The value of stocks:

A focus on the fundamentals

Joseph S. Tanious, CFA
The greatest struggle facing many financial advisors is
overcoming investor emotion.
The Market Insights program is designed to provide our
financial advisor partners with a way to address the markets
and the economy based on logic rather than emotion,
enabling their clients to make rational investment decisions.
To learn more, visit us at www.jpmorganfunds.com/mi.

Joseph S. Tanious, Vice President, is a Market Strategist on

the J.P. Morgan Funds U.S. Market Strategy Team. In this
role, Joseph is responsible for delivering timely market and
economic insight to clients across the country. Since joining
the team, Joseph has been instrumental in developing and
leading the group’s equity research efforts.

Joseph is a CFA charterholder. He also obtained an M.B.A.

Joseph S. Tanious, CFA
in Finance and Economics from Columbia Business School,
Vice President
Market Strategist and a B.A. in Economics from the University of California,
J.P. Morgan Funds Irvine. Joseph also holds series 7, 63 and 65 licenses.
MARKET
INSIGHTS
Table of contents
The value of stocks:
A focus on the fundamentals
Looking forward p. 2
The short run versus the long run p. 2
The fundamentals p. 3
Projected earnings and forward
P/E ratios p. 3
Other valuation metrics p. 4
Shiller’s P/E p. 5
The Q-ratio p. 6
Revenues, margins and prospects
for earnings growth p. 8
Checking the quality of earnings p. 10
The case for equities – a trifecta p. 12
Conclusion p. 13
CHART A: Difference between net flows into stock
and bond funds
Billions, USD, U.S. and international funds
$20
$0
-$20
-$40
-$60
-$80
Jun ’07 Dec ’07 Jun ’08 Dec ’08
Source: ICI, J.P. Morgan Asset Management.
Guide to the Markets, page 40
Foreword
As we meet with investors around the country, one of
the most frequently asked questions we receive is: Why
should I invest in the equity markets? The question is
understandable. After all, this last decade has been
a gut-wrenching rollercoaster ride for investors.
Over the past 10 years, equity investors have had to
stomach the pain of seeing their portfolios fall by over
50% — twice. They’ve seen two recessions, a collapse
in the real estate market, the worst natural disaster
and terrorist events in our nation’s history, and a
surging unemployment rate.
These experiences have shaped the
way that investors view the world and,
ultimately, their behavior. As a result,
more money has been invested in bond
funds than equity funds over the past 30
consecutive months (as shown in the Guide
to the Markets chart to the left), despite a
market that has surged by roughly 70%
since March 2009. It is this clear aversion
to the equity markets that prompted us to
take a fresh look at an old question: Just
how attractive are stocks?
In this white paper, we examine what
stock ownership really is, a number of ways
that stocks are valued, and the prospects
Bond flows exceeded
for future earnings growth and profitability.
equity flows by $26B We arrive at the conclusion that despite the
Jun ’09 Dec ’09 Jun ’10 recent soft patch in economic data, stocks
appear to be an attractive investment
and remain a key allocation in a balanced
portfolio.
1
MARKET
INSIGHTS

The value of stocks: A focus on the fundamentals

Looking forward
It’s easy to lose focus of what stock ownership really is. Some people feel that investing in the
equity markets is a form of gambling. Others feel that stock ownership is a general investment
in economic growth. Some people actually believe that gains or losses in the stock market are
entirely driven by luck and have no rhyme or reason. So before we go any further, let’s take a
step back and look at the dictionary definition of what stock ownership really is:

“A holder of stock (a shareholder) has a claim on a part of the corporation’s

assets and earnings. In other words, a shareholder is an owner of a company.1”
Simply put, buying stock means buying ownership of a business. As a business owner, you are
entitled to the future earnings and cash flow that the business creates. In other words, when
you buy a stock, you have no claims on previous earnings, but you do hold the right to your
share of the future earning stream the business generates. For this reason, before buying into
a business, you should conduct thorough research to form a reasonable estimate as to what
profits you believe the business will generate moving forward. It is this fundamental concept
that drives our focus on forward-looking valuation metrics — a recurring theme you will see
throughout this white paper.

