Global Market Strategy Research

Regional and Sector Strategy: Monthly Update

ESG factors

• Downgrade Health Care to Neutral from Overweight: Valuation — (i) Based onthe metrics we consider, Health Care is by far the most expensive of the 10 GICS inthe MSCI ACWI; (ii) The sector's weight in the MSCI ACWI is currently 25% aboveits 20-year average; (iii) Poor risk/reward: our recently introduced “MaterialityMatrix” illustrates that, from an ESG perspective, Health Care has the second-worstESG likelihood/ESG impact profile of eight MSCI sectors.

• Downgrade Information Technology to Neutral from Overweight: Earnings —Earnings momentum and earnings revisions are both very unfavorable.

• Financials the Only Overweight Sector — Financials is the cheapest sector;earnings trends remain relatively strong. “Diversified Banks” (e.g., Wells Fargo,HSBC, Commonwealth Bank of Australia) account for almost half of Financials;“Investment Banking & Brokerage” represents just 4%.

Figure 1: Regional Rankings

Source: Cornerstone Capital Group

Figure 2: Sector Rankings Arrows Indicate Change vs. Last Month

July 13, 2015

Michael Geraghty Global Markets Strategist +1 212 874 7400

©Sergey Nivens/Crystal Graphics

Regional and Sector Strategy: Monthly Update This month there are no changes to the recommendations in our regional strategy model. Our previous regional recommendations were published in the June 2015 edition of the Cornerstone Capital Regional and Sector Strategy: Monthly Update.

There are, however, material changes to the recommendations in our sector strategy model.

• Health Care: Downgrade to Neutral from Overweight.

• Information Technology: Downgrade to Neutral from Overweight

• Utilities: Upgrade to Neutral from Underweight.

Health Care: Downgrade to Neutral from Overweight We have been Overweight the Health Care sector since September 2014. We are now downgrading the sector to Neutral, with valuation being the primary reason behind the downgrade.

• As Figure 5 (on page 5 below) illustrates, based on the valuation metrics we consider, Health Care is byfar the most expensive of the 10 GICS in the MSCI All Country World Index (ACWI).

• The current weight (12%) of the Health Care sector in the MSCI ACWI is currently 25% above its 20-yearaverage (10%) — Figure 3.

Figure 3: Health Care Sector Weight in MSCI ACWI

*2015 through June 2015Source: MSCI, Cornerstone Capital Group

2 Please see Important Disclosures on the last page of this report.

• Our recently introduced “Materiality Matrix” (see ESG in Sector Strategy: What’s Material?, June 23, 2015) illustrated that, from an ESG perspective, Health Care has the second-worst ESG likelihood/ESG impact profile of eight MSCI sectors — Figure 4. With valuations being extended, any adverse ESG impact could have a material effect on stock prices. In other words, from an ESG perspective, the risk/reward for the sector is currently unattractive. The Materiality Matrix now forms the basis of our ranking of sectors based on ESG metrics (with, for example, Health Care being relatively unattractive as compared to, say, Consumer Discretionary).

Figure 4: ESG Materiality Matrix for Eight MSCI GICS

Source: Cornerstone Capital Group

Information Technology: Downgrade to Neutral from Overweight We have been Overweight the Information Technology sector since we launched the sector strategy model in the spring of 2014. We are now downgrading the sector to Neutral, with earnings being the primary reason behind the downgrade:

• Figure 6 illustrates further deterioration in the earnings momentum of the sector.

• Figure 7 shows that the Information Technology sector’s earnings estimate revisions were sharplynegative i.e., downward revisions by far outpaced any upward revisions.

• Figure 8 illustrates that free cash flow margins in the Information Technology sector are currently atten-year highs, suggesting the potential for disappointment on the downside.

Utilities: Upgrade to Neutral from Underweight We have been Underweight the Utilities sector since the summer of 2014. Figure 5 illustrates that the relative valuation of the sector improved last month reflecting, in large part, the 6% price decline in the MSCI ACWI Utilities index in June. Consequently, the sector is being upgraded to Neutral from Underweight.

3 Please see Important Disclosures on the last page of this report.

Financials: Sole Overweight Sector Figure 2 illustrates that Financials is the only Overweight sector. In contrast to other MSCI GICS:

• Valuation is a positive. It is by far the cheapest of the ten sectors — Figure 5.

