Eotm Special Edition

EYE ON THE MARKET
S P E C I A L E D I T I O N
ag ny &
THE
ecst sy
THE
THE RISKS AND REWARDS OF A CONCENTRATED STOCK POSITION

Hear Michael Cembalest, Chairman of Market and Investment Strategy at J.P. Morgan Asset
Management, discuss the topic of concentration, from the Ecstasy of creating wealth to the
Agony of how concentration can destroy wealth and result in permanent impairment
The Agony and the Ecstasy is a 1961 biographical novel by American author Irving Stone on the life of Michelangelo:
his passion, intensity and perseverance as he created some of the greatest works of the Renaissance period.
Like Michelangelo’s paintings and sculptures, successful businesses are the by-product of inspiration, hard work,
and no small amount of genius. And like the works of the Great Masters, only a small minority stand the test of
time and last over the long run. The Agony and the Ecstasy conveys the disparate outcomes facing concentrated
holders of individual stocks in a world, like Michelangelo’s, that is beset with intrigue, unforeseen risks, intense
competition and uncertainty.
Eye on the Market  J.P. MORGAN EYE ON THE MARKET • J.P. MORGAN
The Agony and the Ecstasy: The Risks and Rewards of a Concentrated Stock Position
Executive Summary
There are many Horatio Alger stories in the corporate world in which an entrepreneur or
CEO has the right idea at the right time and executes brilliantly on a business plan. But
history also shows that forces both within and outside management control led many of
their businesses to suffer serious reversals of fortune. As a result, many individuals are
known not just for the wealth they created through a concentrated position, but also for
the decision they made to sell, hedge or otherwise take some chips off the table. In this
paper, we take a look at the long history of individual stocks, and at the risks and rewards
of concentration. I first analyzed this topic in detail around ten years ago; since that time,
while some things have changed, the overall song remains the same.
Over the long run, some companies substantially outperform the broad market and maintain their
value. However, the odds have been stacked against the average concentrated holder:
• Risk of permanent impairment. Using a universe of Russell 3000 companies since 1980,
roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value. For
Technology, Biotech and Metals & Mining, the numbers were considerably higher.
• Negative lifetime returns vs. the broad market. The return on the median stock since its
inception vs. an investment in the Russell 3000 Index was -54%. Two-thirds of all stocks
underperformed vs. the Russell 3000 Index, and for 40% of all stocks, their absolute returns were
negative.
• After incorporating the issue of single stock volatility, we find that 75% of all concentrated
stockholders would have benefited from some amount of diversification.
Another sobering observation: since 1980, over 320 companies were deleted from the S&P 500 for
business distress reasons, which implies a lot of turnover. This should not be a surprise: capitalism is
based on competition, creative destruction and reinvention. While globalization (and in particular,
China’s acceptance into the World Trade Organization in 2001) expanded the opportunities for
individual companies, it also increased their competitive, regulatory and operational risks.
We start with some empirical analysis, and follow with case studies by sector. While the losses on the
stocks in our case studies may seem obvious or inevitable with the benefit of hindsight, in all likelihood
the company’s management, its board of directors, research analysts, credit rating agencies and its
employees all firmly believed in its long-term success.
Michael Cembalest
J.P. Morgan Asset Management
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Eye on the Market  J.P. MORGAN
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Table of Contents Page

Table of Contents Page
Empirical analysis
Empirical analysis
The steady drumbeat of creative destruction in the S&P 500 3
The steady drumbeat of creative destruction in the S&P 500 3
Falling from grace: catastrophic losses on Russell 3000 companies 4
Falling from grace: catastrophic losses on Russell 3000 companies 4
Success, failure and the distribution of returns on Russell 3000 stocks 6
Success, failure and the distribution of returns on Russell 3000 stocks 6
Why volatility matters and its implications for “optimal” concentrated holdings 8
Why volatility matters and its implications for “optimal” concentrated holdings 8
Sector case studies

Sector case studies
Overview 10
Overview 10
Consumer Discretionary 13
Consumer Staples 15
Consumer Staples 14
Energy 17
Energy 15
Financials 19
Financials 16
Health Care 23
Health Care 19
Industrials 24
Industrials 20
Information Technology 26
Information Technology 21
Materials 30
Materials 25
Telecommunications 32
Telecommunications 26
Utilities 34
Utilities 28
Alternative Energy 37
Alternative Energy 30
A look at the winners (The Ecstasy) 39
A look at the winners (The Ecstasy) 32
Further considerations
Further considerations
The performance of IPOs vs. the broad market 41
The performance of IPOs vs. the broad market 34
What about taxes? 42
What about taxes? 35
Final thoughts on managing concentrated stock positions 43
Final thoughts on managing concentrated stock positions 36
Appendix I: on Chinese government subsidies 44
Appendix I: on Chinese government subsidies 37
Appendix II: Biotech and Life Sciences 45
Appendix II: Biotech and Life Sciences 38
Appendix III: The regional universality of concentration risk 46
Additional Information
Additional Information
Sources 39
Sources 47
Acronyms 40
Acronyms 48
Biography 41
Biography 49
Disclaimer 42
Disclaimer 42
Please note: the results of any particular investment strategy may be uncertain. Particular circumstances may vary,
Please
and note:
other the results
factors of any
may need to particular investment
be taken into accountstrategy may be uncertain.
when deciding Particular circumstances
on any diversification may vary,
plan and timing.
and other factors may need to be taken into account when deciding on any diversification plan and timing.
2
2
2
The steady drumbeat of creative destruction in the S&P 500

A simple place to start when thinking about the risk of concentrated stock positions: how often do
their circumstances change? Since 1957, the S&P 500 has served as a proxy for 500 of the largest,
most successful US-domiciled companies. We have compiled a detailed history of its additions and
deletions since 1980, which forms the basis for this part of the analysis. To be clear, not every S&P 500
deletion was the result of a “problem stock”. Actually, most deleted companies were not the result of
a problem, and reflect benign index removals because: they were acquired at a premium to their
current price; they merged with other companies in the index; or, they reincorporated outside the US.
After sorting through the benign deletions, we focused on the rest: the S&P 500 deletions that were
a consequence of stocks that failed outright, were removed due to substantial declines in
their market value, or were acquired after suffering such a decline. As shown below, there
were over 320 of them since 1980. The pace of distress-based deletions rises during a market crisis or
recession, but there is a steady pulse of business failure during the entire business cycle. Consumer
Discretionary, Technology and Financials accounted for the majority of distress-based deletions.
Number of companies removed from the S&P 500 due Cumulative number of companies removed from the
to distress by year, Number of companies S&P 500 due to distress, Number of companies
30 350
25 300
250
20
200
15
150
10
100
5 50
0 0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013
Source: FactSet, Bloomberg, Standard & Poor's, JPMAM. 2013. Source: FactSet, Bloomberg, Standard & Poor's, JPMAM. 2013.
The spike in index removals during recessions is accurate in time, but misleading in terms of business
risk. Many such companies were much riskier than they seemed during good times, and when the tide
went out with the economy, their operational, financial and competitive weaknesses were revealed.
Our study on the creative

destruction in the S&P 500—a
proxy for some of the world’s
most successful companies—
S&P 500 reveals that, since 1980, over
320 companies were removed
from the index for reasons of
business distress.
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Falling from grace: catastrophic losses on Russell 3000 companies

