was a direct investment in small-cap growth stocks with significant liquidity. At the other end of the spectrum, in 2011, with historically low interest rates and depressed property prices, Brown Advisory recognized a significant investment opportunity in income-producing real estate. High-liquidity options, like real estate investment trusts (REITs), offer some exposure to this asset class, but share prices are largely tied to swings in the equity market. Less liquid vehicles, such as private real estate partnerships, provide a more precise way of capitalizing on this investment opportunity. Other opportunistic investments have involved using multiple investment vehicles at different points along the liquidity spectrum. In late 2008, for example, Brown Advisory identified an opportunity in credit markets after yields relative to Treasury bonds spiked to historic levels in the wake of the financial crisis. To capitalize on this opportunity, we invested directly in relatively liquid corporate bonds as well as credit-oriented private funds with relatively little liquidity. Thus, different opportunities along the liquidity spectrum can meaningfully improve the long-term risk/return profile of a portfolio.

ASSET CLASS

OUR PERSPECTIVE

INVESTMENT OPPORTUNITY

FIXED INCOME

Low yields create unattractive risk/return in much of the fixed income universe; one exception is emerging-market corporate bonds. The U.S. economy is improving and valuations are attractive but risks remain from U.S. political and European financial uncertainty. The eurozone situation is becoming more stable but growth prospects remain poor. Some emerging economies have also slowed but long-term opportunity remains. Inflation appears subdued, but with global central banks aggressively providing stimulus, a resurgence in inflation is possible. Low interest rates and reasonable prices make for a buyers market. Real estate can provide income diversification and low correlation to other assets.

U.S. dollar-denominated emergingmarket corporate bonds Low-beta, income-oriented stocks Domestically focused small-cap stocks De-emphasize developed international stocks Favor small-cap emergingmarkets stocks Maintain a small allocation as an inflation hedge

U.S. EQUITIES

INTERNATIONAL EQUITIES

COMMODITIES

REAL ESTATE

Cash-flowing developed properties below replacement costs Multifamily with strong rental income growth

Whither the Consumer?

The top 10 holdings of the MSCI Emerging Markets index, which account for 17% of the total market capitalization, are dominated by huge, export-oriented corporations. Companies in highlighted rows are state-backed firms. MSCI EMERGING MARKETS INDEX TOP 10 CONSTITUENTS SAMSUNG ELECTRONICS CO TAIWAN SEMICONDUCTOR MFG CHINA MOBILE GAZPROM (RUB) PETROBRAS PN AMERICA MOVIL L CHINA CONSTRUCTION BK H ITAU UNIBANCO PN VALE PNA PETROBRAS ON MARKET CAP (BILLIONS) $101.5 61.6 58.8 56.8 48.4 45.5 41.9 41.6 40.6 36.7

SECTOR Technology Technology Telecom Services Energy Energy Telecom Services Financials Financials Materials Energy

ing markets. A portfolio of such funds can be designed to reduce the peaks and valleys but still participate in the attractive returns offered by emerging markets over a full market cycle.
THE DEBT OPPORTUNITY

SOURCE: MSCI. DATA AS OF 12/31/11.

COVER STORY CONTINUED FROM PAGE 2

Further, many of these smaller, emerging-market companies are poorly covered or in many cases completely undiscovered by Wall Street analysts, creating opportunity for fund managers willing to commit the time and energy to exploit these market inefficiencies. Because emerging-market small-cap companies are less closely followed than their large-cap brethren, they typically trade at lower valuations, allowing diligent, research-driven fund managers to invest in companies with significant and sustained earnings and revenue growth at value-oriented prices.
IMMATURE FINANCIAL MARKETS

