leadership series

i n v e s t m e n t i n s i g hts

November 2011

Equity Sectors: Investment Themes for 2012 and Beyond

For active investors who try to identify secular growth trends, industry dynamics, and paradigm shifts, making targeted and tactical allocations to various equity market sectors can result in portfolio outperformance relative to the broader market over time. During the past decade, the large-cap-oriented S&P 500 Index returned 2.8% on an average annual basis, well below its 9.7% historical average. However, certain sectors within the broader equity market performed fairly well during this below-average period. For example, energy stocks generated an average annual return of 10.3%, while the materials (6.9%) and consumer staples (6.3%) sectors also had solid absolute returns. The only major laggard was the financials sector, which fell nearly 5%. Clearly, there were key drivers that led to such a divergence in performance between the best- and worst-performing sectors during the past decade.* Investors often choose actively managed equity sector mutual funds for the following reasons:

CONTENTS
Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecommunications Utilities 2 6 9 13 19 22 26 30 34 37

Diversification: Desire for greater diversification benefits than investing in specific companies or industries. Sector Rotation Strategies: Desire to tilt a broader equity portfolio toward specific sectors that have demonstrated a historical pattern of outperformance during various phases of an economic cycle. Portfolio Risk Management: Desire to achieve a targeted sector allocation or help minimize risk by overweighting sectors that historically have been less volatile.

Identifying the most compelling themes within each sector can be a critical component to the security selection process. At Fidelity Asset Management, we believe in-depth, fundamental research at the company level can determine the best investment opportunities within each sector. Maintaining a global equity sector research staff also provides a comprehensive point of view on the key themes and ongoing dynamics within each sector. The following article provides a perspective from each of our equity sector leaders on the investment themes they believe are likely to have the greatest influence on the performance of each sector during the coming years. Note: Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market or economic developments.

Consumer Discretionary
John Harris, Portfolio Manager

With industries such as retail, leisure, and media, the consumer discretionary sector comprises a wide array of companies that offer products and services that consumers want more than they need. Because consumers can purchase these items at their discretion, the sector generally exhibits cyclical qualities, performing best during economic recoveries when both wage and investment income are rising. Yet some discretionary categories perform better than others during different stages of the economic cycle, depending on whether they are considered more defensive or interest-rate sensitive. From a more secular perspective, we view the following themes in the consumer discretionary sector as potentially attractive investment opportunities over the next few years.

Internet disruption appears likely to have the potential to dwarf these earlier trends. In the second quarter of 2011, U.S. nominal (not adjusted for inflation) e-commerce sales were up 17.6% from the previous year to $47.5 billion, while total retail sales were up 8.1% to $1,041.7 billion.1 Online sales currently represent 4.6% of total sales, and this share has the potential to climb to 20%30% as mobile computing (smartphones and tablets) continues to revolutionize consumer behavior (see Exhibit 1, below). As the dot-com bubble demonstrated so clearly in the late 1990s, the Internet can break down barriers to entry for retail concepts. But after the bubble burst in March 2000, it was also clear that not all online retailers had viable business models. Judging by their dedicated customers, the early movers who survived tend to provide the best value and service. The most successful e-commerce companies continue to take share from other retailers by improving the user experience. They are constantly changing the EXHIBIT 1: E-commerce sales continue to grow, both on an absolute basis and as a share of total retail sales. E-COMMERCE SALES AND SHARE OF TOTAL RETAIL SALES
e-Commerce Sales $160,000 e-Commerce Sales ($Mil) $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 2000 2004 2009 2006 2008 2003 2005 2002 2007 2001 $0 e-Commerce Sales as % of Total Retail Sales e-Commerce as a % of Total Retail Sales 4.5% 20% CAGR in e-Commerce 4.0% 2000-2009 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%

INVESTMENT THEME
Internet Disruption

KEY TAKEAWAYS

Although Internet sales have so far accounted for only a small share of total retail sales, e-commerce has taken transactions, relationships, marketing, and loyalty away from traditional brick-and-mortar retailers. Retailingand delivering media content and advertising onlinehave changed the business landscape, encroaching on the territory of some, while providing opportunities for others. To take advantage of this theme, investors should consider consumer discretionary companieswhether retail, media, or leisurethat have the potential to benefit from the shift to a multichannel business model.

The Internet has transformed the landscape for consumer discretionary companies. This is most evident in retailing, where e-commerce accounts for an increasing share of transactions and changes how retailers work to build loyal relationships with customers and social networks. There have been other disruptive trends in retailing. Since the late 1970s, big-box home centers have grown from 0% to 50% of the market for home improvement, building materials, and lawn and garden products. Since the 1980s, national discount department and food superstores have captured a 20% share from regional and local supermarkets. 2

Source: U.S. Census Bureau; Annual Retail Trade Survey. CAGR: Compound Annual Growth Rate.

Investment implications
business by offering wider assortments of products and introducing attractive new features, such as loyalty programs that encourage repeat visits and purchases with cash or credit rewards. Technological innovations such as mobile computing are rapidly changing the behavior of consumers, including their discretionary spending. To survive this disruptive trend to traditional retailing, companies need to recognize that an online presence is a core competence. It is no longer enough just to plan for the future; resources should be devoted now. Executive involvement in technology development can be a signal that the company truly understands the importance of a successful, long-term Internet strategy. In our view, investment teams should have close relationships with company managements to be able to pick up nuances about how they are formulating Internet strategies and reshaping retail networks. Its likely that market share will shift as a result of an increase in consumer online spending patterns, and companies that are actively positioning themselves to benefit from this trend may end up being the long-term winners. While the stocks of many early winners can be expensive, the sustainability of their growth may justify their high valuations.

Multichannel distribution approach

Some traditional brick-and-mortar retailers have benefited from the migration to a multichannel business model. Having a strong catalog business in addition to stores provided a head start, and early Internet adopters can now draw on their experience with state-of-the-art e-commerce to take share from their peers. This kind of retailer uses its store base for fulfillment: Customers can order online and pick up in the store on the same day if distribution systems are sophisticated enough. Many customers appreciate the flexibility of having multiple ways to shop at the same retail brand, especially when they want to satisfy immediate needs or avoid the inconvenience and expense of return shipping. Many retailers have been finding e-commerce to be a much more capital efficient way to grow. Some are shrinking their store base, since they can capture traffic online or at other stores. Labor costs generally are lower because fewer employees are needed online, which increases the profitability of retained sales from the remaining stores. Other retailers, who were thought to be insulated from e-commerce because of the products they sell, are starting to look for ways to enhance the business through an online presence. For example, home improvement centers offer how-to videos, interactive product features, and ordering for contractors through mobile devices. Internet disruption is also a major factor in the media space. Advertisers increasingly have been shifting their budgets from traditional mediaprint, radio, outdoor billboardsto reach customers online, where they can provide more personalized engagement. Such messaging is difficult to convey through traditional media, although television advertising spending has been able to hold steady. Similarly in the leisure market, some travel companies have been able to benefit from online strategies, especially hotels and online reservation services.

INVESTMENT THEME
Sustainable Revenue Growth Driven By Emerging Markets

KEY TAKEAWAYS

The trajectory of U.S. consumer spending is likely to be flatter in the coming years than in the 1990s, when levering the household balance sheet and withdrawing home equity fueled exceptional spending growth. With incomes rising in many developing economies, the emerging-market consumer could represent a significant opportunity for many brands. Identifying companies that have the potential to grow revenue by re-deploying capital and accessing new markets is likely to be a key element of successful consumer discretionary investing now and in the future.

During the 1990s, heady rates of U.S. consumer spending growth were supported by households raising the debt on their balance sheets, especially through home equity lines of credit. The subprime mortgage crisis and the bursting of the housing bubble mostly put an end to these options for many consumers. Without them, growth in discretionary spending is likely to slow. During the two years after the 20082009 credit crunch and recession, the stock market and the economy recovered, and many consumer discretionary companieswith only a few exceptionsbenefited as sales productivity and margins rebounded. With global economic growth stabilizing in the later part of 2011, a separation of earnings growth may occur within the sector even without another recession. Some companies will have the capacity for continued growth, while others may not. For example, during the credit-fueled spending binge of the 1990s through the early 2000s, there were about 50 retailers that could expand store square footage at consistent rates of 15%

Technological innovations such as mobile computing are rapidly changing the behavior of consumers, including their discretionary spending. To survive this disruptive trend, companies need to recognize that an online presence is a core competence.
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or higher. Now there are only a few with the potential to re-invest and grow. The companies with the most potential to succeed in the current environment are those with either high visibility for revenue growth from new products or the ability to take advantage of share shiftincreasing market share at the expense of others. In the coming years, identifying effective management should become more apparent as a competitive advantage.

Opportunities in the developing world

With growth prospects in the developed world contracting, the emerging-market consumer represents a significant opportunity for many discretionary brands. In developing countries, roughly one billion are projected to join the middle class by 2020.2 Middleclass consumer spending in these developing nations is expected to rise from nearly $7 trillion to more than $20 trillion in the next decadeabout twice the current consumption in the U.S.3 Forward-looking companies have sought to augment their product and service lines by entering consumer markets in faster-growing economies, such as China and India. Retailers were among the first to capitalize on this trend, and now the Asian gaming market appears to offer long-term structural growth. On the peninsula of Macau, a special administrative region (SAR) of China, the gaming market has a relatively competitive structure with a number of casinos. Gross gaming revenue was up 45% year-to-date through September 2011. Despite paying a 40% tax to the Chinese government, these casinos have been beating analysts earnings expectations with 50% profit margins.4 The Singapore market is smaller, with a duopoly of two casinos, and lower taxes. Japan and Thailand have also considered allowing gambling. There are concerns that Asian governments may want to regulate the pace of growth in the gaming industry: China has occasionally tightened restrictions on visas for travel to the casinos. Nevertheless, given the expansion of the underlying economies and the propensity of these populations to gamblethe amount wagered privately in China is estimated to be several times the size of the government-sanctioned Macau marketthe potential growth in the region remains promising. The theory of gamingthat new supply creates demandappears to hold, and the Asian market seems to be far from a saturation point.

In our view, identifying companies that can sustain revenue growth in existing and emerging markets will likely be critical to successful investing in the consumer discretionary sector.
INVESTMENT THEME
Strength in High-End Consumers

KEY TAKEAWAYS

High-end consumers account for nearly one-third of all discretionary spending in the U.S., and their incomes and employment prospects have held up better during recent economic weakness. In emerging markets, especially in Asia, growing high-net-worth populations have displayed a particular affinity for luxury goods. Companies offering products and services geared toward domestic and international high-end consumers can provide attractive investment opportunities within the sector.

While low-end consumers tend to spend a large portion of their of their incomes on necessities, affluent consumers have always been the leaders of discretionary spending growth. The top 20% of households account for about 50% of income and up to 60% of consumer spending.5 This is a key reason why many companies in the consumer discretionary sector focus on high-end consumers in all economic environments. Faced with a bleak job market in the aftermath of the last recession, the average U.S. consumer has been forced to shift priorities from borrowing and spending on discretionary products and services, to deleveraging and saving. For high-end consumers, however, the outlook has been more positive. Unemployment is lower among the college-educated, giving more of this population a steady source of income, and their balance sheets tend to be more levered to financial markets than real estate, which has been particularly beneficial during the recent economic cycle. As the economy improves, the incomes of affluent households have the potential to grow faster because they are more driven by incentives and geared to the performance of stock, bond, and alternative investments. The companies who have achieved success catering to these higher-end households have been able to build so-called aspirational or lifestyle brands for which consumers are willing to pay more. To achieve this, it is critical not only to establish namebrand recognition, but also to associate the brand with high qualityeven affluent consumers want to feel that they are getting value for their money. Some examples of high-end consumer

Investment implications
Consumer discretionary companies benefited throughout the spending boom at the end of the 20th century. With tighter credit conditions now forcing frugality on consumers in mature economies such as the U.S., retailers and others who can shift market share from their competitors or take advantage of attractive expansion opportunities in developing countries may offer the best long-term growth prospects. In our view, identifying companies that can sustain revenue growth in existing and emerging markets will likely be critical to successful investing in the consumer discretionary sector. 4

goods and services include luxury apparel and footwear brands, as well as retailers who carry such exclusive merchandise.

High-net-worth population growing internationally

The emerging-market consumer also presents a significant opportunity for high-end brands. Just as the middle class is increasing far faster in developing countries than in more mature economies, the growth of the upper class has also been robust. In the Asia-Pacific region, for example, the high-net-worth population is about the same size as in Europe.6 Emerging-market consumers appear to have a particular affinity for luxury goods, especially in China where, according to a recent survey, 70% of consumers see high-end brands as a way to demonstrate their status and success.6 Going forward, these socio-economic trends could buoy the revenue growth of luxury goods companies. Aspirational and lifestyle brands can take advantage of name recognition in developed countries to expand internationally. Most recognized outside the U.S. are brands that are linked to premium products with great fashion appeal, especially those that seem particularly American. A few companies have been able to generate brand and category extensions from this one basic idea.

This is not an option for everyone, however. International markets may recognize the number-one brand, and possibly the numbertwo brand, but probably not the third or fourth. U.S. brands that were early to move into Asia are hitting a tipping point in terms of the contribution of international sales to earnings growth, with a significant portion of sales coming from emerging markets.

Investment implications
Although stock and bond market volatility may hamper spending in the near term, the high-end consumer could be a powerful driver of future growth in the discretionary sector for the following reasons. First, the stronger financial positions of affluent households in the U.S. may support continued discretionary spending. Second, the growing high-net-worth populations in emerging markets increasingly have displayed a taste for luxury goods. In our view, investing to take advantage of this theme will require looking for those companies with the most attractive products and services that will drive strong earnings growth and hence stock returns. Given the increasing share of global wealth creation in developing economies, it is also important to recognize that the growth of the market for high-end tastes is likely to be faster outside the United States.

Consumer Staples
Robert Lee, Portfolio Manager

The consumer staples sector consists of companies that sell relatively low-priced items that consumers use frequently in their daily lives, including food, beverages, and products for personal hygiene or household cleaning. Purchases of these necessities tend to be stable over time, so consumer staples stocks typically are affected less by changes in spending patterns than are other types of consumer products. Although consumers may trade down from name-brand to private-label goods to save money, they generally buy the same amount of staples, such as cereal, milk, toothpaste, and detergent, whether the economy is expanding or contracting. Given such stable, counter-cyclical demand for consumer staples, the sector is often considered to be defensive. On an annual basis from 1963 to 2010, the consumer staples sector outperformed the top 3000 U.S. stocks in 11 out of 12 down-market years. Unlike other traditionally defensive sectors, however, the sector also outperformed in 17 out of 36up-market years.1 The following themes may provide attractive investment opportunities in the consumer staples sector during any market environment.

and incomes have risen, so that a growing share of their populations can now afford consumer products. As such, these markets are an important source of growth for many staples companies. Emerging-market populations still consume only a fraction of what populations in wealthier, developed countries consume. For instance, many living in rural China have gone from brushing with toothpaste once a year to once a day, representing huge incremental growth. By contrast, the populations in Western Europe, Japan, and the U.S. already consume about as much of these basic staples as they can. A North American who already eats a bowl of cereal for breakfast and brushes twice a day is unlikely to eat two bowls or brush nine times. When consumers in emerging markets transition from low-income status to the middle class, their behavior is consistent with past experiences in developed countries. Historically, per-capita spending on food and beverages increases with GDP (see Exhibit 1, below). EXHIBIT 1: Food and beverage spending per capita generally grows as GDP per capita grows.

INVESTMENT THEME
Growth in Emerging Markets
Food and Non-Alcoholic Beverage Spending Per Capita

FOOD & BEVERAGE SPENDING PER CAPITA VS. GDP PER CAPITA FOR SELECTED COUNTRIES

KEY TAKEAWAYS

With 70%80% of the worlds population living in developing countries, emerging markets have been a growth area for many consumer staples companies. As per-capita wealth has risen in these emerging economies, goods considered staples in developed countries have become universal needs and wants. With the increase in global consumption, staples companies have great opportunities to increase their market volumes and accelerate their earnings growth rates.

$5,000 $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 $0 Brazil China $20,000 $40,000 $60,000 $80,000 GDP per Capita Taiwan USA Denmark

From a staples standpoint, consumer wants and needs tend to be similar, regardless of country or culture. Generally speaking, cola tastes good to a large percentage of the population, and toothpaste is viewed as essential to proper oral hygiene. About three-quarters of the worlds population live in developing countries, and historically, many have not been able to afford these items. During the past several years, however, emerging-market economies have modernized 6

Source: ERS/USDA, Euromonitor data, September 2009.

