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Quest™

Quest™. Operation style twist. 24 th May 2012. Quest™ helpline +44 (0)20 7523 8493 quest@canaccordgenuity.com. Nigel Sedgley +44 (0)20 7523 8497 nsedgley@canaccordgenuity.com. Operation style twist: Summary and conclusions. 2008-2009 all over again?

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Quest™

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  1. Quest™ Operation style twist 24th May 2012 Quest™ helpline +44 (0)20 7523 8493 quest@canaccordgenuity.com Nigel Sedgley +44 (0)20 7523 8497 nsedgley@canaccordgenuity.com

  2. Operation style twist: Summary and conclusions 2008-2009 all over again? • There are lots of similarities between events in 2008/9 and recent patterns. • During the 2008/9 trough style performance was volatile but Value ultimately dominated. • The trough in Value in 2008/9 was before the market bottom. • Value rallies tend to be short/sharp events (2-3 quarters) – if you are late, its easy to miss them. • Although the market does not look especially cheap, valuation divergence is high. • Lots of stocks are trading near their trough valuation of the last five years. • The run to safe stocks has left some valuations looking overextended – more than in 2008/9. • During times of profit and cash flow volatility you need to assess Value using stable measures:eg Quest™ market to book, EV/Sales. • Similar Value approach in Nov 08 Quest™ Newsletter delivered strong performance. • Volatility means there will be opportunities. Our screens assess the risk/reward trade off. Page 1

  3. History rhymes: Comparing 2007-2009 with 2010-2012 Value made an absolute low in Nov 2008, but there was lots of volatility around the trough. UK Largecap Then (2007-2009) The troughV,Q neutral,Mmtm -ve Market rallyingValue +ve, Qual neutral, Mmtm -ve Crisis developingValue –ve, Qual +ve, Mmtm +ve Now (2010-2012)to 18th May 2012 Current pattern looks most like Sept 08 Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. Page 2

  4. : What is triAngle? • UK large cap triAngle performance • Market beating stock-picking tool • Company scores updated daily on www.canaccordquest.com • Combining Value, Quality and Momentum • Quest™ metrics mixed with conventional data • Style analysis and themes • triAngle Escalator: Who’s moving up and down • Excellent 12- year track record • 3-pronged approach improves consistency • UK Large – 42/53 +ve quarters, +4.0% average • Pan-Euro – 36/48 +ve quarters, +3.0% average • UK Small – 34/42 +ve quarters, +6.3% average • North America – 18/35 +ve quarters, -0.3% average(Value and the Escalator dominate in the US) • Over 12 years of live experience assessing style trends. Equally weighted triAngle is the most consistent, but there have been a few short/sharp value rallies Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials Page 3

  5. : Factors and composition Baskets are dynamic: They vary over time depending on what currently represents Value, Quality etc. Quest™ valuation Quest™ market-to-book EV/sales rel. LRA Dividend yield rel. LRA P/E rel. LRA CFROC spread Capital growth Equilibrium growth Fixed charge cover CFROC change Value Quality 33% 33% triAngle 33% Momentum 9m-relative trend 100/200-day switch 12m-relative range 30/90 day switch Earnings momentum Page 4

  6. Longer term context: triAngle quarterly backtest Quarterly backtests place recent trends in long-term context – Quality has been strong, Value weak. 2nd best in a decade 3rd Best in a decade 3rd Worstever Equal weightings dangerous at turning points Best for 3 yrs Worst for 3 yrs 9 neg quarters in a row • Value rallies tend to be short/sharp events (2-3 quarters) – 2010/11 saw 9 negative quarters in a row. Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. Page 5

  7. UK end Nov 08-end Feb 09: Value rallied before the market Quality held up More stable value measures leading the way A sign of rotation Fixed charge cover: Feb-May 2009 -13%, May-Aug 2009 -7% Page 6

  8. Which value measures? During times of profit/cash flow volatility you need to assess Value using stable measures:eg Quest market to book, EV/Sales. 2003-6 Kept outperforming after the other value measures waned.M&A, just –in-time capexsupport a sustained rally 2009-11Market to book headed the Value charge and sustained performance 1992-4Price to book worked well (Pan Euro) Mkt troughMarch ‘09 Mkt peakFeb ‘11 Page 7

  9. What is Quest™ market to book? Total market capitalisation (equity + debt + quasi debt) Quest™ market-to-book = ---------------------------------------------------------------------------- Estimated replacement cost of assets Page 8

  10. But how much is now priced in?... market valuation charts Median valuation not far off the trough but close to the ‘new normal’ Stock dispersion is high – lots of cheap stocks and expensive stocks look dearer than in 08/09 Corporate action, policy response less likely to be as helpful this time, but less solvency risk New Normal? New Normal? Prices as at 9th May Page 9

  11. Quest™ market-to-book: What is the opportunity? Level + dispersion There are as many cheap stocks as summer 2009. Market levelUses average market cap for the year As at May 24 UK Large cap Europe ex UK small 12% below LRA 16% below LRA Dispersion CITN/ Newsletter articles “Time to get into the Q” “Slowly moving up the Q” “Who is still left in the Q?” “Time to rejoin the Q” As at May 24 “Jostling about in the Q” Page 10