The prior section looks at stocks that were deleted from the S&P 500. However, the “distress” rate of
individual stocks is higher than the index deletion rate, since there are stocks that suffer substantial
price declines from which they do not recover, irrespective of whether they remain in an index. And
what about small and mid cap stocks which are not captured by the S&P 500?
To broaden our analysis, we analyzed all stocks that were members of the Russell 3000 at any time
from 1980 to 2014, a database of 13,000 large cap, mid cap and small cap stocks. We then defined
what we believe a concentrated stock holder would see as a catastrophic loss: “a decline of 70% or
more in the price of a stock from its peak, after which there was little recovery such that the
eventual loss from the peak is 60% or more.” How often does this take place? As shown in the
table, 40% of all stocks suffered such a permanent decline from their peak value. Remember, we are
not talking about temporary declines during the tech boom-bust or during the financial crisis, but large,
permanent declines that were not subsequently recovered. Technology, Telecom, Energy and
Consumer Discretionary had the highest loss rates. In terms of subsectors, Biotech (part of Health
Care) and Metals & Mining (part of Materials) had loss rates over 50%.
Total % of companies experiencing

"catastrophic loss",
Around 40% of all stocks experienced
Sector 1980 - 2014 catastrophic declines, when defined as a
All sectors 40% 70% decline from peak value with
Consumer Discretionary 43% minimal recovery. This is a subjective
Consumer Staples 26% cutoff point; many concentrated holders
Energy 47% would see smaller permanent declines as
Materials 34% equally unacceptable, and whose risk
Industrials 35% should be mitigated. The outcomes
Health Care 42% based on a variety of thresholds suggest
Financials 25% that for many concentrated holders,
Information Technology 57%
diversification should be a central part of
Telecommunication Services 51%
wealth management planning.
Utilities 13%
Source: FactSet, J.P. Morgan Asset Management.
When do such catastrophic declines happen? The next chart shows the percentage of companies at
any given time experiencing a catastrophic loss. These loss rates tend to rise during recessions and
market corrections, but there’s a steady pace of distress even during economic expansions. I don’t
think we should draw too many conclusions from the decline in loss rates in 2010-2013; they have
been dampened by the longest and largest monetary experiment in the history of the Federal Reserve,
during which time the real cost of money has been negative for more than 5 years. There is also a
natural tailing off at the end of the chart, given that there is less time for companies to fail.
Catastrophic loss rates on Russell 3000 companies
% of companies in the process of suffering a catastrophic,
unrecovered loss of 70% or more
The Russell 3000 Index measures the
performance of the largest 3,000 US
20% companies representing approximately
98% of the investable US equity market.
15% It is reconstituted annually to ensure that
new and growing companies are
10% reflected.
5%
0%
1980 1985 1990 1995 2000 2005 2010
Source: FactSet. J.P. Morgan Asset Management.
4
4
When looking at the timing of catastrophic loss rates by sector, a few are similar to the overall market:
Consumer Discretionary, Materials, Health Care and Industrials. Some sectors experience loss rates that
are consistently above (Technology) or below (Staples and Utilities) market levels.
Information Technology: loss rates higher than the R3000 Cons. Staples & Utilities: loss rates lower than the R3000
Companies in the process of suffering a catastrophic, unrecovered loss Companies in the process of suffering a catastrophic, unrecovered loss
50% 30%
Inf ormation Technology Consumer Staples
40% Utilities
Russell 3000
20% Russell 3000
30%
20%
10%
10%
0% 0%
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
Source: FactSet. J.P. Morgan Asset Management. Source: FactSet. J.P. Morgan Asset Management.
Loss rates in Energy, Telecommunications and Financials tell the story of their respective points of
distress. For Energy, the oil price collapse of the early 1980’s and natural gas price collapse of 2008-
2011 were catalysts for rising business failures and falling stock prices, while the energy price rally of
the mid 2000’s reduced loss rates. In the case of Telecommunications, loss rates were lower than the
broad market in the 1980’s and early 1990’s. After the passage of the 1996 Telecommunications Act,
loss rates rose in a deregulated environment (see pages 32-33 for more details in our case study
section). And finally, the last chart shows the spike in Financial sector distress beginning in 2008, and
also during the 1991 recession; outside of these periods, Financial sector distress was lower.
Energy: catastrophic loss rates vs. the Russell 3000 Telecom: catastrophic loss rates vs. the Russell 3000
Companies in the process of suffering a catastrophic, unrecovered loss Companies in the process of suffering a catastrophic, unrecovered loss
50% 50%
Energy Telecommunication Services
40% 40%
Russell 3000 Russell 3000
30% 30%
20% 20%
10% 10%
0% 0%
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
Source: FactSet. J.P. Morgan Asset Management. Source: FactSet. J.P. Morgan Asset Management.
Financials: catastrophic loss rates vs. the Russell 3000