• Earnings trends are relatively strong. Figure 6 illustrates that earnings momentum has been stable, whileFigure 7 shows that downward earnings revisions have essentially been matched by upward revisions.

As a point of clarification, the largest sub-industry in the MSCI ACWI Financials Index is “Diversified Banks” (e.g., Wells Fargo, HSBC, Commonwealth Bank of Australia), which account for almost half of the sector. By contrast, the “Investment Banking & Brokerage” sub-industry represents just 4%.

A key factor driving earnings momentum in the Diversified Banks sub-industry is the trend in net interest margins i.e., the difference between the cost of funding and the lending rate. In the U.S., the likelihood of Federal Reservetightening is a positive in this regard. In the Eurozone, although the European Central Bank has been cutting short-term interest rates, longer-term rates have been dropping as well. This combination has, in general, been a positive for net interest margins of banks in the region.

That said, in both Europe and the U.S., low interest rate environments coupled with low leverage will likely mean that traditional measures of bank efficiency — most notably Return on Equity (ROE) — will remain lackluster. However, it’s important to bear in mind that the fixation by many investors on ever-higher ROEs helped fuel some of the excesses of the 2007-08 credit bubble, given that the easiest way boost ROEs is to use ever greater amounts of leverage.

Now, with banks facing higher capital requirements and curbs on leverage, many investors have turned to Return on Assets (ROA) to get a better view of how efficiently banks are operating in the new environment.

4 Please see Important Disclosures on the last page of this report.

Sector Strategy Update We have updated the inputs to the Cornerstone Capital Sector Strategy Model in which we rank the ten GICs in the MSCI ACWI.

Figure 5 illustrates that, based on the valuation metrics we consider, Health Care is by far the most expensive of the 10 GICS in the MSCI ACWI.

Figure 5: Sector Valuations (20% of Aggregate Weight) Arrows Indicate Change vs. Last Month

Source: Cornerstone Capital Group

Figure 6 illustrates further deterioration in the earnings momentum of the Information Technology sector (and, also, in the Underweight Industrials sector).

Figure 6: Earnings Momentum (25% of Earnings Weight) Arrows Indicate Change vs. Last Month

Source: Cornerstone Capital Group

Up = More Expensive Down = Less Expensive

5 Please see Important Disclosures on the last page of this report.

Figure 7 shows that the Information Technology sector’s earnings estimate revisions were sharply negative i.e., downward revisions by far outpaced any upward revisions.

Figure 7: Earnings Revisions (25% of Earnings Weight)

Source: Cornerstone Capital Group

Figure 8 illustrates free cash flow margins for the sectors, both current and historical. Free cash flow margins in the Information Technology sector are currently at ten-year highs, suggesting the potential for disappointment on the downside.

Figure 8: Free Cash Flow Margins (25% of Earnings Weight)

Source: Cornerstone Capital Group

6 Please see Important Disclosures on the last page of this report.

Figure 9 illustrates change in shares outstanding by sector over the past twelve months, with issuance being considered “negative” (i.e., dilutive), and buybacks being regarded as positive for shareholders.

Figure 9: Net Share Issuance = 25% of Earnings Weight

Source: Cornerstone Capital Group

Figure 10 summarizes the current sector recommendations and Figure 11 illustrates the dispersion of the sector scores.

Figure 10: Sector Recommendations

Source: Cornerstone Capital Group

7 Please see Important Disclosures on the last page of this report.

Figure 11: Ranking Sectors by Weighting Valuation, Earnings and ESG Scores Arrows Indicate Change vs. Last Month

Source: Cornerstone Capital Group

Finally, we noted above that our recently introduced “Materiality Matrix” (see ESG in Sector Strategy: What’s Material?, June 23, 2015) now forms the basis of our ranking of sectors based on ESG metrics. Figure 12 summarizes the weightings of the valuation, earnings and ESG metrics in our regional and sector strategy models.

Figure 12: Weightings of Valuation, Earnings and ESG Metrics in Regional and Sector Strategy Models

Source: Cornerstone Capital Group

8 Please see Important Disclosures on the last page of this report.

Gauging Governance Globally — Spotlight on South Africa In the June edition of Cornerstone’s Journal of Sustainable Finance & Banking, we placed a Spotlight on South Africa for leadership on corporate governance. Not only was the country at the forefront of factoring ESG issues into its exchange listing requirements, it now requires integrated corporate reporting.