  12. Quest™ market-to-book strategies 1) Buy cheapest companies on market-to-book 2) Consider pricing relative to a long-term view of asset’s productive capacity over their lifetime. Take Value AND Quality into account. 3) What if no mean reversion? – need to consider valuation relative to the ‘new normal’ Desire to avoid Value traps: Solvency, asset write downs (badwill) Quest™ market-to-book Q-discount (10yr) = ------------------------------------------------------ Cyclical average CFROC / WACC Quest™ market-to-book Q-discount (+12m) = ------------------------------------------------------ +12m CFROC / WACC Page 11

  13. Value screen I: UK Quest™ market-to-book – Time to rejoin the Q? Our favourite screen which links Valuation with Quality – worked well in 2008 Updated weekly on Q-files. Page 12

  14. Value screen II: Trough valuations Stocks trading with 10% of five-year trough valuation on Quest™ market to book Ranked by mkt cap Priced 9th May A potential source of ideas: • Some stocks will be cheap fora reason. • Others will be genuine opportunities • Screen also available for EV/sales and other triAnglemetrics Page 13

  15. Value screen III: Superscreen Criteria A broad based value screen using the Quest website screening function 15% more upside than 10y average Upside on Quest and cheaper than usual triAngle Value score Mkt to book below LRA Quality filters (optional) Page 14

  16. Value screen III: Value supererscreen stocks Quality Criteria >15 >0 >5 <0.8 Ranked by mkt cap A-B A B 21 May Quality filters.1) Lots of debt/quasi debt . 2) Negative EPS momentum. Signal of risk of a profit warning? Full screen on www.canaccordquest.com Page 15

  17. Over-extended valuations: The other side of the Value trade Companies which have outperformed but now lack value support Outperformed Lacks value support Compare with EV/sales Other risks Page 16

  18. Over-extended valuations: The other side of the Value trade >15 <13/33 >0 >1 >1 21 May If EV/sales is higher than historic (long-run average), is that justified by higher margins. If so, is that margin sustainable? Page 17

  19. Performance of the Q-discount screen from Nov 08- Q discount screen worked well In 2008. Source: Quest Newsletter Nov 2008 Source: Datastream Rel to WIEROP$ Page 18

  20. Appendices

  21. What is Quest™? Decision support tool for equity investors Impartial corporate financial analysis Idea generation and idea validation Combines conventional and proprietary metrics ‘Glass box’, not a black box Web-based products – www.canaccordquest.com Helping investors make money since 1996 Page 20

  22. What is Cash Flow Return On Capital? Cash Flow Return On Capital (CFROC) Real (replacement cost) Post-tax Return On Gross Invested Capital Better insight into corporate performance and valuation (takes into account all the capital used, asset life, asset mix, return of capital) IRR calculation not A/B Wealth creation Screening Risk management tools Stocks & Products (C) Non-depreciation asset release = €15 (A) Gross cash flow = €10 Value tools Performance M&A (D) Asset life = 14 years (B) Gross invested capital = €100 Cash Flow Return On Capital (IRR) = 6.0% Page 21

  23. Quest™ valuation overview Cash Flow Returns in a DCF model • Use consensus forecasts – 2-years forward • Forecast gross cash flows – existing assets wind-down • Forecast growth rate – reversion to mean • Forecast Cash Flow Return On Assets – future investment returns (reversion to mean) • Forecast net cash flows – implicit • Discount back using WACC for Enterprise Value Reversion to the mean High CFROA Low CFROA High growth Page 22

  24. Value • A broad-based view • Five Value factors: • Quest™ valuation • Quest™ market-to-book • EV/sales rel LRA • Dividend yield rel LRA • P/E rel LRA • Mix of absolute and relative measures Tesco: Quest™ valuation Centrica: Dividend yield relative to market and history Page 23

  25. : Quality • Aim to emulate the Quest™ Strategy page • Is it a good or a bad company? • High return/ growth stocks • Five Quality factors: • CFROC spread (5-year average) • Real capital growth (3-year average) • Equilibrium growth (3-year average) • Fixed charge cover (solvency FY1) • CFROC change (FY1) • Measures ability to generate shareholder value Tesco PLC: Cash flow returns Tesco PLC: Invested capital and equilibrium growth Page 24

  26. : Momentum • Combination of price and earnings • Five Momentum factors: • Nine-month relative trend • 100/200 day switch • 12-month relative range • 30/90 day switch • Earnings momentum (consensus) • Mixture of long, medium and short-term measures Page 25

  27. How the triAngle score is calculated • Each stock is compared to its universe • All 15 factors ranked in deciles • 10 = ‘good’, 1 = ‘bad’ • Add the five measures in each category and divide by 1.5 • Gives scores for Value, Quality and Momentum (/33) • Add together category score to get overall triAngle score • Rank all the stocks in the universe, then re-decile Page 26

  28. triAngle history: Value, Quality and Momentum 12 years of live triAngle history Value works in short sharp burst – normally when valuation dispersion is high. During the credit crunch, and in H2 2011, Quality and Momentum were the main drivers Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. Page 27

  29. Pan-Euro market-to-book performance But, will there be a ‘dash for trash’ this time? Quality filters don’t help when the market takes off Or did we see it in January? Q discount has lagged behind To 23 May 2012 Page 28

  30. Performance: Global Style Matrix: Risk off gain Wealth creation Screening Risk management tools Stocks & Products Value tools Performance M&A Data to 18th May 2012 Source: Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. Page 29

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