Companies in the process of suffering a catastrophic, unrecovered loss
30%
Financials
A meaningful number of companies are
Russell 3000
always in the process of suffering sharp,
20% unrecovered price declines at any given
time, even during an economic expansion.
10%
0%
1980 1985 1990 1995 2000 2005 2010
Source: FactSet. J.P. Morgan Asset Management.
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ORGAN
Success, of lifetime returns on Russell 3000 stocks
Focusing
Success, only on and
failure the risk
theofdistribution
failure missesofhalf the picture:
lifetime returns Russell rewards
theonpotential of a concentrated
3000 stocks
stock position. There are a number of ways to assess the risks and rewards involved. One approach is
Focusing
to look atonly on theand
all stocks riskcompute
of failuretheir
misses half the“lifetime”
respective picture: the returnsrewards
potential
price vs. the of a concentrated
Russell 3000 (i.e.,
stock
startingposition.
with theThere time are
when a number of ways
the company to exists
first assessinthe risksform
public and rewards involved.
and reports a stockOne approach
price, is
and until
to
its look at all stocks
last reported priceand compute
in 2014 theirthe
or until respective “lifetime”
date at which it wasprice returns
merged, vs. the Russell
acquired 3000other
or for some (i.e.,
starting with the
reason delisted 1
). time
The when the company
chart below firstresults,
shows the exists inwhich
publiccanform
be and reports aas
summarized stock price, and until
follows:
its last reported price in 2014 or until the date at which it was merged, acquired or for some other
• The median 1stock underperformed the market with an excess lifetime return of -54%. In other
reason delisted ). The chart below shows the results, which can be summarized as follows:
words, in most cases, a concentrated holder would have been better off invested in the market.
• The median stock underperformed the market with an excess lifetime return of -54%. In other
• Two-thirds of all excess returns vs. the Russell 3000 were negative, and for 40% of all
words, in most cases, a concentrated holder would have been better off invested in the market.
stocks, returns were negative in absolute terms.
• Two-thirds of all excess returns vs. the Russell 3000 were negative, and for 40% of all
• Historically, there were some extreme winners: the right tail is ~7% of the universe and includes
stocks, returns were negative in absolute terms.
companies that generated lifetime excess returns more than two standard deviations over the mean.
• Historically, there were some extreme winners: the right tail is ~7% of the universe and includes
Distribution
companies that of excess lifetime
generated returns
lifetime on individual
excess returns more stocks
thanvs. Russell
two 3000,
standard 1980-2014over the mean.
deviations
Number of stocks
2,100
Distribution of excess lifetime returns on individual stocks vs. Russell 3000, 1980-2014
Median
Number
1,800 of stocks
2,100 Extreme winners
1,500 Median
1,800
Extreme winners
1,200
1,500
900
1,200
600
900
300
600
0
300
> 0% > 0%
> 100% > 100%

> 150% > 150%
> 200% > 200%
> 250% > 250%
> 300% > 300%
> 350% > 350%
> 400% > 400%
> 450% > 450%
> 500% > 500%
> 550% > 550%
> 600% > 600%
> 650% > 650%
> 700% > 700%
> 750% > 750%
> 800% > 800%
> 850% > 850%
> 900% > 900%
> 950% > 950%
> -450%> -450%
> -400%> -400%
> -350%> -350%
> -300%> -300%
> -250%> -250%
> -200%> -200%
> -150%> -150%
> -100%> -100%
> 50% > 50%

> -50% > -50%
> 1000%> 1000%

> 1050%> 1050%
> 1100%> 1100%
> 1150%> 1150%
> 1200%> 1200%
> 1250%> 1250%
> 1300%> 1300%
> 1350%> 1350%
> 1400%> 1400%
> 1450%> 1450%
> 1500%> 1500%
> 1550%> 1550%
> 1600%> 1600%
> 1650%> 1650%
> 1700%> 1700%
> 1750%> 1750%
> 1800%> 1800%
> 1850%> 1850%
> 1900%> 1900%
> 1950%> 1950%
> 2000%> 2000%
> 2050%> 2050%
0
Time-adjusted lifetime price return on each stock vs. the Russell 3000 Index
Time-adjusted lifetime price return on each stock vs. the Russell 3000 Index
The relative
Source: frequency
FactSet, of success
J.P. Morgan Asset and failure shown above is not sensitive to when companies were
Management.
created. For example, in one scenario, we excluded all Technology, Biotech and other companies that
The relative
went public frequency
between 1995 of success and failure
and 2000 in ordershown
to testabove is not
whether thesensitive to when
subsequent companies
collapse in manywere of them
created.
had For example,
an outsized impactinon onethescenario, we excluded
results above. They do all not;
Technology,
even when Biotech and other
excluding thesecompanies
companies,that the
went public
median returnbetween 1995 andthe
is still negative, 2000 in order of
percentage to companies
test whether the subsequent the
underperforming collapse
indexinismany of them
still around
had an outsized
two-thirds, and the impact on the results
percentage above.
of winners They
is still do not; even when excluding these companies, the
7%.
median return is still negative, the percentage of companies underperforming the index is still around
two-thirds, and the percentage of winners is still 7%.
1
We compare stock price returns to Russell 3000 price returns. When including the impact of dividends on both
individual stocks and the Russell 3000, the results do not change materially, even for the Utilities sector.
1
We compare stock price returns to Russell 3000 price returns. When including the impact of dividends on both 6
6individual stocks and the Russell 3000, the results do not change materially, even for the Utilities sector.
6
E ye o n t h e M a r k e t  J.P. MORGAN
The
E y e osuccess/failure
n t h e M a r k e t distribution
J . P . M O R G Ais
N similar
across most sectors. As shown EYE ON THE returns
below, MARKET on• the
J.P. MORGAN
median stock were negative in each sector; 60%-70% of stocks in most sectors generated lifetime
2
excess
The returns less than
success/failure the Russell is
distribution 3000 ; a third
similar or more
across most generated
sectors. As negative
shownabsolute returns;
below, excess and on
returns
aside
the from Consumer
median stock wereStaples, the
negative in percentage
each sector;of60%-70%
extreme winners was
of stocks in in single
most digits.
sectors generated lifetime
excess returns less than the Russell 3000 2; a third or more generated negative absolute returns; and
Analysis of lifetime returns by sector, 1980-2014
aside from Consumer Staples, the percentage of extreme winners was in single digits.
Median excess Percentage of stocks Percentage of stocks Percentage of
Analysis of lifetime returnsreturn
by sector, 1980-2014with negative
vs Russell with negative extreme winner
Sector 3000
Median excess Percentage of stocks Percentage ofreturns
EXCESS returns ABSOLUTE stocks stocks of
Percentage
All Sectors return-54%
vs Russell with negative
64% with negative
40% extreme7%winner
Sector
-62% EXCESS65%returns ABSOLUTE44% returns stocks
7%
All Sectors Staples
Consumer -54%
-3% 64%
51% 40%
26% 7%
15%
Consumer
Energy Discretionary -62%
-93% 65%
72% 44%
48% 7%
6%
Consumer
Materials Staples -3%
-73% 51%
66% 26%
34% 15%
8%
Energy
Industrials -93%
-58% 72%
64% 48%
37% 6%
7%
Materials
Health Care -73%
-39% 66%
60% 34%
42% 8%
Industrials
Financials -58%
-21% 64%
58% 37%
30% 7%
6%
Health Care Technology
Information -39%
-63% 60%
71% 42%
53% 8%
6%
Financials
Telecommunication Services -21%
-57% 58%
68% 30%
54% 6%
Information
Utilities Technology -63%
-141% 71%
85% 53%
14% 6%
0%
Telecommunication
Source: Services
FactSet. J.P. Morgan -57%
Asset Management. 68% 54% 6%
Utilities -141% 85% 14% 0%
Source: FactSet.
Here’s J.P. Morgan
a synthesis of what we have done so far. Cisco Systems
Asset Management.
Stock price
The first step measured the frequency of a stock $80
price suffering
Here’s a catastrophic
a synthesis of what decline.
we haveThis doneis aso far. Cisco
$70 Systems
Stock price Eventual loss from
painful
The firstevent; however, the
step measured some concentrated
frequency holders
of a stock peak of: -67%
$60
$80
price say, “a decline
mightsuffering from unsustainable
a catastrophic decline. Thismarket is a
$50
$70 Eventual loss from
painful
valuations event;
washowever, some
painful, but concentrated
I still benefited holders Max loss from
$40
$60 peak of: peak of: -67%
-86%
might
substantially decline
say, “afrom from
being unsustainable
concentrated market
in the stock. Since inception stock
valuations
My originalwas painful,
basis butlow,
was very I stillso
benefited
things turned out $30 price return of 27%
$50
Max loss from
annually vs. market
substantially
fine in the long from being
run.” concentrated
There are many in the stock.
examples of $20
$40
returns of 8% peak of: -86%
Since inception stock
My
this original
paradigm, basis was very low,
particularly so things turned
in Technology. Take out $10 price return of 27%
$30
Cisco,
fine in whose
the long business modelare
run.” There survived
many the tech of
examples $0 annually vs. market
$20
collapse. It suffered a hugeinprice decline from returns 1994
of 8%
this paradigm, particularly Technology. Takeits $10
1990 1998 2002 2006 2010 2014
peak and
Cisco, has business
whose only recaptured a small amount
model survived the techsince Source: Bloomberg, J.P. Morgan Asset Management. July 2014.
$0
then, but It
collapse. still generated
suffered substantial
a huge excessfrom
price decline returns
its 1990 1994 1998 2002 2006 2010 2014
vs. theand
peak market overrecaptured
has only the long run for its original
a portion concentrated
since then, holders.
Source: Bloomberg,That’s the Asset
J.P. Morgan purpose of theJuly
Management. second
2014.
step:still
but life-cycle
generated analyses of stock
substantial pricereturns
excess returns,vs.tothe
look for stocks whose returns were positive over the
long runover
market despite interim
the long runcollapses and volatility.
for its original concentratedThe negative
holders. skew
That’s ofthe
thepurpose
distribution onsecond
of the the priorstep:
page shows
life-cycle that while
analyses some
of price stockstogenerated
returns, volatile
look for stocks but positive
whose returnslife-cycle returns
were positive (like
over theCisco), many
long run
more did
despite not. collapses and volatility. The negative skew of the distribution on the prior page shows
interim
that while some stocks generated volatile but positive life-cycle returns (like Cisco), many more did not.
The frequency of catastrophic declines and the negative skew in the distribution of
individual
The stockofreturns
frequency compound
catastrophic our and
declines perception of concentrated
the negative skew in thestock risk, andof
distribution suggest
individual stock returns
that diversification play compound ourrole
an important perception ofplanning
in wealth concentrated stock
for most risk, and suggest
entrepreneurs.
that diversification play an important role in wealth planning for most entrepreneurs.
2
In the case of Utilities, the frequency of negative absolute returns is very low, while the frequency of negative
excess returns is high. This is a reflection of the lower returns on utility stocks, which are offset by their much
2lower catastrophic loss rate. While utility stock risk is lower than the market, there have been more than a few
In the case of Utilities, the frequency of negative absolute returns is very low, while the frequency of negative
examples
excess of extreme
returns is high.utility
This distress, as explained
is a reflection in thereturns
of the lower case study section.
on utility stocks, which are offset by their much
lower catastrophic loss rates. While utility stock risk is lower than the market, there have been more than a few 7
examples of extreme utility distress, as explained in the case study section. 7
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Why volatility matters and its implications for “optimal” concentrated holdings
To many clients, stock price changes over the long run are all that matter, rather than anything that
happens in between. However, volatility can be an important signal since it tells us something about
the risk of a stock. Not everyone agrees that interim price movements are a good proxy for “risk”; in
some cases, they aren’t. However, over the long run, returns and volatilities tend to track each
other pretty closely. For purposes of this
Higher volatility usually associated with lower stock
analysis, we define risk as “volatility of price returns, Universe: Russell 3000 stocks, min. 3 years of
negative stock price movements”; in other returns, 1980-2014
words, we look at volatility from falling stock 200%
Annualized stock price return