INVESTMENT THEME
As long as these developing economies continue to progress along the same path, staples companies have a tremendous opportunity to grow if they can get their products to those consumers. Staples manufacturers looking to expand into emerging markets face some challenges, however. Items have to be produced locally, and distributed with a certain scale to be affordable. Building local manufacturing and distribution infrastructure is expensive, as is doing the marketing and education to set the brand apart and create demand. Companies need to make significant capital investments to tap the growth opportunity in developing countries. Some have made those investments; others have not. Many large multinationals have already entered these markets and established manufacturing, distribution, and brand awareness. These companies can benefit from their first-mover advantage as consumer incomes continue to rise, while newcomers will have to incur huge expenses to catch up. Competitive Industry Structure

KEY TAKEAWAYS

Industries with fewer dominant companies are likely to have more pricing power than fragmented industries. Relatively small changes in industry structure can have a big impact on pricing and profitability. Focusing on concentrated industries whose participants enjoy higher margins may be a way to distinguish potential investments in consumer staples.

Investment implications
The global middle class is expanding at a rapid rate, driven by rising wealth in developing countries. As incomes increase, consumer staples become universal needs, wants, and conveniences, presenting tremendous opportunities for growth from geographical expansion. Along with volume gains, another favorable dynamic for both domestic-facing businesses and multinational companies is the potential to eventually get new emerging-market customers to trade up into higher-priced products. Higher prices boost profit margins, which in turn can improve earnings growth. Given the high cost of entering these new markets, companies that have already invested in building the global infrastructure required to take advantage of these opportunities should be well positioned. The emerging markets theme is not new; in fact, there has been a sizable payoff in the past decade, as consumption of staples in these economies has increased from an estimated 5% of U.S. consumption levels to an estimated 13% during the past 10 years.2 In our view, however, emerging-market consumption is likely to increase even more significantly, providing a lot more runway over the next decade. Major multinational players should be the major beneficiaries of this consumption growth, thanks to their early investments in these developing markets.

Industry structure plays a key role in determining the allocation of pricing power among companies in the consumer staples sector. Concentrated industries with only one or two dominant participants tend to have more ability to set prices than fragmented industries with five or more companies, whose customers can shop around more easily for bargains. Even small changes in industry structure can make a big difference in pricing power and relative competitiveness. The contrast between U.S. brewers and bakers demonstrates the importance of industry structure. Until recently, there were three large beer manufacturers whose products were distributed nationally. Beer pricing was generally in line with the rate of inflationor even below itsince one of the three participants was always willing to act as a price spoiler and would undercut the other two to gain share. As a result, none of the national brewers could significantly raise prices on a consistent basis. In 2008, two of the brewers formed a joint venture to operate as one company. Ever since, pricing has strengthened dramatically, growing fasternot slowerthan the rate of inflation. The loss of just one brewer has improved the profitability of the two surviving entities. U.S. bakers face a very different industry structure. In this highly fragmented industry, several regional bakeries sell bread at very low margins as they compete for market share. Historically, any attempt to create a national baker has failed. Without one dominant baker that would be big enough to buy the others, the bread industry is likely to stay fragmented, and all participants may continue the struggle to maintain profitability.

Investment implications

In our view, identifying dominant consumer staples companies that can achieve price stratification within concentrated industries is likely to be a compelling long-term investing strategy.
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Within the consumer staples sector, not many industries are as concentrated as brewing, nor as fragmented as baking. In general, however, the fewer the participants, the better the profit margin structure. Industries can enjoy more pricing power even with a few major players. In addition, new entry is generally difficult in staples because of the economies of scale required to start a profitable business. As a result, most industries tend to become more consolidated, and they rarely get less consolidated over time. In our view, identifying dominant consumer staples companies that can achieve price stratification within concentrated industries is likely to be a compelling long-term investing strategy.

INVESTMENT THEME
Brand Power of such items are aware of this trend, yet some maintain strong sales levels because consumers continue to be emotionally tied to these indulgent products and buy them. Other food manufacturers have developed or acquired alternative brands associated with health and wellness, such as organic foods, but so far these efforts have not been a major differentiator of success.

KEY TAKEAWAYS

Some everyday consumer products can trigger emotional reactions, which can heighten the perception of quality. Indulgent products are often consumed to satisfy emotional rather than basic needs, and advertising can help to associate certain brands with emotional indulgence. Investing in companies that have been able to develop these emotionally indulgent brands may be a profitable strategy in the consumer staples sector.

Staples are typically necessities that are consumed frequently, but these goods are not always viewed as commodities. When consumers have emotional reactions to particular types of products, they often perceive that these items are higher quality than other alternatives. Companies that are able to associate such positive feelings with their brands tend to have brand power, which means that they can charge higher prices than their competitors. The choices consumers make about baby food and shredded cheese serve to illustrate this distinction. Many parents have a strong emotional involvement with their infants, and this can influence their decision to buy the best quality of baby food. A higher price often signals higher quality, while a lower price can trigger a negative emotional response. In fact, there can even be a stigma against the cheapest baby food product, which may be determined to be not good enough for my baby. Shredded cheese, on the other hand, is often viewed as more of a commodity. One package of shredded cheese may be considered as good as any other, with price being the only distinguishing factor. If there is no emotion involved in the consumers choice, branded shredded cheese is likely to be priced competitively with private labels or generics. Indulgent products, such as chocolate and ice cream, are by definition emotional, because consuming them indulges a want rather than a need. Name-brand products that have been successfully positioned as indulgences often can command premium prices. While store brands may be able to mimic the quality at a lower price, they cannot produce the same sense of indulgence. Consumers have become more health conscious over time, and some staples companies have responded by shifting product portfolios away from lines that are considered unhealthy, including candy, snack foods, and soft drinks. Traditional manufacturers

When consumers have emotional reactions to particular types of products, they often perceive that these items are higher quality than other alternatives. Companies that are able to associate such positive feelings with their brands tend to have brand power.
A corollary of the brand power theme is serving the high-end consumer, especially during periods of pronounced economic cyclicality. On average, U.S. consumers are more price sensitive during economic downturns, but this average emphasizes the two-thirds of the population who are more affected by recessions and hence become more frugal, while the other third continues the same spending patterns. In the current cycle, the U.S. economy has not affected more affluent consumers, so indulgent products are still selling relatively well. This may not benefit all manufacturers, since many have broad portfolios of products targeted to all types of consumers. But producers of so-called luxury staples, such as distilleries with top-shelf brands, may be able to benefit from the ongoing spending power of high-end consumers.

Investment implications
Consumer choices about basic needs tend to be rational, while indulging emotions often triggers irrationality. When there is an emotional involvement with a product, even an everyday staple can prompt a positive reaction and a perception of higher quality. Manufacturers whose products satisfy these emotional needs can benefit from a better pricing structure, so these companies may be promising candidates for investment in the consumer staples sector, regardless of the economic backdrop and the future direction of the broader equity market.

Energy
John Dowd, Portfolio Manager
The performance of energy stocks historically has been cyclical in nature, meaning they tend to outperform the broader market during periods of economic expansion and lag during economic deceleration. More specifically, energy stocks historically have outperformed at the mid and late stages of an economic cycle, when an expansion is firmly entrenched and demand for energy commodities and energy services is at or near peak levels. During the past couple of years, the energy sector has become increasingly more complex. Geopolitical tensions in the Middle East and North Africa have raised the risk of crude-oil supply disruptions. The major crude-oil spill in the Gulf of Mexico in the spring of 2010 raised the probability of increased industry regulation for U.S. oil producersa source of uncertainty with regard to future earnings. Elsewhere, the earthquake and tsunami in Japan during the spring of 2011 also posed new challenges to global supply and demand. Despite this more complex backdrop, we believe there are a few compelling dynamics underway in the energy sector that have the potential to significantly alter the landscape and provide attractive opportunities for long-term investment. underground. Hydraulic fracturing involves blasting huge volumes of water, sand and chemicals deep underground, which creates fissures or fractures that allow the natural gas trapped inside shale rock to flow out. This new drilling technology was initially adopted and applied to improve the extraction of natural gas in shale rock formations. Its success led to an increase in the supply and lower prices for natural gas. More recently, exploration companies began applying the same fracking techniques at old conventional crude-oil basins that had been viewed as unproductive based on traditional drilling methods. The results have been favorable, leading to what many in the industry are referring to as a renaissance in domestic oil and natural gas drilling. During the past decade, the long-term bull case for the stocks of U.S. companies involved in the exploration and discovery of crude-oil has been largely premised on rising global demand, the inability to grow domestic supply, and rising prices. There has been little production growth outside of the Organization of the Pertroleum Exporting Countries (OPEC) during this period. As a result, weve seen rising crude-oil prices, followed by an increase in drilling to stave off rising global demand growth. More recently, energy exploration and production companies have been adding new unconventional wells to existing crude-oil reservoirs, resulting in extensions of proved reserves (Exhibit 1, below). EXHIBIT 1: New drilling techniques have been applied to old reservoirs to boost the extractions of natural gas and crude oil. EXTENSIONS TO OLD RESERVOIRS AS % OF PRIOR YEAR RESERVES
18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 1976 1991 1967 1982 1988 1994 1997 1970 1973 1979 2000 2003 2006 2009 1985 0.00% Oil Natural Gas

INVESTMENT THEME
The Emergence of More Productive New Drilling Techniques

KEY TAKEAWAYS

New techniques for extracting natural gas and crude-oil from the earth have helped ease concerns about the inability of U.S.-based energy producers to grow domestic supply and offset the countrys heavy dependence on foreign sources for these commodities. These unconventional new drilling techniques have lowered the overall cost structure for companies engaged in the exploration of traditional energy sources, such as crude oil and natural gas. More-productive drilling techniques have led to an overall increase in mid-continent U.S. oil production, which has led to lower pricing for refiners.

New drilling technologies

Advances in horizontal drilling and hydraulic fracturing techniques (commonly referred to as fracking) are allowing U.S. exploration companies to tap natural gas and crude-oil reserves embedded in previously impenetrable rock trapped thousands of feet 9

Source: Haver Analytics, Baker Hughes, U.S. Department of Energy.

The productivity of fracking for both commodities has been beneficial for integrated energy producers, but also for companies focused primarily on drilling. The number of drilling rigs has increased substantially during the past couple of years (see Exhibit 2, below). Elsewhere, energy services companies are benefiting from increased service demand and higher service intensity associated with these new techniques.

EXHIBIT 3: The price of domestically produced crude oil in the mid-continent states (West Texas Intermediate) has fallen significantly relative to imported (Brent North Sea) crude oil during the past couple of years. COST SPREAD ($) BETWEEN MID-CONTINENTPRODUCED CRUDE AND BRENT NORTH SEA CRUDE
$20.00 $15.00 $10.00 $5.00 $0.00 -$5.00 -$10.00 -$15.00 -$20.00 -$25.00 -$30.00 1/1/2008 1/1/2009 1/1/2010 1/1/2011

The impact of productive drilling

Overall, these new drilling technologies have led to an increase in onshore U.S. crude-oil production of about 400,000 barrels per day, which represents the first increase in 30 years.1 This increase in mid-continent U.S. oil production has led to lower, more-attractive prices relative to imported crude oil (Brent North Sea), and improved profit margins for domestic refiners, chemical makers, and other purchasers of locally-produced crude (see Exhibit 3, right). Historically, the U.S. crude-oil infrastructure has been built for the country to be a net consumer/importer of oil from a global standpoint, so these new drilling techniques and the increase in U.S. production is potentially game-changing for many participants. At some point in the future, could the U.S. grow enough onshore crude production to pressure global crude-oil prices? Could a further increase in production necessitate the construction of additional domestic pipelines to transport crude oil from the midcontinent states to the Gulf coast? These are some of the dynamics we are monitoring.

Source: Bloomberg as of Nov. 4, 2011.

Investment implications
Unconventional drilling is likely to have a major impact on supply growth and future energy consumption around the world over the

EXHIBIT 2: The number of drilling rigs in operation in the U.S. has risen sharply during the past couple of years. U.S. DRILLING ACTIVE RIG COUNTS
1200 Horizontal Rigs (Oil & Gas) 1000 All Oil Rigs 800 600 400 200 0

next decade. With respect to natural gas, the U.S. Energy Information Administration estimates there are 2,552 trillion cubic feet of natural gas in the United States, or 110 years of use at 2009 consumption levels, due largely to the application of new drilling practices.2 With U.S. politicians and entrepreneurs alike looking to leverage such an abundant resource, the effects of more productive unconventional drilling could spread throughout the entire global energy paradigm. This trend is already being seen in the retirement of older coal-generating power plants in places such as China, and the adoption of natural gas vehicles in Asia, Latin America, and the Middle East. Meanwhile, unconventional drilling techniques also could have a significant impact on crude-oil markets. Today, this drilling technology is being adopted in oil fields in Canada, Argentina, and Eastern Europe, and may lead to a significant global increase in non-OPEC production in the years ahead. We recognize that new unconventional drilling technologies have the potential to put downward pressure on energy commodity prices around the world over the long term, which may be helpful at various times for some industry participants and detrimental to others. We are also mindful that falling energy prices would have a significant destabilizing effect and geo-political ramifications for major energy-producing countries. Overall, the energy sector is potentially on the cusp of transitioning from a resource-constrained world to one that has a much better production profile due to improvements in drilling techniques.

Source: Haver Analytics, Baker Hughes, U.S. Department of Energy.

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1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

INVESTMENT THEME
The Growth of the Liquid Natural Gas Market

KEY TAKEAWAYS

Global demand for natural gas has increased in recent years due to greater interest in its more environmentally friendly properties relative to coal and crude oil, and the increased adoption of natural-gas-fired power generation plants. Improvements in the technology that harnesses and liquifies natural gas from reserves has led to increased production, transportation, and usage of liquefied natural gas (LNG) throughout the world.

The greater emphasis by energy producers to invest in the technology needed to develop and transport LNG is a theme that we expect to be relevant for some time.
in 5-to-6 years, which is a rough average. Some modern LNG operations are expected to be in use for as long as 30 years, with significantly slower annual rates of declining productivity. In addition, many large energy producers have legacy assets (e.g., onshore or offshore fields) that are maturing and fading in productivity, and have thus reconstructed their portfolios to newer, untapped natural gas assets. As a result, growth in the production and servicing of liquefied natural gas has increased significantly during the past couple of years.

A bounty of natural gas

For many decades, the primary focus of exploration for energy sources had been the search for crude-oil deposits. More recently, large integrated energy producers are putting a greater emphasis on the exploration and production of natural gas for the following reasons: New technology has allowed companies to more efficiently harness, liquify and transport natural gas to new and existing markets. Stricter environmental regulations and a greater awareness of the cleaner properties of natural gas relative to other energy commodities, such as coal and crude oil, have led to rising global demand for natural gas. New hydraulic fracturing drilling techniques have led to an abundant global supply of natural gas. Companies can more effectively extract natural gas from shale rock formations in the earth, both in new locations, stranded locations, and older wells that had been drilled and viewed as less productive using traditional drilling techniques. Increasing demand for natural-gas-generated electricity in emerging market countries has increased amid escalating economic growth. Regions with large reserves of natural gas, such as Australia, Qatar, the United States, and Russia, have been at the forefront of the development of liquefied natural gas (LNG). In 2009, the U.S. became the largest natural gas producer in the world, with shale accounting for about 20% of domestic production.

Rising global demand for LNG

There are a couple of sources for rising global demand for LNG. First, demand for LNG has increased in emerging-market countries, which have generally experienced stronger economic growth rates. For example, imports of LNG have surged in China during the past year. Second, since the tsunami/earthquake that hit Japan in the spring of 2011 shut down a portion of its nuclear power generation capacity, the country has made LNG a greater focus of its current and future plans for power generation.

EXHIBIT 4: Shipping volume of LNG has increased significantly during the past decade. GLOBAL LNG IMPORTS
40.0 35.0 30.0 Total bcf/d 25.0 20.0 15.0 10.0 5.0 Jan - 95 Nov - 95 Sep - 96 Jul - 97 May - 98 Mar - 99 Jan - 00 Nov - 00 Sep - 01 Jul - 02 May - 03 Mar - 04 Jan - 05 Nov - 05 Sep - 06 Jul - 07 May - 08 Mar - 09 Jan - 10 Nov - 10 0.0

Increased capital investment

The untapped abundance of natural gas deposits around the world has motivated many large energy exploration and production companies to invest and reinvest capital in new LNG technology. Specifically, natural gas can be more easily liquefied, frozen and transported around the world (see Exhibit 4, right). For example, there are industrial boats that now have more sophisticated liquefaction facilities on board, allowing them to mobilize more quickly from one drilling location to another over the ocean. Many of these large integrated energy producers have shifted a greater percentage of their infrastructure portfolios to focus more on LNG production because the plants and facilities are projected to have longer production cycles and slower rates of decline than those for conventional oil. For example, a state of the art crudeoil facility may run its course and deplete a reserves oil capacity 11

Source: PIRA Energy Group, Fidelity Asset Management as of Nov. 7, 2011. bcf/d - billion cubic feet per day. Global LNG Imports volume in chart represents sum total of LNG that was shipped and reached a port destination during month stated.

