Morgan stanley - Growth Matters

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					                                                                MORGAN            STANLEY                  RESEARCH
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May 28, 2013
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US Equity Strategy                                                                                      Phillip Neuhart
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Growth Matters
                                                                                                        Yaye Aida Ba
                                                                                                        Yaye.Ba@morganstanley.com

There’s potential we remain in a band of slow
                                                                Exhibit 1
economic growth for some time. There is also the
                                                                Stocks Outperform in the 12 Months Prior to
possibility of stronger growth helping corporate
                                                                their Transitions to Growth Cohorts
profitability in the 2H of 2013. Does it matter whether a
stock is freshly minted as a growth (or non-growth) stock or                   Cumulative Relative Performance Before and After a
                                                                                       Cohort Transition, Since Dec. 1972
has been persistently in growth (non-growth) status for the       1.1
past several years? Yes! If one wants to gain exposure
                                                                  1.0
to growth as a style bet, a basket of “mixed growth”
stocks (recently transitioned to growth) is a more                0.9

efficient way to obtain this exposure than a basket of            0.8
                                                                                                                            Mixed to Persistent
                                                                                                                            Lapsed to Mixed
persistent growth stocks.                                                                  Transition                       Non-Growth to Mixed
                                                                  0.7


                                                                  0.6
The persistent growth cohort is different today from                 (15)       (10)          (5)           0          5            10            15
in the past: it’s now relatively cheaper, lower beta                                                      Months

and less sensitive to overall style moves. Meanwhile,           Source: Factset, Morgan Stanley Research
non-growth stocks are higher beta and more expensive
than in the past. You don’t want to own persistent
                                                                Early detection of stocks transitioning to mixed
growth as a cohort, as it consistently
                                                                growth or persistent growth cohorts is rewarded by the
underperforms. Why? It’s a mix of (mostly) good stocks
                                                                market: stocks coming from non-growth rise by 30% on
that outperform as long as they remain in the growth
                                                                average in the 12 months before entering mixed
cohort and a minority of bad stocks that tend to
                                                                growth, while stocks coming from lapsed growth rise by
dramatically underperform when they exit. Identifying
                                                                15% on average in the 6 months prior to entering
likely exit candidates is key (see sidebar) to investing in
                                                                mixed growth. Modest outperformance continues in
this group, and the best-performing quant factors aid in
                                                                the first quarter after the transition for stocks entering
this task. Once stocks exit, the underperformance is
                                                                mixed growth. Similar degrees of negative relative
nearly complete, and lapsed growth cohort (recently
                                                                performance occur for stocks exiting growth cohorts.
transitioned to non-growth) performance generally
exceeds that of persistent growth. Mixed growth
                                                                Transition-related performance helps to explain the
stocks tend to be more associated with a theme or
                                                                asymmetry in quant factor performance: factors work
story (e.g., housing, HD and LOW today); they were the
                                                                better at capturing underperformance in mixed and
archetypes of the Tech Bubble and Collapse. Identifying
                                                                persistent growth cohorts, but fare better at identifying
stocks that will remain in mixed growth is beneficial to
                                                                outperformance in lapsed growth and non-growth.
performance, but less so than in persistent growth. This
could be particularly pertinent heading into the 2H 2013
and its expected growth rebound. Valuation matters
more for stock selection in mixed growth, but the cohort        Morgan Stanley does and seeks to do business with
is a more efficient way to play a style bet than is             companies covered in Morgan Stanley Research. As
persistent growth. The “lapsed growth” cohort is                a result, investors should be aware that the firm may
increasingly composed of tech stocks. Unlike                    have a conflict of interest that could affect the
                                                                objectivity of Morgan Stanley Research. Investors
non-growth, where valuation matters most, a range of
                                                                should consider Morgan Stanley Research as only a
factors is useful in selecting lapsed growth stocks: high       single factor in making their investment decision.
cash balances, share count reduction, accruals and
                                                                For analyst certification and other important
momentum help to identify outperformers.                        disclosures, refer to the Disclosure Section,
                                                                located at the end of this report.
                                                                     MORGAN        STANLEY       RESEARCH

                                                                     May 28, 2013
                                                                     US Equity Strategy




Growth Persistence
In this note, we study the characteristics and performance                     mixed growth; the difference is not large, at 1.6% per
of US equities based on their style classification and                         year. Conditional risk-adjusted performance can have
persistence. We partition the Top 500 stocks into four cohorts,                swings of +/- 4% per year in all cohorts. Quant
after first removing financials: persistent growth stocks, stocks              factors are better at identifying future
that have recently transitioned to growth (mixed growth                        underperformers in mixed and persistent growth,
stocks), stocks that have recently transitioned to non-growth                  and somewhat better at identifying outperformers in
(lapsed growth stocks) and stocks that are persistently                        lapsed growth and non-growth. Transitions to
non-growth. The starting point for this analysis is our                        mixed growth or persistent growth are associated
proprietary equity style model (see “US Equity Strategy: Do                    with substantial outperformance in the year prior
You Have Style?” April 23, 2012), where we partition stocks                    to the transition; conversely, stocks leaving these
into thirds – growth, neither and value – on a quarterly basis. In             cohorts significantly underperform in the year
the last two weeks we have received multiple questions about                   prior to their exits. In some types of transitions, the
growth stocks due to the fact that the second half of the year is              under- or outperformance continues for several
a potential inflection point – either growth picks up or it                    months after the transition. Transitions between
disappoints.                                                                   cohorts are relatively rare, but have increased in
                                                                               frequency over the last 10 years. Switching from
In addition to classifying stocks, we must select a time interval              mixed to lapsed growth and back is over twice as
over which to measure persistence. Too short of an interval                    likely as leaving persistent growth or non-growth.
gives too few stocks in the transitioning cohorts (and is                      Cumulative 12-month residuals of each cohort have
inconsistent with the idea of persistence), while too long of an               been modest recently, indicating that there has been
interval gives too few persistent growth stocks. We argue that –               no “sub-style” call. Previously, there were periods
without over-optimizing the amount of history – 48 months                      of large divergence, even after accounting for beta
provides a good balance in membership between the                              and style.
transitioning and persistent cohorts.
                                                                              Persistent growth stocks: Among the largest US
By excluding financials, we are able to use our full complement                stocks, AAPL, GOOG, IBM, ORCL and AMZN are in
of quant factors when we discuss systematic stock selection in                 persistent growth. Tech, discretionary and health
each cohort. The remaining stocks in the Top 500 usually                       care stocks are the most numerous in persistent
number between 400 and 450, down slightly from the 1970s                       growth. Persistent growth stocks are generally
and early 1980s, but with no discernible trend thereafter. Style               expensive relative to the market, but the current
persistence can become conflated with size persistence: we                     valuation premium for these stocks is low, with both
minimize this effect by classifying style on a larger universe of              trailing and forward price-to-earnings at the 35th
over 1000 stocks. When stocks exit the Top 500, they generally                 percentile. Persistent growth stocks have
retain their style classifications; these existing classifications             underperformed the market and the other cohorts in
are then used when stocks re-enter the Top 500.                                the last 10 and 40 years, with lower average returns
                                                                               and comparable or higher volatility. After being the
Main results:                                                                  highest beta cohort prior to 2008, the persistent
                                                                               growth cohort now has the lowest beta. Prior to
        Overall, correlations among the cohorts are at a                      the Tech Bubble, persistent growth had the largest
         40-year high. The number of non-growth stocks                         style sensitivity; subsequently, mixed growth has
         has fallen by more than half since the mid-1980s,                     replaced it as the cohort most reactive to growth
         while the number of lapsed and mixed growth stocks                    versus value performance. For persistent growth
         has risen. All three cohorts are similarly-sized today.               stocks, free cash flow works best at 3-month
         Since 1972, cumulative performance has been                           horizons, while free cash flow and momentum are
         best for non-growth stocks, except for a brief period                 best over 12-month periods.
         in the Tech Bubble when mixed growth was best.
         Risk-adjusted performance is positive for non-growth                 Mixed-growth is dominated by discretionary stocks,
         and lapsed growth, and negative for persistent and                    but over 60% were tech stocks during the Bubble. The




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                                                                    MORGAN            STANLEY            RESEARCH

                                                                    May 28, 2013
                                                                    US Equity Strategy




         mixed growth cohort, not the persistent growth cohort,     Exhibit 2

         is the archetype of the Tech Bubble, with wildly           The Number of Non-Financial Stocks in the Top 500
         inflated valuations, strong risk adjusted returns during   Has Ranged from 400 to 450 over the Last 45 Years
         the Bubble, and sharply negative risk adjusted returns
                                                                                 Number of Stocks Total in All Four Cohorts (48 Month History)
         in the Collapse. Mixed growth stocks currently have a                                  Top 500 but Not in Financials
                                                                     500
         neutral valuation on forward and trailing earnings. For     450
         mixed growth stocks, valuation factors work best            400
         at both 3- and 12-month holding periods. KO, V and          350
         HD are examples of mixed growth stocks.                     300
                                                                     250

        Lapsed growth stocks are currently expensive on             200
                                                                     150
         trailing earnings, but cheap on forward earnings,           100
         meaning their expectations are high going forward            50
         and today is a key pivot point for assessing growth of        0
                                                                           69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13
         this group. Tech has grown to the largest sector
         within lapsed growth, as formerly high-flying tech         Source: Factset, Morgan Stanley Research
         stocks have dropped out of growth. For lapsed
         growth stocks, a combination of accruals,                  In Exhibit 3, we show the number of stocks in the persistent
         momentum, high cash levels and valuation works             growth cohort with five periods used to measure persistence:
         well at both 3- and 12-month horizons. XOM,                24, 36, 48, 60 and 120 months. The number of stocks declines
         MSFT, WMT and JNJ are in lapsed growth.                    as the history increases, while the volatility of counts declines.
                                                                    For factor efficacy analysis, we split cohorts into thirds each
        Non-growth stocks are historically expensive               month, and if the number of stocks is too small, the results can
         today, with trailing P/E at the 92nd percentile and        be idiosyncratic rather than being driven by a group-wide
         forward P/E at the 87th percentile. Valuation and          sensitivity. The 120-month history is clearly too long, while the
         share count reduction work for non-growth stocks at        24-month history is unnecessarily short, based on counts. We
         both 3- and 12-month intervals. CVX, GE, and T are in      selected the 48-month history as being the longest (among five
         non-growth.                                                tested) that has sufficient minimum counts.