The short run versus the long run

If there’s one thing we’ve learned from our collective experience as investors, it’s that in the long
run, equity prices are determined by their fundamentals. Anytime we notice a dislocation in the
equity markets, we need to take a step back and ask ourselves the following question: “Have
the fundamentals changed?” If the answer is “yes,” we should re-evaluate our assumptions
and our investment thesis. But if the answer is “no,” then what we have is short-term volatility,
which is often driven by uncertainty.
Sadly, today’s environment contains
CHART B: Extreme Levels of Volatility & Uncertainty Don’t Last Forever no shortage of uncertainty. There’s
3-month moving avg of daily absolute % change in the DJIA uncertainty about how proposed
legislation will affect markets, lingering
3.5% questions around how Europe will
3-month
3.0% moving average
resolve its sovereign debt issues,
2.5%
worries about the willingness of banks
2.0%
1.5% to lend or of businesses to create jobs
Average: 0.73%
1.0% — the list goes on. What’s important to
0.5% recognize, however, is that eventually
0.0%
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
the uncertainty will pass, outcomes will
be priced into markets and the focus will
Source: Dow Jones, FactSet, J.P. Morgan Asset Management. Data as of 7/30/10.
Guide to the Markets, page 50 once again return to the fundamentals.

1
www.investopedia.com
2
The fundamentals
There are several different ways to determine the fundamental value of a stock or group of
stocks (a market). When looking at an individual security, a combination of forward and trailing
multiples, along with more academic approaches to valuation (such as a discounted cash flow
[DCF] analysis) are common. Creating an effective DCF for one company requires at least five
to 10 years of reliable projections and assumptions for growth and the cost of capital, with
the caveat that the output is only as
reliable as the inputs. In other words, the CHART C: Stocks are Closely Correlated to Forward Earnings
quality of the research matters. While you Estimates in the Long Run
could certainly run this type of analysis S&P 500 total return and next 12-month EPS
for an entire index, doing this well for
500 companies (the S&P 500 Index for
S&P 500 – Total Return Index (left) S&P 500 – Earnings per Share (right)
example) requires an entire team of
experienced analysts. $3,000 $120

When looking at a market, we generally $2,500 $100

focus on price to forward earnings. While
other metrics are also useful, it appears $2,000 $80
that in the long run, stocks are closely
$1,500 $60
correlated to forward earnings estimates,
as illustrated in Chart C. Here, we observe
$1,000 $40
an R-squared of 0.76 between forward-
looking earnings estimates and the $500 $20
total return index for the S&P 500. This
suggests that 76% of the variance in total $0 $0
return can be explained by variance in the
Dec-92
Dec-93
Dec-94
Dec-95
Dec-96
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
earnings estimates, and that expected
earnings are in fact a reasonable Source: Standard & Poor's, FactSet, J.P. Morgan Asset Management.
predictor of stock market returns.

Projected earnings and forward P/E ratios

In considering forward price/earnings (P/E), the critical step is to decide which “E” - or earnings
value - to use. When trying to assess the opportunity in the equity markets, rather than relying
on one particular analyst or team’s estimates of projected earnings, we believe that using
consensus estimates across Wall Street will yield a better prediction with less variance. The
trouble with this, of course, is that analysts typically don’t nail earnings projections on the
head. For example, in the last three quarters, roughly 75% of S&P 500 companies have actually
exceeded analyst estimates, as analysts tend to overshoot earnings during a recession and
undershoot earnings during a recovery. According to disciples of behavioral finance, this is a
function of a phenomenon known as “anchoring.” Additionally, these estimates look 12 months
into the future, while stock values depend on much more than just that. However, despite
what seem to be shortfalls in these numbers, analyst estimates have directionally been rather
accurate and, as such, are useful for P/E analysis.

3
MARKET
INSIGHTS

In looking at forward P/E ratios as of July 31, 2010, Wall Street expects S&P 500 operating
earnings to be $84 in 2010 and $96 in 2011. Based on the S&P 500’s closing price of 1102 (7/30),
the index was trading at 12.1x forward earnings (next 12 months of earnings). Chart D, from the
Guide to the Markets, illustrates this price/earnings ratio for the S&P 500 over the past 18 years.
Although forward P/E ratios have limited historical data, based on an 18-year average, equity
markets appear undervalued. Thus, it is worth understanding what has helped to compress the
P/E multiple. As this is being written, a stock market correction has depressed the numerator
(“P”), while earnings projections in the
CHART D: S&P 500 Index, Forward P/E Ratio denominator (“E”) continue to move
Average +/- one standard deviation higher. The dislocation in direction
between the numerator and denominator
28x of the P/E ratio highlights how short-term
price movements can deviate from the
24x fundamentals. The last time we saw a
multiple of 12.1x forward earnings in the
20x S&P 500 was in late March 2009, when
Average: 16.6x the equity markets began an epic 70%
16x rally over the following 12 months.