Investment implications
The abundance of global natural gas and the advent of new technology to harness the commodity are supportive of engineering and construction companies that can produce the LNG capabilities needed by large integrated energy companies. The greater emphasis by energy producers to invest in the technology needed to develop and transport LNG is a theme that we expect to be relevant for some time.

EXHIBIT 5: The number of deepwater drilling rigs in use has increased sharply during the past several years. GLOBAL DEEPWATER RIGS IN OPERATION
180 Total Global Rig Supply 160 140 120 100 80 60 Jan 2005 Jun 2005 Nov 2005 Apr 2006 Sep 2006 Feb 2007 Jul 2007 Dec 2007 May 2008 Oct 2008 Mar 2009 Aug 2009 Jan 2010 Jun 2010 Nov 2010 Apr 2011 Sep 2011 Source: IHS ODS-Petrodata, Jan. 1, 2005 - Nov. 4, 2011. Depth: 4,000 feet or greater. Total Global Rig Supply: the number of rigs available and in operation over the course of a month.

(2005-2011)

INVESTMENT THEME
The Renaissance in Deepwater Exploration

KEY TAKEAWAYS

The combination of more sophisticated drilling techniques, deepwater rigs, and seismic wave and imaging technology have provided energy producers with greater opportunity to explore for energy commodities in previously inaccessible deepwater regions. Many energy producers view deepwater drilling as a relatively untapped frontier that could provide a source of production growth over the next several years.

New technology drives exploration

Improvements in seismic wave technology, which allows companies to measure the make-up of the earth below the ocean floor, have allowed more companies to effectively search and discover new oil reserves. In addition, the imaging technology that allows companies to view the make-up of the earth has also improved. New drilling and deepwater technologies are being adopted for exploration in ultra deepwater basins around the world that had previously been viewed as inaccessible, such as in the Arctic Ocean, and off the coasts of Africa and Eastern Russia. Many large energy producers have invested in the development of new deepwater platforms, seismic and imaging technology, and drilling rigs to search for new sources of crude oil and natural gas (see Exhibit 5, above).

Investment implications
We believe many companies are viewing deepwater exploration as a major source of growth in the coming years, and are investing in resources that will allow them to tap into this new frontier. There are a variety of companies that could benefit from this trend, including deepwater rig manufacturers, energy and construction companies, and energy transportation companies.

12

Financials
Ben Hesse, Portfolio Manager
The financial sector continues to face several challenges. Continued economic improvement is critical to ongoing repair of the U.S. financial system, but the global economys deceleration in the third quarter of 2011 has raised concerns about a double-dip recession in the U.S. This decelerating global growth outlook has led to increased financial distress in the eurozone, making it more difficult for fiscal austerity measures to reduce debt burdens relative to underlying economic output. The aftermath of the 20082009 financial crisis left a different environment than most post-war economic recoveries, with deleveraging in the financial, consumer, and housing sectors creating deflationary pressures. As a result, unlike in most mid-cycle expansions, monetary policy has yet to tighten and credit has recovered slowly. Elsewhere, the U.S. housing market remains challenged and consumer debt levels remain elevated. Several financial regulatory reform proposals also threaten to reduce profitability in the sector. In addition, core inflation is accelerating across the globe, which historically has been a negative for financial assets. On the positive side of the ledger, credit conditions have improved during the past year, which historically has been a favorable driver for financial stocks, especially banks. On average, loan growth has turned positive, the ratio of nonperforming loans has declined, and delinquency rates have falleneven for the most toxic loan books. From a valuation perspective, stocks on average have been trading roughly in line with the market on a forward-earnings basis, but are significantly discounted on a cash-flow and book-value basis. This is particularly true for large U.S. banks, which generally are very well capitalized but have been universally punished amid the macro market dynamics influencing investor behavior. Despite this mixed backdrop, our financials equity research team believes there are a few interesting investment themes that bear monitoring over the course of 2012 and beyond.

The percentage of non-performing loans in the Chinese banking sector has fallen to an all-time low. If the current growth trajectory for the largest Chinese banks continues, it may shift the competitive landscape in the industry and lead to greater appreciation for the Chinese currency.

The rise of Chinas banks

During the past five years, while other large global banks were forced to write-down loan and securities losses, re-capitalize themselves, and de-lever their balance sheets, China quietly became the home of three of the worlds largest banks based on market capitalization. A decade ago, none of these banks were publicly traded entities. The growth of the Chinese banks is astonishing when looking at other metrics as well. The Chinese banking system had about $3 trillion in total loans outstanding in 2006. Since then, loans in the Chinese bank system have doubled, in part due to a government stimulus boost in 2009. Earnings have followed as well. In 2010, one major Chinese bank generated net income of $24 billion, up from $6 billion in 2006, and above the $17 billion in net income generated by a major U.S. bank in 2010.1

Projected growth at current run-rate

The largest Chinese banks have estimated that their respective annual loan growth will continue in the 10%-20% range over the next few years.1 Given that the biggest U.S. and European banks are likely to be shrinking their balance sheets in the coming years, the largest Chinese banks could potentially be twice the size of the largest U.S. and European banks by the middle of the current decade.

Historical loan crises and Chinese government response

Chinese banks have not been without their challenges in dealing with severe non-performing loan (NPL) crises. Until 1999, Chinas banking sector had been dominated by four large state-owned banks (SOBs) that accounted for more than 70% of both credits to enterprises and household deposits. By 1999, an acceleration of defaults and delinquent loans turned into a major crisis for these SOBs, and three of them would have been viewed as insolvent had their assets been marked to market. Thereafter, the Chinese government set up four asset management companies to carve out NPLs from these banks (similar to the Resolution Trust Corp. set up by the U.S. government after the savings & loan crisis in

INVESTMENT THEME
The Growth of Chinese Banks

KEY TAKEAWAYS

During the past decade, the largest banks in China have grown to be among the largest in the world in terms of market capitalization, total loans outstanding, and earnings.

13

the 1980s). Nearly $170 billion in bad loans was transferred to the Chinese asset management companies from 1999-2000, and another $50 billion was absorbed in 2004. During the past several years, the Chinese government has taken a series of measures designed to build a stronger banking system, including: the recapitalization of the SOBs, adoption of the international standard accounting system, and introduction of debt-equity swaps as an instrument for dealing with bad debt. The government also raised tens of billions of dollars to help write off bad debt via IPOs of stock for Chinese banks. During the first half of the 2000s before the Chinese banks were re-capitalized by the government, non-performing loans represented 10%-20% of total outstanding loans in the banking sector. Currently, nonperforming loans at Chinese banks represent only about 1.5% of outstanding loans, which is near an all time low (see Exhibit 1, below).

the front end of a decelerating real estate market. Whether these property-sector imbalances lead to a large-scale real estate slump and widespread loan losses for banks in China remains to be seen, but its something were monitoring closely.

Investment implications
A world dominated by Chinese banks could have several important investment implications. First, large Chinese banks could become aggressive acquirers of foreign banks, a potentially beneficial event for shareholders of acquired institutions. Second, with vastly larger balance sheets, the Chinese banks could force competitive downward pressure on pricing across the spectrum of products and services in an attempt to gain market share, which would be a positive for customers but a negative for the earnings and stock prices for some U.S. and European banks. Third, the sheer projected size of Chinese banks in a few years time (relative to global peers and the Chinese economy) might encourage regulators to facilitate the development of Chinas capital markets. This maturation could drive appreciation and convertibility of the Chinese currency, and further its rise as an alternative to the U.S. dollara dynamic that would significantly influence the global financial and geopolitical spectrum.

Signs of caution
However, there are increasing concerns about lending quality in Chinas local government segment. During the past year, Chinese authorities have tightened monetary policy, which has slowed the pace of bank credit extended to mortgage applicants, small and medium enterprises, and other entities. Nevertheless, Chinas building boom has largely continued, and residential construction starts have far outpaced sales. With supply outstripping demand, extreme property valuations in major cities, and initial signs of financial distress among property developers, China may be at EXHIBIT 1: The Chinese banking industrys non-performing loan ratio has declined during the past decade. NON-PERFORMING LOAN RATIO FOR CHINESE BANKING SECTOR (1999-2010)
40% 37.9% 35% 30% 25% 20% 15% 10% 5% 1999 2001 2002 2003 2004 0%
19.2% 14.9% 12.2% 8.4% 5.2% 4.4% 4.0% 1.5% 1.0% 0.8%

INVESTMENT THEME
The Age of Austerity

KEY TAKEAWAYS

Elevated fiscal budget deficits and debt levels, rising borrowing costs, and sluggish economic growth have caused some European sovereigns to implement austerity measures during the past couple of years to improve their creditworthiness and meet debt service payments. If successful, fiscal austerity can provide a more favorable backdrop for financial assets over the long term, but it typically has led to slower economic growth in the short terman environment that historically has not been favorable for bank stock performance.

Understanding the need for fiscal austerity

The escalating fiscal government deficits and high sovereign debt levels of many developed countries during the past few years have been a driving source of increased volatility in the financial markets. While the size of a countrys fiscal deficit and debt level are critical to its creditworthiness, a countrys ability to grow its economy fast enough to service its debt is also important. As such, highly indebted countries with bleak outlooks for economic growth have watched the yields on their outstanding debt rise as market participants begin to question their growth prospects and their ability to pay. In a self-fulfilling feedback loop, higher interest rates make a countrys fiscal challenges even greater, leading to even greater concerns about these countries ability to service their outstanding debt.

11%

2005

2006

2007

2008

2009

Chinese Banks Industry NPL Ratio

Source: Red Capitalism Book, Wind, Company data, PBOC, CLSA Asia-Pacific Markets, Bloomberg, FMR Research 1999-2010.

14

2010

Peripheral eurozone countries have been facing these challenges most acutely during the past couple of years, while other countries with large deficits and high debt levels, such as the U.S. and Germany, are seen as less challenged due to their relatively more favorable growth prospects. Generally speaking, countries facing these fiscal challenges have three main options: 1) undertake fiscal austerity policy measures, which include spending cuts, tax increases, and benefit reductions; 2) pursue monetary policy measures, such as currency devaluation to spur export growth or inflationary money policy to make domestic debt easier to pay; or 3) debt restructuring (de facto default, through altering terms of the repayment to bondholders).

The implementation of fiscal austerity

When the U.K. became the first major country to implement widespread austerity initiatives in the spring of 2010, Prime Minister David Cameron coined this era The Age of Austerity. According to the European Unions Treaty of Maastricht criteria, European Union (EU)-member states may not have a budget deficit that exceeds 3.0% of their Gross Domestic Product (GDP). Several countries exceeded that threshold in 2010, and have since been implementing austerity measures (see Exhibit 2, below).

EXHIBIT 2: Several EU-member states 2010 government budget deficits rose as percentage of their GDP at the end of 2010. Through austerity and other measures, these countries respective target budget deficits are projected to decline over time.
Central Government Predicted Government Budget Deficit as a Budget Deficit as % of GDP 2010 Percentage of GDP France 7.70% 2011: 6.0% 2013: 3.0% 2014: 2.0% Greece Ireland Italy Portugal Spain UK 10.46% 11.90% 4.80% 6.94% 5.17% 10.08% 2011: 7.0% 2014: 3.0% 2015: 2.9% 2012: 2.7% 2011: 4.6% 2011: 6.0% 2015: 1.0%

GREECE: GOVERNMENT BUDGET DEFICIT AS % OF GDP

20% 20% 20% 15% 15% 15% 10% 10% 10% 5% 5% 5% 0% 0% 0% 2009 2010 2011 2009 2009 2010 2010 2011 2011 Greece: Govt Budget Decit as % of GDP Greece: Govt Budget Decit as % of GDP Greece: Govt Budget Decit as % of GDP 16.22% 16.22% 16.22% 10.46% 10.46% 10.46% 7.00% 7.00% 7.00%

ITALY: GOVERNMENT BUDGET DEFICIT AS % OF GDP

6% 6% 6% 5% 5% 5% 4% 4% 4% 3% 3% 3% 2% 2% 2% 1% 1% 1% 0% 0% 0% 2009 2010 2012 2009 2009 2010 2010 2012 2012 Italy: Govt Budget Decit as % of GDP Italy: Govt Budget Decit as % of GDP Italy: Govt Budget Decit as % of GDP 5.23% 5.23% 5.23% 4.80% 4.80% 4.80% 2.70% 2.70% 2.70%

IRELAND: GOVERNMENT BUDGET DEFICIT AS % OF GDP

16% 15.20% 15.20% 14% 16% 16% 15.20% 12% 14% 14% 10% 12% 12% 10% 8% 10% 6% 8% 8% 4% 6% 6% 2% 4% 4% 0% 2% 2% 0% 0% 2009 2010 11.90% 11.90% 11.90%

3.00% 3.00% 3.00% 2014

2.90% 2.90% 2.90% 2015

2009 2010 2014 2015 2009 2010 2014 2015 Ireland: Govt Budget Decit as % of GDP Ireland: Govt Budget Decit as % of GDP Ireland: Govt Budget Decit as % of GDP

Source: Haver Analytics, European Institute web site (http://www.europeaninstitute.org/Special-G-20-Issue-on-Financial-Reform/austerity-measures-in-theeu.html) as of Oct. 21, 2011.

15

Investment implications: Austerity creates a challenging environment for banks

Austerity is unequivocally negative for banks in the short term because it generally results in weaker economic growth. For example, when governments reduce spending on development projects, welfare, and other programs, it can hinder employment and GDP growth. At the same time, an increase in taxes and fees on port and road transportation, licensing, and permits can put pressure on consumer spending. A lower-spending, slowergrowth environment typically means reduced revenue for banks, as well as higher credit costs. If austerity is successful over the long-term, history shows that the result will be more sustainable economic growthwhich is positive for banks. In the early 1990s, both Canada and Sweden made large fiscal adjustments to reduce their deficits and stabilize their government debt-to-GDP ratios over multi-year periods. If austerity is unsuccessful at containing deficits, sovereign defaults are then priced into the market. In recent months, the yields on outstanding Greece debt have risen sharply, at times indicating the likelihood of a default. If additional policy measures to contain the Greek debt crisis arent successful, the banking sector in Greece will need to be re-capitalized, potentially thru nationalization. This negative market perception of Greeces near-term outlook for austerity measures and economic growth has led to significant volatility and poor performance for bank stocks in the country, and in other countries on the periphery of Europe that have implemented austerity (see Exhibit 3, right). Our view is that the backdrop will continue to be challenging for European bank stocks over the next few years, as well as U.S. bank stocks as the country embarks on its own austerity path.

tion may provide banks with a tail wind of loan growth that is supportive of profits and stocks.

The role of the GSEs

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) were originally established by the U.S. government to enable the growth of affordable homeownership. They accomplish this objective by buying mortgage loans (from originators, such as banks), packaging mortgages into mortgage-backed securities (MBS), and guaranteeing the payments of conforming mortgages (those meeting certain guidelines, such as debt-to-income ratio). Through these activities, the GSEs help to increase the availability of mortgages, provide liquidity to the mortgage-security markets, and ultimately lower the cost of financing for mortgage borrowers. Since Fannie Mae was privatized in 1968 (and Freddie created in 1970), the GSEs operated as quasi-private entities with implicit government backing. They possessed the dual objectives of trying to generate profits for stockholders while still fulfilling their initial public objective of boosting U.S. homeownership. Both sides benefited from the quasi-government status of the two GSEs, with Fannie and Freddie being able to borrow more cheaply while passing along the cost savings in the form of cheaper mortgage financEXHIBIT 3: The performance of bank stocks in countries that have implemented austerity measures has been relatively weaker than the overall equity market returns in these respective countries. BANKING SECTOR PERFORMANCE RELATIVE TO OVERALL SOVEREIGN EQUITY MARKET
180% 160% 140% 120% 100% 80% 60% 40% 20% 0% Greece Bank Relative UK Bank Relative Spain Bank Relative Ireland Bank Relative

INVESTMENT THEME
Potential Restructuring of the GSEs

KEY TAKEAWAYS

Government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac together play an enormous role in the functioning of the U.S. housing and fixed-income markets, as they own or guarantee more than half of all outstanding U.S. mortgages and are directly or indirectly tied to more than 40% of the investment-grade bond market. During the past year, the U.S. Treasury expressed views on how it might reduce its significant involvement in the mortgage market over time, an involvement that escalated in 2008 when the U.S. government placed the GSEs into conservatorship in the midst of financial crisis. Although it is unlikely that the future state of the GSEs and the governments large role in the mortgage market will be resolved in the near term, the possibility of a future private market solu-

Source: Bloomberg, Fidelity Asset Management as of Sep. 12, 2011. See index definitions on page 41.