                                                                    Exhibit 3
                                                                    The Number of Persistent Growth Stocks Declines
Growth Persistence and Its Impact on Performance                    with the History Used in Persistence Definition

                                                                                             Number of Persistent Growth Stocks
In this section, we discuss properties of each growth cohort.
                                                                     160
There are four buckets for Top 500 stocks (excluding
financials): persistent growth (stocks in growth for 48 or more      140

months); lapsed growth (stocks falling out of growth in the last     120

48 months); mixed growth (stocks returning to growth in the          100

last 48 months); and non-growth (persistently not in growth).         80

In the appendix, we describe our construction methodology in          60

detail.                                                               40

                                                                      20             24 Months             36 Months            48 Months
                                                                                     60 Months             120 Months
In Exhibit 2, we show the total number of stocks in the four           0
cohorts over time. The difference between 500 and this total is            72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

essentially the number of financial stocks in the Top 500. Prior    Source: Factset, Morgan Stanley Research
to the mid-1980s, this number was around 50 stocks; it has
increased since then, resulting in overall counts of 400 to 430     The decline in the number of (persistent) non-growth stocks in
non-financial stocks in the last 25-30 years.                       Exhibit 4 is due to two effects: The number of financial stocks in
                                                                    the Top 500 has generally increased over the past decades,
                                                                    meaning that the overall universe of non-financial stocks has
                                                                    declined. More importantly, the number of large-cap and



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                                                                                   May 28, 2013
                                                                                   US Equity Strategy




mega-cap technology stocks has increased since the 1980s;                          Exhibit 5

these stocks may not have persistent growth status, but they                       Using a 48-Month History Produces Similarly Sized
are rarely (persistent) non-growth.                                                Persistent, Mixed and Lapsed Growth Cohorts
                                                                                                Average and Minimum Count by Cohort (48 Month Lookback)
Over the last few years, the counts of the four cohorts have                                                  June 1967 through April 2013
                                                                                    160
converged and mingled; a larger fraction of stocks are transient
                                                                                                Average
                                                                                    140
in their style classifications today than in the past. This is                                  Minimum
consistent with other measures – such as increased correlation                      120

and convergence of beta – indicating that style distinctions are                    100

blurring (see US Equity Strategy: The Style Call, April 15,                          80

2013).                                                                               60

                                                                                     40
Exhibit 4                                                                            20
The Number of Persistent Non-Growth Stocks Has                                        0
Trended Downward since the mid-1980s                                                      Persistent Growth     Mixed Growth    Lapsed Growth      Non-Growth

                                                                                   Source: Factset, Morgan Stanley Research
              Number of Stocks by Cohort: Stocks in Top 500 but Not in
                           Financials (48 Month History)
 300
                                                               Persistent Growth   We show the current cohort classification of largest 12 stocks
 250                                                           Mixed Growth        in each cohort by market cap, as well as the total market cap in
                                                               Lapsed Growth
                                                                                   12 largest names in Exhibit 6.
 200                                                           Non-Growth

 150                                                                               The persistent growth category tends to contain idiosyncratic
 100                                                                               stocks – AAPL, GOOG, IBM, etc, whose expectations are
                                                                                   based on the individual, specific merits of the companies.
  50
                                                                                   Investors may disagree as to whether these stocks can
   0                                                                               maintain their runs of strong growth, but the arguments are
       69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13
                                                                                   likely to be focused on the particular company, rather than on a
Source: Factset, Morgan Stanley Research                                           sector, the market or the overall economy.

Choosing a look-back period shorter than 48 months would                           Mixed growth tends to contain more “story” stocks – home
produce mixed growth and lapsed growth cohorts that are                            improvement companies, for example – whose fortunes
occasionally too small for reliable performance analysis (i.e.,                    depend on the trajectory of the recovery. There is much less
the returns become too idiosyncratic). On the other hand,                          total market cap available in the largest mixed growth stocks
choosing a look-back period longer than 48 months resulted in                      than in the other cohorts. Could this be, in part, responsible for
the persistent growth cohort sometimes being too small.                            large moves in the group?
Without trying to “optimize” a look-back period, we settled on
48 months as our historical window to determine status.
Exhibit 5 shows the average and minimum count by cohort
using a 48-month look back period.




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                                                                             MORGAN            STANLEY            RESEARCH

                                                                             May 28, 2013
                                                                             US Equity Strategy




Exhibit 6                                                                    Characteristics by Growth-Persistence Cohort
All Cohorts Now Contain 12 Stocks of $60 Billion or
More, but Mixed Growth Is Smaller Overall                                    Tech stocks grew to dominate the persistent growth category in
                           Largest Persistent Growth Stocks                  the mid-1990s; health care has also increased its share
                                                                 Mkt. Cap.
             Ticker      Name                                       ($M)
                                                                             (Exhibit 7).
             AAPL        Apple Inc.                               416,255
             GOOG        Google Inc. Cl A                         272,939    Exhibit 7
             IBM         International Business Machines Corp.    224,819
             ORCL        Oracle Corp.                             154,689    The Persistent Growth Cohort is Dominated by
             AMZN
             QCOM
                         Amazon.com Inc.
                         QUALCOMM Inc.
                                                                  115,484
                                                                  106,322
                                                                             Tech, Health Care and Discretionary Stocks
             MCD         McDonald's Corp.                         102,416
             SLB         Schlumberger Ltd.                         98,951                      Percentage of Persistent Growth Stocks by Sector
             UPS         United Parcel Service Inc. Cl B           81,806
             GILD        Gilead Sciences Inc.                      76,930     100%
             MA          MasterCard Inc. Cl A                      68,145                                                                         Utilities
             NKE         Nike Inc. Cl B                            56,834
                                                                               80%                                                                Telecom
             Total                                               1,775,589
                                                                                                                                                  Tech
                             Largest Mixed Growth Stocks                                                                                          Health Care
                                                                               60%
                                                                 Mkt. Cap.
             Ticker      Name                                       ($M)                                                                          Staples
             KO          Coca-Cola Co.                            188,284      40%                                                                Discretionary
             V           Visa Inc.                                111,528
                                                                                                                                                  Industrials
             HD          Home Depot Inc.                          108,851
             AMGN        Amgen Inc.                                78,158      20%                                                                Materials
             ABBV        AbbVie Inc.                               73,910                                                                         Energy
             MO          Altria Group Inc.                         73,337
                                                                                0%
             MMM         3M Co.                                    72,270
                                                                                     69 72 75 78 81 84 87 90 93 96 99 02 05 08 11
             NWSA        News Corp. Cl A                           72,234
             BA          Boeing Co.                               69,318
             UNP         Union Pacific Corp.                       69,118    Source: Factset, Morgan Stanley Research
             EBAY        eBay Inc.                                 67,845
             FB          Facebook Inc.                             65,868
             Total                                               1,050,721   Currently and throughout most of its history, the mixed growth
                            Largest Lapsed Growth Stocks
                                                                             cohort has been dominated by discretionary stocks (Exhibit 8).
                                                                 Mkt. Cap.   During the Tech Bubble, however, tech stocks comprised over
             Ticker      Name                                       ($M)
             XOM         Exxon Mobil Corp.                        395,650    60% of this group.
             MSFT        Microsoft Corp.                          276,352
             WMT         Wal-Mart Stores Inc.                     257,564
                                                                             Exhibit 8
             JNJ         Johnson & Johnson                        236,811
             PG          Procter & Gamble Co.                     210,409    Discretionary Stocks Currently Dominate the Mixed
             PM          Philip Morris International Inc.         158,069
             MRK         Merck & Co Inc                           142,252
                                                                             Growth Cohort, but Tech Ruled in the Bubble
             PEP         PepsiCo Inc.                             127,416
             CSCO        Cisco Systems Inc.                       111,357                        Percentage of Mixed Growth Stocks by Sector
             UTX         United Technologies Corp.                83,923
             BMY         Bristol-Myers Squibb Co.                 65,260      100%
             LLY         Eli Lilly & Co.                          60,566                                                                          Utilities
             Total                                               2,125,628
                                                                               80%                                                                Telecom
                              Largest Non-Growth Stocks                                                                                           Tech
                                                                 Mkt. Cap.
                                                                               60%                                                                Health Care
             Ticker      Name                                       ($M)
             CVX         Chevron Corp.                            237,517                                                                         Staples
             GE          General Electric Co.                     231,941      40%                                                                Discretionary
             PFE         Pfizer Inc.                              211,513
                                                                                                                                                  Industrials
             T           AT&T Inc.                                203,146
             VZ          Verizon Communications Inc.              154,237      20%                                                                Materials
             INTC        Intel Corp.                              118,505                                                                         Energy
             DIS         Walt Disney Co.                          113,112
                                                                                0%
             CMCSA       Comcast Corp. Cl A                       109,011
             COP         ConocoPhillips                           73,750             69 72 75 78 81 84 87 90 93 96 99 02 05 08 11
             OXY         Occidental Petroleum Corp.                71,900
             CVS         CVS Caremark Corp.                        71,620    Source: Factset, Morgan Stanley Research
             UNH         UnitedHealth Group Inc.                  61,069
             Total                                               1,657,319
                                                                             As many investors have noticed, tech stocks are becoming an
Source: Factset, Morgan Stanley Research
                                                                             increasingly large component of lapsed growth (Exhibit 9).




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                                                                                   MORGAN             STANLEY                 RESEARCH

                                                                                   May 28, 2013
                                                                                   US Equity Strategy




Exhibit 9                                                                          Exhibit 11
Tech Has Recently Become the Largest Constituent                                   Lapsed Growth Now Contains Almost as Many Tech
of the Lapsed Growth Cohort                                                        Stocks as Persistent Growth (and More than Mixed)
                    Percentage of Lapsed Growth Stocks by Sector                                           Number of Technology Stocks by Cohort

 100%                                                                               90               Persistent Growth
                                                                   Utilities        80               Mixed Growth
  80%                                                              Telecom                           Lapsed Growth
                                                                                    70
                                                                   Tech                              Non-Growth
                                                                                    60
  60%                                                              Health Care
                                                                                    50
                                                                   Staples
                                                                                    40
  40%                                                              Discretionary
                                                                                    30
                                                                   Industrials
  20%                                                              Materials        20

                                                                   Energy           10

   0%                                                                                0
        69 72 75 78 81 84 87 90 93 96 99 02 05 08 11                                     69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13


Source: Factset, Morgan Stanley Research                                           Source: Factset, Morgan Stanley Research



Health care membership has risen recently in the non-growth                        Persistent growth stocks once had a much higher fraction in
cohort (Exhibit 10), while tech still remains a small portion of                   high quality than did the other cohorts (Exhibit 12). Since the
this group.                                                                        Financial Crisis, however, all four cohorts have converged in
                                                                                   their percentages of quality stocks.
Exhibit 10
Utilities and Discretionary Are the Most Populous                                  Exhibit 12
Sectors in the Non-Growth Cohort                                                   All Four Cohorts Currently Have Similar
                                                                                   Concentrations of High Quality Stocks
                     Percentage of Non-Growth Stocks by Sector
                                                                                                          Percentage of High Quality Stocks by Cohort
 100%
                                                                                    100%
                                                                   Utilities
                                                                                                                                                            Persistent Growth
  80%                                                              Telecom
                                                                                     80%                                                                    Mixed Growth
                                                                   Tech                                                                                     Lapsed Growth
  60%                                                              Health Care                                                                              Non-Growth
                                                                   Staples           60%

  40%                                                              Discretionary
                                                                   Industrials       40%

  20%                                                              Materials
                                                                   Energy            20%
   0%
        69 72 75 78 81 84 87 90 93 96 99 02 05 08 11                                  0%
                                                                                           80   82   84   86   88   90   92   94   96   98   00   02   04     06   08   10   12
Source: Factset, Morgan Stanley Research
                                                                                   Source: Factset, Morgan Stanley Research

Exhibit 11 shows the counts of technology stocks in each
cohort over time. Lately, technology has increased its count in                    Mixed growth often has a larger fraction of junk stocks than the
the persistent and lapsed growth groups.                                           other cohorts (Exhibit 13); while it still leads today, there is little
                                                                                   difference among the groups in their concentrations of junk
                                                                                   names.