If the best way to play the rise of the middle class is through small-cap consumer stocks, how should you get exposure to the other industries in emerging markets? The first answer is
4 THE ADVISORY MARCH 2012

carefully. Emerging markets today are dominated by foreign, institutional investors since many countries have not yet developed a local investment culture. These immature financial markets tend to have highly volatile prices, as liquidity movements drive stock prices up and down to a far greater extent than fundamentals do. A recent example is 2008, when most emerging countries were able to maintain strong economic growth but the markets sold off more than 50% because of the financial crisis. We recommend that investors maintain sizable exposures to emerging-markets equities but recognize that the volatility in these markets makes that allocation difficult to stick with during market downdrafts. To help alleviate the stress of market swings, we recommend for qualified purchasers a collection of long/short hedge funds specializing in the emerg-

The final component of our recommended allocation to emerging markets is exposure to U.S. dollardenominated emerging-market corporate bonds, for three primary reasons. The first is attractive absolute yields: dollar-denominated investment-grade emerging-market bonds yield more than 7% today, similar to high-yield (junk) bonds. The second driver is the likelihood of favorable monetary policy coming from the U.S. and central banks in emerging economies. In 2010 and 2011, central bankers in many emerging nations were forced to aggressively tighten monetary policy in an effort to fight inflation, causing GDP growth in many countries to slow. In fact, Brazils GDP even turned negative in the fourth quarter. With growth and inflation now falling, we expect to see many countries cut interest rates to restimulate growth. The final catalyst is the possibility that various credit rating agencies will upgrade many corporations in the emerging markets. To date, the agencies have tended to hold the debt rating of many companies at or below the level of the country in which a company is located. As these well-run corporations further improve their balance sheets, ratings agencies are relaxing their informal standard and upgrading these companies. In sum, the emerging markets will remain the growth story for years to come. Investors need to make sure that their portfolios are actually positioned to benefit.

From Boring to Booming

Investors are starting to see the beauty of high-quality, dividend-paying stocks.

BY M I C H A E L F O S S , C FA

quity-income investing, with its emphasis on dividend yield and blue-chip stocks, doesnt normally get a lot of media coverage. But as last year went on, the outperformance of these strategies drew the spotlight. In 2011, the top 30% of dividend-paying companies in the S&P 500 produced an average total return of 8.5%, compared to the S&P 500s 2.1% return. Brown Advisorys own Equity Income strategy, which my colleague Brian Graney and I manage together, produced a return of close to 12%. Numbers like that spurred Barrons magazine to put an article on dividend-based investing on its cover on January 23. We are boring no more. The attention (not to mention the returns) is gratifying, but in fact we started calling for the comeback of dividend investing more than a year ago. Heres our investment thesis. First, todays low interest-rate environment will probably last through 2014. Low bond yields make equity dividends relatively more attractive. To illustrate, the S&P 500s overall dividend yield is higher than the 10-year U.S. Treasury bond yield for only the second time in more than 50 years, and over 200 members of the S&P 500 have dividend yields higher than the T-bond, compared to approximately 100 a year ago. Second, many corporations are in excellent financial shape, with strong balance sheets, low investment needs and impressive profitability. The S&P 500 grew earnings 13% in 2011, and raised dividends 15%, the fastest rate of dividend growth in seven years. The consensus estimate for 2012 profit growth is

9%, so if profits continue to climb, so too should dividends. Third, dividend payout ratios which is the portion of earnings that companies return to shareholders as dividendsare at historically low levels. Today, the payout ratio of the S&P is 28%, compared to a long-term average of 40%. So even if earnings moderate in the future, theres still plenty of opportunity for firms to increase their payouts. They should. Retiring Baby Boomers are increasingly looking for opportunities that provide more income than bonds and possess lower volatility than the broad equity marketstwo qualities of the stocks of mature, stable businesses that pay dividends. So as corporate leaders contemplate how to allocate their capital with a view to bolstering share prices, many are improving their dividend payouts. Finally, dividend growth is correlated with inflation; as prices and revenues increase, firms tend to increase dividends apace. While equity-income stocks are not an inflation play, the income stream is certainly more protected than most bond investments.