12x Other valuation metrics

Most recent: 12.1x Some argue that earnings can be
8x manipulated by companies and,
’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10
therefore, analysts should study other
Source: Standard & Poor's, FactSet, J.P. Morgan Asset Management.
Guide to the Markets, page 6 metrics in determining the market’s
value. One example would be cash flow,
which is much harder to manipulate in
CHART E: Valuation Matters the long run. So, in addition to looking at
S&P 500 index valuation measures earnings, we also look at other multiples
to determine whether equities are over-,
Historical Averages
under- or appropriately valued. In Chart
Valuation 1-Year 3-Year 5-Year 10-Year 15-Year
Measure Description Latest Ago Average Average Average Average E, from the Guide to the Markets, you can
see how the S&P 500 is trading relative
P/E Price to Earnings 12.1x 14.3x 13.3x 13.9x 16.0x 17.2x
to earnings as well as cash flow, book
P/B Price to Book 2.1 1.9 2.3 2.5 2.8 3.2
value, sales and dividends. What’s really
P/CF Price to Cash Flow 8.0 8.4 8.7 9.4 10.9 11.2 interesting to see is that by almost any
P/S Price to Sales 1.1 1.1 1.1 1.2 1.4 N/A metric you choose to look at, and by any
Div. Yield Dividend Income 2.2% 2.3% 2.3% 2.2% 1.9% 1.9% historical average shown, equities appear
Source: Standard & Poor’s, FactSet, J.P. Morgan Asset Management.
undervalued.
Guide to the Markets, page 5

4
Shiller’s P/E
While our preferred method of using CHART F: Price/Earnings Ratio
S&P 500, annual data, 1880-2010
forward earnings to value equities
suggests the stock market is undervalued, 50
there are other valuation methods that 45 2000

Price/Earnings Ratio (CAPE)

suggest the opposite. One of the most 40
popular trailing multiples currently used 35 1929
Price/Earnings Ratio
30
is Shiller’s Cyclically Adjusted P/E ratio2
1901 1966
25 20.6x
(CAPE) as shown in Chart F. This method, 20
developed by Yale University’s Robert 15 1981
1921
Shiller, uses an inflation-adjusted price 10
5
for the S&P 500 (at a point in time),
0
divided by average inflation-adjusted 1880 1900 1920 1940 1960 1980 2000
earnings over the previous 10 years. Year
The idea behind this is that earnings are Source: Robert Shiller, Standard & Poor’s, J.P. Morgan Asset Management.
both volatile and cyclical; however, if you
adjust earnings for inflation and take an average of these numbers over a 10-year period,
you should be able to identify whether the market is appropriately valued. As of June 30,
2010, Shiller’s P/E ratio was approximately 20x earnings, whereas the long-term average is
approximately 16x earnings. This suggests that equities are possibly overvalued, and certainly
not undervalued.
While we believe that investors should take trailing metrics into account, we also think they can
generate misleading results, as illustrated in the timeline in Chart G on the next page.
Price is defined as the closing price of the index at one specific point in time. Trailing earnings
are often defined as the sum of the last four quarters of earnings. As a result, a trailing P/E
ratio equals a current price divided by the last year’s results. While these trailing multiples
can be useful as a reality check and to gauge future estimates, the ratio is entirely backward-
looking. If, for example, earnings over the last four quarters were extremely depressed due to
a recession, the multiple might suggest stocks are expensive (a result of a small denominator),
when in fact the U.S. may be entering an economic recovery, and stocks are actually cheap.