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                                                                                             MORGAN            STANLEY              RESEARCH

                                                                                             May 28, 2013
                                                                                             US Equity Strategy




Exhibit 13                                                                                   Exhibit 14
Mixed Growth Generally Has the Highest                                                       Persistent Growth Stocks Are Now Cheap versus
Concentration of Junk Stocks                                                                 their Historical Market-Relative Multiple
                            Percentage of Junk Stocks by Cohort                                                       Persistent Growth Cohort Valuation
 100%
                            Persistent Growth                                                 4.0x                                                  Relative Price-to-Earnings
                            Mixed Growth                                                                                                            Relative Price-to-Forward Earnings
  80%                                                                                         3.5x
                            Lapsed Growth                                                                                                           Relative Price-to-Book
                            Non-Growth                                                        3.0x
  60%
                                                                                              2.5x

  40%                                                                                         2.0x

                                                                                              1.5x
  20%
                                                                                              1.0x

   0%                                                                                         0.5x
        80   82   84   86   88   90   92   94   96   98   00   02   04   06   08   10   12           69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Source: Factset, Morgan Stanley Research                                                     Source: Factset, Morgan Stanley Research


Valuations by Growth Persistence Cohorts                                                     Stocks in the non-growth cohort have almost exclusively been
                                                                                             cheaper than the overall market on trailing and forward
For each cohort, we compute the median trailing earnings yield                               earnings, as well as on price-to-book (Exhibit 15). Currently,
over time, as well as the median forward earnings yield and the                              these stocks are at historically rich valuations: at 0.98x
median book-to-price, then take reciprocals; we also compute                                 the market in trailing and forward P/E, they are at the 92nd
relative to the market in each case. This approach is relatively                             and 87th percentiles, respectively; they are also at the 72nd
robust (though not sufficiently so for mixed growth stocks in the                            percentile on price-to-book.
Tech Bubble), as a few large companies generally cannot
produce extreme valuations.                                                                  Exhibit 15
                                                                                             Non-Growth Stocks Are Historically Expensive on
Persistent growth stocks have generally been more expensive                                  Trailing and Forward Earnings and on Book/Price
than the market on trailing and forward earnings and on book                                                         Non-Growth Growth Cohort Valuation
(Exhibit 14). Relative to history, persistent growth stocks are
                                                                                              1.1x             Relative Price-to-Earnings
currently cheap vs. their own history. At 1.37x relative trailing                                              Relative Price-to-Forward Earnings
P/E and 1.34x relative forward P/E, they are at their 36th and                                1.0x             Relative Price-to-Book
35th percentiles, respectively. On price-to-book, the group is                                0.9x
neutrally valued, with a 54th percentile value of 2.37x.                                      0.8x

                                                                                              0.7x

                                                                                              0.6x

                                                                                              0.5x

                                                                                              0.4x
                                                                                                     69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

                                                                                             Source: Factset, Morgan Stanley Research


                                                                                             During the Tech Bubble, the median mixed growth stock had
                                                                                             extreme valuations in both trailing and forward P/E. Currently,
                                                                                             however, the group is neutrally valued relative to its history: at
                                                                                             1.27x trailing and 1.24x forward P/E, it is in the 49th percentile
                                                                                             of its history relative to the market. For lapsed growth stocks,
                                                                                             different valuation measures give opposite results: on trailing
                                                                                             P/E, the group is currently expensive, at 1.08x, in the 81st
                                                                                             percentile, but on forward P/E it is cheap, at 1.00x (30th



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                                                                              May 28, 2013
                                                                              US Equity Strategy




percentile). This implies higher than average                                 Exhibit 17

earnings-growth expectations for the lapsed growth                            Lapsed Growth Stocks Now Yield as Much as
cohort.                                                                       Non-Growth Stocks

                                                                                                            Dividend Yield by Cohort
Extreme Valuation
                                                                               10%
                                                                                                                                              Persistent Growth
                                                                                9%                                                            Mixed Growth
To capture extreme valuations, both from negative (forecast)
                                                                                8%                                                            Lapsed Growth
earnings and from high multiples on positive forward earnings,                  7%                                                            Non-Growth
we count the fraction of stocks whose forward earnings to price                 6%
ratio is less than 0.01 (Exhibit 16). Such stocks would have                    5%

forward P/Es exceeding 100x or have negative earnings.                          4%
                                                                                3%
During the Tech Bubble, over 60% of mixed growth stocks had
                                                                                2%
such extreme valuations. Meanwhile, at the peak, less than
                                                                                1%
20% of persistent growth stocks had extreme valuations – this                   0%
was on a par with non-growth stocks. There is an echo of the                         69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

mixed growth valuation bubble later in lapsed growth
                                                                              Source: Factset, Morgan Stanley Research
valuations, as mixed growth stocks became lapsed growth
stocks. Extreme forward valuations have been less common                      The total yield – including both dividends and net share
since the Bubble.                                                             buybacks – among lapsed growth stocks has been about the
                                                                              same as that on non-growth stocks since the Financial Crisis
A similar chart constructed using trailing earnings to price                  (Exhibit 18).
shows that 70% of mixed growth stocks had extreme trailing
earnings valuations. During the recent Financial Crisis, lapsed               Exhibit 18
and non-growth were the cohorts with the largest numbers of                   Lapsed Growth and Non-Growth Cohorts Have Had
stocks at extreme valuations, with nearly 40% of non-growth                   Similar Total Yields during the Recovery
stocks in that category; this was due to sharp declines in
                                                                                                              Total Yield by Cohort
realized earnings, rather than optimistic projections.
                                                                               10%                                                     Persistent Growth
Exhibit 16                                                                      9%                                                     Mixed Growth
Extreme Valuations on Estimated Earnings Were                                   8%                                                     Lapsed Growth
Common in Mixed Growth during the Tech Bubble                                   7%                                                     Non-Growth
                                                                                6%
                Percentage of Stocks with Extreme Valuation by Cohort           5%
                          Forward Earnings-to-Price < 0.01                      4%
 70%                                                                            3%
                   Persistent Growth
 60%                                                                            2%
                   Mixed Growth
                                                                                1%
 50%               Lapsed Growth
                                                                                0%
 40%               Non-Growth
                                                                                     69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

 30%
                                                                              Source: Factset, Morgan Stanley Research
 20%

 10%                                                                          Performance of the Growth-Persistence Cohorts
  0%
       69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13   We compute the equal-weight monthly returns of each cohort
                                                                              and summarize performance (Exhibit 19). Persistent growth
Source: Factset, Morgan Stanley Research
                                                                              stocks have consistently underperformed those in other
                                                                              cohorts, with the lowest average return over 40 years and
Yields by Growth Persistence Cohort
                                                                              second highest volatility. The lower volatility of the
                                                                              non-growth cohort is not surprising given its larger size (and
Dividend yields among lapsed growth stocks are now equal to
                                                                              greater diversification); however, the non-growth cohort
those of non-growth stocks (Exhibit 17), after having lagged for
                                                                              also has the highest average return. Lower average returns
the last 45 years.
                                                                              could be compensation for lower tail risk, but persistent



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growth stocks have significant negative skewness and                           Exhibit 20

excess kurtosis. Consequently, persistent growth stocks do                     Cumulative Performance Has Been Best for
not constitute much of a tail-risk hedge relative to other                     Non-Growth (Except Briefly during the Tech Bubble)
cohorts.                                                                                                 Growth of $1 Since 1972 by Cohort
                                                                                                           Equal-Weighted Performance
                                                                                $100
Over the last 10 years (post-Tech Bubble and Collapse, but                                       Persistent Growth
                                                                                 $90
including the Financial Crisis and recovery), growth stocks                                      Mixed Growth
                                                                                 $80
                                                                                                 Lapsed Growth
generally have underperformed. Persistent growth stocks                          $70             Non-Growth
slightly outperformed mixed growth stocks, but lagged lapsed                     $60
growth and non-growth stocks.                                                    $50
                                                                                 $40
Exhibit 19                                                                       $30

Persistent Growth Stocks Have Underperformed                                     $20
                                                                                 $10
those in Other Cohorts
                                                                                  $0
                       Statistics by Cohort Since Feb. 1972                            72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

                             Persistent    Mixed        Lapsed
                                                                               Source: Factset, Morgan Stanley Research
Statistic                     Growth       Growth       Growth    Non-Growth
Annualized Avg. Return         8.50%       10.10%       10.80%      12.15%
Standard Deviation             20.5%       20.9%         18.8%      15.4%      Persistent growth tends to underperform net of 6 factor
Information Ratio               0.42         0.48         0.58        0.79     contributions, while non-growth tends to outperform.
Skewness                       (0.30)       (0.38)       (0.56)      (0.48)
Kurtosis                        1.52         2.58         2.81        2.99
                                                                               Differences are not large, at 1.6% per year.

                                                                               The preceding analysis used absolute returns that combine
                    Statistics by Cohort for the Last 10 Years
                                                                               systematic and idiosyncratic (to the cohort) risks. We have
                             Persistent    Mixed        Lapsed
Statistic                     Growth       Growth       Growth    Non-Growth
                                                                               developed a 6-factor risk model, including the equity market,
Annualized Avg. Return         9.76%       9.19%        13.90%      14.28%     two size spreads, a style factor, a quality/junk spread and
Standard Deviation             16.4%       17.5%         17.7%       16.3%     momentum. For more details on this model and the underlying
Information Ratio               0.59         0.53         0.78        0.87
Skewness                       (0.82)       (1.27)       (0.73)      (0.98)
                                                                               factors (based on proprietary models in many cases), see US
Kurtosis                        2.48         3.62         3.14        3.38     Quant Research: The Definition of Insanity, May 5, 2013.
Source: Factset, Morgan Stanley Research
                                                                               Applying this model to the cohort returns allows us to
                                                                               decompose performance into factor-based contributions and
Starting in 1972, we compute the cumulative compound                           excess returns (i.e., cohort alpha).
returns of each cohort in Exhibit 20. Persistent growth has
consistently had the worst cumulative performance, while                       Over the last 30 years, persistent growth stocks have
non-growth has mostly had the best cumulative performance.                     generated a small negative alpha (-0.4% per year) relative
Mixed growth lagged non-growth prior to the Tech Bubble,                       to our 6-factor model (Exhibit 21). Mixed growth stocks
briefly overtook it as the best performer, then fell back into                 also had a negative alpha, while lapsed growth and
second place. During the Financial Crisis, mixed growth                        non-growth cohorts produced positive alphas, with the
slipped to third place behind lapsed growth.                                   latter at 1.2% per year. While none of these alphas is
                                                                               statistically significant, they confirm that the underperformance
                                                                               of persistent growth stocks is not simply due to systematic
                                                                               exposures of the group.




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Exhibit 21                                                                                 Exhibit 23
Risk-Adjusted Performance Has Been Better for                                              Persistent Growth Is Now the Lowest-Beta Cohort
Lapsed Growth and Non-Growth Stocks
                                                                                                                     Rolling 60-Month Equity Market Beta by Cohort

                         Median 60-Month Annualized Alpha by Cohort
                                                                                            1.8                 Persistent Growth
                              February 1984 through April 2013
                                                                                                                Mixed Growth
  1.4%
                                                                                            1.6                 Lapsed Growth
  1.2%
                                                                                                                Non-Growth
  1.0%                                                                                      1.4
  0.8%
  0.6%                                                                                      1.2
  0.4%
                                                                                            1.0
  0.2%
  0.0%                                                                                      0.8
 (0.2%)
 (0.4%)                                                                                     0.6
 (0.6%)                                                                                           84     86    88    90    92   94    96   98    00   02     04   06   08   10   12
             Persistent Growth        Mixed Growth     Lapsed Growth         Non-Growth
                                                                                           Source: Factset, Morgan Stanley Research
Source: Factset, Morgan Stanley Research

                                                                                           Prior to the Tech Bubble, persistent growth cohort returns were
Although full-period excess return differences among the                                   more sensitive to style (growth versus value) returns than
cohorts are modest, conditional (rolling) performance                                      those of the mixed growth cohort, but this reversed in 2000
differences can be quite large (Exhibit 22). At various times,                             (Exhibit 24). Thus, if one wants to gain exposure to growth
60-month annualized alphas of each cohort have exceeded 6%                                 as a style bet, a basket of mixed growth stocks is a more
in magnitude. During the Tech Bubble, for example, mixed                                   efficient way to obtain this exposure than a basket of
growth alpha annualized at 6%, but fell to -6% when the Bubble                             persistent growth stocks.
collapsed. Recently, mixed growth stocks have
underperformed, as lapsed growth and non-growth stocks                                     Exhibit 24
produced positive alpha.                                                                   Style Sensitivities of Persistent Growth and Mixed
                                                                                           Growth Reversed in 2000
Exhibit 22
Conditional Risk-Adjusted Returns Have Varied                                                                         Rolling 60-Month Style Sensitivity by Cohort

Substantially in All Four Cohorts                                                            0.4

                                                                                             0.2
                         Rolling 60-Month Annualized Alpha by Cohort
                                                                                             0.0
  8%                    Persistent Growth
                        Mixed Growth                                                        (0.2)
  6%
                        Lapsed Growth
                                                                                            (0.4)
  4%                    Non-Growth
  2%                                                                                        (0.6)

  0%                                                                                        (0.8)              Persistent Growth           Mixed Growth

 (2%)                                                                                                          Lapsed Growth               Non-Growth
                                                                                            (1.0)
 (4%)                                                                                               84    86    88    90   92    94   96    98   00     02   04   06   08   10   12
 (6%)
                                                                                           Source: Factset, Morgan Stanley Research
 (8%)
        84    86   88     90     92    94   96   98   00   02   04     06   08   10   12
                                                                                           For much of the 1990s and parts of the 2000s, persistent
Source: Factset, Morgan Stanley Research                                                   growth had the highest sensitivity to quality-stock
                                                                                           outperformance (Exhibit 25). Recently, however, all four
Persistent growth was the highest-beta cohort prior to the                                 cohorts have similar, near zero quality/junk biases in their
Financial Crisis (peaking in 2006), but is now the lowest-beta                             returns.
cohort (Exhibit 23). Equity betas of the other three cohorts are
currently quite similar.