Portfolio Manager, Brown Advisory Equity Income & Flexible Value Strategy

INSIDE THE BIG TENT

Equity income is a big tent indeed; look closely and you will find vastly different investment approaches within it. Yield-focused strategies simply try to maximize current income from stock holdings (while trying to avoid high-yielding stocks that may be at risk of a dividend cut), and hybrids throw bonds or other fixed income investments into the mix. On the other hand, dividendgrowth strategies tend to identify fast-growing companies that pay dividends but may have low current yields. Classic equity-income strategies, such as the one we manage at Brown Advisory, attempt to balance the objectives of current income and dividend growth. Owning high-quality stocks with yields above Treasuries and room for dividend growth seems like a sound approach to us.

CATEGORY Yield-Focused Hybrids Dividend Growth Classic Equity Income

INVESTMENT APPROACH Higher income, but can be lower quality Use bonds and other instruments May be lower yielding but higher quality Balances current yield and dividend growth/ quality of company

THE ADVISORY

MARCH 2012

Embracing the Idiosyncratic

Constructing private equity portfolios is equal parts art and science.
s if there wasnt enough burn tactics are gone. Rather, winning to discuss, the role of private-equity strategies differentiate private equity in our themselves these days by fundameneconomy jumped on- tally transforming businesses. Better stage during the Repub- alignment between owners and manlican presidential primaries in January agers through shared equity interest is and February. Opposing candidates a motivator, but it really boils down to questioned whether Bain Capital, Mitt the imperative of achieving enhanced Romneys former private-equity firm, performance for the survival of manBY GEOFF CAREY, CFA has been a net benefit to the U.S. For- agement and private-equity investors. Portfolio Manager gotten in the rough and tumble argu- In the short term, restructurings can ment, among other things, is the fact suppress employment, but ultimately that teachers, firemen, policemen and success is determined by growing rev- sufficient to cover capital calls during other state employees are the primary enues through more effective business periods of depressed public markets. beneficiaries of private equity, through strategies. For many companies backed Further, having adequate liquidity also their public pension funds. Universi- by private-equity capital, competitive- provides flexibility to engage in tactical ties, foundations and corporate pen- ness is returned through introducing opportunistic investing that may also sion funds round out the majority new products, improving operations, involve private equity funds. Because of private-equity investors. From an entering new markets and making se- capital is typically drawn down over overall employment standpoint, some lective acquisitions. These proven pri- three- to five-year investment periods, 20 million U.S. workers hold jobs in vate-equity management techniques it is not necessary to retain the full companies backed by private equity or have been adopted by leaders of public private-equity commitment in conseroriginally funded by venture capital, competitors, with favorable implica- vatively invested reserves, but it is genrepresenting 18% of total U.S. em- tions for overall U.S. competitiveness. erally advisable to keep a third or so of ployment, according to the Private Eqoverall commitments in more liquid, uity Council/National Venture Capital ALLOCATING THE UNUSUAL shorter-duration fixed income. Association. Now in the crosshairs of At Brown Advisory, all asset-allocation Our job in building portfolios the electorate, Bain Capitals 138-com- discussions begin with our three buck- that include private-equity investpany portfolio presently employs one et approach, which includes an oper- ments is to make informed judgments million people and generates over ating account for cash and liquidity regarding tradeoffs of a clients over$160 billion in revenue. needs, a core portfolio for growth and all risk tolerance, liquidity requireOur intent here is not to jump income, and an opportunistic compo- ments and performance objectives. into the political fracas but rather to nent for tactical and higher-risk, often We rely on quantitative inputs but provide investors some perspective on illiquid investments. Within the core ultimately make decisions based on the role private equity plays in the na- bucket, private equity, venture capital qualitative assessments. tional economy as well as our invest- and real assets can play an important Thats partly because private equity ment portfolios. The fact is, contrary role in promoting long-term growth, is a thorny asset class from an allocato the rhetoric, the days when profits but this allocation should be made in tion point of view. First, private-equity could be driven primarily by slash-and- the context of an operating account returns are widely dispersed with no
6 THE ADVISORY MARCH 2012