prices rather than from falling and rising ones.
150%
I find that most investors prefer this definition
of risk (technically referred to as semi- 100%
deviation), since they are not worried about 50%
the risk of rising prices. As shown, if the
0%
volatility of your stock is rising sharply,
chances are that its returns are falling. -50%
-100%
Next, we factor risk into the equation of 0% 20% 40% 60% 80% 100% 120% 140%
being a concentrated stockholder. With 20- Downside volatility (semi-deviation)
20 hindsight, we can compute the “optimal” Source: FactSet, J.P. Morgan Asset Management.
combination of any stock with the Russell
3000. In other words, what combination of each stock and the Russell 3000 would have
delivered the best risk-adjusted return? Such an approach did not always hold a lot of a high-
returning stock if its volatility was too high. Similarly, it held more of a lower-returning stock if it
exhibited attractive diversification benefits vs. the Russell 3000. The results tell us something about the
frequency with which concentrated holders would optimally choose to own different amounts of their
stock, if the issue of price volatility mattered to them.
The bar chart below shows the results. There were quite a few cases when the optimal course of action
from a risk-adjusted perspective was to own 100% in the concentrated stock: that happened around
6% of the time (500 observations in our data set). However, in the majority of cases, it made sense to
own no more than 30% of the concentrated stock, and often none of it. This is not a surprise; as per
page 6, if two-thirds of stocks underperformed the Russell 3000, it is very unlikely that a risk-adjusted
approach would want to own many of them since it would prefer to own the Russell 3000 instead.
Optimal mix of a concentrated stock position with the