16

3/3/2010 4/3/2010 5/3/2010 6/3/2010 7/3/2010 8/3/2010 9/3/2010 10/3/2010 11/3/2010 12/3/2010 1/3/2011 2/3/2011 3/3/2011 4/3/2011 5/3/2011 6/3/2011 7/3/2011 8/3/2011 9/3/2011

EXHIBIT 4: Through the GSEs 55% stake in the domestic home loan market, the U.S. government is the largest owner of outstanding home mortgages (left). The U.S. governments participation in the domestic mortgage market is significantly higher than other countries (right). BREAKDOWN OF U.S. MORTGAGE MARKET OWNERSHIP
U.S. Residential Mortgage Holders GSEs Banks ABS Issuers Thrifts Credit Unions Finance Companies MTG REITs Others Total $mm 5,775 2,207 1,265 431 321 281 21 230 10,531 % Total 55% 21% 12% 4% 3% 3% 0% 2% 100%
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% U.S. UK 0% France 25%

GOVERNMENT OWNERSHIP OF COUNTRYS TOTAL OUTSTANDING LOANS

45%

Government Ownership/Total Mortgage Loans 2010

Source: Federal Reserve, Company data, UKFI, BSA, FMR, as of Oct. 31, 2011.

ing to American homeowners. However, the delicate balance they maintained as both profit-seeking companies and public service agencies has been the source of recent troubles. Today, the U.S. government plays a much larger role in the U.S. housing market than any other developed nation, with ownership of more than half of all outstanding home loans (see Exhibit 4, above).

position as rising home foreclosures continued to result in marketdowns of their mortgage security holdings. Given their large roles in both the mortgage market and the investment-grade bond market, and with their inability to raise capital and regain investor confidence on their own, the governments unusual action was deemed necessary to calm global markets and attempt to hold down mortgage borrowing costs. Further instability in the GSEs represented the risk of an even larger bout of turmoil. The U.S. government effectively took managerial control of the GSEs, operating them solely for the public objectives of providing affordable mortgages to homeowners and liquidity to the housing market. At the same time, the U.S. Treasury also announced the beginning of a series of purchases of new mortgage-backed securities guaranteed by Fannie and Freddie, representing the first

2008 financial crisis brought change

In September 2008, at the peak of an escalating financial crisis driven by a slumping housing market and a weak economy, the U.S. government put government-sponsored mortgage giants Fannie Mae and Freddie Mac into conservatorship, officially ending their status as quasi-private sector companies. At the time, Fannie and Freddie faced rising borrowing costs, falling share prices, and a corporate structure with an uncertain future. These conditions made raising capital from private investors nearly impossible, and placed their razor-thin capital positions in an increasingly perilous

17

time the Treasury directly bought mortgages in an attempt to prop up the housing market using taxpayer money. These developments represented an ambitious expansion of the U.S. government, which agreed to play a more direct and active role in the housing financing market than at any point since the GSEs were privatized in the late 1960s/early 1970s (see Exhibit 5, right). Moreover, the GSE conservatorship significantly expanded the balance sheet of the federal government, an assumption of trillions of dollars of debt onto its books.

EXHIBIT 5: The U.S. governments stake in the U.S. mortgage market has increased during the past few years. U.S. GOVERNMENT OWNERSHIP OF OUTSTANDING MORTGAGE DEBT (20072011)
50% 45% 40% 36% 35% 30% 25% 20% 15% 10% 5% 0% 2007 39% 43% 44% 44% 45% 45% 46%

Investment implications
The future of the GSEs is likely to be a source of considerable debate in the coming years, as the current state is unsustainable. Realistically, any change in the current state of government conservatorship may not occur until after the 2012 elections, but the debate is already underway. This past year, the U.S. Treasury presented its views on how to reduce government involvement in the mortgage market over time. While a consensus is unlikely to be reached in the near term, one likely outcome could be the replacement of Fannie and Freddie with some form of private market solutionand one that involves the GSEs being replaced by banks. If the U.S. government eventually moves in this directiona major policy shiftit would provide a multi-decade, multi-trillion loan growth opportunity for large U.S. regional banks.

2010 Q2

2010 Q4

2010 Q3

2010 Q1

%Fed ownership of outstanding mortgage debt Source: Bloomberg, Fidelity Asset Management as of Sep. 12, 2011.

18

2011 Q1

2008

2009

Health Care
Eddie Yoon, Portfolio Manager
Periods of dramatic change can create new opportunities, and this is especially true in the health care sector. Composed of companies that make or deliver health-related products and services, this sector is generally less sensitive to swings in the economy than other, more cyclical sectors. While even health care faces secular headwinds, the potential solutions to these problems offer opportunities for investors. EXHIBIT 1: As the U.S. population ages, Medicare costs are likely to escalate. OVER-65 POPULATION AND MEDICARE SPENDING
75 70 65 65+ year olds (millions) U.S. Population Over 65 Medicare Spending 6.9% 6.4% 5.9% Medicare as % of GDP 5.4% 4.9% 4.4% 50 45 40 35 30 Estimates 1990 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2020 2030 3.9% 3.4% 2.9% 2.4% 1.9%

INVESTMENT THEME
Increased Health Care Utilization

60 55

KEY TAKEAWAYS

Aging populations in developed countries will need more health care. As emerging markets adopt modern medical practices, their consumption of health care will increase. Growing global utilization may benefit providers of low-cost, high-volume health care products that will be demanded in both developed and developing countries.

Older and less healthy populations in the developed world are expected to drive increased usage of medical procedures and therapies. In the U.S. alone, the over-65 population is on track to more than double in the next 20 years. As this demographic group gets larger, and with it, spending on health care, the costs of the federal governments Medicare program are projected to likewise double over the same period (see Exhibit 1, right). Specifically, manufacturers of relatively low-cost but high-volume medical products such as sutures, needles, and intravenous (IV) catheters are positioned to profit from additional surgical procedures and hospital stays. Producers of more expensive medical devicessuch as replacement knees and hips, pacemakers, and defibulatorsand hospitals and other health care facilities may also see their volumes increase, although attempts by governments and insurance companies to contain costs by putting pressure on reimbursement rates may limit the rate of growth of these health care providers. Emerging markets are another driver of increased utilization. Currently, the percentage of GDP spent on health care is much lower in these markets than in developed countries. As the developing world becomes more affluent and adopts modern health care 19

Source: 2008 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds.

products and services, per-capita spending has the potential to rise quickly (see Exhibit 2, page 20). There is also evidence that populations become more susceptible to medical conditions such as obesity and diabetes as they become more prosperous. U.S. health care companies are viewed as bestin-class across the world, so there may be an opportunity to develop strong export industries in pharmaceuticals and medical devices, among others, to rapidly growing countries such as China and Brazil.

Investment implications
Aging populations in the developed world and the adoption of modern health care by the developing world are expected to drive increased usage of medical products and services. Understanding these trends can help to focus investments in companies that can benefit from the secular tailwind of growing global utilization of health care, while staying away from companies that face the headwinds of pricing pressures and reduced reimbursement rates.

EXHIBIT 2: Rapidly growing emerging markets spend less on health care, but per-capita spending has been rising. PER-CAPITA TOTAL EXPENDITURE ON HEALTH (USD)
U.S. +58% 8,000 7,000 6,000 5,000 4,703 4,000 3,000 2,000 1,000 0 265 734 96 475 44 169 China 21 45 India 7,410 BRICs Total +234% 2000 2009

If these rising costs cannot be borne by the public sector, and society is unwilling to accept restricting access to health care through rationing and other means, alternatives must be found in the private sector. Eventually costs could be shifted to consumers, but in the near term, limiting the growth of health care expenditures may be a betterand perhaps the onlysolution. Companies with deflationary business models can help to cut costs in the first place, and they are expected to be part of the solution to arrest the growth of health cares share of GDP. Some classic examples of deflationary business models are health care information technology to digitize medical records and pharmacy benefits managers to standardize prescription drug treatments. In addition, generic drug makers have gained prominence with the prospect of $117 billion in branded pharmaceuticals going off patent in the U.S. through 2020.2 Other value propositions include coated catheters, which can command a pricing premium of as much as 200% because they cut the risk of urinary tract infections (UTI) by an estimated 50%. These infections are often caused by uncoated catheters that are put in wrong, and treating a UTI may cost a hospital from $30,000 to $100,000. Techniques to limit blood loss in general surgery can also yield big savings, and bio-erodible sutures eliminate the cost of suture removal.

United States Brazil

Russia

Note: Data at average US$ exchange rate as of Mar 10, 2011. Source: World Health Organization. BRICs: Brazil, Russia, India, and China.

INVESTMENT THEME
Deflationary Business Models

Investment implications
Spending on health care has been rising as a share of GDP, and the global growth slowdown has made government budgeting for these expenditures even more difficult. Economy-wide deflation may have a negative association, but medical cost deflation could be the best way to make health care spending grow slower than GDP. Firms in the health care sector with ideas that can help to bend the cost curve down should be well positioned to take advantage of the trend to cut health-care costs. EXHIBIT 3: Global health care expenditures are high, especially in the United States. HEALTH EXPENDITURE SHARE OF GDP
30% 25%

KEY TAKEAWAYS

Governmentsthe largest payers for health careare facing significant fiscal challenges. Rationing of resources or access to care is politically and socially unacceptable, as is shifting costs to consumers. Bending the cost curve down may be the only way to limit the growth of future spending.

Demographics are not the only driver of rising health care costs in the U.S. When passed in March 2010, the Patient Protection and Affordable Care Actpopularly called Obamacarewas intended to lower spending on medical care over time. However, by improving accesspotentially adding 32 million new insured patients to the health care system by 2014this reform legislation may be more likely to bend the cost curve up than down. The public sector is the biggest provider of health care around the world. In the current environment of weak global economic growth, many governments are facing difficult budgetary situationsif not outright fiscal crises. The U.S. is no exception. The U.S. spends $2.4 trillion per year on health care, the highest amount in the developed world. Public and private health care costs represent 16% of total economic output, and by 2025, this share is expected to grow to 25% of GDP (see Exhibit 3, right).1 Further increases in medical costs are not economically sustainable. In the U.S. and elsewhere, rising health care costs threaten to crowd out other public-sector investments into more productive areas that could enable and support stronger economic growth. 20

2008 (OR LATEST YEAR AVAILABLE)

20% 15% 10% 5% OECD Average Japan Canada U.S. 2025 Est. Netherlands U.S. Current Mexico Switzerland S. Korea Sweden Norway Germany France 0% U.K.

Source: Organization for Economic Co-operation and Development (OECD) Health Data 2010. Includes public and private expenditure.

INVESTMENT THEME
Personalized Medicine

EXHIBIT 4: Innovation is in our DNA; the cost per genetic data point is falling dramatically. COST TO SEQUENCE A HUMAN GENE 1990PRESENT
100,000.00 10,000.00 1,000.00 13 years ~$3,000,000,000

KEY TAKEAWAYS

$Millions

Game-changing innovation in biotechnology and medical devices can drive growth in the health care sector. Human genetic sequencing will enable the development of true personalized medicine. This trend is still in its infancy, but capital investments from the public and private sectors will help targeted diagnostics and lifesaving therapies become a reality over the next 1520 years.

100.00 10.00 1.00 0.10 0.01 0.001 1990 2001 < 2 weeks ~$10,000 2007 2009 2012 Moores Law

Health care has seen continued innovation, from the smallpox vaccine at the end of the 18th century, to the first organ transplant in the middle of the 20th century, to the sequencing of the human genome at the beginning of the 21st century. Such advances can drive growth in the health care sector. A key enabler of the trend toward personalized medicine is the ability to harness DNA data through genetic sequencing. The first human genome was sequenced in 2003 after more than 13 years and at a cost of nearly $3 billion. Soon, sequencing a human gene could take less than two weeks and cost as little as $10,000 (see Exhibit 4, right). Biotechnology has been one of the most highly innovative health care industries. As knowledge of biology continues to grow exponentially, we are entering the era of Biotech 2.0, in which targeted diagnostic tests are accelerating advances in the truly life-changing therapies of personalized medicine. Molecular diagnostics are at the leading edge of genetic profiling. With an estimated 90% of prescription drugs working only about 50% of the time, prescribing physicians could use molecular diagnostics to test for specific genetic mutations which might cause one drug to be harmful, while another might be safe. This could not only save 50% of drug costs, but also help prevent a leading cause of unintended death.3 Nutrition and wellness companies are also using DNA data to create products that target consumers based on their unique disease or health profiles. Companies that provide genetic sequencing diagnostic kits and services for labs hold the key to harnessing the DNA data required to fuel fundamental research and commercial product development. The U.S. personalized medicine market is estimated at $232 billion today, and is projected to double to $450 billion by 2015, an increase of 11% per year.4 In the medical devices industry, new techniques are being developed to deliver heart valves through catheters into a beating heart,

Cost of sequencing a genome is falling faster than Moores Law (cost of computing power declines 50% every 18 months). Source: Company data, Life Technologies, June 2010.

rather than through invasive open-heart surgery that requires cracking ribs open and stopping the heart. Such procedures have the potential to save lives and fundamentally change the way cardiologists practice medicine.

Investment implications
New innovations in the health care sector can create compelling opportunities, but it is important to understand that these are long-term endeavors, which may require 1520 years of research before there is any significant payoff. Such a lengthy investment horizon to achieve what is so clearly a public good might argue for government funding, and the U.S. National Institutes of Health (NIH), with a budget of $30.7 billion, have so far supported the core work in bioscience leading to personalized medicine.5 The focus on federal deficit reduction may limit the NIH budget going forward, so private sources of funding will be needed to fill the gap. It is also important to recognize that developing personalized drug therapieslike all other medical breakthroughswill involve significant trial-and-error. Understanding the underlying science, as well as in-depth knowledge of the participants in the research process, will be essential elements of a successful approach to investing in personalized medicine. If the pattern of innovation and commercialization in the information technology sector is any guide, however, such patience and diligence are likely to be rewarded.

21

Industrials
Tobias Welo, Portfolio Manager

The industrials sector consists of companies engaged in providing industrial and commercial equipment and services, distribution operations, and transportation. One of the hallmarks of industrials is the diversity of end markets served by the companies within the sector. From construction and farming machinery, to airlines and railroads, to waste management and consulting service companies, the industrials sector has a very broad set of constituents. It is also global in scope, featuring more exposure to emerging markets than any other sector. While industrials is considered a cyclical sector, some industries and businesses outperform in the earlier part of the economic cycle, and others outperform in the mid and late stages of the economic cycle.

industrial industries is overestimated. While many major Chinese industrial companies have solid domestic market share, few, if any, currently have strong footholds outside of China. Our research shows that its competitive export threat in many industriesparticularly within developed markets such as the U.S. and Europeis minimal, and is likely to remain so for at least the next decade. Nevertheless, we have great respect for how Chinese companies are progressing and the competitive threat they represent longer term.

Barriers to entry
As of now, Chinese industrials are almost non-existent in developed markets. In the McKinsey survey referenced earlier, global management teams reported that the ability of China to produce quality goods was among their lowest worries. Along those lines, our analysis demonstrates that China faces a number of other barriers to overcome before it can be considered a legitimate competitive threat to developed markets (Exhibit 1, below). Our research shows that what benefits Chinese companies in their domestic marketlike government support and low-cost manufacturing/laborare less advantageous abroad. While some companies in certain Chinese industries are closer to competing with foreign manufacturers (e.g., cranes, concrete pumps, power transmission), others are well behind the curve (e.g., aerospace components, automation, mining equipment, gas power generation) due to the EXHIBIT 1: A snapshot of Chinas major competitive disadvantages. ASSESSING END MARKET RISK: 5 KEY BARRIERS TO ENTRY

INVESTMENT THEME
Competitive Threat from China

KEY TAKEAWAYS

Many business leaders believe China poses the biggest competitive threat to developed-market companies in a number of industrial industries. While acknowledging Chinas growth, our analysis tells us that the competitive threat is overestimated, and that China is faced with a number of barriers to entry. Chinas ability to gain market share is highly dependent on industry-specific dynamics, but regardless of where it is on the competitive threat road map, multiple investment opportunities exist within the industrial universe.