2
www.econ.yale.edu/~shiller
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MARKET
INSIGHTS

As we mentioned at the start of this

CHART G: Stock Price is Determined by Expected Future Earnings paper, when investing in equities, it’s
important to note that the intrinsic value
of a stock is determined by its expected
future cash flows, not its trailing results.
P Today E+1 E+2 E+3 E+4 When an investor buys a stock, he or she
is buying ownership, or a share, in what is
E-4 E-3 E-2 E-1 (Price is determined by expected earnings) ultimately the future earnings stream of a
Source: J.P. Morgan Asset Management. company. And while trailing results can be
used to build expectations, the investor
must realize that past performance is no
guarantee of future results, and must try his or her best to estimate future earnings.
For this reason, we believe that trailing metrics should not be the sole determinant of market
valuations. While they can help keep investors from making overly aggressive estimates about
future earnings, they are historic results, and do not take into account a changing economy or
growth prospects.
As a trailing metric, Shiller’s P/E is not much different. This past decade saw two severe
earnings recessions that have ultimately depressed the denominator in Shiller’s P/E ratio. It is
also worth noting that Shiller’s P/E uses “earnings as reported” in the denominator, and thus
includes massive write-offs. Indeed, over the past decade, S&P 500 “earnings as reported”
have averaged just 80.1% of operating earnings, compared to an average 90.4% of operating
earnings in the prior decade3. While this ratio takes 10 years of historic earnings in an attempt
to normalize earnings throughout the business cycle, it still takes the price of the index at one
point in time (determined by expected future earnings) and divides it by historic results (which,
in this case, are skewed downward), leaving out potential growth.

The Q-ratio
In addition to trailing multiples, another valuation metric that is used is the Q-ratio4 (developed
by James Tobin), which also suggests that equities may be overvalued. This ratio, shown for
all non-financial corporations in the Guide to the Markets Chart H, measures a stock’s price
divided by the replacement cost of the company’s assets. The idea is that, over time, you should
see consistency in the price investors are willing to pay for assets. Therefore, if the long-term
average Q-ratio is 0.8, and the current Q-ratio is 1.0, investors are paying too much for assets,
and equity markets are overvalued.
The ratio is calculated by taking the market price (often by using the stock price), and dividing
it by the replacement cost of tangible assets (such as equipment, inventories, etc.) along
with financial assets. First, it should be noted that financial assets as a share of total assets
have risen dramatically over the years. In 1950, financial assets comprised 23.2% of total

3
Standard and Poor’s
4
6 “Asset Markets and the Cost of Capital.” James Tobin and W.C. Brainard, 1977, Economic Progress, Private
assets, whereas they make up 53.8% of
total assets, today5. If it is the case that CHART H: Q-Ratio, Stock Price Relative to Company Assets
investors find financial assets more liquid Price to net asset value, all U.S. non-financial corporations
or attractive than physical ones, this

Less Attractive
might imply that the Q-ratio should have 2.0x

risen over the years.

A second issue to consider is that this 1.5x
calculation doesn’t take into account
Most recent: 1.0x
certain intangible assets. How do you
determine the value of the Coca Cola 1.0x
40-year average = 0.8x
brand? How about the Apple brand? If

More Attractive
you looked at each of these company’s
0.5x
balance sheets, you wouldn’t actually
find a line item with the brand’s value,
and you certainly couldn’t dream up a 0.0x
replacement cost. To the extent that the ’70 ’75 ’80 ’85 ’90 ’95 ’00 ’05 ’10
value of certain intangible assets (such as Source: Federal Reserve table B.102, J.P. Morgan Asset Management.
a brand) can grow over time, the Q-ratio, Guide to the Markets, page 5

which cannot capture these assets, might

understate the value of stocks.
A third issue – and perhaps the biggest – lies in the fact that the Q-ratio compares price to the
replacement value of a structure, not the projected value that the actual business creates. The
best way to illustrate this point is by using an example. Consider a street vendor in New York
City who sells chicken over rice from a cart (delicious). These vendors work consistent hours
on particular street corners in an attempt to draw repeat business from customers in the local
area. Their repeat business is largely dependant on how good their food is. One street vendor in
particular has become very famous by word of mouth, even though he only operates between
the hours of 7 p.m. and 4 a.m. The Q-ratio for this vendor would equal the price (whatever the
market calls for it), divided by the replacement value of his cart, stove and license to operate
on the street. This ratio could conceivably be quite high. But it doesn’t take into account the
fact that he has a queue of at least 30 people waiting in line at all hours of business, even at
3 a.m., rain or snow. Rumor has it this vendor grosses over $1 million per year operating his
cart. For this reason, we’d stress the same point we’ve made a couple of times earlier: When an
investor buys a stock, he or she is buying ownership and, ultimately, the future earnings stream
of a company. While we are open to different measures and interpretations of valuation, one of
the Q-ratio’s major shortcomings is that it simply doesn’t capture everything.