Russell 3000, 1980-2014, number of observations
3,500
3,000
2,500
2,000
1,500
1,000
500
0
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Optimal concentrated stock weight
8
8
As a last step in our empirical analysis, we weave together each of the three risk factors we
have examined so far: the risk of catastrophic loss, the risk of underperforming the Russell
3000 and finally, the risk of heightened volatility that subjected concentrated holders with
insufficient diversification to a very wild ride.
In the table below, we show the percentage of stocks in each sector that:
• suffered a catastrophic loss; or
• generated negative absolute lifetime returns; or
• generated negative excess lifetime returns vs. the Russell 3000; or
• experienced high volatility such that the optimal portfolio process described on the prior page
chose to own no more than 20% in the stock.
In other words, all the cases in which some amount of diversification would have made sense. With
the benefit of hindsight, in around three-quarters of all cases, diversification could have played an
important role in sustaining family wealth.
Percent of stocks whose concentrated holders
would have benefited from diversification, 1980-2014
Sector Percent
All sectors 74%
Consumer Discretionary 74%
Consumer Staples 58%
Energy 81%
Materials 75%
Industrials 75%
Health Care 72%
Financials 63%
Information Technology 82%
Telecommunication Services 74%
Utilities 87%
9
9
Sector
EYE
E ON
ye o n case
tTHE
he Mstudy
a r k e tforensics
MARKET  •
J . J.P.
P . MMORGAN
ORGAN
A deeper
Sector casedivestudies:
into catastrophic stock price
some forensics loss reveals important
on catastrophic loss realities of global business dynamics.
There are hundreds of cases to choose from; the ones selected illustrate different paradigms and
factors
A deeperaffecting
dive intostocks that suffered
catastrophic stock substantial and permanent
price loss reveals importantimpairment.
realities of globalWe focus on large
business cap
dynamics.
(and the
There areupper end of mid
hundreds casescap), since many
to choose from;were “household
the ones names”
we selected at thedifferent
illustrate peak of paradigms
their success.thatIt is
not always
resulted simple to explain
in substantial why a company
and permanent suffered
impairment. We a focus
decline,
onsince
largeacap combination of fundamental
(and the upper end of mid
factors and the whims of investor sentiment are involved. The descriptions
cap), since many were “household names” at the peak of their success. It is not always represent oursimple
perception
to of
the primary
explain why factors;
a companyother explanations
suffered maysince
a decline, be just as plausible. ofNote
a combination that thesefactors
fundamental examples
andwere chosen
the whims
in the
of summer
investor of 2014;
sentiment areover time, many
involved. “Lazarus” stocks
The descriptions come
represent ourback from theofdead,
perception so it is fair
the primary to
factors;
assume
other that some of
explanations them
may mayasrecover
be just fromNote
plausible. theirthat
current levels.
these examples were chosen in the summer of
2014;
In over studies,
the case time, manythere“Lazarus” stocksofcome
are instances back over-expansion,
leveraged from the dead, so it is fair totowards
particularly assumethethatendsome
of aof
them may recover from their current levels.
business cycle, and examples of management misreading rapidly-changing industry dynamics and
competitive
In factors.there
the case studies, There were
are also examples
instances of companies
of leveraged that mismanaged
over-expansion, particularly atowards
large acquisition;
the end ofwe a
were not surprised to find these instances, since most studies we have seen
business cycle, and examples of management misreading rapidly-changing industry dynamics estimate M&A failure
and rates
3
at 50% to 80%
competitive of allThere
factors. transactions
are also.examples
However,ofmany of the companies
companies suffereda due
that mismanaged largetoacquisition;
factors largely
we
outside
were notmanagement’s control.
surprised by this, since We
mostliststudies
some ofwethese
have exogenous
seen estimatefactors
M&Ainfailure
the box on the
rates facing
at 50% to 80%
page. After reviewing
of all transactions 3
the companies
. However, affected suffered
many companies by them,due
it isto
not clear that
factors evenoutside
largely the bestmanagement
management
teams in the world could have done much to alter the ultimate outcome.
control. We list some of these exogenous factors in the box on the facing page. In these cases, it is
not clear
While that catastrophic
some even the best losses
management
on the teams in thepages
following world may
couldseem
have obvious
done much or to alter the with
inevitable
ultimate outcome.
the benefit of perfect hindsight, in all likelihood the company’s management, its board of
directors,
While someresearch analysts,
catastrophic credit
losses on rating agenciespages
the following and itsmayemployees all firmly
seem obvious believed in
or inevitable its
with
long-term
the benefitsuccess.
of perfect hindsight, in all likelihood the company’s management, its board of
directors, research analysts, credit rating agencies and its employees all firmly believed in its
Notes aboutsuccess.
long-term the charts
Some examples show pre-Chapter 11 prices of companies that have since emerged from bankruptcy
and areabout
Notes now the
thriving with sound operating businesses (e.g., Charter Communications and Calpine), in
charts
which case the primary problem was
Some examples show pre-Chapter 11often
pricesthe
of firm’s prior that
companies capital structure.
have All stocks
since emerged fromarebankruptcy
shown
through their final reported pricing date, which is either July 31, 2014, or an earlier
and are now thriving operating businesses (e.g., Charter Communications and Calpine). All stocks date when the are
shown through their final reported pricing date, which is either July 31, 2014, or an earlier dateon
company was acquired, merged or delisted and which is noted below the chart. Price histories when
many
the stocks reflect
company split adjustments
was acquired, merged or that took place
delisted over time,
and which suchbelow
is noted that historical
the chart.prices
Priceappear lower
histories on
than the
many levels
stocks at which
reflect split they were once
adjustments thatquoted.
took place over time, such that historical prices appear lower
than the levels at which they were once quoted.
3
The earliest analyses performed in the US and Europe in the 1970’s found merger and acquisition failure rates
of 40%-50%. More recent estimates are higher. Wharton’s “Why Do So Many Mergers Fail” cites professor
Robert
3 Holthausen,
The earliest whose
analyses failureinrate
performed theestimates range from
US and Europe in the50%-80%. A 2010
1970’s found mergerstudy
andfrom McKinsey
acquisition estimates
failure rates
failure rates of 66%-75%. And in a 2010 book from Mitchell Lee Marks (San Francisco State
of 40%-50%. More recent estimates are higher. Wharton’s “Why Do So Many Mergers Fail” cites professor University, and an
advisor in 100 mergers
Robert Holthausen, andfailure
whose businessratetransitions), failurefrom
estimates range rates50%-80%.
are estimated at 75%.
A 2010 study from McKinsey estimates
failure rates of 66%-75%. And in a 2010 book from Mitchell Lee Marks (San Francisco State University, and an 10
advisor in 100 mergers and business transitions), failure rates are estimated at 75%.
10
10
Force Majeure: a partial list of exogenous factors that can put companies at risk and
which are outside management control
• commodity price risks that cannot be hedged away