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Exhibit 25                                                                               Exhibit 26
Quality/Junk Sensitivities of All Four Cohorts Are                                       There Has Not Been Much of a Sub-Style Call
Currently About the Same                                                                 Recently – though it Has Mattered in the Past
                    Rolling 60-Month Quality/Junk Sensitivity by Cohort                                  12-Month Cumulative Residual Performance by Cohort

  0.3
                                                                                           15%                                 Persistent Growth          Mixed Growth
  0.2                                                                                                                          Lapsed Growth              Non-Growth
                                                                                           10%
  0.1
                                                                                            5%
  0.0
                                                                                            0%
 (0.1)
                                                                                           (5%)
 (0.2)
                                                                                          (10%)
 (0.3)
                   Persistent Growth         Mixed Growth                                 (15%)
 (0.4)
                   Lapsed Growth             Non-Growth
 (0.5)                                                                                    (20%)
         84   86   88   90    92   94   96    98   00     02   04   06    08   10   12            03   04      05     06     07     08     09      10    11     12       13


Source: Factset, Morgan Stanley Research                                                 Source: Factset, Morgan Stanley Research



To track month-to-month risk-adjusted performance of each                                The four cohorts have six correlation pairs. Based on the
cohort, we compute residuals using our 6-factor model.                                   minimum correlation among these pairs, the cohorts are at a
Residuals take the factor sensitivities for the cohort from the                          40-year high in correlation (Exhibit 27).
prior month (computed over rolling 60-month intervals) and use
                                                                                         Exhibit 27
them to compute factor contributions in the current month. No
                                                                                         Correlations among the Cohorts Are Currently at
intercept is subtracted in computing these residuals. As the
                                                                                         Historically High Levels
monthly residuals can be noisy, we sum them over rolling
12-month periods. The resulting performance is similar to what
                                                                                                            Rolling 60-Month Correlations of Growth Cohorts
a hedged trading strategy would return in each case: it filters
                                                                                          1.0
out much of the systematic risk in each cohort to give a more                             0.9
clear indication of cohort-specific performance.                                          0.8
                                                                                          0.7

Recent residual performance shows non-growth stock                                        0.6
                                                                                          0.5
outperformance (Exhibit 26) and persistent growth stock
                                                                                          0.4
underperformance; the magnitudes are not large, however, at                               0.3            PERSISTENT_MIXED                       PERSISTENT_LAPSED
around 5% in each case. Thus, there has been no “sub-style”                               0.2            PERSISTENT_NON_GROWTH                  MIXED_LAPSED
call within an overall non-call on style.                                                 0.1            MIXED_NON_GROWTH                       LAPSED_NON_GROWTH
                                                                                          0.0
                                                                                                75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11
At times, there have been strong sub-style calls, such as prior
to the Financial Crisis, when persistent growth stocks sharply                           Source: Factset, Morgan Stanley Research
underperformed non-growth stocks. Lapsed growth stocks
rallied strongly at the start of the recovery and mixed growth                           Transitions
stocks underperformed in 2010 and 2011.
                                                                                         Stocks in persistent growth can go to lapsed growth, stay in
                                                                                         persist growth or leave the Top 500 stock universe.

                                                                                         At end of month t, we form a persistent growth set and record
                                                                                         the number of stocks. At the end of month t+1, we count the
                                                                                         number of stocks from month t that remain in persistent growth,
                                                                                         the number going to lapsed growth and the number leaving the
                                                                                         universe altogether. We then repeat this procedure for each
                                                                                         month in the history.




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Given a stock’s current growth persistence cohort, only certain                  Exhibit 29

types of transitions are possible; we illustrate these in Exhibit                Transitions between Cohorts Are Relatively Rare
28. Aside from staying in their current states, stocks in                                         Cohort Transition Probabilities: Since Dec. 1972
persistent and non-growth cohorts can undergo an active
                                                                                                                                     Transition to
transition (to lapsed or mixed growth, respectively), due to a
                                                                                                            Persistent        Mixed              Lapsed
change in classification by our style model, or they can exit the                                            Growth           Growth             Growth        Non-Growth
                                                                                 Original Cohort
universe (acquired or becoming too small). Stocks in mixed or                    Persistent Growth            92.7%                0.0%           3.1%             0.0%
lapsed growth can each have an active transition (to lapsed or                   Mixed Growth                  3.7%               83.6%           7.2%             0.0%
mixed growth, respectively) or a passive transition (to                          Lapsed Growth                 0.0%                6.7%          85.7%             3.1%
                                                                                 Non-Growth                    0.0%                1.6%           0.0%            94.6%
persistent or non-growth, respectively). In a passive transition,
                                                                                 Source: Factset, Morgan Stanley Research
the stock is not reclassified by the model; instead, a prior
(different) classification rolls off the end of the 48-month
persistence window. Stocks in mixed and lapsed growth can                        For the four active transitions, probabilities are higher in the
also exit the universe.                                                          last 10 years than they were over the entire 40-year period
                                                                                 (Exhibit 30). This is consistent with it being more difficult
Exhibit 28                                                                       to distinguish between styles based on historical criteria,
Depending on the Cohort, Only Certain Types of                                   such as beta. Passive transitions, where an historically
Transitions Are Possible                                                         distant equity style category rolls off, are slightly less frequent
                                                                                 today, compared with their long-run values (perhaps because
                             Cohort Transitions
                                                                                 fewer stocks remain in these cohorts due to more-likely active
                                                                                 transitions).
                               Mixed Growth

                                                                                 Exhibit 30
Non-Growth                                                   Persistent Growth   Active Transitions Are More Likely Today Than in
                               Lapsed Growth
                                                                                 the Past
                                                                                                             Cohort Transition Probabilities

                                                                                  10%                                                                     Since Dec. 1972
             Exit Universe                        Enter Universe                                             Active Transitions
                                                                                   9%                                                                     Last 10 Years
Source: Morgan Stanley Research                                                    8%
                                                                                   7%

Each quarter, we count the number of stocks undergoing each                        6%
                                                                                                                                                     Passive Transitions
                                                                                   5%
type of transition and cumulate these over the sample to obtain                    4%
unconditional transition probabilities.                                            3%
                                                                                   2%
                                                                                   1%
In Exhibit 29, we show the probabilities of transitioning
                                                                                   0%
between growth persistence cohorts over the full, 40-year                               Persistent to   Mixed to    Lapsed to       Non-Growth     Mixed to      Lapsed to
                                                                                          Lapsed        Lapsed        Mixed          to Mixed     Persistent    Non-Growth
period. Generally, these transitions are infrequent. Other
than staying in their current states, moving back and forth                      Source: Factset, Morgan Stanley Research
between mixed growth and lapsed growth are the most
common – but still occur just 7% of the time. Passive                            Transitions to Growth – In Exhibit 31, we show the
transitions between mixed and persistent, and between lapsed                     cumulative market-relative performance of stocks that
and non-growth are next most common (these occur when a                          transition to growth cohorts (persistent or mixed growth). In all
single instance of a different state finally rolls off). Least                   three cases, the stocks dramatically outperform in the
common are transitions from persistent states, either growth                     period preceding the transition (it would not have been
(3.1%) or non-growth (1.6%). We do not show the transition                       know prior to the fact). The premium is largest in going
probabilities to or from outside the universe; consequently,                     from non-growth to mixed, and smallest for the “passive”
rows and columns do not quite sum to 100%.                                       transition of going from mixed to persistent growth. In the
                                                                                 case of transitions from lapsed to mixed, the
                                                                                 outperformance does not begin until just six months prior
                                                                                 to the transition; these stocks are more transitory, by




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definition, and the shifts may therefore be harder to spot                              The asymmetry of the growth cohorts is evident by the
in advance.                                                                             premium that stocks receive just to stay in them (Exhibit 33).
                                                                                        Since it is uncertain whether these stocks will remain, and the
After the transition occurs, there is still a few percent of                            ones that leave dramatically underperform, there is value in
outperformance, on average, for the two active transitions.                             being able to predict that stocks will not transition from
Investors must generally act quickly, however, as it is                                 growth. The premium for staying is over twice as large for
gone within a few months.                                                               mixed growth as for persistent growth (due to larger
                                                                                        uncertainty in the former). Post-transition, there is of course no
Exhibit 31                                                                              premium for staying.
Stocks Transitioning to Growth Cohorts Outperform
Prior to the Transition                                                                 Exhibit 33
                                                                                        Stocks Receive a Large (Small) Premium for
                 Cumulative Relative Performance Before and After a                     Remaining in Mixed (Persistent) Growth
                        Cohort Transition, Since Dec. 1972
   1.1
                                                                                                         Cumulative Relative Performance Before and After a
                                                                                                                Cohort Transition, Since Dec. 1972
   1.0
                                                                                           1.1
   0.9
                                                                                           1.0
                                                             Mixed to Persistent
   0.8
                                                             Lapsed to Mixed               0.9
                            Transition                       Non-Growth to Mixed                                                                     Remain Persistent
   0.7
                                                                                           0.8                                                       Remain Mixed
   0.6                                                                                                                                               Remain Lapsed
                                                                                                                    Transition
      (15)        (10)         (5)           0          5             10           15      0.7                                                       Remain Non-Growth
                                           Months
                                                                                           0.6
Source: Factset, Morgan Stanley Research                                                      (15)        (10)         (5)           0          5             10         15
                                                                                                                                   Months