5
B.102 Balance Sheet of Non-farm Non-financial Corporate Business
7
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INSIGHTS

Revenues, margins and prospects

CHART I: Revenues are Rebounding for earnings growth
S&P 500 sales per share growth, year-over-year GDP growth
While the recent growth in earnings
has been impressive, we often hear the
(% 1YR) S&P 500 – Sales Per Share (left) (% 1YR) Gross Domestic Product (right)
argument that it has been entirely driven
20 10 by margin improvement as companies
15 8 have slashed costs. While it’s certainly true
10 that operating margins have improved,
6
5 it’s also true that revenues have bounced
0 4 back significantly. Chart I illustrates the
-5 2 year-over-year percent change in sales
-10
0
per share for the S&P 500; it’s clear
-15 that there has been a sharp rebound in
-20 -2 revenue growth. Another takeaway from
-25 -4 this chart is to observe the relationship
between gross domestic product (GDP)
Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09
growth and revenue growth for the S&P
Source: Standard & Poor's, FactSet, J.P. Morgan Asset Management.
500. Over the last 10 years, we have
observed a strong correlation between
year-over-year percent change in sales
per share for the S&P 500 and year-over-year percent change in GDP. The R-squared of 0.75
suggests that 75% of the variance in revenue growth can be explained by the variance in
economic growth. This relationship shouldn’t really surprise anyone. If you think about it, as
the economy continues to grow, the largest companies in the U.S. should benefit from that
growth in the form of increased demand. Additionally, U.S. companies function in a global
marketplace, with S&P 500 companies deriving over 40% of their revenues from business
outside the United States. Thus, even if you believe the domestic economy will grow at a very
low rate, any positive nominal GDP growth should still translate into revenue growth for S&P
500 companies, with their international business only adding additional fuel to the fire.
In addition, as companies have improved their operating margins over this past economic cycle,
each incremental dollar of sales today should translate into stronger earnings as compared
with the fourth quarter of 2008, when S&P 500 operating earnings hit an all-time low (Chart
J). Although the recovery in margins should slow as companies continue to hire, we believe
there’s still room for improvement, as we are well off the high of 2007.

8
On a side note, we’ve recently heard the
argument that earnings growth must CHART J: Margins Still Have Room for Improvement
slow down; we know that companies S&P 500 operating margins, quarterly profits
are starting to hire (which is good for
S&P 500 – Operating Margin (left) Quarterly profits (right)
the overall economy) and, as a result of 20%
the increased cost, margins will begin $28
18%
to shrink and earnings growth will
16% $23
eventually go to zero. This is a little ironic.
Three quarters ago, when we were talking 14%
$18
about the opportunity in equities, the 12%
pushback we received was that “all the 10%
$13
earnings growth is coming from margin 8%
improvement from layoffs, and there’s no 6% $8
revenue growth – how can earnings keep 4%
growing?” Today, we hear the argument $3
2%
that “sure, revenue growth has come
0% ($2)
back, but it doesn’t matter because
Aug–04

Aug–06

Aug–08
Dec-03

Apr–05

Dec–05

Apr–07

Dec–07

Apr–09

Dec–09
companies are hiring and margins can
only get worse from here – how can
earnings keep growing?” Sometimes, Source: Standard & Poor's, FactSet, J.P. Morgan Asset Management.

we just can’t win. For that reason, we

take a chapter from our microeconomics
textbook and offer the following thought.
When business owners see increased demand for products or services, they have a choice
to make. Their instinct may be to pay their current workers overtime to meet the additional
demand but, eventually, the workers’ productivity will max out. Once that happens, business
owners must make a simple choice: Should they forego the additional sales, or hire additional
workers to meet the incremental demand? The laws of microeconomics suggest that business
owners should continue adding workers until they reach a point at which their marginal revenue
equals marginal cost. In other words, assuming that the business is profitable, owners should
continue hiring each additional worker until they meet that incremental demand. It also means
that business owners shouldn’t hire any extra workers beyond what they need to meet the
demand. Otherwise, the extra cost of hiring that nth worker won’t be offset by the incremental
sale, and it will ultimately eat into their profits.
Looking at the broader market, this means that the rate at which costs begin to increase
(margins deteriorate) should be lower than the rate at which companies see their revenues
grow. Ultimately, these wide margins are healthy in a growing economy as increased sales
should translate into stronger earnings over the subsequent quarters.