• government policy examples: changes in service reimbursement rates, a slowdown in FDA
approval patterns, bandwidth and other public domain privatizations which increase the scope
of competition, changing subsidies for renewable energy, changes in carbon tax regimes and
fracking rules, government-sponsored enterprises with a lower cost of funds crowding out
private sector activity, changes in the interpretation of anti-trust rules, shifts from capacity
pricing to merchant pricing (natural gas), etc.
 on government action, deregulation has proven to be just as disruptive as re-regulation,
particularly as it relates to boom–bust cycles in telecommunications, utilities and broker-
dealers
• foreign competitors whose market share is magnified by government subsidies and
exchange rate manipulation
 China’s exchange rate management and subsidies to its auto, steel, solar, paper and glass
companies are primary examples (see Appendix I for more details)
• intellectual property infringement by domestic or foreign firms (see Appendix I)
• the impact of patent trolls, estimated to cost US businesses upwards of $20 billion per year
• changes in US or foreign government tariff or trade policy
• fraud by non-executive employees, which according to SEC investigations from 1997-2007
accounted for ~30% of all instances; or fraud by employees or management in companies that
you acquire, or which acquire you
• technological innovation that effectively provides consumers with enough information to
bypass intermediaries and distributors
• a shift in buying power to the firms’ customers resulting from consolidation
• unconstrained expansion by competitors, leading to a collapse in pricing power
11
11
EYE ON THE MARKET • J.P. MORGAN
Consumer Discretionary
Future success may seem assured once a company establishes a brand presence, but our
study reveals that plenty can go wrong even for mature companies.
12
Consumer Discretionary has seen its fair share of catastrophic declines (see list on following page). Big
box multi-line retailing, online retailers, auto parts, print media, publishers, music, faddish apparel and
restaurant chains make up most of the list. One factor perhaps underappreciated by concentrated
holders: according to Nielsen surveys, US consumers are less brand-loyal than their counterparts
in Europe, Asia, the Middle East and Latin America when it comes to mobile phones, personal
electronics, electronic appliances, beauty products, health/medical products, in-store retail and
cable/internet service. They’re also more likely to switch brands for a better price. Many brands
enjoyed success during their initial expansion phase, but faced challenges when organic new store
growth slowed, and when consumer tastes changed. Radio, music and print media struggled with
shifting technology, which put a lot of pressure on ad revenues (e.g., a 57% drop in newspaper ad
revenue from 2000 to 2009).
Once the pioneer of discount retailing, management Overleveraged cable television acquisition spree paid
outflanked by Walmart and Target, and underinvested for with inflated stock price; accounting issues
in merchandise, key locations and supply chain $25
$30
Kmart Corporation
$25 $20
Charter Communications
$20 $15
$15
$10
$10
$5
$5
$0 $0
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: Bloomberg. May 2003. Source: Bloomberg. November 2009.
Surpassed by digital competitors; low barriers of entry Bad timing: leveraged theme park acquisitions heading
$90 into a recession
$80 $40
Weight Watchers International Inc. $35
$70
$60 $30
$50 $25 Premier Parks Inc. (Six Flags)

$40 $20
$30 $15
$20 $10
$10 $5
$0 $0
2002 2004 2006 2008 2010 2012 2014 1996 1998 2000 2002 2004 2006 2008 2010
Source: Bloomberg. July 2014. Source: Bloomberg. May 2010.
Scorched earth strategy works too well: fending off The Organic sales growth hits a wall at 2,000 stores,
Limited (via spinoff of Neiman Marcus and massive debt) acquisition of a key but fading rival compounds the
doomed the company's future problem
$180 $35
$160
$30
$140
$120 Carter Hawley Hale $25
Stores (Broadway Stores) Sunglass Hut International Inc.
$100 $20
$80 $15
$60
$10
$40
$20 $5
$0 $0
1988 1989 1990 1991 1992 1993 1994 1995 1994 1995 1996 1997 1998 1999 2000 2001
Source: Bloomberg. October 1995. Source: Bloomberg. April 2001.
13
12
EYE
E y e ON
o n THE MARKET
the M a r k e t  •J J.P.
.P. MMORGAN
ORGAN
There are dozens of other cases we could have chosen to illustrate examples of distress in the
Consumer Discretionary sector. The table below shows some of the more recognizable names. Some
date back to the 1980’s, while others are more recent.
Select Consumer Discretionary stocks in the Russell 3000 suffering unrecovered, catastrophic
losses (see page 4 for definition) by industry, 1980 to 2014
Auto Components Household Durables (continued) Media (continued)