Transitions from growth – Conversely, stocks transitioning                              Source: Factset, Morgan Stanley Research
from growth cohorts tend to underperform in the months
prior to the transition (Exhibit 32). Symmetrically, the                                Factor Efficacy
largest penalty, on average, occurs for transitions from
persistent to lapsed growth; underperformance starts to                                 We measure factor efficacy by dividing each category into
occur 12 months out. For mixed to lapsed transitions, the                               thirds for each factor (T1 is the set of stocks ranked best and T3
underperformance does not begin until six months prior.                                 is the set ranked worst). Given the modest numbers of stocks
Post-transition, stocks undergoing both types of active                                 in some groups, we cannot use quintiles or finer gradations of
transitions continue to underperform.                                                   rankings. Once the stocks are classified, we hold them for 12
                                                                                        months and compute their equal weighted return. The returns
Exhibit 32                                                                              from these rolling 12-month holding periods are then averaged
Stocks Transitioning from Growth Cohorts                                                to obtain the average factor performance. For each cohort, we
Underperform Prior to the Transition                                                    show the 10 best-performing factors, in terms of the average
                                                                                        T1-T3 spread, from 1973 to 2013.
                 Cumulative Relative Performance Before and After a
                        Cohort Transition, Since Dec. 1972
   1.4                                                                                  For stocks in the persistent growth cohort, free cash flow
   1.3                                                       Persistent to Lapsed       variables work the best over 12-month periods (Exhibit 34),
                                                             Mixed to Lapsed
   1.2                                                                                  with stronger performance on the short side. Estimate
                                                             Lapsed to Non-Growth
   1.1                                                                                  dispersion is also a negative signal in this group, as are
   1.0                                                                                  accruals – this is consistent with investors looking for clues
   0.9
                                                                                        about which stocks are prone to exit this group. Poor
   0.8
                            Transition                                                  momentum is also a good negative signal, but strong
   0.7
                                                                                        momentum is not necessarily a reason to buy a persistent
   0.6
      (15)        (10)         (5)           0          5             10           15   growth stock.
                                           Months

Source: Factset, Morgan Stanley Research




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Exhibit 34                                                                                 Exhibit 36
Free Cash Flow and Momentum Work Best for                                                  Accruals, Cash and Momentum Are Best in Lapsed
Persistent Growth Stocks at 12-Month Horizons                                              Growth at 12-Month Horizons
             12-Month Factor Efficacy within Persistent Growth Stocks                                   12-Month Factor Efficacy within Lapsed Growth Stocks
                             1973 through April, 2013                                                                 1973 through April, 2013

Factor                                          T1           T3      T1-T3        Rank     Factor                                          T1           T3      T1-T3        Rank
Free Cash Flow Yield                              2.29   %    (6.03)% 8.32 %        1      Accruals*                                         3.64   %    (2.20)% 5.84 %        1
Enterprise Value-to-Free Cash Flow*               2.29   %    (5.96)% 8.25 %        2      Reduction in Shares Outstanding*                  3.99   %    (1.78)% 5.77 %        2
Estimate Dispersion*                              3.84   %    (3.61)% 7.45 %        3      9-Month Price Momentum                            3.07   %    (0.87)% 3.94 %        3
Free Cash Flow-to-Debt                            0.36   %    (5.66)% 6.02 %        4      Cash-to-Assets                                    2.77   %    (1.10)% 3.87 %        4
Price-to-Earnings*                                0.43   %    (5.44)% 5.87 %        5      Cash-to-Debt                                      2.71   %    (1.15)% 3.86 %        5
Accruals*                                         0.97   %    (4.87)% 5.85 %        6      Cash-to-Market Cap                                3.08   %    (0.73)% 3.81 %        6
Enterprise Value-to-EBITDA*                       0.58   %    (5.24)% 5.82 %        7      Enterprise Value-to-Operating Income*             3.22   %    (0.58)% 3.80 %        7
6-Month Price Momentum                            0.78   %    (4.84)% 5.62 %        8      12-Month Price Momentum                           3.07   %    (0.50)% 3.58 %        8
12-Month Price Momentum                           0.81   %    (4.73)% 5.53 %        9      Interest Coverage                                 2.38   %    (1.19)% 3.58 %        9
9-Month Price Momentum                            0.78   %    (4.64)% 5.42 %       10      Receivables Turnover                              2.78   %    (0.77)% 3.55 %       10

Source: Factset, Morgan Stanley Research Note: * indicates that low values are preferred   Source: Factset, Morgan Stanley Research Note: * indicates that low values are preferred


For stocks in mixed growth, valuation factors, including free                              In the non-growth cohort, the top factors are almost entirely
cash flow, are among the strongest (Exhibit 35). As with                                   valuation oriented (share count reduction is a notable
persistent growth stocks, the emphasis is on flagging potential                            exception) and performance is stronger for favored than
underperformers. Both trailing and forward price-to-earnings                               disfavored stocks. Factor performance is strong in the top third
factors work, as does estimate dispersion. Unlike persistent                               of stocks, but only modestly below the market in the bottom
growth, however, negative momentum is not a strong                                         third of stocks (Exhibit 37). Using factors that incorporate
(negative) signal in mixed growth.                                                         information from the firms’ capital structures is clearly
                                                                                           important in this cohort – not surprising given the higher debt
Exhibit 35                                                                                 levels in these stocks.
Valuation Factors Work Best for Stock Selection in
Mixed Growth at 12-Month Horizons                                                          Exhibit 37

              12-Month Factor Efficacy within Mixed Growth Stocks
                                                                                           Valuation Factors Dominate Non-Growth Stock
                           1973 through April, 2013                                        Selection at 12-Month Horizons
                                                                                                     12-Month Factor Efficacy within Non-Growth Growth Stocks
Factor                                          T1           T3      T1-T3        Rank
                                                                                                                      1973 through April, 2013
Price-to-EBITDA*                                  1.40   %    (6.15)% 7.55 %        1
Enterprise Value-to-Free Cash Flow*               2.35   %    (5.04)% 7.39 %        2
                                                  2.40   %    (4.88)% 7.27 %        3      Factor                                          T1           T3      T1-T3        Rank
Free Cash Flow Yield
                                                  1.15   %    (5.86)% 7.01 %        4      Enterprise Value-to-Operating Income*             4.75   %    (1.06)% 5.81 %        1
Price-to-Operating Income*
                                                  0.85   %    (6.02)% 6.87 %        5      Enterprise Value-to-EBITDA*                       4.74   %    (0.92)% 5.66 %        2
Enterprise Value-to-EBITDA*
                                                  1.24   %    (5.56)% 6.79 %        6      Reduction in Shares Outstanding*                  4.15   %    (0.98)% 5.13 %        3
Free Cash Flow-to-Debt
                                                  1.43   %    (5.33)% 6.76 %        7      Price-to-Sales*                                   4.13   %    (0.97)% 5.10 %        4
Enterprise Value-to-Operating Income*
                                                  2.06   %    (3.67)% 5.74 %        8      Price-to-Operating Income*                        4.49   %    (0.32)% 4.81 %        5
Estimate Dispersion*
                                                  0.94   %    (4.70)% 5.64 %        9      Price-to-EBITDA*                                  4.69   %     0.00 % 4.69 %        6
Price-to-Earnings*
                                                  0.17   %    (5.05)% 5.22 %       10      Free Cash Flow Yield                              4.37   %    (0.31)% 4.69 %        7
Price-to-Forward Earnings*
                                                                                           Enterprise Value-to-Free Cash Flow*               4.16   %    (0.34)% 4.51 %        8
Source: Factset, Morgan Stanley Research Note: * indicates that low values are preferred   Free Cash Flow-to-Debt                            3.90   %    (0.57)% 4.47 %        9
                                                                                           Return on Invested Capital                        4.31   %     0.34 % 3.97 %       10

A wide variety of factors are useful for stock selection within                            Source: Factset, Morgan Stanley Research Note: * indicates that low values are preferred
lapsed growth stocks, although performance spreads are not
as wide as they are for growth or lapsed growth (Exhibit 36):                              Averaging the annualized T1 and T3 performances of the top
accruals, momentum, reduction in shares outstanding and high                               10 factors for each cohort, we observe that quant factors are
cash balances all appear in the top 10 factors. Consistent with                            better at identifying potential underperformance in the
these stocks adopting a less-growth oriented stance after                                  growth cohorts and somewhat better at forecasting
transitioning to lapsed growth, debt-related factors (such as                              outperformance in non-growth cohorts (Exhibit 38). For
interest coverage) also appear in this set.                                                managers that can take both long and short positions, the
                                                                                           average spread (opportunity) is greatest in the growth cohorts
                                                                                           and smallest in the lapsed growth category. The left-hand bars




                                                                                                                                                                                      14
                                                                                           MORGAN        STANLEY         RESEARCH

                                                                                           May 28, 2013
                                                                                           US Equity Strategy




in Exhibit 38 are consistent with a “reverse lottery”: stocks that                         Appendix
remain in either growth cohort receive a modest positive return,
while those stocks – that (improbably) exit growth suffer large                            Methodology: We classify stocks in the Top 500
negative returns. The challenge and payoff is in identifying                               (ex-financials) into one of four cohorts based on their history of
these stocks.                                                                              style classifications according to the following procedure:

Exhibit 38                                                                                      1.   At the end of each month, we classify stocks as
Quant Factors Are Able to Identify Underperformers                                                   growth or non-growth within our Model Universe
in Persistent and Mixed Growth at 12-Month Periods                                                   (Russell 1000 or Largest 1000 stocks), using our
                               12-Month Factor Efficacy:
                                                                                                     proprietary equity style model. Approximately 1/3 of
                    Average T1 and T3 Performance of Top 10 Factors                                  stocks are classified as growth stocks each month.
  6%                            1973 through April 2013
                   T1
  4%               T3
                                                                                                2.   We restrict this set to the Top 500 stocks, as we want
                                                                                                     to focus on style persistence among larger stocks, but
  2%                                                                                                 we retain the style classifications of Step 1.
  0%
                                                                                                3.   We exclude financials and stocks with no style
 (2%)                                                                                                classifications (recent IPOs or stocks that have
 (4%)
                                                                                                     dramatically increased in market cap). The reason for
                                                                                                     excluding financials is that a number of factors are not
 (6%)                                                                                                applicable to this sector and we want to use a large
          Persistent Growth    Mixed Growth        Lapsed Growth         Non-Growth
                                                                                                     factor universe for our factor efficacy tests. Due to the
Source: Factset, Morgan Stanley Research                                                             persistent value status of most financials, results for
                                                                                                     three cohorts are not materially affected.
For robustness, we repeated this factor efficacy analysis at a
3-month holding period and found very similar results. In                                       4.   Next, we classify the remaining stocks into four
particular, an average of 8 factors are common within the top                                        cohorts:
10 for each cohort, and the asymmetry in T1-T3 performance is
also present at a 3-month horizon (Exhibit 39).                                                           a.    If a stock has only been classified as growth
                                                                                                                over the last 48 months (or has at least 25
Exhibit 39                                                                                                      months of history and has been only
In Persistent and Mixed Growth, Quant Factors Are                                                               classified as growth), it is a persistent
Adept at Selecting Underperforming Stocks                                                                       growth stock.
                                3-Month Factor Efficacy:
                    Average T1 and T3 Performance of Top 10 Factors                                       b.    If a stock is now in growth, but has at least
  1.5%                          1973 through April 2013
                                                                                                                one month of non-growth status in the last
                     T1
  1.0%               T3
                                                                                                                48 months, or is entirely in growth but has 24
                                                                                                                or fewer months of data, it is a
  0.5%
                                                                                                                mixed-growth stock.
  0.0%
                                                                                                          c.    If a stock is now in non-growth, but has at
 (0.5%)                                                                                                         least one month of growth status in the last
 (1.0%)
                                                                                                                48 months, then it is a lapsed growth
                                                                                                                stock.
 (1.5%)
           Persistent Growth    Mixed Growth       Lapsed Growth         Non-Growth
                                                                                                          d.    If a stock has only non-growth status over
Source: Factset, Morgan Stanley Research Note: * indicates that low values are preferred                        the last 48 months, even if it has fewer than
                                                                                                                48 months of data, it is classified as a
                                                                                                                non-growth stock.