In a 2008 McKinsey Consulting survey of management teams across the globe, China was viewed as being the greatest competitive threat of any emerging region.1 Corporate executives regarded the nations low-cost manufacturing ability as its key competitive advantage. Chinas economic expansion during the past decade has been remarkable, and companies and investors around the world are closely monitoring this developing market and its overall impact on the global economy. But while it is true that Chinese companies are taking share in a number of end markets, our analysis leads us to believe that, contrary to popular opinion, the competitive threat from China in 22

1 2 3 4 5

Weak product sophistication (technology) Difficulty in sourcing key components Lack of a strong distribution network High service requirements Government involvement

aforementioned barriers to entry. For example, few Chinese companies have the technology, research/development infrastructure, and safety and emission standards to compete with U.S. and European component suppliers. As such, U.S. and European component suppliers have a competitive advantage in China and abroad. The growth and expansion of Chinese industrial companies have followed a general pattern. Most of the prominent Chinese industrial companies today started out as state-sponsored entities in end markets that the government felt were strategic. The subsequent growth of these Chinese companies has generally followed a three-step process: 1. Develop capabilities and establish large market share positions in China itself. 2. Expand to other emerging markets such as India, Russia, and Indonesia. 3. Enter developed markets (a point at which very few Chinese companies/industries have arrived). This strategic progression is further illustrated in Exhibit 2 below, which also shows how close (and how far away) various Chinese industries are from entering developed markets. Logically, the rate of Chinese market share gains in other emerging markets will be relatively faster than in developed economies.

specific competitive dynamics. In consideration, weve identified several potential themes for investment. For example, to simply avoid the threat of Chinese competition, investors may want to consider industries in which China is very early in their development, such as aerospace suppliers, automation, oil/gas equipment, and health care. Conversely, in industries where the Chinese have made the most domestic progress, such as cranes, shipbuilding, wind, construction equipment, and power distribution, foreign companies with high China and emerging-market exposure are probably most at risk. Chinese companies that appear poised to take global market share are potential opportunities; we believe machinery, auto, and trucking companies are among them. Finally, in our analysis, we believe suppliers of key component technologies across end markets are well-positioned to benefit from the global expansion of Chinese original equipment manufacturers, which rely on the technological sophistication of component providers.

INVESTMENT THEME
Energy Efficiency

KEY TAKEAWAYS

Investment implications
While the Chinese are gaining share in many end markets, there are also industries in which they are losing share. The direction and rate of market share moves are highly dependent on industry-

Growing demand and a limited supply of natural resources, combined with increased social and political focus, are driving consumers and corporations toward more efficient technologies and ways to consume fewer natural resources.

EXHIBIT 2: Based on our analysis, few Chinese industrial industries pose a significant competitive threat in developed markets. THE CHINESE COMPETITIVE THREAT ROAD MAP
Concrete Pumps Cranes Shipbuilding Wind Turbines Power T&D Construction Equipment Enter Other Auto Emerging Rail Markets Class 8 Trucks Chinese AWPs Least Advanced Min Hydraulics Establish ing Dies Equ Large Share in el P Farm E ipm Hea owe quip ent lthc r Ge Chinese Market men are nera t Oil/G Equ tors as E ipm Auto Aero ent ngin mat spa es ion ce State-Sponsored Company in China Time Source: Fidelity Asset Management, Nov. 15, 2011. Enter Developed Markets

Chinese Most Advanced

23

Global Market Share

Global power consumption is expected to steadily increase over the next two decades, requiring new and better supply-side solutions. The adoption of energy-efficient products is a multiyear trend that could generate strong returns on investment.

Energy efficiency is a compelling investment opportunity in companies developing the technologies that drive more efficient use of resourcesand energy in particular. Growing demand and a limited supply of natural resources are driving consumers and corporations toward more energy-efficient technologies. The usage and protection of natural resources continues to be a major social and political issue as well. Society as a whole has become more conscious about protecting the environment from pollution and the sometimes-harmful side effects of procuring, processing and consuming natural resources. Governments globally are also looking to secure resources needed to fuel economic growth and maintain a stable quality of life for their citizens. However, it hasnt been until more recently that going green has become an economic decision for many corporations and consumers. Demand for natural resources is rising due to a combination of factors, including population growth, increased power consumption in developed economies, and the rapid modernization of emerging markets. These forces are expected to drive up global power consumption by nearly 50% (see Exhibit 3, below) by 2035. This demand growth has already led to higher energy costs, which will rise even more if current supply constraints for commodities such as oil and coal remain intact. Since December 2001, prices for electricity and gasoline have risen 183% and 40%, respectively.2 As a result, both consumers and corporations have felt the energy inflation pinch and are seeking new ways to cut costs. EXHIBIT 3: Power consumption is expected to climb roughly 50% during the next 25 years. WORLD ENERGY CONSUMPTION (QUADRILLION BTU)
800 700 600 500 400 300 200 100 0 2007 2015E 2020E 2025E 2030E 2035E Non-OECD OECD +49%

Technological innovation within industrials is creating solutions to real problems. Future power needs will be met through a combination of developing technologies, both in the source and use of energy. Many of the supply-side solutions, such as solar energy or unconventional drilling, have good potential, but are still early in their adoption and face economic, political or environmental pressures. However, on the usage side, companies developing more efficient lighting, engines and HVAC systems are seeing strong adoption. Many of these energy-saving technologies already have payback periods of just 3-5 years, making buying energy-efficient technologies an easy call for both the homeowner and the corporate CFO. The U.S. Energy Information Agency (EIA) estimates that the adoption of energy-efficient technologies could lead to an 8%-13% decrease in per capita commercial energy consumption, and that is despite the modernization of massive populations in emerging markets. The energy-efficiency industry is characterized by high-quality companies with strong balance sheets, solid cash flows and proven management teams. There are four chief segments of power usage: transportation, residential, commercial and industrial.

Investment implications
Analyzing the technological developments across each of these segments is the key to determining the market and investment opportunities in the industry. While the energy-efficiency industry may experience volatility due to business cyclicality, the adoption of energy-efficient products appears to be a multi-decade trend that could generate strong profits. Companies with a technological advantage should be able to capitalize on the trend and drive favorable returns for shareholders.

INVESTMENT THEME
Infrastructure Replacement

KEY TAKEAWAYS

Much of the infrastructure in the United States is in disrepair, presenting a potential long-term investment opportunity in companies charged with rebuilding America. A similar case exists in developed markets overseas, and the build-out of infrastructure in emerging markets could represent a $6 trillion opportunity. Government budget deficits around the world have opened the doors to private investment, easing previous barriers to entry.

Source: U.S. Energy Information Agency (EIA), as of Dec. 16, 2010.

Nearly every category of Americas infrastructureits roads, bridges, schools, rail transit, levees, aviation systems, etc.are crumbling, neglected by years of underfunding and low maintenance. High-profile infrastructure catastrophes, such as the levee failures during Hurricane Katrina and the Minnesota bridge collapse in 2007, are calling attention to the problem, but at a heavy price. Meanwhile, billions of dollars need to be invested to upgrade Americas electric grids to meet both current needs and future growth.

24

In his State of the Union address in January 2011, President Obama emphasized the need to start rebuilding America:
Our infrastructure used to be the best, but our lead has slipped. South Korean homes now have greater Internet access than we do. Countries in Europe and Russia invest more in their roads and railways than we do. China is building faster trains and newer airports. Meanwhile, when our own engineers graded our nations infrastructure, they gave us a D.
3

EXHIBIT 4: According to one engineering organization, it will take significant investment to improve the grade-point average of Americas infrastructure.
2009 Report Card for Americas Infrastructure Aviation Bridges Dams Drinking Water Energy Hazardous Waste Inland Waterways Levees Public Parks and Recreation Rail Roads Schools Solid Waste Transit Wastewater Americas Infrastructure GPA Estimated 5-Year Investment Need Note: Each category was evaluated on the basis of capacity, condition, funding, future need, operation and maintenance, public safety, and resilience D C D DD+ D DDCCDD C+ D DD $2.2 trillion A = Exceptional B = Good C = Mediocre D = Poor F = Failing

The engineers to which he referred are the American Society of Civil Engineers (ASCE). Every four years, the ASCE publishes a report card on the condition of Americas overall infrastructure. The most recent one was released in 2009. As President Obama pointed out, the grades were alarming (see Exhibit 4, right). The World Economic Forum, which in 1995 listed U.S. infrastructure as tops in the world, now ranks the America in 23rd place.4 To improve that ranking and bring our nations infrastructure back to a state of good repair, the ASCE estimates that it will take an investment of $2.2 trillion in public and private funding over the next five years.5

A global concern
Aging infrastructure is not just a domestic problem. Other major post-industrial nations are struggling with the same issue. For example, in February, the European energy commissioner categorized Europes electricity infrastructure as aging and not prepared for future challenges.6 To help address this shortcoming, the European Union announced in October 2011 its intention to invest 50 billion euros ($68 billion) by 2020 in new cross-border transport, energy, and broadband projects.7 By definition, the replacement cycle theme is more of a developed-market theme than an emerging-market (EM) one. Nevertheless, the EM opportunity is considerable. For developing nations, the problem isnt so much an issue of replacing infrastructureits a lack of infrastructure to begin with. Future economic growth in emerging markets largely depends on urbanization and industrialization. Accordingly, emerging-market governments are committing $6.3 trillion to address the need for infrastructure, according to report by Bank of America Merrill Lynch.8 Infrastructure is a key foundation of any economy and typically represents a sizable component of a nations GDP. But with many governments around the world facing rising budget deficits, privatization and private funding have increased considerably. As a result, previous barriers to entry for private investorssuch as high minimum investments and a lack of liquidityare being overcome.

Source: American Society of Civil Engineers, 2009 Report Card for Americas Infrastructure (http://www.asce.org/reportcard/).

on upgrading and maintaining this infrastructure. Also, infrastructure generally has high development costs and is often in use for multiple decades, meaning it is managed and financed on a long-term basis. In emerging markets, the push for infrastructure has expanded the investment opportunity exponentially. This strong global demand for new and improved infrastructure makes it a potentially lucrative area for investmentone with stable long-term cash flows streams, capital appreciation, and low correlation with other asset classes. All investing entails risk, and infrastructure is no exception. If government spending is insufficient in the U.S. and if regulatory obstacles occur in emerging markets, the rate of growth could suffer. But, given the seemingly inevitable and considerable spending expected on infrastructure around the world, it has the potential to be a profitable opportunity over the short, medium, and long term, and we will be watching it closely.

Investment implications
In developed markets, older infrastructure is becoming rundown. This depreciation leads to billions of dollars spent

25

Information Technology
Charlie Chai, Portfolio Manager

The information technology (IT) sector includes companies that study, design, develop, implement, support, or manage computer-based systems. Whether providers of components, hardware and equipment, or software services, IT firms tend to have a multinational presence and cater to a particular endmarketenterprise or consumerand specific sectors, such as government, industrials, and financials. The performance leadership of these categories varies during the business cycle: components and consumer-related stocks tend to be earlycycle, hardware stocks are typically mid-cycle, and software services and enterprise-related stocks are generally late-cycle. Technology has been characterized as having a higher overall risk profile relative to other sectors, largely because the sector is driven by continuous innovation, with rapid obsolescence as a consequence. While many tech companies have reached a more mature phase of the lifecycle during the past 10 years, there are compelling early-stage themes that hold promise for investors in technology.

cations to unprecedented levels. In the process, these companies acquired significant expertise in how to run a data center efficiently in terms of capital and operating costs, including power and cooling costs. They also learned how to operate with flexibility, ramping up and down applications with big user bases and high traffic volumes. Delivering computing power to customers became a way for Internet companies to smooth utilization peaks and valleys, while generating new streams of revenue at minimal incremental cost. At the same time, dramatic increases in the throughput of hardware and software resulted from innovations in data-center technology, especially the virtualization of servers, storage, and networking. Multiple virtual machines can run multiple applications on different operating systems on a single physical computer or across multiple computers, improving performance and availability, while reducing capital and administrative costs. At the enterprise level, the cloud can replace expensive in-house data centers and IT departments with state-of-the-art technology networks that are not only cheaper, but also more flexible and reliable. Outsourcing IT can benefit an organization in several ways. Workloads can be shifted to virtualized platforms from legacy proprietary platforms that have been costly to develop, maintain, and upgrade. Centralized networks can achieve economies of scale, providing a better cost structure for hardware. Shifting workloads to external resource clouds enables scalable and on-demand computing, so that companies can offload at usage peaks or even outsource completely. For consumers, cloud computing will allow applications to be delivered from a remote data center over a network to a variety of personal devicessmartphones, tablets, and so on. Applications can run in network browsers, which will accelerate content delivery, while applications that still run on local hardware and operating systems can connect to the cloud for data and updates. Shifting functionality to the cloud can make personal devices less expensive and more powerful. Even within businesses, cloud functionality has supported a consumerization of IT as end-user demand for mobility and the desire to use best-of-breed devices have moved purchase decisions from IT managers to employees. Technology users face some trade-offs when moving to the cloud. Privacy and security controls may be issues for enterprises and con-

INVESTMENT THEME
Cloud Computing

KEY TAKEAWAYS

Virtualization technologies have successfully decoupled hardware from software and services, dramatically lowering the per-unit cost of networks, servers, and storage devices. Enterprises and consumers have become more open to outsourcing their applications and data to the metaphorical cloud. Investments in providers of Internet infrastructure, applications, and security have the potential to benefit from the trend toward centralized computing.

Every decade or so, there is a major architectural shift in technology where a dominant ecosystem emerges and results in massive wealth creation. Cloud computingusing networks rather than local computers to manage data and run softwarerepresents such a shift today. Even after the technology bubble burst in 2000, major Internet companies and some data-center hosting companies experienced rapid growth in traffic and data, forcing them to scale their appli26

sumers alike, especially given the possibility that cyber attacks could infiltrate cloud networks. Recognizing that the cloud may actually offer an advantage if the provider can hire the best security experts in the field, consumers are becoming more comfortable with semipublic/private environments, and organizations are increasingly willing to allow the external management of data security.

Users will benefit initially from lower start-up costs, and developers of popular applications can generate significant subscriber revenue on an ongoing basis.

Investment implications
Opportunities to invest in the cloud ecosystem include platform providers, whose value-added will likely be in the management software to run large-scale virtualized systems. The complexity of these systems allows little scope for standardization and commoditization, so even though the cloud is still hotly contested, early providers are likely to capture the majority of market share. They may even benefit from the creativity of othersnamely, application developers whose products run on their infrastructure platforms. Initially there may be boutique virtualization and security providers. As customers become more concentrated, however, a limited number of platform providers may become more powerful and acquire these boutiques, so that eventually 510 cloud vendors may offer data security as a key part of their vendor value proposition. There are still some questions about this ecosystem: How will different clouds interact? Will there be a federation of clouds? What about data that are too sensitive to risk a security breach on the cloud? Will browsing through commercial networks raise concerns about privacy and the collection of personal information? Successful investing in cloud computing will require thoroughly understanding the transformation of the technology as well as the potential regulatory issues that may surface. Cloud computing may be in the early stage, but this trend is already beginning to change the face of innovation in the information technology sector.

Accessing software as a service (SaaS) is a direct result of cloud computing. Under the traditional model, even a small- or mediumsized enterprise (SME) would incur significant start-up costs of software application licensing and installation, as well as ongoing expenses for maintenance, renewals, upgrades, and professional services such as IT consultants. Similarly, consumers had to purchase and support software on their own computers. With SaaS, the cost of starting and running a business has fallen dramatically. Computing power is now a commodity, delivered like any other utility on a pay-per-use model. The SME can implement new software applications and add capacity incrementally. The application provider maintains the infrastructure, saving the subscriber the cost of hardware servicing and obsolescence every 35 years. The feedback from subscriber usage patterns can allow the software provider to make continuous improvements. Frequent updates can occur automatically in the centralized version available to all subscribers, who no longer need to pay for renewals and upgrades, or to hire expensive consultants for retraining in the new versions. Businesses can benefit from the ability to access industry-leading customer relationship management (CRM) tools through the cloud. Another organizational need that can be met successfully with a cloud-based model is enterprise resource planning (ERP) for essential corporate functions, including finance and accounting, operations, and human resources. Similarly, consumers can use cloud networks to access applications and share files for word processing, spreadsheet analysis, and tax preparation, among many others. They can also benefit as newer and cheaper apps can be developed and delivered faster as a service. Providers of consumer-oriented applications can take advantage of having more direct channels to their customers, so that their great ideas and coding ability can be tested online and continuously upgraded as users demand new features. Once again, there are some tradeoffs associated with SaaS relative to the traditional model. Along with the privacy and security concerns inherent in cloud computing, firms lose the ability to customize applications to their exact needs. However, such customization has often been found to be ineffective and inefficient, since most business needs are similar. Lengthy development projects tend to result in shelfware that is too late to market and never implemented.