Dana Corp. Kaufman & Broad Home Corp. RH Donnelly Corp.
Delphi Corporation Maytag Corporation Savoy Pictures Entertainment, Inc.
Federal-Mogul Corp. Pillowtex Corp. Warner Music Group Corp.
Goodyear Tire & Rubber Company Sealy Corp. Westwood One Inc.
Lear Corporation Standard Pacific Corp. XM Satellite Radio Holdings
Visteon Corp. Sunbeam Corporation
Zenith Electronics Corporation Multiline Retail
Department Stores Ames Department Stores Inc.
Federated Department Stores Inc. Internet & Catalog Retail Bradlees Discount Store Inc.
Macy's, Inc. barnesandnoble.com inc. Caldor Corp.
Buy.com Inc. Circle K Corp.
Distributors Drugstore.Com Inc. Filene's Basement Corp.
GNC Energy Corp. eToys, Inc. J. C. Penney Company, Inc.
Subaru of America Inc. Home Shopping Network, Inc.
Lillian Vernon Corporation Specialty Retail
Diversified Consumer Services Nutrisystem, Inc. Aeropostale, Inc.
Apollo Education Group Inc. Spiegel Inc. bebe stores, Inc.
Corinthian Colleges Inc. Webvan Group, Inc. Blockbuster Inc.
Education Holdings 1 Inc. Boise Cascade Corporation
ITT Educational Services Inc. Leisure Products Borders Group Inc.
Learning Tree International Inc. Baldwin Piano & Organ Company Chico's FAS, Inc.
Callaway Golf Company Circuit City Stores, Inc.
Hotels Restaurants & Leisure LeapFrog Enterprises, Inc. Coldwater Creek Inc.
Bally Total Fitness Holding Corp. Polaroid Corporation CompUSA Inc.
Boston Chicken, Inc. Worlds of Wonder, Inc. Design Within Reach, Inc.
Boyd Gaming Corporation Eddie Bauer Holdings Inc.
Checkers Drive-In Restaurants, Inc. Media FAO Schwarz, Inc.
Chi-Chi's Inc. Adelphia Communications Corporation Heileg-Myers Furniture Co.
Churchs Fried Chicken, Inc. Cablevision Systems Corporation Jennifer Convertibles Inc.
Coleco Industries, Inc. Carolco Pictures Inc. Just For Feet, Inc.
Cosi, Inc. Clear Channel Outdoor Holdings Inc. Lechter's Inc.
Krispy Kreme Doughnuts, Inc. Crown Media Holdings Inc. Office Depot, Inc.
Luby's, Inc. Emmis Communications Corporation RadioShack Corp.
Monaco Coach Corporation Gannett Co., Inc. Restoration Hardware Inc.
Morton's Restaurant Group Inc. Harcourt Brace Jovanovich Inc. Sharper Image Corp.
Patriot American Hospitality Inc. Harte-Hanks Inc. Talbots Inc.
Rainforest Cafe, Inc. Idearc Inc. Today's Man Inc.
Shoney's Inc. Intelsat Corporation
Sizzler Restaurants International Inc. Interpublic Group of Companies, Inc. Textiles Apparel & Luxury Goods
TCBY Enterprises, Inc. Loews Cineplex Entertainment Corp. Burlington Industries Inc.
Trump Hotels & Casino Resorts, Inc. Martha Stewart Living Omnimedia, Inc. Crocs, Inc.
McClatchy Company Fruit of the Loom Ltd.
Household Durables New York Times Company Jones Apparel Group Inc.
Centex Corp. Orion Pictures Corporation L.A. Gear, Inc.
Hovnanian Enterprises, Inc. Readers Digest Association Inc. North Face, Inc.
14
13
Consumer Staples
As noted on page 5, Consumer Staples have a lower rate of catastrophic price decline than the market
as a whole. The Staples that did suffer such declines were often low-margin supermarket, drug store
and convenience store chains that struggled to compete with the rise of Walmart (Bruno’s, Drug
Emporium, Food Lion, A&P, SuperValu, Pantry Inc. and Winn-Dixie); we only review one of them below
since the narratives are similar. According to a 2009 study from Dartmouth, when a Walmart opens in
a new market, median sales drop 40% at similar high-volume stores, 17% at supermarkets and 6% at
drug stores. There are some other episodes worth discussing, which we review as well. The first one
below refers to the 15-year US-European banana war, an illustrative example of risks around trade and
tariffs. Eventually, Europe reached a deal under which it planned to provide equal treatment to all
importers. Unfortunately, this came too late for companies like Chiquita Brands.
Chiquita expanded during trade talks to open European Competition in low-margin supermarkets from Walmart
banana market, suffers when Europe opts to maintain and Publix too much for “America’s Supermarket”
imports from former colonies; 2001 Chapter 11 filing $60
$60
United Brands Company (Chiquita) $50
$50
$40
$40 Winn-Dixie Stores Inc.
$30
$30
$20
$20
$10 $10
$0 $0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 1981 1984 1987 1990 1993 1996 1999 2002 2005
Source: FactSet. March 2002. Source: Bloomberg. November 2006.
Sometimes there’s no room for #3 (behind Duracell and Over-leveraged Revlon runs into deep-pocketed
Energizer); non-core acquisitions (pet supply) outside competitors (J&J, P&G), and loses
company core competence $500
$45
$40 $400
$35
Rayovac Corporation
$30 $300
$25 Revlon Inc.
$20 $200
$15
$10 $100
$5
$0 $0
1998 2000 2002 2004 2006 2008 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Source: Bloomberg. August 2009. Source: Bloomberg. July 2014.
Doing business in China involves under-regulated supply Chapter 22? Hostess first went bankrupt in 2004, citing
chains and the lack of consumer safeguards reduced demand for high-carb snacks and rising
$50 labor/energy costs
$40
$40
Synutra International Inc. $30
$30
$20
$20
$10 $10
Hostess Brands
(Interstate Bakeries)
$0 $0
2006 2007 2008 2009 2010 2011 2012 2013 2014 1992 1994 1996 1998 2000 2002 2004 2006 2008
Source: Bloomberg. July 2014. Source: Bloomberg. February 2009.
15
14
Energy
Our analysis shows that equipment, service and drilling companies, along with the core
exploration and production companies, are some of the most risky within the Russell 3000.
16
Energy
Energy rivals Technology as the sector most ideally suited to discussions about concentration risk. The
nature of exploration and production, commodity prices, business cycle risks, environmental accident
risks and regulatory issues create a volatile backdrop for many oil and gas stocks. Event risk in E&P
spiked during the oil price decline in the early 1980’s, and almost every time since when a commodity
price falls unexpectedly, such as during the natural gas price decline of 2009. Energy stock price
volatility is not just an issue for E&P: out of 27 S&P 500 industries with at least 8 stocks, Energy
Equipment & Services exhibited the highest volatility from 2002 to 2012, even higher than Metals &
Mining, Software and Semiconductors (recent equipment/services catastrophic loss examples include
McDermott, Willbros and Hercules). Business risk in the Energy sector is not confined to oil/gas and
related services: despite the world’s voracious use of coal (up 50% since 2000, with 2013 as the
highest year of global coal consumption as a % of primary energy since 1970), coal companies face
plenty of challenges as well.
Largest coal company in the world; global expansion Texas-based natural gas company suffers from
designed to reduce impact of US regulations and nat collapse in natural gas prices, and leverage (45% of
gas boom ended up damaging margins revenue in Q1 2014 used to pay interest expense)
$100 $45
Peabody Energy Corporation Quicksilver Resources Inc.
$40
Similar stock price declines: Similar stock price
$80 $35
Arch Coal, Alpha Natural declines: Chesapeake,
Resources, Consol, James $30 SandRidge, Comstock,
$60 River, Patriot Coal $25 Exco, Ultra Petroleum,
Penn Virginia
$20
$40
$15
$20 $10
$5
$0 $0
2002 2004 2006 2008 2010 2012 2014 2000 2002 2004 2006 2008 2010 2012 2014
Source: Bloomberg. July 2014. Source: Bloomberg. July 2014.
When core competence is in shallow water, deepwater Owners of Deepwater Horizon, the semisubmersible
operations can be high risk for companies providing drilling rig which caught fire, exploded and then sank in
construction equipment and services the Gulf of Mexico
$35 $175
$30 $150
Transocean
$25 $125
McDermott International Inc.
$20 $100
$15 $75
$10 $50
$5 $25
$0 $0
1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Early 1980's: OPEC over-supply and lower oil demand What happens to the largest operator of oil tankers