                                                                                                                                                                 15
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                                                                     May 28, 2013
                                                                     US Equity Strategy




    5.   Some stocks may exit the universe during the month,         Portfolio
         but the remaining stocks, as well as those that are
         new to the model universe, are re-classified at the end     Our overweight sectors are health care, industrials, and
         of the month according to the above procedure.              technology. We recommend underweights in consumer
                                                                     discretionary and consumer staples (Exhibit 40).
Comments:
                                                                     Exhibit 40

        There is an asymmetry in our cohort definitions, in         We Are Overweight Health Care, Industrials, and
         that we require sufficient history to classify a stock as   Technology
         persistent growth, whereas no minimum is required
                                                                       4%                                     Morgan Stanley Sector Recommendations
         for (persistent) non-growth classification. This                                                                 As of May 2013
                                                                       3%
         asymmetry reflects the fact that only 1/3 of stocks at        2%
         any time are growth and this status must be                   1%
         repeatedly affirmed.                                          0%
                                                                      (1%)

    
                                                                      (2%)
         A stock is classified as persistent growth even if it
                                                                      (3%)
         drops out of the Top 500 (but continuously retains its       (4%)
                                                                                Overweights - Health Care, Industrials, Technology
                                                                                Market-Weights - Financials, Materials, Telecoms, Utilities, Energy
         Model Universe growth classification) and returns in         (5%)      Underweights - Staples, Discretionary
         the last 48 months. Thus, our persistence is                 (6%)




                                                                                                                    Technology




                                                                                                                                                                                               Energy
                                                                                  Health Care




                                                                                                                                     Materials




                                                                                                                                                                                                           Discretionary
                                                                                                Industrials




                                                                                                                                                  Financials




                                                                                                                                                                                 Utilities




                                                                                                                                                                                                                           Staples
                                                                                                                                                                      Telecoms
         exclusively on style and not on size.

        Having a “buffer” of stocks between 500 and roughly
         1000 in market cap that are classified consistently is
                                                                     Source: Factset, Morgan Stanley Research
         important to isolating style persistence: if we had
         defined style on the Top 500 only, stocks would enter
                                                                     The relative performance of our portfolio to the S&P500 since
         and leave the style classifications due to relative cap
                                                                     inception (Exhibit 41) is 4.6%.
         changes. This latter formulation would therefore
         conflate style and size persistence, rather than            Exhibit 41
         focusing on style persistence.                              Our Portfolio Has Outperformed the S&P 500 (Total
                                                                     Return) by 460 bps Since Inception at the Beginning
Since one goal of this analysis is to study factor efficacy by       of 2011
cohort, the stock count within the persistent growth cohort is an
important limiting variable. We selected the amount of history                                                                   MOST Strategic Portfolio Performance
                                                                                                                                  December 31, 2010 to May 24, 2013
(look-back period) based on the minimum counts over time
                                                                        45.0%                                                                                  42.3%
with 24, 36, 48, 60 and 120 month histories. Too short of a
                                                                        40.0%                           37.7%
history gives (tautologically) a fixed fraction of stocks in
                                                                        35.0%
persistent or non-growth, while too long of a history gives too         30.0%
few persistent growth observations to conduct factor efficacy.          25.0%
                                                                        20.0%
                                                                        15.0%
                                                                        10.0%
                                                                                                                                                                                                        4.6%
                                                                         5.0%
                                                                         0.0%
                                                                                                              S&P                                              Portfolio                     Relative Performance


                                                                     Source: Morgan Stanley Research. Past performance is no guarantee of future returns.
                                                                     Performance includes dividends but excludes transaction costs.

                                                                     Our portfolio has underperformed the market by 1.0%
                                                                     year-to-date (Exhibit 42), with some stock selection in
                                                                     technology hurting recent performance.




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                                                                                                  May 28, 2013
                                                                                                  US Equity Strategy




Exhibit 42                                                                                        performance. Please recall we use a combination strategy we
Our Portfolio Has Gained on the Market Over the                                                   call "quantamental" to form the portfolio. We typically start with
Last Two Weeks, And Is Now Lagging by 100bps                                                      Overweight-rated stocks by our analysts that also screen well
YTD                                                                                               in our quantitative alpha models. We typically remove stocks
                                                                                                  that are no longer ranked highly by our quantitative models or
                              MOST Strategic Portfolio Performance
                               December 31, 2012 to May 24, 2013                                  have been subsequently downgraded by our fundamental
   18.0%            16.7%                                                                         analysts, although to keep portfolio turnover low we try to do
                                              15.6%
   16.0%                                                                                          this at a moderate pace.
   14.0%
   12.0%
                                                                                                  Exhibit 43 contains the portfolio performance attribution details
   10.0%
    8.0%                                                                                          about sectors and stocks and their contribution to the
    6.0%                                                                                          performance. Stock selection in health care, materials (US
    4.0%
                                                                                                  chemicals in 2012), staples, discretionary, and utilities has
    2.0%
    0.0%
                                                                                                  been strong, while stock selection in financials, technology,
   (2.0%)                                                               (1.0%)
                                                                                                  and industrials has been poor.
                     S&P                     Portfolio          Relative Performance

                                                                                                  The full portfolio is shown in Exhibit 44. For those interested in
Source: Morgan Stanley Research. Past performance is no guarantee of future returns.
Performance includes dividends but excludes transaction costs.
                                                                                                  our quantitative output, please go to
                                                                                                  www.morganstanley.com/equitystrategy and use the alpha
For reference, the “MOST Strategic Portfolio” is published each                                   screener product for output from our 3-month model (MOST)
week and we generally only make changes on Friday nights                                          and our 24-month model (BEST). A video tutorial is available
and publish the changes early Monday mornings, and                                                there, or we or your Morgan Stanley salesperson can give you
therefore believe our clients can roughly mirror the                                              a brief demonstration.



Exhibit 43
Our Sector Bet in Health Care Has Helped Drive Outperformance
                                  MOST Strategic Portfolio Performance Attribution December 31, 2010 to May 24, 2013

                                                           Portfolio                                            S&P 500
                                             Relative Sector    Sector                 Relative       Sector     Sector Relative       Sector    Stock
Sector                                       Weight Weight      Return                 Return         Weight     Return Return       Allocation Selection Total
Overweight                                     7.4%    48.0%      37.6%                  (2.5%)        40.6%      40.1%   2.4%         1.0%      (1.6%)   (0.7%)
  Health Care                                  3.4%   16.0%       69.8%                   9.1%        12.6%       60.7%  23.0%          0.9%      1.2%     2.0%
  Industrials                                  2.9%   13.0%       24.6%                  (9.0%)       10.1%       33.6%  (4.0%)        0.3%      (0.5%)   (0.2%)
  Information Technology                       1.1%   19.0%       19.5%                  (9.7%)       17.9%       29.2%  (8.4%)        (0.2%)    (2.3%)   (2.5%)

Market-Weights                                   0.3%       37.0%          36.3%         8.0%          36.7%      28.3%    (9.3%)      0.6%        2.8%      3.3%
 Financials                                      0.5%       17.0%          22.9%        (7.3%)         16.5%      30.2%    (7.5%)      (0.3%)      (1.1%)    (1.4%)
 Materials                                       0.6%        4.0%         127.0%       114.8%           3.4%      12.2%   (25.5%)      0.0%        3.1%      3.1%
 Telecommunication Services                      0.1%        3.0%           4.7%       (32.2%)          2.9%      37.0%    (0.7%)      (0.4%)      (0.6%)    (0.9%)
 Utilities                                      (0.4%)       3.0%          58.1%        23.0%           3.4%      35.1%    (2.6%)      0.4%        1.3%      1.6%
 Energy                                         (0.6%)      10.0%          25.9%        (0.1%)         10.6%      26.0%   (11.6%)       0.8%        0.1%      0.9%

Underweights                                    (7.7%)      15.0%          70.9%        17.6%          22.7%      53.3%   15.6%        (0.9%)      2.8%      2.0%
  Consumer Discretionary                        (2.9%)       9.0%          72.0%        14.4%          11.9%      57.5%   19.9%        (0.7%)      1.0%      0.3%
  Consumer Staples                              (4.8%)       6.0%          69.3%        20.7%          10.8%      48.6%   10.9%        (0.2%)      1.9%      1.7%


Total                                            0.0%      100.0%          42.3%                      100.0%      37.7%                0.7%        3.9%      4.6%
Source: Factset, Morgan Stanley Research




                                                                                                                                                                       17
                                                                         MORGAN        STANLEY        RESEARCH

                                                                         May 28, 2013
                                                                         US Equity Strategy




Morgan Stanley is currently acting as financial advisor to InterOil Corporation ("InterOil") with respect to its exclusive negotiations with
ExxonMobil Papua New Guinea Ltd., a subsidiary of ExxonMobil, on the development of Petroleum Retention License 15, which
comprises the Elk and Antelope fields in the Gulf Province of Papua New Guinea. The proposed transaction is subject to the
negotiation of a definitive agreement, required regulatory approvals and other customary closing conditions. InterOil has agreed to
pay fees to Morgan Stanley for its financial advisory services which are contingent upon the consummation of a transaction. Please
refer to the notes at the end of the report.

Morgan Stanley is currently acting as financial advisor to Google Inc. ("Google") with respect to its proposed stock dividend, as
announced on April 12, 2012. Certain aspects of the proposal are subject to approval by Google's shareholders. Google has agreed
to pay fees to Morgan Stanley for its financial advice. Please refer to the notes at the end of the report.

Morgan Stanley is acting as financial advisor to Eloqua, Inc. ("Eloqua") in relation to the proposed acquisition of Eloqua by Oracle
Corporation as announced on December 20, 2012. The proposed transaction is subject to approval by Eloqua shareholders,
regulatory approval and other customary closing conditions. This report and the information provided herein is not intended to (i)
provide voting advice, (ii) serve as an endorsement of the proposed transaction, or (iii) result in the procurement, withholding or
revocation of a proxy or any other action by a security holder. Eloqua has agreed to pay fees to Morgan Stanley for its financial
services. Please refer to the notes at the end of the report.




                                                                                                                                               18
                                                                                                      MORGAN             STANLEY                RESEARCH

                                                                                                      May 28, 2013
                                                                                                      US Equity Strategy