Cloud computing may be in the early stage, but this trend is already beginning to change the face of innovation in the information technology sector.
INVESTMENT THEME
Software as a Service

KEY TAKEAWAYS

As virtualization and other technology developments break the link between applications and the hardware on which they run, software can be offered as a service rather than a product. The shift from servers to services can provide tremendous cost savings in application development and maintenance to a variety of businesses.

Investment implications
By eliminating the need to acquire and implement proprietary IT infrastructure, the cloud is reducing the costly barriers to entry faced by start-up businesses, especially the costs to develop and

27

maintain software applications. When software is obtained on a subscription basis as a service from a third-party provider, and not purchased as a product, companies are no longer responsible for the ongoing expenditures required to manage applications internally. Consumers can also avoid buying expensive software by paying only for what they use. Software developers are able to test, improve, and deliver applications to enterprises and consumers more rapidly and cheaply. Given these benefits, SaaS is estimated to be growing at a 17% annual rate.1 Cloud providers have been able to capitalize on the SaaS trend by taking a share of the revenue from applications delivered on their Internet infrastructure. Having the ability to identify the software developers who can find ways to profit directly from their own creativity is likely to be critical to investing in this paradigm.

EXHIBIT 1: Globally, mobile data has been expanding exponentially. GLOBAL MOBILE DATA TRAFFIC 20102015
7 92% CAGR 2010 6 5 4 3 2.2 2 1 0.2 0 2010 1.2 0.6 2011 2012E 2013E 2014E 2015E 3.8 6.3

INVESTMENT THEME
Big Data

KEY TAKEAWAYS

New types of large data sets have emerged because of advances in technology, including mobile computing, and these data are being examined to generate new revenue streams. More traditional types of business data have also expanded exponentially, and companies increasingly want and need to analyze this information visually and in real time. Big data will be driven by providers of internet media platforms, data amalgamation applications, and integrated business software and hardware systems.

Exabyte = 1 million terabytes. CAGR: Compound Annual Growth Rate. Source: Cisco VNI Mobile, 2011.

The concept of big data generally refers to two concurrent developments. First, the pace of data accumulation has accelerated as a wider array of devices collect a variety of information about more activities: website clicks, online transactions, social media posts, and even high-definition surveillance videos. A key driver of this flood of information has been the proliferation of mobile computing devices, such as smartphones and tablets. Mobile data alone are expected to grow at a cumulative annualized rate of 92% between 2010 and 2015 (see Exhibit 1, right). Second, businesses are looking to derive interesting insights from customer profiles and actions to help them develop products and services, as well as recommendation engines that can drive sales. Yet this new kind of information is considered unstructured because there is usually more textand sometimes audio and videothan numbers, so it is not suited to traditional database models. Current relational database management systems (RDBMS) can handle only structured data, which account for about 15% of total data. Unstructured datathe larger 85% sharerequire other methods.2 Fortunately, technology hardware has evolved to facilitate the analysis of unstructured data. Distributed systems divide problems 28

into multiple tasks, which can be solved by parallel computing computers built with multiple processors that work simultaneously. The acceptance of Internet-based cloud computing has also played a role in the explosive growth of big data, as has virtualization on the application side. Such technologies provide higher performance at lower cost, while improving flexibility, reliability, and scalability. As the volume and variety of data have expanded, the expense of gathering, analyzing, and managing data has contracted. Businesses are taking advantage of these developments to use IT in new ways. Foremost is the application of predictive analytics, which can help determine that if a, b, and c, happen, then there is a good chance that d, e, and f will also happen. This is far from just a science-fiction scenario of machines starting to think for us. Internetbased companies are investigating usage patterns to help optimize website design and content creation to boost traffic and sales. Financial institutions are segmenting customers by credit card behavior and tailoring products to specific risk profiles. Retailers are capturing data feeds from rewards card programs and online transactions to influence what product inventory to carry and how to price it. All types of companies are acquiring and mining data from social networks to conduct real-time research on breaking trends.3 More broadly, big data technologies have the potential to fundamentally change how business is conducted. The algorithms developed to analyze the new sources of information described above can also be applied to more traditional forms of enterprise

Exabytes per Month

data to optimize plant utilization and labor force deployment, for example. Companies are just starting to scratch the surface, but they may be able to realize the potential when they master the technologies needed for rigorous examination and experimentation with big data.

nies offering IT services and middleware that connects separate software applications. This theme is also having an impact on existing players in the database, storage, and business intelligence markets. Equipment manufacturers and resellers have taken notice, and many have acquired providers of software solutions for managing and analyzing unstructured data. Investors hoping to capitalize on this theme need to be aware that once a technology market becomes more mature, there is inevitably consolidation. The key to investing in long-term winners in the big data space is identifying companies that will have escape velocity. In other words, companies that reach a certain critical size ahead of their competitors will likely continue to command a dominant share of the market.

Investment implications
At the same time that the amount of data has increased exponentially, the cost of analyzing data has decreased dramatically. The growing desire to perform real-time analyticswhether to test product and service innovations or to inform business decisionmakingis driving the development of infrastructures and applications to handle big data. Overall change in the technology markets has accelerated, which tends to be positive for compa-

29

Materials
Tobias Welo, Portfolio Manager

The materials sector comprises companies that are involved in the discovery, production, and processing of both raw materials (gold, copper, timber) and synthetic materials (chemicals, containers, packaging, and steel). The sector is made up of three primary industry groups: 1) chemicals, 2) metals and mining, and 3) paper and packaging companies. While materials is considered a cyclical sector, industry performance can vary within the sector due to supply levels and the health of end markets. Many components of the sector are considered to be performance leaders during the early stages of an economic cycle, particularly chemicals and paper products. Conversely, some companies within the materials sector have very defensive characteristics, such as companies that make bottles and cans. Some segments tend to have their own cycles. For example, agriculture is typically driven by factors related to weather, regulatory concerns, and emerging-market demand. Gold, meanwhile, is sensitive to the ebbs and flows of the global economy.

protein (Exhibit 1, below). Increased food demand from emerging economiesa result of higher per capita incomeis responsible for much of the increased consumption. For example, Chinese per capita consumption of meat and dairy rose 91% and 300%, respectively, from 1992 to 2007.2 While demand growth has been strong for some time, the recent sustained period of high global growth has taken a large toll on global inventories, particularly of grains. This creates a multiplier effect on the demand for agriculture, as it takes nearly 10 pounds of corn to develop one pound of beef.3

A boom in biofuels
Another important driver of agriculture demand is the increasing use of biofuels. The rising economic and environmental costs of fossil fuels have mobilized world political leaders to search for alternatives, such as ethanol made from corn or sugar. In America, 40% of the corn crop is currently diverted to make fuel for cars.4 Many analysts expect that the U.S. ethanol mandate set by the Renewable Fuel Standards, a program created under the Energy Policy Act of 2005, will continue to grow. In October 2010, the EPA granted partial approval for usage of E15, a blend of 15% ethanol and 85% gasoline.

INVESTMENT THEME
Agriculture Demand

KEY TAKEAWAYS

The rising global population is contributing to a substantial increase in food consumption and demand, particularly from emerging markets. The proliferation of biofuels is another major driver of agriculture demand, and higher prices as well. A dwindling supply of arable land is compounding the demand challenges, but creating opportunities for companies that can provide more efficient ways to grow and harvest crops.

EXHIBIT 1: Global food consumption is on the rise. DAILY CALORIE CONSUMPTION PER CAPITA
1964-66 3500 1974 -76 1984-86 1997-99 2015 est 2030 est

Based on our analysis, there is a compelling investment opportunity in the agriculture industry due to strong demand, limited natural resources, and a finite number of supply solutions. Continued world population growth has always been a stable driver of agricultural product consumption. The world population is expected to increase from 6.9 billion in mid-2011 to 9.3 billion in 2050.1 Placing more pressure on demand are two factors: changing diets and biofuels. As consumers in developing regions improve their standard of living, they are also consuming more food and, in particular, more 30

3000

2500

2000

1500 World

Developing Countries

Industrial Countries

Source: United Nations (www.fao.org).

Biofuel mandates in the U.S. and the European Union that favor domestic production will continue to put pressure on prices. According to the United Nations (U.N.), world food prices in 2011 were at their most expensive levels in real terms since the U.N. first began tracking the numbers in 1990. Grains, in particular, saw sharp increases: corn prices were up 53% and wheat prices rose 47%.5

added to the soil annually, potash stays in the ground for multiple years. As a result, farmers tend to put off investing in potash while crop prices are low, and then buy it when high prices give them strong incentive to boost yields. Potash producers are making a huge margin todayand they should continue to display strong pricing power because of a global potash shortage thats likely to last several years. Seed companies also have a strong outlook. This space is dominated by just a few competitors, so they tend to be stable, highreturn businesses. In addition, pricing power is also improving due to innovation, as seed producers continue to develop new seeds that can improve crop yields. Seeds appear to be an attractive opportunity in the long term because it is likely to be a supplyconstrained market (see Exhibit 2, below left).

Supply limited by acreage and crop yield

Many companies in the agriculture industry are providing solutions to the worlds food crisis by helping farmers increase crop yields. For example, producers of potash, phosphates and nitrogen are providing the needed ingredients to improve land fertility. In addition, makers of agriculture equipment are developing more efficient technologies, including GPS-enabled harvesting machines that make harvesting crops more efficient, while lessening the negative impact on soil. Finally, agricultural chemical companies are developing genetically modified seeds with traits that make them less susceptible to pests and disease.

INVESTMENT THEME
United States as a Low-Cost Chemical Producer

Investment implications
While there are certain to be economic and natural forces that lead to swings in earnings for the agriculture sector, we believe it still offers attractive long-term investment opportunities. Private investment in agriculture globally is expected to double to around $5 billion to $7 billion in two years.6 The key will be to identify those companies with the technological and operational advantages that can drive potentially favorable returns. Specifically, we see opportunities in fertilizers, particularly potash producers. Potash is one of the three main types of fertilizer, along with nitrogen and phosphates. Unlike nitrogen, which must be EXHIBIT 2: Food demand is rising across the earth, but the amount of arable land has steadily declined. ARABLE LAND PER CAPITA (HECTARES)
0.60 0.50 0.40 0.30 World Africa Eastern Asia Southern Asia

KEY TAKEAWAYS

U.S. chemical companies are one of the largest users of natural gas, which is a key input into many chemical processes. Helped by large supplies of shale gasnatural gas trapped in sedimentary rocksthe balance of trade for the U.S. chemical industry turned from a $140 million deficit into a $4.6 billion surplus. The low price and abundant supply of natural gas in the U.S. gives domestic chemical companies a significant advantage over foreign competitors, who rely on more expensive crude oil.

The chemicals industry is by far the largest segment of the materials sector. Chemicals are the raw materials used in almost every manufacturing process and end market imaginablesuch as plastics, paints, fuels, fabrics, glass, cosmetics, pharmaceuticals, and literally tens of thousands of others. More than 96% of all manufactured goods are directly touched by chemistry, and many are the building blocks of materials that are feeding economic growth around the world. Drug innovations based in chemistry have helped increase the life expectancy in the U.S. by 30 years over the past century.7 Today, we see a number of trends in the chemicals industry that appear capable of driving higher margins for years to come. One in particular involves natural gas, a key input in chemical production.

Natural gas: low prices, abundant supply

0.20 0.10 0.00

Source: United Nations (www.fao.org).

U.S. chemical companies are among the worlds biggest consumers of natural gas, which serves as both the primary raw material in countless end products, as well as the primary energy source used in the manufacturing process itself. Because of their dependence on natural gas, chemical company profit margins are very sensitive to the price and supply of natural gas. Currently, both dynamics appear to be extremely favorable for U.S. chemical companies that use natural gas as a key input.

2000

31

2004

2008

1968

1984

1988

1964

1996

1976

1980

1992

1972

EXHIBIT 3: Shale gas is expected to account for nearly half of all U.S. natural gas production by 2035. U.S. NATURAL GAS PRODUCTION (19902035, TRILLION CUBIC FEET PER YEAR)
30 25 20 15 10 5 Alaska 0 1990 2000 2009 2015 Tight gas Lower 48 onshore conventional Lower 48 offshore Coalbed methane 2025 2035 History 2009 Projections

Shale gas

Source: U.S. Energy Information Administration.

Strong emerging-market demand: As recently as 15 years ago, emerging markets represented less than 25% of global chemical demand. Today, they account for as much as 55% of total demand. Even after accounting for this recent strong growth, per capita chemical usage in emerging markets remains far below the levels in developed markets.12 Greater substitution of plastics and chemicals for other materials: Some of the first commercial products of the chemicals industry 150 years ago were synthetic pigments created as a substitute for expensive natural dyes. This substitution trend continues today and has accelerated as highpriced commodities (such as metals, energy, and agricultural products) have supported the economic payback of using plastics and other chemicals. One example is the 75% increase in total plastic content per automobile during the past decade, as everything from bumpers, windows, and engine components are today regularly made out of high-performance plastics.13 Innovation: New chemical products and production routes continue to drive growth in agriculture, energy, electronics, and pharma/nutrition. Chemistry plays a critical role in such things as improving crop yields with less water, increasing power storage in smaller batteries, and enabling the functionality of the touch screen of an iPhone.

Investment implications
Large discoveries of shale gasnatural gas trapped in sedimentary rocksand modern extraction techniques have made the United States practically free of imported natural gas. In 2008, the U.S. imported 13% of its natural gas supply. That share is expected to fall to less than 1% by 2035. In 2009, shale gas represented 16% of all U.S. natural gas production. By 2035, shale gas is estimated to account for 47% of domestic natural gas production (see Exhibit 3, above).8 As new supplies of shale gas surged, natural gas prices dropped by half from 2005-2009, and manufacturers have benefited accordingly. In 2010, U.S. chemical exports increased 15%, turning the balance of trade from a $140 million deficit to a $4.6 billion surplus.9 The abundant, low-cost natural gas supply provides U.S. companies with a huge competitive advantage over their European and Asian competitors, many of which produce chemicals from more expensive crude oil. In a recent speech, American Chemistry Council (ACC) President and CEO Cal Dooley said, Shale gas is proving to be a game-changer for Americas chemistry industry, giving domestic chemical manufacturers a significant competitive edge for the first time in yearsnew investments and new plants have already been planned and announced by several U.S. chemical companies.10 The U.S. chemicals industry is heavily levered to global economic expansion, which is quite positive for its sales and earnings growth. The ongoing industrialization of massive populations and emerging markets, such as China, India, and Latin America, has been increasing demand for chemicals and other materials needed to support the growing global demand for food, power, infrastructure, and other basic components of modern lifestyles. All of our work suggests this will be a multiyear theme, which puts chemical companies in a good competitive position.

INVESTMENT THEME
Gold as Reserve Currency

KEY TAKEAWAYS

With the U.S. government deep in debt, some are calling for gold to replace the U.S. dollar as the worlds primary reserve currency. For the first time in several decades, central banks around the world recently became net buyers of gold. Although silver is a precious metal like gold, it doesnt have golds strategic reserve currency status. Nevertheless, it can perform similarly under the right conditions.

Accelerated global demand for chemicals

During the decade that ended in 2009, global demand for chemicals accelerated 110 basis points (1.1 percentage points) relative to the prior decade, to a compound annual growth rate of 4.4%.11 There are three key drivers of this pick-up in demand growth: 32

The U.S. dollar has been the worlds primary reserve currency since World War I. In times of global economic uncertainty, central banks around the world would flock to the U.S. dollar to preserve the value of their savings. But lately, the perceived status of the dollar has begun to fadelargely due to the U.S. governments

multitrillion dollar debt level and declining credit quality. Given the federal governments current fiscal situation, some countries are calling for a new reserve currency to replace the U.S. dollar. As a result, many nations are increasingly turning to other alternatives, and gold has been the primary benefactor. Seeking to diversify their foreign exchange exposure, central banks became net buyers of gold in 2010 for the first time in 21 years. Some of the largest buyers of the past two years have been central banks in India, Mexico, Russia, South Korea, and Thailand. Going forward, the World Gold Council expects more of the same, saying: We anticipate that this trend will continue, with further acquisitions by emerging-market central banks and no resumption of significant sales by those in advanced economies.14

EXHIBIT 4: The price of gold has a positive relationship with the growth in global foreign currency reserves. PRICE OF GOLD RELATIVE TO FOREIGN-EXCHANGE RESERVES
11 10 9 8 7 6 5 4 3 2 1 0 Global FX Reserves ($trillion) Global FX Reserves Gold Price 1600 1400 1200 Gold Spot $ 1000 800 600 400 200 Dec- 07 Dec- 04 Dec- 08 Dec- 09 Dec- 00 Dec- 01 Dec- 02 Dec- 03 Dec- 05 Dec- 06 Dec- 10 0

The gold standard

Individuals, institutions, and governments all over the world are attracted to golds appeal as a strategic reserve currency and a kind of financial asset insurance policy. That is partly a result of golds historic role as a strategic reserve currency. Some forget that golds role as the base currency goes back thousands of years, and that most of todays fiat, or faith-based, paper currencies were originally linked to the gold standard monetary system, which began in 1875 and lasted until the beginning of World War I. The system was ultimately dropped, however, because the financial burden of the war was so great that there was not enough gold to exchange for the excess money governments were printing. Nevertheless, gold is still the only commodity that central banks around the world hold as a component of their foreign exchange reserves (see Exhibit 4, right).