9
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INSIGHTS

Checking the quality of earnings

CHART K: Corporate Profitability In an effort to understand corporate
S&P 500 return on equity & cash as % of current assets
fundamentals and get a better sense of
the quality of earnings, it helps to take a
ROE (left) Cash as % of Current Assets (right)
look at profitability ratios and compare
18% 28%
them over time.
16% 26%
14%
One of the most commonly used
24%
12% profitability ratios is return on equity
22%
10% (ROE), which is calculated as net income/
20%
8% equity. As the name suggests, ROE
18% attempts to quantify the investment
6%
4% 16% return on a company’s shareholders’
2% 14% equity. Chart K illustrates annualized ROE
0% 12% for the S&P 500 back to 1993. The cycles
12/31/1993
12/30/1994
12/29/1995
12/31/1996
12/31/1997
12/31/1998
12/31/1999
12/29/2000
12/31/2001
12/31/2002
12/31/2003
12/31/2004
12/30/2005
12/29/2006
12/31/2007
12/31/2008
3/31/2009
6/30/2009
9/30/2009
12/31/2009
3/31/2010
of profitability are apparent throughout
economic expansions and contractions,
and it appears that ROE is improving in
the current recovery.
Annual LTM quarterly
As a side note, we’ve added corporate
Source: Standard and Poor’s, Compustat, FactSet, J.P. Morgan Asset Management.
cash as a percentage of current assets to
the same chart. Emerging from a deep
recession, companies are holding on to excess cash in a manner that we’ve never seen. The
interesting part is that ROE is continuing to rise even though companies haven’t begun to
deploy their cash. This excess cash, beyond what’s needed to fund a company’s operations,
is essentially fuel sitting in the reserve tank waiting to be spent, and can ultimately further
stimulate growth and profitability.
As we take a closer look at ROE, we notice another interesting trend. Charts L-N highlight the
breakdown of ROE over the same time period. Using what is known as a DuPont analysis, we
can get a sense for how companies have generated profits over the last two business cycles.
The DuPont analysis breaks down ROE into three components: net income/sales, sales/assets
and assets/equity. (If you multiply these three ratios together, algebraically, you end up with
net income/equity, which is ROE.)

10
Net income/sales (Chart L), also known
as the company’s net profit margin, CHART L: Net Profit Margin
measures bottom-line profitability: For S&P 500 net income / sales
each dollar of sales, how effective is
Net Income / Sales Average SD+1 SD-1
the company at translating sales into 10%
earnings? Sales/assets (Chart M), also 9%
8%
known as the asset turnover ratio, 7%
measures the company’s efficiency: How 6%
effective is the company in generating 5%
4%
sales given the size of its balance sheet? 3%
Assets/equity (Chart N), also known as 2%
1%
financial leverage, measures the leverage 0%
on a company’s balance sheet: Given the
12/31/1993
12/30/1994
12/29/1995
12/31/1996
12/31/1997
12/31/1998
12/31/1999
12/29/2000
12/31/2001
12/31/2002
12/31/2003
12/31/2004
12/30/2005
12/29/2006
12/31/2007
12/31/2008
3/31/2009
6/30/2009
9/30/2009
12/31/2009
3/31/2010
size of assets, what portion of a company
is capitalized with debt rather than
equity?
Coming out of this economic cycle, Annual LTM quarterly

we notice a clear trend in the quality Source: Standard and Poor’s, Compustat, FactSet, J.P. Morgan Asset Management.

of earnings. The breakdown of ROE

shows that companies have cut costs to
improve margins and, as a result, net CHART M: Asset Turnover Ratio
profit margins have risen substantially, S&P 500 sales / assets
ultimately driving the recent pickup in
Sales / Assets Average SD+1 SD-1
profitability (Chart L). 55%
Over the same period, companies 50%
managed to maintain, if not improve, 45%
their asset turnover ratio by increasing 40%
overall efficiency throughout this past
35%
recession. One can also argue that if
dividend payments pick up, the asset 30%

turnover ratio will increase (less cash on 25%

12/31/1993
12/30/1994
12/29/1995
12/31/1996
12/31/1997
12/31/1998
12/31/1999
12/29/2000
12/31/2001
12/31/2002
12/31/2003
12/31/2004
12/30/2005
12/29/2006
12/31/2007
12/31/2008
3/31/2009
6/30/2009
9/30/2009
12/31/2009
3/31/2010
balance sheet = smaller denominator)
thereby further lifting ROE (Chart M).