Exhibit 44
The MOST Strategic Portfolio With Fundamental Analyst Recommendations and MOST Alpha Rankings
                                                                                                        Weight                         Price            Inclusion      MOST       MS Analyst
                                                 Ticker     Company                               S&P 500    Portfolio        Latest       Inclusion      Date        Quintile     Rating
    Consumer Discretionary                                                                         11.9%        9.0%
       Hotels Restaurants & Leisure              YUM        Yum! Brands Inc.                                   2.00%          69.21          49.05     12/31/2010       Q1        Overweight
       Media                                     CBS        CBS Corp (Cl B)                                    1.00%          50.74          19.05     12/31/2010       Q2        Overweight
       Media                                     NWSA       News Corp. Cl A                                    1.00%          33.09          30.36      3/15/2013       Q2        Overweight
       Media                                     LBTYA      Liberty Global Inc. Cl A                           1.00%          75.56          76.93      5/10/2013       Q1        Overweight
       Automobiles                               GM         General Motors Co.                                 2.00%          32.87          25.21     11/23/2012       Q3        Overweight
       Specialty Retail                          LTD        L Brands Inc.                                      1.00%          49.79          50.49      4/26/2013       Q1        Overweight
       Multiline Retail                          TGT        Target Corp.                                       1.00%          69.72          51.22     12/30/2011       Q1           NC
    Consumer Staples                                                                               10.8%        6.0%
       Food & Staples Retailing                  COST       Costco Wholesale Corp.                             3.00%         114.39          72.21     12/31/2010       Q1           NC
       Food Products                             MDLZ       Mondelez International Inc. Cl A                   1.00%          30.95          20.62     12/31/2010       Q2        Overweight
       Tobacco                                   PM         Philip Morris International Inc.                   2.00%          94.12          58.53     12/31/2010       Q2        Overweight
    Energy                                                                                         10.7%       10.0%
       Integrated Oil & Gas                      CVX        Chevron Corp.                                      3.00%         125.45          91.25     12/31/2010       Q2        Overweight
       Oil & Gas Storage & Transportation        KMI        Kinder Morgan Inc.                                 2.00%          40.58          33.72     11/23/2012       Q1       Equal-Weight
       Oil & Gas Storage & Transportation        MWE        MarkWest Energy Partners L.P.                      3.00%          68.25          50.84     11/23/2012       NA        Overweight
       Oil & Gas Storage & Transportation        WMB        Williams Companies Inc                             2.00%         36.67           32.70      5/4/2012        Q5        Overweight
    Financials                                                                                     16.4%       17.0%
        Insurance                                ACE        ACE Ltd.                                           1.00%          89.77          64.31      6/17/2011       Q4        Overweight
        Commercial Banks                         PNC        PNC Financial Services Group Inc.                  2.00%          71.11          60.83      1/21/2011       Q3        Overweight
        Insurance                                CB         Chubb Corp.                                        2.00%          88.01          57.89      9/23/2011       Q1       Equal-Weight
        Consumer Finance                         AXP        American Express Co.                               1.00%          75.30          66.09      3/15/2013       Q1       Equal-Weight
        Consumer Finance                         COF        Capital One Financial Corp.                        3.00%          61.13          55.19      3/15/2013       Q1        Overweight
        Commercial Banks                         FITB       Fifth Third Bancorp                                3.00%          18.25          17.71      5/10/2013       Q1        Overweight
        Diversified Financial Services           JPM        JPMorgan Chase & Co.                               3.00%          53.66          42.42     12/31/2010       Q1        Overweight
        Capital Markets                          BEN        Franklin Resources Inc.                            2.00%         162.92         117.57      5/4/2012        Q1       Equal-Weight
    Health Care                                                                                    12.8%       16.0%
       Health Care Providers & Services          ABC        AmerisourceBergen Corp.                            2.00%          54.44          34.12     12/31/2010       Q1       Equal-Weight
       Pharmaceuticals                           BMY        Bristol-Myers Squibb Co.                           2.00%          47.40          29.12       7/8/2011       Q5       Equal-Weight
       Health Care Providers & Services          MCK        McKesson Corp.                                     2.00%         117.33          77.74       2/4/2011       Q5       Equal-Weight
       Life Sciences Tools & Services            A          Agilent Technologies Inc.                          1.00%         45.59           36.88     11/23/2012       Q5        Overweight
       Health Care Providers & Services          CAH        Cardinal Health Inc.                               4.00%         47.18           38.31     12/31/2010       Q1        Overweight
       Health Care Equipment & Supplies          COV        Covidien PLC                                       1.00%         65.17           52.50      6/17/2011       Q2        Overweight
       Health Care Equipment & Supplies          SYK        Stryker Corp.                                      1.00%          66.99          56.29      9/21/2012       Q4        Overweight
       Pharmaceuticals                           PFE        Pfizer Inc.                                        3.00%          29.04          18.15      9/16/2011       Q1        Overweight
    Industrials                                                                                    10.0%       13.0%
        Aerospace & Defense                      HON        Honeywell International Inc.                       3.00%          79.29          61.72      9/17/2012       Q3        Overweight
        Aerospace & Defense                      GD         General Dynamics Corp.                             2.00%          77.35          60.60      9/16/2011       Q3           NC
        Road & Rail                              UNP        Union Pacific Corp.                                1.00%         156.86         130.89       1/4/2013       Q4        Overweight
        Industrial Conglomerates                 DHR        Danaher Corp.                                      3.00%          62.10          53.49     11/23/2012       Q3        Overweight
        Air Freight & Logistics                  FDX        FedEx Corp.                                        1.00%          97.81         109.07      3/15/2013       Q2        Overweight
        Aerospace & Defense                      UTX        United Technologies Corp.                          3.00%          95.04          78.85     12/30/2010       Q3        Overweight
    Information Technology                                                                         17.9%       19.0%
        Software                                 MSFT       Microsoft Corp.                                    2.00%          34.27          27.91     12/31/2010       Q2        Overweight
        Computers & Peripherals                  AAPL       Apple Inc.                                         2.00%         445.15         422.40      1/6/2012        Q5        Overweight
        Software                                 ORCL       Oracle Corp.                                       2.00%          34.05          31.19     6/17/2011        Q4        Overweight
        IT Services                              ACN        Accenture PLC                                      1.00%          82.22          65.60     9/17/2012        Q1        Overweight
        Computers & Peripherals                  EMC        EMC Corp.                                          3.00%          23.65          22.90     12/31/2010       Q4       Equal-Weight
        Semiconductors                           CY         Cypress Semiconductor Corp.                        2.00%          11.03          11.18       1/4/2013       Q4           NC
        Software                                 WDAY       Workday Inc.                                       1.00%          66.16          67.41      5/10/2013       Q5       Equal-Weight
        Software                                 SYMC       Symantec Corp.                                     3.00%          22.85          22.93      2/22/2013       Q2        Overweight
        IT Services                              MA         MasterCard Inc. Cl A                               3.00%         571.44         345.97      1/17/2012       Q3           NC
    Materials                                                                                      3.4%         4.0%
       Chemicals                                 LYB        LyondellBasell Industries N.V. Cl A                1.00%         65.72           34.50     10/28/2011       Q4        Overweight
       Chemicals                                 CHMT       Chemtura Corp.                                     1.00%          23.10          15.70     10/12/2012       Q2           NC
       Chemicals                                 MON        Monsanto Co.                                       2.00%         104.84          79.02      4/5/2012        Q2        Overweight
    Telecommunication Services                                                                     2.9%         3.0%
        Diversified Telecommunication Services   T          AT&T Inc.                                          2.00%          36.75          29.38     12/31/2010       Q3       Equal-Weight
        Wireless Telecommunication Services      CCI        Crown Castle International Corp.                   1.00%          73.72          67.55     11/23/2012       Q1        Overweight
    Utilities                                                                                      3.3%         3.0%
         Electric Utilities                      AEP        American Electric Power Co. Inc.                   1.00%          47.70          35.98     12/31/2010       Q4       Equal-Weight
         Electric Utilities                      DUK        Duke Energy Corp.                                  1.00%          68.88          60.45     11/23/2012       Q1        Overweight
         Multi-Utilities                         SRE        Sempra Energy                                      1.00%          79.61          56.30      1/20/2012       Q4        Overweight
                                                                                                  100.0%       100.0%

Source: Morgan Stanley Research. Past performance is no guarantee of future results. Price performance does not take transaction costs into account. For companies included in the portfolio, all
important disclosures including personal holdings disclosures and Morgan Stanley disclosures appear on the Morgan Stanley public website at www.morganstanley.com/researchdisclosures.
++Rating for this company has been removed from consideration in this report because, under applicable law and/or Morgan Stanley policy, Morgan Stanley may be precluded from issuing such
information with respect to this company at this time. NC = Not covered.




                                                                                                                                                                                                    19
                                                                                                                                           MORGAN                STANLEY   RESEARCH

                                                                                                                                           May 28, 2013
                                                                                                                                           US Equity Strategy