Source: U.S. Energy Information Administration.

up and down more than gold by speculative investors. When the world becomes concerned about economic growth, as it did in 2008, silver can perform worse than gold because most of its key uses are industrial and it doesnt possess status as a reserve currency. In 2008, silver declined 50% versus golds increase of 5%.

Investment implications
Regardless of whether or not gold becomes the new primary reserve currency, we believe opportunities still abound in the precious metal. Investors should consider gold as a means of potentially protecting purchasing power against the prospects of inflation, a weak or declining dollar, and reflationary monetary and fiscal policies. Against this backdrop, investment demand and jewelry demand, especially from India and China, remain robust even as we have continued to see both higher highs and higher lows in the gold pricethe typical trademarks of a secular bull market. While demand for gold has increased, total global mine production has been roughly flat, with few major new discoveries. This trend should help preserve the current lofty price of the yellow metal.

What about silver?

Silver is a precious metal like gold, but it doesnt have golds strategic reserve currency status. Foreign central banks have been adding gold as a percentage of their foreign exchange reserves, but not silver. Silver, however, against a backdrop of global economic growth and negative real interest rates, can perform like high-beta gold, meaning that it tends to be driven by similar factors as gold, but often with more extreme moves. That was the case in 2010 when silver increased 90% versus golds 24%. Silver is also a less-liquid market than gold and its price can be moved

33

Telecommunications
Kristina Salen, Portfolio Manager

The telecommunications sector consists of companies offering fixed-line telecommunications, wireless communications and data transmission services. The sectors market capitalization is dominated by integrated telecommunications providers, and is rounded out by regional telecom operators, pure-play wireless service providers, wireless tower companies and enterprise network-based service providers. Historically, the telecom sector has been considered relatively defensive, with counter-cyclical qualities and stable cash flows and earnings. Because of its defensive qualities and relatively high dividend-yield profile, telecom has typically delivered strong relative performance during periods of economic weakness. However, the sectors future performance may hinge on the outcome of a developing movement toward convergence. The lines between the telecom, technology, Internet and media industries are starting to blur, redefining the traditional communications company model. Today, telecom companies are offering services that, historically, they had never offered before, such as broadband and video. Conversely, cable and satellite companies are offering phones and wireless services, while Internet and technology companies are offering communication services. All of these companies are converging onto a central pointtrying to be the one device in consumers pockets that provides all the communication, information, and entertainment they need. Several long-term subsector themesparticularly those related to wireless infrastructurehave emerged from the convergence trend. Companies that can take advantage of them could be well positioned to generate substantial growth for years to come.

Companies that can tie revenue to data consumption and/or with emerging-market exposure appear best-suited to benefit from the multiyear growth trends in the wireless industry.

During the past few years, the surge in wireless data consumption due to rapid smartphone and tablet adoption could serve as the catalyst for a long-term investment theme. Increased wireless data consumption had been the lifeblood of wireless revenues for much of the past decade. From 2003 to 2008, for example, the average revenue per user (ARPU) of data for the seven largest U.S. carriers grew from $1 to nearly $13.1 Despite this growth, however, the revenues of wireless carriers and providers have been pressured of late. Wireless subscription growth in the U.S. has slowed as the market becomes more saturated following several years of feverish growth. Competitive strains on pricing have further weakened the link between data consumption and revenue. So, too, has consumer demand for unlimited data plans instead of the more profitable per usage fees. Consumers are becoming much more voracious in their appetite for mobile communications of all ilksnot just for text, which is the cheapest form of data communicationbut for video and Internet access as well. In fact, wireless network usage in the U.S. is expected to increase at a compound annual growth rate of 47.8% between now and 2020 (see Exhibit 1, page 35). Wireless carriers will need to make massive investments in their networks in order to handle this increase in volume. As a result of these multiple pressures on revenues, it has become increasingly difficult for some companies to profit from the wireless data boom.

Investment implications
Nevertheless, while these are headwinds for some of the largest players in the industry, there are a select group of wireless carriers with rising subscriber bases and a track record of successfully tying revenue to data consumption. Collectively, they represent a compelling opportunity with positive long-term growth prospects. Successful players in the industry are responding to the lack of subscriber growth by focusing on organic growth opportunities that have the potential to boost revenues. Wireless companies with exposure to emerging markets may be particularly well positioned to benefit from increased data consumption. Relative to developed markets, emerging markets have

INVESTMENT THEME
Wireless Data Consumption

KEY TAKEAWAYS

Wireless data consumption has experienced tremendous growth both in the U.S. and internationally as consumers demand more and cheaper data on their mobile devices. Infrastructure improvements, wireless saturation, and stiff competition are pressuring the revenues of wireless companies.

34

EXHIBIT 1: Wireless network usage is projected to soar during the next decade. U.S. WIRELESS NETWORK USAGE
70,000 60,000 50,000 40,000 30,000 20,000 10,000 2010 2020E 2012E 2013E 2015E 2016E 2018E 2019E 2011 2014E 2017E 0

(MB BILLIONS)

Understanding spectrum is crucial to understanding the potential investment opportunity represented by wireless data. Spectrum refers to the entire range of electromagnetic radio frequencies used in the transmission of sound, data and video. This includes radio, television, military radar, remote control toys and spectrum is what carries voice between mobile phones and online information from one computer to the next, wirelessly.

Finite supply
There is a finite supply of spectrum and a limited number of buyers of it around the world. In the United States, spectrum is sold at Federal Communications Commission (FCC)-administered auctions to qualified bidders. Spectrum is an extremely valuable asset. In industry circles, it is referred to as beachfront property because it is a finite resource. FCC Chairman Julius Genachowski recently called spectrum the lifeblood of the wireless ecosystem. He also has said that mobile broadband could surpass all prior platforms in their potential to drive economic growth and opportunity.3 The number of devices and applications using the wireless spectrum is growing quickly. In response, the FCC has taken steps to provide more wireless spectrum to meet the demand. In its National Broadband Plan released in 2010, the FCC set forth a five-year plan to add another 300MHz of spectrum to the 500MHz used for licensed wireless use, including voice, text, and data applications offered by wireless providers that own parts of the wireless spectrum in specific geographic areas. Wireless carriers with high levels of spectrum have the capacity to handle more data over their networks. But those with insufficient spectrum depth must either acquire it or build more tower sites to avoid forcing users to compete for the same antenna. Both of these alternatives require significant capital expenditures that can run in the hundreds of thousands of dollars per tower site. Increased data consumption also has bid up the cost of spectrum. These are key considerations when evaluating spectrum carriers. As is the case with wireless data consumption, emerging markets may represent a sizable growth opportunity within the spectrum arena. A recent World Bank econometric analysis of 120 countries estimated that for every 10% increase in the penetration of broadband services, there is an increase in economic growth of 1.3%. The study also reported: As most developing countries are at an early stage of broadband development, they are likely to gain the most from investing in these networks to reach the critical mass for higher impact and before the diminishing returns take effect.4

Source: Fidelity Asset Management, as of Sept. 30, 2011. Usage reported in billions of megabytes (MB blns).

three times the number of wireless subscriptions and are growing them four times as fast; wireless penetration is one-quarter of what it is in developed markets and is growing 8% per year; and profit margins in emerging markets are higher than in developed ones.2 Wireless data consumption has evolved into a multiyear investment opportunity in both developed and emerging markets. The wireless data theme may be further bolstered by the recent deployment of 4G technology. An easing of competitive pricing pressures could further brighten the telecom outlook. Though challenges exist, wireless data continues to be the fastest growth area in the telecommunications sector, creating a foundation for multiple opportunities to benefit from consumers insatiable appetite for data on-the-go.

INVESTMENT THEME
Ownership of Spectrum

KEY TAKEAWAYS

Spectrumfrequencies used in the transmission of voice, data and videois a finite and extremely valuable asset within the telecom sector. Wireless carriers with high levels of spectrum may be poised to benefit considerably from convergence and the rapid increase in wireless data consumption. There are a limited number of spectrum carriers in the world, and those with exposure to a potential wireless boom in emerging markets may be especially well positioned to profit from this growth.

35

Investment implications
There are various ways to play the spectrum theme; one of the primary ways is through domestic and/or global spectrum carriers. Finite supply and extremely strong demand often make for a strong investment thesis in any industry, and spectrum is likely to be no exception. As the world becomes increasingly wireless, the availability of spectrum becomes an exponentially more crucial component in meeting this demand. Identifying wireless carriers with adequate levels of spectrum that can turn future data consumption into revenue and earnings growth will likely be the key to success in this industry.

EXHIBIT 2: The number of cell sites in the U.S. has risen during the past decade, but the rate of growth has slowed.
Cell Site Growth (19972009) Date 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Total Cell Sites Year-over-Year Growth 5-Yr Running Avg Growth 38,650 57,674 74,157 95,733 114,059 131,350 147,719 174,368 178,025 197,576 210,360 220,472 245,912 49% 29% 29% 19% 15% 12% 18% 2% 11% 6% 5% 12% 28% 21% 19% 13% 12% 10% 8% 7%

INVESTMENT THEME
The Opportunity in Towers

KEY TAKEAWAYS

The number and efficiency of cellular towers have expanded in line with the increase in wireless data consumption. More and more operators are leasing antenna space to other users to mitigate the risk and expense of cell tower construction and maintenance. Revenue per tower should expand as more infrastructure sharing, spectrum, and next-generation technology are deployed.

Source: CTIA - The Wireless Association; FCC, as of October 2010.

Another way to participate in the build-out of wireless infrastructure is by investing in the owners and operators of cellular towers, which enable the back-and-forth transmission of wireless communications and data. Towers are essential to enabling the growth in wireless data consumption. As sales of smartphones, tablets and other mobile devices continue to climb, demand for the data bandwidth that is transmitted through towers will likely increase as well. Typically, a cell phone tower is built either by a tower operator or by a wireless carrier looking to expand its network coverage. From the beginning of 1999 through the end of 2009, the number of towers (also known as cell sites) in the U.S. more than tripled (see Exhibit 2, above). However, the initial tower construction is where companies and investors take on the most risksuch investments are fixed, sunk and irreversible. Maintaining and upgrading towers adds additional cost and risk. However, current industry dynamics are helping to alleviate both cost and risk. Since the towers make up the bulk of investments of a mobile operator, more and more operators are working toward sharing towers, so the rate of new tower growth has slowed (see Exhibit 2). Towers can be engineered for various purposesfrom increasing capacity to upgrading signal quality to expanding network coverage. Partly as a result of this flexibility, network infrastructure sharing and outsourcing are finding strong acceptance with mobile operators around the world as an effective way to cut down coverage costs.

Tower operators can create a strong source of recurring revenue by leasing antenna space on their networks to other users, such as mobile carriers, and TV and radio stations. These leases often pay for the cost of the tower itself, in addition to expanding the network of mobile towers. And, unlike the carriers, tower companies generally arent subject to price wars that cut into profits. Therefore, revenue per tower should continue to expand as more spectrum and next-generation equipment are deployed.

Investment implications
Year-over-year cell site growth has been slowing. This trend is due in part to the saturation of wireless availability. In the U.S., an estimated 99.6% of the population now has wireless access.5 Therefore, its likely that new cell-site growth will emphasize increased capacity, which, on some levels, can be considered a substitute for new spectrum. In this context, tower sharing offers a compelling proposition. Sharing allows operators to develop better commercial applications and significantly reduce entrance and development riskwhich will be crucial to taking advantage of the growth potential offered by emerging markets.

36

Utilities
Douglas Simmons, Portfolio Manager

The stocks of utility companies are often viewed as a defensive investment during a perceived or actual economic slowdown, primarily because electricity, natural gas, water, steam and cooled air tend to be viewed as basic essentials that are less susceptible to the trajectory of the economy relative to products and services in other sectors. In our view, there are macroeconomic developments taking place in the world that could significantly influence the earnings growth and dividend payouts of utilities companies over the next few years, and lead to stock performance differentiation.

came with a more aggressive compliance timeline than most industry and market participants had expected. By mid-November, the EPA is also expected to announce its final rule on the Mercury and Air Toxics Standards (MATS), which was proposed in March 2011 and is expected to put additional restrictions on air emissions from power plants. While it remains unknown how stringent this forthcoming rule will be, the proposed MATS rule would require utilities to install new technology to reduce mercury and acid gases, including sulfur dioxide scrubbers, nitrogen oxide emission controls, and fabric filters. As with CSAPR, we believe it is likely that this rule also could be more stringent than consensus expectations.

INVESTMENT THEME
Stricter Environmental Regulations and an Expected Shift in Power Generation

Declining capacity and upward pressure on power prices

In recent months, our research department has been evaluating the utility sectors overall capacity. Weve examined each company to gauge which of them has either small or old coal-fired plants, and then determined which companies we believe are likely to either spend the money on new equipment to comply with these new rules or close down certain plants. Generally speaking, it is not economical to retrofit small coal-fired plants with new technology. In our opinion, new regulations and expected plant closures will result in a reduction of 10% of the current coal-fired power generation capacity, which reflects 40,000-50,000 megawatts or 4.5%-5.0% of the total U.S. power generation capacity (see Exhibit 1, page 38).1 Our research suggests this reduction of capacity will lead to tightening power markets and cause the marginal cost of power to rise, providing a boost to the earnings capacity of surviving companies. Like most commodity industries, power prices are determined by the marginal unit of production, but we believe the power markets will tighten regardless of the level of commodity prices (raw inputs to power generation).

KEY TAKEAWAYS

The recent approval of stricter clean air regulations by the U.S. Environmental Protection Agency is likely to force certain utilities operating coal-fired power plants to install costly technology and equipment to comply with these new standards. Many electric utility providers may find it cost-prohibitive to retrofit older or smaller coal-fired units and cheaper to simply shut down these units, a development that could lead to a 4.5%-5.0% reduction in overall generating capacity in the United States. A loss of capacity of this magnitude is likely to cause the marginal cost of power to rise over time, with the primary beneficiaries being utilities whose fleets are comprised of nuclear, natural-gas-fired and environmentally compliant coalfired plants.

New EPA regulations on coal-fired power plants

U.S. environmental regulators recently proposed and enacted new legislation that has forced some coal-fired power plant operators to choose between installing new equipment to keep these plants up and running or to shut them down altogether. In July 2011, the Environmental Protection Agency (EPA) issued the Cross-State Air Pollution Rule (CSAPR) mandating that 27 states reduce power plant emissions of sulfur dioxide and nitrogen oxide that contribute to ozone or fine-particle pollution in other states by 2014, with implementation starting in 2012. This regulation included tougher-than-expected emissions caps, and 37

Investment implications
The stricter regulatory environment will create winners and losers among power producers within the utilities sector, as the U.S. power generation fleet transitions away from coal-fired plants and toward natural gas-fired power plants and renewable resources. Among the beneficiaries will be those utility companies that are viewed as clean or those that are already in the process of becoming compliantmeaning they currently generate all or a

EXHIBIT 1: Approximately 10% of the coal-fired power generation capacity in the United States is at risk of being shut down due to tougher environmental regulations. U.S. COAL-FIRED POWER PLANTS 2011 Small U.S. Coal Plants
300,000 250,000 Capacity (MW) 200,000 150,000 100,000 50,000 8,336 9,225 11,754 14,044 10,678 0 0-100 101-200 201-300 301-400 401-500 >500 284,103 160,000 140,000 120,000 Capacity (MW) 100,000 80,000 60,000 40,000 20,000 0 5,456 0 - 10 9,239 11 - 20 21 - 30 31 - 40 > 40 66,109 108,688

Older U.S. Coal Plants

148,648

Plant Size (MWs) Coal Plants at Risk Total Capacity at Risk (MW) Installed Coal Generation % of Capacity at Risk Source: Fidelity Asset Management as of Sept. 30, 2011. 38,045 370,000 10%

Plant Age Years

large portion of power via nuclear-powered, natural gas-powered plants or environmentally compliant coal-fired plants. These companies could experience higher returns on equity and improved profit margins because of the loss of power generation capacity. The so-called dirty utility producersthose with a portion or all of their fleet comprised of noncompliant coal-fired plants that are small or oldwill experience challenges. Many companies will view it too costly to install new equipment for these plants to comply with new EPA regulations, and choose to close them. The closure of these plants is likely to pressure the earnings of these companies. At the same time, in certain regions where there are several utility providers that operate dirty coal-powered plants that dominate the market, those with the scale and resources to install new equipment and have already moved to become compliant with the new rules will likely have an edge in the survival race. Finally, there is likely to be some political rhetoric in advance of the 2012 presidential election that suggests a political party shift in the White House could attempt to stymie this new legislation. However, our view is that its not a matter of whether these stricter emission rules will be enforced, but a matter of when. 38

INVESTMENT THEME
Abundant Low-Cost Natural Gas

KEY TAKEAWAYS

New technologies that extract natural gas from shale rock formations in the earth have led to an abundant supply and lower prices for the commodity. As a result of these dynamics, the U.S. is going to increasingly become more reliant on natural gas as a source of energy. Utility companies that currently use natural gas to produce power are well positioned to benefit from this long-term secular trend in abundant, low-cost natural gas.