BY MARK COLLINS

Director of Private Equity

investable index. The performance da- We will continue this practice going well as the fortitude to stay the course tabases that do exist to track private eq- forward, but in addition, we are devel- in the darkest days enhances the prosuity returns are rife with survivorship oping this year a vintage fund vehicle pects for long-term outperformance. bias, or the tendency of failing funds that will allow for client participation to suddenly drop out of databases, ar- across our offerings on essentially the GLIMPSING THE MEGATRENDS tificially inflating the average returns same economic basis as beforebut As stated, one invests in private equity of remaining funds. Together with with much more flexibility. Note that over a period of years, so instead of tryepisodic fund raising and variations in real estate as well as other income-pro- ing to pick a precise entry point based fund reporting and communications, ducing private-equity strategies will on the days macroeconomic winds, private equity is characterized by dis- fall outside this vintage-year vehicle. one should look instead to the longtinctive as well as quirky attributes. Within private equity, conven- term trends to invest alongside. As we Since part of the appeal of private tional wisdom encourages consistent look ahead, we find plenty of opporequity is the ability to tap into the participation over vintage years. In tunity in macro trends and company unique qualities of individual manag- contrast to the public markets, the risk formation. Within technology, mega ers and strategies, we are reluctant to of market timing plays out over much themes including social media, cloud overly diversify this asset class, which longer time frames. Were mindful of computing, big data storage and cyis charged with generating the highest the merits of consistent participation, bersecurity underpin explosive growth. returns. Depending on the prevail- but we also adjust commitment size In the health care sector, health care ing private-equity environment and based on our appraisal of the attrac- services and IT demands are spawnthe availability of managers in whom tiveness of the subsectors of private eq- ing promising electronic records and we have high conviction, we typically uity. Not surprisingly, some of the best payment companies. Within clean introduce our clients to only four to long-term returns are achieved during technology, the next generation of eight funds a year. periods when private equity is compar- energy efficiency, energy storage, polatively out of favor. For example, 2001 lution control, alternative energy and ACCESSING THE EXCLUSIVE was one of the best-performing vintage resource extraction companies are on In assessing funds as they come to mar- years in decades, with a median fund the march. And in private equity, a ket, we draw on industry relationships internal rate of return of 26.8%, ac- recession-prone global economy will and our Alex. Brown & Sons roots. cording to Preqin. In our view, a con- generate opportunities for skillful (Alex. Brown was, for many years, trarian mindset is advantageous both managers to restructure and transthe countrys leading underwriter of in terms of fund commitment as well form global companies. These and venture-backed IPOs.) We also draft as having an overall asset allocation other major long-term return drivers, behind the longstanding expertise of framework that can sustain a private- along with specialty strategies, will be certain partners and benefit from the equity program during public market expressed in our forthcoming privateinsight of clients and board members downturns. During these times, the equity fund opportunities. of our firm. Further, we are themati- pace of capital calls often increases as cally proactive as we ferret out strate- managers seek to invest in temporargies and funds with a discernible edge ily depressed or mispriced assets while whether in the form of regional or sec- distributions are few and far between. tor expertise. We have found that our most successOur approach over the years has ful funds are investing when others been to form feeder funds to enable cli- are on the sidelines. They also throttle ents to access individual funds at com- back when valuations are extended mitment levels below the $5 million and work most aggressively for distriminimum common in the industry. butions. Having liquidity available as
THE ADVISORY MARCH 2012 7

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The views expressed are those of the authors and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospects and is for informational purposes only. It should not be construed as a research report. The S&P 500 Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include market capitalization, financial viability, liquidity, public float, sector representation and corporate structure. An index constituent must also be considered a U.S. company. The Barclays Capital U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS. An investor cannot invest directly in an index. Brown Advisory is the marketing name for Brown Advisory, LLC, Brown Investment Advisory & Trust Company, Brown Advisory Securities, LLC, Brown Advisory, Ltd., and Brown Advisory Trust Company of Delaware, LLC..