In a previous report, we examined the significance of governance for country equity valuations using both “top-down” (governance at the national level) and “bottom up” (governance at the corporate level) metrics — see Gauging Governance Globally: Macro and Micro Metrics, September 15, 2014. We highlighted that a multiple regression generated an R-squared of 0.16 between equity valuation at the country level and four measures of governance:

• The World Economic Forum’s Corporate Governance score.

• The World Bank’s Ease of Doing Business Index.

• Transparency International’s Corruption Perceptions Index.

• The World Bank’s Worldwide Governance Indicators.

We then took a weighted average of the four macro governance measures to rank the eight regions / countries in our regional strategy model in terms of a composite governance score. The rankings (from best to worst): (i) Australia; (ii) U.K.; (iii) North America; (iv) Japan; (v) Europe ex the U.K.; (vi) Latin America; (vii) Emerging Asia; (viii) the Central and Eastern Europe, Middle East and Africa (CEEMEA) region.

In terms of the CEEMEA region, the country with the largest weight in the MSCI Emerging Markets EMEA Index is South Africa — a 45% weight as of April 2015. Other countries with large weightings include Russia (23%), Poland (9%) and Turkey (8%). Figure 13 illustrates that, if South Africa is treated as a standalone country, it ranks much higher than either (i) the CEEMEA region as a whole or (ii) three European countries: Portugal, Spain and Italy.

Figure 13: The Cornerstone Capital Governance Composite

Source: Cornerstone Capital Group

9 Please see Important Disclosures on the last page of this report.

A few points to note:

• The scores for the regions in Figure 13 are based on the weights of the component countries in therelevant MSCI index. So, even though South Africa has a much bigger weight (45%) than Russia (23%),the extremely poor scores for governance in Russia (and the mediocre scores for Poland and Turkey)mean that the CEEMEA region as a whole ranks last in our governance composite.

• Our governance composite is calculated by weighting the four measures of governance outlined above.The WEF Corporate Governance rank gets the heaviest weight given its relatively strong correlationwith country P/Es. Despite its low R-squared, we included The World Bank’s Worldwide GovernanceIndicators because a statistical analysis reveals that a four-variable model is more statistically significantthan a three variable model (i.e., one that excludes the World Bank Worldwide Governance indicators).

Figure 13 illustrates that South Africa ranks very well for governance at the corporate level — i.e., the World Economic Forum’s Corporate Governance score and the World Bank’s Ease of Doing Business Index — but not as well at the national level i.e., the Corruption Perceptions Index and the World Bank’s Worldwide Governance Indicators. That South Africa ranks well for governance at the corporate level is not that surprising.

The Evolution of World Class Corporate Governance in South Africa

Landmark events in the evolution of corporate governance in South Africa were the King I Report on Corporate Governance in 1994 and the King II Report on Corporate Governance in 2002 (both named after retired Supreme Court judge Mervyn E. King who chaired committees on corporate governance). While neither of these reports specified mandatory requirements for companies, their guidelines were selectively adopted by the Johannesburg Stock Exchange (JSE) as listing requirements.

Following the publication of the King III Report on Corporate Governance in 2009, the JSE mandated the disclosure of sustainability information starting in the 2010 financial year and subsequently mandated the disclosure of integrated reporting starting in 2011.

• Companies are mandated to disclose the policies that they have in relation to a series of ESG issues aswell as to report on the actions that they take to achieve the objectives of their policies. (However, itshould be noted that no specific guidelines have been provided, or standards set, to require disclosurealong a specific set of metrics.)

• Integrated reports must describe the value creation process inside an organization and discuss acompany’s impact on stakeholders as well as the strategies for mitigating any potentially negativeimpacts on society.

ESG reporting was widespread among many of the large firms in the economy even before the recently mandated disclosure of sustainability information. Following the initiatives outlined above, corporate governance is now widely considered to be world-class in South Africa.

10 Please see Important Disclosures on the last page of this report.

Appendix 1: Summary Statistics

Figure 14: Global Equity Markets Data

Source: Cornerstone Capital Group, Bloomberg

11 Please see Important Disclosures on the last page of this report.

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Michael Geraghty is the Global Markets Strategist at Cornerstone Capital Group. He has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi.

michael.geraghty@cornerstonecapinc.com

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