Drilling innovation
New drilling technologies have allowed energy exploration companies to more effectively extract natural gas from shale rock formations in the earth, both in new locations, remote locations, and older wells that had been drilled and viewed as less productive using traditional drilling techniques. As a result, the supply of natural gas has increased significantly, causing commodity prices to decline and remain low.

Game-changer for certain companies

Our view is that this abundant supply of low-cost natural gas will shift the competitive landscape in the utilities sector. Given its low cost, we believe U.S. corporations and consumers will become increasingly more reliant on natural gas as a source of fuel over the next several years. To meet this expected growing demand, there is an increasing need for infrastructure to transport and process natural gas, a fuel used to generate about one-fifth of the electric power produced in the United States today. Our view is that this is one of the few secular growth themes in the United States that will play out over the next several years.

EXHIBIT 2: While the yields provided by utilities stocks have historically traded at a slight discount to 10-year U.S. Treasury Bond yields, they were recently trading at a premium of more than 200 basis points. UTILITIES SECTOR DIVIDEND YIELDS VS. 10-YR. TREASURY BOND YIELDS
400 300 Relative Yield (basis points) 200 100 0 (100) (200) (300) Relative Yield (bps) +1 Standard Deviation Average -1 Standard Deviation

Expected beneficiaries
Natural gas utility companies that already own pipelines in particular regions allowing the fuel to be transported should become beneficiaries of this infrastructure build-out because of their strategic locations and existing operations. In addition, gas utilities that own or are expanding their natural gas processing operations are also well positioned. More specifically, there are many small-to-mid-sized utility providers in certain regions that own natural gas transmission and gathering pipelines, processing plants, in addition to their gas utilities, and thus have the potential to grow their earnings by building out additional processing and takeaway capacity.

1985

1990

1995

2000

2005

2010

Investment implications
Our view is that natural gas-generating utilities are exceptionally positioned to benefit from new discoveries of natural gas and the growing reliance of the United States on natural gas over the next decade. We believe the combination of an abundant supply and low-cost natural gas will drive further construction in expansive infrastructure capabilities to transmit, process and utilize natural gas as the commodity becomes more instrumental in helping to meet the countrys energy needs.

Source: FactSet as of August 31, 2011. Past performance is no guarantee of future results. In addition to yield, different types of bonds may also differ in investment objectives, costs and expenses, liquidity, safety, guarantees or insurance, fluctuation of principal or return, and tax features, which should also be considered.

INVESTMENT THEME
Alluring Yield Growth

KEY TAKEAWAYS

In the current low-yield environment for investment-bonds, investors looking for income might consider utilities stocks as one way to obtain a relatively higher yield with lower risk compared to equities in other sectors. A utility company that issues a high dividend payout or historically has increased its dividend yield tends to be one that has relatively stable cash flow and operates in a mature industry. Utilities companies with management teams that are focused on increasing their dividend payoutsreturning excess capital to investorsare likely to experience upward pressure on their stock prices.

yields relative to the yields offered by other securities, such as investment-grade bonds. Historically, the average dividend yield on utilities stocks has traded at a slight discount to the 10-Year U.S. Treasury bond yield, but as of Sept. 30, 2011 the yields on utilities stocks traded at a sizable premium of 230 basis points over Treasuries (see Exhibit 2, above). That yield spread premium has been a good leading indicator of returns for utilities stocks. After yield spreads last peaked in 2003, the utilities sector produced annualized total returns of 18% and 17%, respectively, over the next three- and five-year periods.2 With recent Federal Reserve statements pointing to low policy rates for the foreseeable future and the U.S. economy showing evidence of a slowdown, utilities stocks may be a relatively attractive option for incomeseeking investors.

Utilities: source of equity income

Given the macroeconomic challenges and sovereign fiscal imbalances present in the marketplace today, many investors may be apprehensive about investing in equities, regardless of their relatively attractive yields. However, those income-seeking investors willing to absorb a higher level of risk in owning utilities over investment-grade bonds can take some comfort in sectors historical characteristics. The utilities sector has been among the least economically sensitive of the 10 major equity market sectors, due

Relatively attractive yields

In the current market climate, utilities stocks may provide investors with a steady source of income given their higher dividend 39

largely to their relatively steady revenue streams and profit outlooks, lower operational risk, and the timeless demand for power among consumers and businesses. Investing for equity income in the utilities sector has also provided the benefit of lower volatility relative to non-dividend-paying stocks.3 Further, when inflationary pressures arise, utilities stocks that pay dividends may protect their income streams better than bonds thanks to the possibility of rising stock prices to offset inflation.

Another area of focus will be on regulated utilities that charge electricity rates below the national average. These companies may be more likely to see a future boost in regulated rates, which provides a boost to the earnings and potential an increase in their dividend payouts. Given the challenging economic backdrop and the Feds stated monetary policy outlook, the current strong investor appetite for yield in the marketplace is likely to persist for some time. In this environment, we believe companies likely to return capital to shareholders by boosting their dividend will lead to upward pressure on stock prices, and help differentiate the better performers in the sector. EXHIBIT 3: Companies with higher dividend yields and lower payout ratios have tended to outperform in the long term. DIVIDEND YIELD AND PAYOUT RATIO (19842011) 4000 3500 Index Level (100 = 12/31/84) High Yield -Low Payout Low Yield - Low Payout High Yield -High Payout Low Yield - High Payout

Evaluating the intentions of management teams

At Fidelity, a key focus of our security selection process in the utilities sector is trying to identify companies that are not only willing to allocate capital in the form dividend yields, but those with an intent on increasing their dividend yields. In our discussions with management teams, we are trying to assess which of them have sound corporate balance sheets and intend to use their free cash flows to boost dividend payouts as a way to demonstrate the stability of their businesses. At the same time, were also making assessments about which dividend-yielding utility companies are positioned to sustain those payouts to investors. [Editors note: U.S. investors tend to interpret a dividend cut as a negative statement about a companys profit outlook.]

Investment implications
What we believe differentiates our approach from competitors is that we are not just trying to identify and own the highest-yielding companies. More importantly, were looking for companies that have superior profit growth prospects and are willing to aggressively grow their dividend. For example, given the stricter environmental regulations present today, many utility companies may be forced to allocate more of their free cash flow to upgrade their power generation plants to become compliant with new clean-air emission rules. For some of these capital-constrained companies, increased spending on new environmental equipment will likely prohibit the potential to boost their dividend payouts. For this reason, in the coming year we plan to target companies that operate in a relatively more supportive regulatory climate. In addition, we believe focusing on companies with both attractive current yields and lower current payout ratios will be a beneficial strategy. A low payout ratio indicates dividend growth potential, while a high payout ratio indicates less cash to increase dividends. Historically, companies with high dividend yields and low payout ratios have outperformed historically (see Exhibit 3, right).

3000 2500 2000 1500 1000 500

2004

2002

2006

2000

2008

1988

1990

1994

1996

1984

1998

1986

1992

Analysis using the Russell 1000 Index dividend yields and payout ratios. Dividend yield is the last 12 months dividend divided by the last price for the period. The payout ratio is the dividend paid out over the year divided by the earnings over the year. High and low defined as the top and bottom thirds, respectively. Source: FactSet, FAM (AART) as of July 31, 2011. Past performance is no guarantee of future results.

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2010 2011

Views and opinions expressed are as of Oct. 31, 2011, and may change based on market and other conditions. Investment decisions should be based on an individuals own goals, time horizon, and tolerance for risk. Past performance is no guarantee of future results. Investing involves risk, including risk of loss. Diversification does not ensure a profit or guarantee against loss. You cannot invest directly in an index. Because of their narrow focus, investment in one sector tend to be more volatile than investment that diversify across many sectors and companies. *Broader equity market performance reflects S&P 500 Index returns. Sector performance reflects returns for each of the 10 sector components of S&P 500 Index. Ten-year average annual returns for S&P 500 index and respective sectors from Sep. 30, 2001 to Sep. 30, 2011. Historical average annual S&P 500 return from Jan. 1, 1926 to Sep 30, 2011. Source: FactSet, Fidelity Asset Management as of Sep. 30, 2011. The S&P 500 , a market-capitalization-weighted index of common stocks, is a registered service mark of the McGraw-Hill Companies, Inc. and has been licensed for use by Fidelity Distributors Corporation. The following is a definition of the S&P 500 sectors: Consumer Discretionary Companies that tend to be the most sensitive to economic cycles. Consumer Staples Companies whose businesses are less sensitive to economic cycles. Energy Companies whose businesses are dominated by either of the following activities: The construction or provision of oil rigs, drilling equipment and other energy-related service and equipment, including seismic data collection. The exploration, production, market, refining and/or transportation of oil and gas products, coal and consumable fuels. Financials Companies involved in activities such as banking, consumer finance, investment banking and brokerage, asset management, insurance and investments, and real estate, including REITs. Health Care Companies in two main industry groups: Health care equipment suppliers, manufacturers, and providers of health care services; and companies involved in research development, production and marketing of pharmaceuticals and biotechnology products. Industrials Companies whose businesses manufacture and distribute capital goods, provide commercial services and supplies, or provide transportation services. Information Technology Companies in technology software & services and technology hardware & equipment. Materials Companies that are engaged in a wide range of commodity-related manufacturing. Telecommunication Services Companies that provide communications services primarily through fixed line, cellular, wireless, high bandwidth and/ or fiber-optic cable networks. Utilities Companies considered electric, gas, or water utilities, or companies that operate as independent producers and/or distributors of power. Consumer Discretionary 1 U.S. Census Bureau: Quarterly Retail E-Commerce Sales, 2nd Quarter 2011, August 16, 2011.
2 3 4 5 6

Energy 1 Bloomberg, Fidelity Asset Management as of Oct. 31, 2011.

2

What is shale gas and why is it important?, www.eia.doe.gov.

Financials 1 FactSet, Bloomberg, Fidelity Asset Management as of Sep. 30, 2011. Greece equity market index: Athens Stock Exchange General Index, a capitalization-weighted index of Greek stocks listed on the Athens Stock Exchange. The index was developed with a base value of 100 as of December 31, 1980. Greece bank stock index: AFTSE/Athex Bank Index, a capitalization-weighted index of all the stocks designed to measure the performance of the bank sector of the Greek Stock Exchange. U.K. equity index: FTSE 350 Index, a capitalization-weighted index comprising of all the components of the FTSE 100 and the FTSE 250. The index represents approximately 90% of the U.K. equity market by capitalization. The starting base value was set at the FTSE ALL Share closing value of 682.94 as of December 31, 1985. U.K. bank stock index: FTSE 350 Banks Index, a capitalization-weighted index of all stocks designed to measure the performance of the banking sector of the FTSE 350 Index. The index was developed with a base value of 1,000 as of December 31, 1985. The parent index is NMX. Index adopted ICB classification effective 1/2/06. Spain equity market index: Madrid Stock Exchange General Index (MADX), a capitalization-weighted index that measures the performance of a selected number of Continuous Market stocks. The index was developed with a base value of 100 as of December 31, 1985. Spain bank stock index: Madrid Stock Exchange Bank Index, a capitalization-weighted index of all stocks designed to measure the performance of the banking sector of the MADX Bank Index. Ireland equity market index: Irish Stock Exchange Overall Index, a capitalization-weighted index of all official list equities in the Irish Stock Exchange, but excludes U.K. registered companies. The index has a base value of 1000 as of January 4, 1988. Ireland bank stock index: Irish Stock Exchange Financial Index, a subgroup of the ISEQ Overall Index of the Irish Stock Exchange. It is a capitalization-weighted index with a base value of 1000 as of January 4, 1988. Health Care 1 The Long-Term Outlook for Health Care Spending, Congressional Budget Office, December 2007.
2 3 4

IMS Health, 2010. U.S. Census Bureau, Population Division.

The New Science of Personalized Medicine, PricewaterhouseCoopers, October 2009, page 3. U.S. Research Budget Cuts May Slow Personalized Cancer Drugs, Group Says, Bloomberg.com, September 20, 2011.
5

Industrials 1 McKinsey Quarterly conducted the survey in April 2008 and received 1,555 responses from a representative sample of executives at companies around the world. Haver Analytics, Department of Energy for regular grade retail gasoline, Bureau of Labor Statistics for CPI-U Household Electricity, through Jan. 30, 2011.
2

The Coca Cola Company. McKinsey Quarterly: Capturing the Worlds Middle Class. Company data, Fidelity Asset Management. U.S. Census Bureau.

http://www.whitehouse.gov/the-press-office/2011/01/25/remarkspresident-state-union-address, Jan. 25, 2011.

3 4 5

Merrill Lynch Wealth Management, Capgemini: World Wealth Report 2010. Consumer Staples 1 Haver Analytics, Fidelity Asset Management.
2

The Economist, Life in the Slow Lane, April 28, 2011.

American Society of Civil Engineers, 2009 Report Card for Americas Infrastructure (http://www.asce.org/reportcard/).
6 7

The Parliament.com, Feb. 10, 2011. Reuters, Oct. 19, 2011.

Euromonitor, Fidelity Asset Management as of Nov. 7, 2011.

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Industrial Insights, October 11, 2010.

Information Technology 1 McKinsey Quarterly, Clouds, big data, and smart assets: Ten techenabled business trends to watch, August 2010. Bank of America Merrill Lynch estimates cited by Qatalyst Partners, Autonomy Overview, January 2011.
2

Robert Lee Hotz, Decoding Our Chatter, Wall Street Journal, Oct. 1, 2011.
3

Materials 1 United Nations, 2010 Revision of World Population Prospects. U.N. FAO data on Chinese food consumption based on the twoyear periods ending in 1992 and 2007.
2 3

National Agricultural Statistics Service, as of Sep. 30, 2011.

Time Magazine, Why Biofuels Help Push Up World Food Prices, Feb. 14, 2011.
4, 5

Reuters, Feb. 14, 2011. http://www.reuters.com/article/2011/04/25/us-agriculture-investment-interview-idUSTRE73O0H320110425.

6 7, 8, 10 9

American Chemistry Council, July 2011.

Institute for Energy Research, May 2011. U. S. Energy Information Administration, Dec. 2010. Chemical Market Associates, Inc., based on ethylene, 2010. World Gold Council, Feb. 2011.

11, 12 13 14

Telecom 1 Fidelity Asset Management. Based on the top seven U.S. wireless carriers by market share.
2 3 4

FactSet, Fidelity Asset Management, as of Aug 30, 2010. Bloomberg Businessweek, April 29, 2011.

World Bank, Broadband Infrastructure Investment in Stimulus Packages: Relevance for Developing Countries, published May 2009. Federal Communications Commission technical paper, Mobile Broadband: The Benefits of Additional Spectrum, Oct 2010.
5

Utilities 1 U.S. Energy Information Administration, Fidelity Asset Management as of Sep 26, 2011.
2 3

Morningstar data as of August 31, 2011.

Since 1984, the stock price volatility of the highest dividend payers by quartile (15.5%) was less than the average volatility of the Russell 1000 Index (18.2%). Source: FactSet as of 6/30/11. Investment and workplace savings plan products and services offered directly to investors and plan sponsors by Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street Smithfield, RI 02917 Investment and workplace savings plan products and services distributed through investment professionals by Fidelity Investments Institutional Services Company, Inc., 100 Salem Street, Smithfield, RI 02917 598689.8.0 201110-1694 2011 FMR LLC. All rights reserved.

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