Annual LTM quarterly

Source: Standard and Poor’s, Compustat, FactSet, J.P. Morgan Asset Management.

11
MARKET
INSIGHTS

While financial leverage always has and

CHART N: Financial Leverage will continue to play a powerful role in
S&P 500 assets / equity profitability, the bounce back in ROE
throughout this recovery hasn’t been
Assets / Equity Average SD+1 SD-1
620% dependent on leverage. In fact, like the
600% household sector, companies appear to
580% be actively deleveraging. Presumably, this
560% will eventually come to an end and, once
540% companies begin to use leverage, we
520% should see a corresponding increase in
500% overall ROE (Chart N).
480%
The case for equities – a trifecta
12/31/1993
12/30/1994
12/29/1995
12/31/1996
12/31/1997
12/31/1998
12/31/1999
12/29/2000
12/31/2001
12/31/2002
12/31/2003
12/31/2004
12/30/2005
12/29/2006
12/31/2007
12/31/2008
3/31/2009
6/30/2009
9/30/2009
12/31/2009
3/31/2010
6/30/2010
We are believers in diversification. A
well-balanced portfolio with a variety of
relatively uncorrelated assets is the best
Annual LTM quarterly approach for investors over the long
Source: Standard and Poor’s, Compustat, FactSet, J.P. Morgan Asset Management. run; it is important to protect against
the possibility of what could go wrong,
while at the same time being able to take advantage of what could go right. It goes without
saying that one of these asset classes, for most investors, is equities. But beyond the obvious
“diversification case” for equities, for long-term investors, we feel that there is a more specific
case for equities in today’s environment, based on three key points. First, the valuations look
attractive: Whether we look at earnings, cash flow or any other forward multiple, equities
appear to be fundamentally undervalued. Second, profitability is improving: ROE has risen and
appears to be nearing its long-term average only one year following the deepest recession
since the Great Depression. Third, companies are sitting on reserves and are waiting for the
opportunity to spend: As we look at the level of cash sitting on balance sheets and the power of
leverage that companies have yet to utilize, we suspect that profitability will continue to improve
in the years to come. As we think about these three forces coming together in combination with
a low inflationary, low interest rate environment (generally a positive business environment),
we believe that equities are poised to outperform. We would argue that this warrants a higher
stock multiple, and further solidifies our view that equities are attractive.

12
Conclusion
A few general thoughts to recap our views:
• We believe that fundamentals ultimately drive the price of stocks and that long-term investors
should focus on forward earnings and profitability.
• As we look at a variety of forward valuation metrics, including price-to-earnings and price-to-
cash flow, it appears that equities are fundamentally undervalued.
• Profitability as measured by return on equity has come back to its long-term average only one
year after a very deep recession, while companies have managed to retain record amounts
of cash over the same period.
• Recent growth in profitability has been driven by improved margins and operational efficiency;
leverage has actually declined over this cycle as companies have focused on strengthening
their capital structures, resulting in quality earnings.
As we hope for the best, we encourage investors to be prepared for the worst. The biggest risks
to equity markets are those that cannot be predicted. For this reason, while we are bullish and
believe that equities are attractive, it’s important that investors maintain a balanced approach,
with exposure to equities as well as other asset classes that will help reduce volatility over the
long term.

13
To learn more about the
Market Insights program,
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www.jpmorganfunds.com/mi.
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should not be relied on for investment recommendations. Past performance is no guarantee of future results.
The price of equity securities may rise or fall because of changes in the broad market or changes in a company’s financial condition,
sometimes rapidly or unpredictably. These price movements may result from factors affecting individual companies, sectors or
industries selected for the Fund’s portfolio or the securities market as a whole, such as changes in economic or political conditions.
Equity securities are subject to “stock market risk” meaning that stock prices in general (or in particular, the prices of the types of
securities in which a fund invests) may decline over short or extended periods of time. When the value of a fund’s securities goes down,
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