History of Portfolio Changes
                                                                                                   Price When
                                                                                                Removed or Latest                  S&P 500 Total     Relative
Ticker   Company                                 Date Added   Date Removed   Price When Added         Price         Total Return     Return        Performance
ABT      Abbott Laboratories                     12/31/2010      2/4/2011           47.91             46.12            -2.8%           4.2%            -7.1%
ACE      ACE Ltd.                                 6/17/2011                         64.31             89.78            45.2%          29.7%            15.5%
ACN      Accenture PLC                           12/31/2010     1/6/2012            48.49             51.83             9.2%           1.6%             7.6%
ACN      Accenture PLC                            9/17/2012                         65.60             82.22            27.8%          12.9%            14.9%
AFL      AFLAC Inc.                              12/31/2010     6/17/2011           56.43             45.02           -19.2%           1.1%           -20.3%
A        Agilent Technologies Inc.               11/23/2012                         36.88             45.59            24.2%          17.1%             7.1%
ALB      Albemarle Corp.                         12/31/2010    10/28/2011           55.78             55.13            -0.3%           2.2%            -2.5%
AGN      Allergan Inc.                           12/31/2010     6/17/2011           68.67             80.84            17.9%           1.1%            16.8%
AEE      Ameren Corp.                             9/16/2011     1/20/2012           30.42             31.64             5.3%           8.2%            -2.8%
AEP      American Electric Power Co. Inc.        12/31/2010                         35.98             47.70            45.6%          31.2%            14.4%
AXP      American Express Co.                    12/31/2010     1/21/2011           42.92             46.00             7.6%           2.0%             5.6%
AXP      American Express Co.                     3/15/2013                         66.09             75.30            14.2%           5.7%             8.5%
ABC      AmerisourceBergen Corp.                 12/31/2010                         34.12             54.44            63.9%          31.2%            32.7%
AMR      AMR Corp.                                 7/8/2011     9/16/2011            5.50              3.54           -35.6%          -9.5%           -26.1%
ANN      Ann Inc.                                 12/2/2011     9/17/2012           24.43             38.69            58.4%          17.4%            40.9%
AAPL     Apple Inc.                                1/6/2012                        422.40            445.15             8.0%          29.1%           -21.1%
ACI      Arch Coal Inc.                          12/31/2010     9/23/2011           35.06             15.26           -55.6%          -9.6%           -45.9%
T        AT&T Inc.                                5/25/2012                         33.69             36.75            14.4%          25.2%           -10.8%
AVP      Avon Products Inc.                      12/31/2010     2/4/2011            29.06             29.25             0.7%           4.2%            -3.6%
AXS      AXIS Capital Holdings Ltd.               9/23/2011     5/4/2012            25.43             34.38            38.0%          20.5%            17.5%
BHI      Baker Hughes Inc.                       12/31/2010    12/30/2011           57.17             48.64           -13.9%           0.0%           -13.9%
BAC      Bank of America Corp.                   12/31/2010     7/8/2011            13.34             10.70           -19.6%           6.9%           -26.5%
BEN      Franklin Resources Inc.                   5/4/2012                        117.57            162.92            42.1%          20.5%            21.6%
BK       Bank of New York Mellon Corp.           12/31/2010     9/23/2011           30.20             18.52           -37.5%          -9.6%           -27.9%
BMY      Bristol-Myers Squibb Co.                  7/8/2011                         29.12             47.40            71.0%          22.8%            48.2%
CAT      Caterpillar Inc.                        10/19/2012      1/4/2013           83.86             94.92            13.8%           2.3%            11.5%
CAM      Cameron International Corp.             12/31/2010     1/28/2011           50.73             52.48             3.4%           1.5%             2.0%
CAH      Cardinal Health Inc.                    12/31/2010                         38.31             47.18            28.6%          31.2%            -2.6%
CAVM     Cavium Inc.                              2/17/2012     1/4/2013            36.01             32.48            -9.8%           7.7%           -17.5%
CBS      CBS Corp (Cl B)                         12/31/2010                         19.05             50.74           171.1%          31.2%          140.0%
CTL      CenturyLink Inc.                        12/31/2010      4/5/2012           46.17             38.52            -8.7%          11.2%           -19.9%
CF       CF Industries Holdings Inc.               7/8/2011     10/4/2011          149.01            124.10           -16.4%         -16.4%            -0.1%
CVX      Chevron Corp.                           12/31/2010                         91.25            125.45            46.8%          31.2%            15.6%
CB       Chubb Corp.                              9/23/2011                         57.89             88.01            56.3%          45.2%            11.1%
CCI      Crown Castle International Corp.        11/23/2012                         67.55             73.72             9.1%          17.1%            -7.9%
CHMT     Chemtura Corp.                          10/12/2012                         15.70             23.10            47.1%          15.5%            31.7%
CSCO     Cisco Systems Inc.                       2/17/2012     5/10/2013           20.29             21.10             7.0%          20.0%           -13.0%
COF      Capital One Financial Corp.              3/15/2013                         55.19             61.13            11.3%           5.7%             5.6%
COH      Coach Inc.                              12/31/2010     12/2/2011           55.31             62.20            13.9%          -1.1%            15.0%
CL       Colgate-Palmolive Co.                    9/23/2011     3/15/2013           44.46             56.04            30.1%          37.3%            -7.2%
CMA      Comerica Inc.                           12/31/2010     9/23/2011           42.24             22.49           -46.0%          -9.6%           -36.4%
COST     Costco Wholesale Corp.                  12/31/2010                         72.21            114.39            71.7%          31.2%            40.5%
COV      Covidien PLC                             6/17/2011                         52.50             65.17            27.7%          29.7%            -2.0%
CY       Cypress Semiconductor Corp.               1/4/2013                         11.18             11.03            -0.4%          12.5%           -12.8%
DHR      Danaher Corp.                           12/31/2010     9/16/2011           47.17             45.94            -2.5%          -3.3%             0.8%
DHR      Danaher Corp.                           11/23/2012                         53.49             62.10            16.2%          17.1%            -0.9%
DAL      Delta Air Lines Inc.                    12/31/2010      7/8/2011           12.60              9.35           -25.8%           6.9%           -32.6%
DOW      Dow Chemical Co.                          4/5/2012      1/4/2013           33.42             33.63             3.5%           4.9%            -1.4%
DVN      Devon Energy Corp.                      12/31/2010     4/15/2011           78.51             87.82            12.1%           4.9%             7.1%
DIS      Walt Disney Co.                          1/28/2011     10/4/2011           38.85             29.86           -23.1%         -11.9%           -11.2%
DUK      Duke Energy Corp.                       11/23/2012                         60.45             68.88            16.5%          17.1%            -0.6%
EP       El Paso Corp.                           12/31/2010     7/13/2012           13.76             #N/A              #N/A           7.9%             #N/A
EMC      EMC Corp.                               12/31/2010                         22.90             23.65             3.3%          31.2%           -27.9%
EMR      Emerson Electric Co.                    10/19/2012     3/15/2013           48.25             57.59            21.1%           8.9%            12.2%
ETR      Entergy Corp.                            9/16/2011     1/20/2012           65.60             69.93             7.9%           8.2%            -0.3%
ESRX     Express Scripts Holding Co              12/31/2010      2/4/2011           54.05             57.13             5.7%           4.2%             1.5%
F        Ford Motor Co.                          12/31/2010     3/11/2011           16.79             14.36           -14.5%           3.7%           -18.2%
FDX      FedEx Corp.                              3/15/2013                        109.07             97.82           -10.3%           5.7%           -16.0%
FITB     Fifth Third Bancorp                      5/10/2013                         17.71             18.25             3.0%           1.0%             2.1%
GD       General Dynamics Corp.                   9/16/2011                         60.60             77.35            33.5%          35.7%            -2.2%
GE       General Electric Co.                     4/15/2011     7/8/2011            20.04             18.99            -4.5%           1.8%            -6.3%
GM       General Motors Co.                      11/23/2012                         25.21             32.87            30.4%          17.1%            13.3%
GOOG     Google Inc. Cl A                        12/31/2010     9/16/2011          593.97            546.68            -8.0%          -3.3%            -4.7%
GSIC     GSI Commerce Inc.                       12/31/2010     7/22/2011           23.23              NA                NA            6.9%              NA
HAL      Halliburton Co.                         10/28/2011     5/4/2012            39.13             32.53           -16.4%           6.5%           -22.9%
HES      Hess Corp.                               7/13/2012     3/15/2013           43.29             72.51            68.2%          15.0%            53.2%
HON      Honeywell International Inc.             9/17/2012                         61.72             79.29            30.5%          12.9%            17.6%
HPQ      Hewlett-Packard Co.                     12/31/2010     6/17/2011           42.10             35.00           -16.4%           1.1%           -17.5%
INTC     Intel Corp.                             12/31/2010     2/18/2011           21.03             22.14             6.1%           6.8%            -0.6%
IBM      International Business Machines Corp.   12/31/2010      7/8/2011          146.76            176.49            21.2%           6.9%            14.4%
INTU     Intuit Inc.                             12/31/2010     2/17/2012           49.30             57.38            17.0%           8.2%             8.8%
JPM      JPMorgan Chase & Co.                    12/31/2010                         42.42             53.66            32.5%          31.2%             1.3%
KFT      Mondelez International Inc. Cl A        12/31/2010                         31.51             30.95            61.2%          31.2%            30.1%
KMI      Kinder Morgan Inc.                      11/23/2012                         33.72             40.58            22.6%          17.1%             5.5%
LBTYA    Liberty Global Inc. Cl A                 5/10/2013                         76.93             75.56            -1.8%           1.0%            -2.8%
LRCX     Lam Research Corp.                       2/18/2011     7/22/2011           56.10             44.26           -21.1%           0.1%           -21.3%
LO       Lorillard Inc.                           5/13/2011    11/23/2012           37.17             41.09            18.2%           5.3%            12.9%
LTD      L Brands Inc.                            4/26/2013                         50.49             49.79            -1.4%           4.3%            -5.6%
LYB      LyondellBasell Industries N.V. Cl A     10/28/2011                         34.50             65.72           117.6%          28.4%            89.2%
MA       MasterCard Inc. Cl A                     2/17/2012                        396.00            571.44            44.8%          21.2%            23.6%
MON      Monsanto Co.                             4/5/2012                          79.02            104.84            34.5%          18.0%            16.5%
MCD      McDonald's Corp.                         9/23/2011     1/4/2013            87.37             89.85             6.9%          29.0%           -22.1%
MCK      McKesson Corp.                           2/4/2011                          77.74            117.33            53.2%          25.8%            27.4%
MHS      Medco Health Solutions                  12/31/2010     7/8/2011            61.27             55.26            -9.8%           6.9%           -16.7%
MSFT     Microsoft Corp.                         12/31/2010                         27.91             34.27            29.8%          31.2%            -1.3%
MSI      Motorola Solutions Inc.                  7/8/2011      2/17/2012           45.08             50.63            13.3%           1.3%            12.0%
MWE      MarkWest Energy Partners L.P.           11/23/2012                         50.84             68.25            37.5%          17.1%            20.4%
NBR      Nabors Industries Ltd.                  12/31/2010      4/8/2011           23.46             31.56            34.5%           5.6%            28.9%
NTRS     Northern Trust Corp.                    12/31/2010     4/15/2011           55.41             51.78            -6.0%           4.9%           -11.0%
NOC      Northrop Grumman Corp.                   9/16/2011     9/17/2012           54.82             66.48            25.1%          20.2%             4.9%
NVE      NV Energy Inc.                          12/31/2010     9/16/2011           14.05             14.74             7.5%          -3.3%            10.8%
NWSA     News Corp. Cl A                          3/15/2013                         30.36             33.09             9.0%           5.7%             3.3%
OXY      Occidental Petroleum Corp.              12/31/2010     9/17/2012           98.10             90.06            -4.7%          16.2%           -20.9%
ORCL     Oracle Corp.                             6/17/2011                         31.19             34.05            10.9%          29.7%           -18.8%
PFE      Pfizer Inc.                             12/31/2010     2/4/2011            17.51             19.30            11.4%           4.2%             7.1%
PFE      Pfizer Inc.                              9/16/2011                         18.15             29.04            68.6%          35.7%            32.9%
PM       Philip Morris International Inc.        12/31/2010                         58.53             94.12            72.6%          31.2%            41.4%
PNC      PNC Financial Services Group Inc.        1/21/2011                         60.83             71.11            22.6%          28.5%            -6.0%
PNW      Pinnacle West Capital Corp.              3/11/2011     9/16/2011           43.56             44.21             3.9%          -6.8%            10.7%
PNW      Pinnacle West Capital Corp.              1/20/2012     7/13/2012           47.75             53.05            13.3%           3.1%            10.2%
PG       Procter & Gamble Co.                     4/8/2011       1/6/2012           61.90             66.36             9.7%          -3.8%            13.5%
QCOM     QUALCOMM Inc.                           12/31/2010     4/15/2011           49.49             53.14             7.8%           4.9%             2.8%
RNR      RenaissanceRe Holdings Ltd.             12/31/2010     4/15/2011           63.69             69.08             8.9%           4.9%             3.9%
RNR      RenaissanceRe Holdings Ltd.              7/8/2011      5/10/2013           71.25             90.40            29.5%          21.6%             7.9%
COL      Rockwell Collins Inc.                   12/31/2010      1/6/2012           58.26             56.55            -1.3%           1.6%            -2.9%
SLB      Schlumberger Ltd.                       12/31/2010     5/10/2013           83.50             76.82            -5.1%          29.9%           -35.0%
SRE      Sempra Energy                            1/20/2012                         56.30             79.61            46.8%          25.4%            21.4%
SYK      Stryker Corp.                            2/4/2011      7/22/2011           58.51             56.88            -2.2%           2.6%            -4.8%
SYK      Stryker Corp.                            9/21/2012                         56.29             66.99            20.3%          13.0%             7.4%
SYMC     Symantec Corp.                           2/22/2013                         22.93             22.85            -0.3%           8.8%            -9.2%
TFM      Fresh Market Inc.                       12/30/2011    11/23/2012           39.90             62.38            56.3%          12.1%            44.3%
TGT      Target Corp.                            12/30/2011                         51.22             69.72            40.1%          31.2%             8.9%
TYC      Tyco International Ltd.                 12/31/2010     4/15/2011           41.44             51.70            25.3%           4.9%            20.4%
TRV      Travelers Cos. Inc.                      4/15/2011      1/4/2013           59.80             74.06            28.9%          11.1%            17.8%
UNP      Union Pacific Corp.                     12/31/2010     5/25/2012           92.66            111.88            23.5%          4.8%             18.7%
UNP      Union Pacific Corp.                      1/4/2013                         130.89            156.86            20.4%          12.5%             7.9%
UNH      UnitedHealth Group Inc.                 12/31/2010     9/17/2012           36.11             54.48            54.2%          16.2%            38.0%
URS      URS Corp.                               12/31/2010     1/4/2013            41.61             40.65            -0.4%          16.6%           -17.0%
UTX      United Technologies Corp.               12/30/2011                         73.09             95.04            34.3%          31.2%             3.1%
WAG      Walgreen Co.                             7/8/2011     12/30/2011           44.07             33.06           -24.0%          -6.4%           -17.5%
WDAY     Workday Inc.                             5/10/2013                         67.41             66.16            -1.9%           1.0%            -2.8%
WPI      Actavis Inc.                            12/31/2010      7/8/2011           51.65             69.85            35.2%           6.9%            28.4%
WLP      WellPoint Inc.                           2/4/2011      9/16/2011           65.07             67.70             5.2%          -7.2%            12.4%
WMB      Williams Companies Inc                   5/4/2012                          32.70             36.67            16.0%          20.5%            -4.4%
WU       Western Union Co.                        2/18/2011    11/23/2012           21.66             12.80           -38.1%          4.9%            -43.0%
XOM      Exxon Mobil Corp.                        7/22/2011     5/25/2012           85.22             82.08            -1.4%          -2.0%             0.7%
XOM      Exxon Mobil Corp.                        7/13/2012     9/17/2012           85.47             91.91             8.2%          7.7%              0.5%
YUM      Yum! Brands Inc.                        12/31/2010                         49.05             69.21            47.0%          31.2%            15.8%




Source: Factset, Morgan Stanley Research




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                                        % of                   % of % of Rating
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Equal-weight/Hold            1250        44%         479         47%         38%
Not-Rated/Hold                105         4%          27          3%         26%
Underweight/Sell              473        17%         123         12%         26%
Total                       2,862                   1028
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                                                                                                                                                             21
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                                                                                              US Equity Strategy




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                                                                                             May 28, 2013
                                                                                             US Equity Strategy




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