due to recession hurts E&P and equipment/servicers when tanker rates decline by 40%-50%; leverage and
$3,500 some aging vessels compound the problem
Western Company of North America $80
$3,000
$70
Similar stock price declines: Frontline Ltd.
$2,500 Dome Petroleum, Edisto Resources, $60
Southland Royalty, Apache, Parker Drilling
$2,000 $50
$40
$1,500
$30
$1,000 $20
$500 $10
$0
$0
2000 2002 2004 2006 2008 2010 2012 2014
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989
Source: FactSet. March 1989. Source: Bloomberg. July 2014.
17
15
Financials
In Financials, we see that the influence of public policy can rapidly change the behavior of
other players in the industry, altering the risk profile of a concentrated holder’s position.
18
Financials
There’s a long list of banks, brokerage firms, mortgage insurers, REITs and specialty finance companies
that suffered permanent price declines during the financial crisis of 2008-2009. What’s interesting for
purposes of understanding concentration risk in Financials: the role that government policy can
play in altering or influencing the behavior of private sector firms. As described in a November
2013 Eye on the Market (“Course of Empire”), US government-sponsored enterprises took a lot of the
oxygen out of the room: the green and red lines in the chart show the increase in high-risk lending
undertaken by the GSEs which predated the massive increase in subprime and Alt A lending by the
private sector (black line). The GSE increases move roughly in tandem with lending standards which
required the GSEs to make more low and moderate income loans (blue line). This timeline is not meant
to absolve the private sector, which made some horrendous and well-documented underwriting
decisions; the point is to understand what government actions and policies preceded them.
The Course of Empire: Prelude to Destruction
Percent of annual underwriting (except Fannie/Freddie share based on total outstanding balances)
60%
Freddie Mac/Fannie
55% Mae underwriting
Fannie/Freddie share of GSE
50% FHA LTV >=97% that exceeded
+ Private sector traditional standards
45% 1
2
in selectively
40% disclosed portfolio
35% GSE Low & Moderate
3
Income lending target 1. Non-traditional Freddie Mac
30% 2. Freddie cash out CLTV > 75%
4
25% 5 3. Fannie/Freddie DTI > 38%
4. Fannie purchase loan CLTV > 90%
20% 5. Fannie/Freddie DTI >= 42%
15%
10% Private sector subprime and Alt A % of
5% total origination
0%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: American Enterprise Institute. J.P. Morgan Asset Management. November 2013.
A brief summary of the timeline (see November 18, 2013 Eye on the Market for more details)
In 1990, Fannie Mae and Freddie Mac (government-sponsored enterprises) adhered to prudent underwriting on
single family mortgages: the vast majority had debt-to-income ratios below 38%, loan-to-values below 90% on
purchase loans, or loan-to-values on cash-out refinancing loans below 75%. The GSEs had a one-third share of
outstanding mortgages. Private sector subprime had existed for decades, but was limited in size at ~10% of
annual residential mortgage origination. Home ownership rates and home prices relative to income and
replacement cost were stable at post-war averages.
The era of sound GSE lending did not last. The 1992 “Federal Housing Enterprises Financial Safety and
Soundness Act” enabled the Department of Housing and Urban Development to set formalized minimum
affordable lending standards for the GSEs. HUD first set Low & Moderate Income standards at 30% of annual
GSE acquisitions, and raised them to 50% in the week before the November 2000 election. Home ownership
rates jumped, and home prices relative to replacement cost, rent and household income began to rise above
historically stable levels.
By 2002, the GSEs had increased their market share from one-third to 60% as the size of the mortgage market
rose by 2.5x vs. 1990. Freddie Mac’s non-traditional loans were ~45% of their annual acquisitions and
guarantees, and more than 40% of Fannie Mae’s Alt A (low documentation) loans qualified for the HUD-
determined affordable housing goals. Note that the GSE revolution took place before the explosion in private
sector subprime and Alt A loans.
In 2003, the private sector found a way to compete: the deepening of private mortgage backed securities
markets. Home prices surged further, and the mortgage market doubled in size vs. 2002. The private sector
regained market share, mostly through subprime and Alt A loans which rose to 40% of annual origination. To
be clear, private sector defaults and losses per dollar on subprime were much worse than on GSE loans,
particularly when related to malignant derivative offshoots.
19
16
EYE
E ON
ye o n tTHE
he MMARKET
a r k e t  •J . J.P.
P . MMORGAN
ORGAN
Another large part of the financial crisis Growth in assets and major financial sector legislation
resulted from under-capitalized risk-taking Index, 12/31/1992 = 100
1,000
at the 5 large broker-dealers. As background,
900 Broker-dealers $4.2 Trillion
in the mid 1970’s, broker-dealers like Merrill 5 institutions
800
Lynch, DLJ and A.G. Edwards were leveraged SEC Uniform Net
700
from 5-to-1 to 8-to-1. Most of their activities Capital Rule Change
600
were “brokering” (acting as agent), not 500
“dealing” (acting as principal). Commission Gramm-Leach-
400 $10 Trillion
deregulation then reduced their core profitability Bliley Act
300 513 institutions
(commissions declined from 61% of industry 200
Commercial banks
revenues in 1965, to 40% in 1976, to 16% in 100
>$1billion in assets
1990), leading many firms to push for ways to 0
take on higher leverage and higher risk. In 2004, Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Dec-07
the SEC eliminated the Net Capital Rule that had Source: FDIC, Bloomberg.
limited broker-dealer leverage at 12-1 since
1975. As shown in the chart, broker-dealer balance sheets soared after this took place. By 2006,
broker-dealers were leveraged around 30/35-1, with the 5 largest balance sheets comprising $4.2
trillion in assets, and the rest is history.
In terms of what has happened since, the chart below shows the degree to which stock prices of the
largest S&P 500 banks and capital markets firms recovered relative to June 2007 levels. Surviving firms
are now adhering to stricter capital standards not only via higher minimum requirements, but also in
improved quality of capital (more reliance on loss-bearing capital like tangible common equity and the
exclusion of trust preferreds from Tier 1 capital altogether). Furthermore, US banks have made a
substantial transition away from wholesale (interbank) liquidity, which has fallen from 47% to 27% of
all funding. All things being equal, these steps should reduce event risk in the financial system.
However, banks are still highly exposed to the business cycle, credit losses and changes in monetary
policy; substantial risks of concentrated ownership remain.
S&P 500 Banks, Brokers and Consumer Finance firms: changes in stock price vs. June 2007
Current index level, 6/30/2007=100
150
140
Higher than June 2007 stock price
130
Below June 2007 stock price
120 Delisted or acquired*
110
100
90
80
70
60
50
40
30
20
10
0
Synovus
Schwab
E*TRADE
WaMu
Wachovia
Bank of America
Comerica
Commerce Banc.
KeyCorp
Goldman Sachs
Zions Bancorp
Regions
US Bancorp
Merrill Lynch
SunTrust
Bear Stearns
Countrywide
SLM Corp
Fifth Third Bank
M&T Bank
BB&T Corp
JPMorgan Chase
PNC Financial
Wells Fargo
Amer. Express
Citigroup
CIT Group
Huntington
National City
Morgan Stanley
Marshall & Ilsley

First Horizon
Lehman
Capital One
Source: Bloomberg. J.P. Morgan Asset Management. July 31, 2014. *Delisted or acquired stocks shown as of last reported price bef ore delisting or acquisition.
20
17
As for Financial concentration risk before 2008, there was a spike in distress in banks and thrifts during
the consumer-led recession of the late 1980’s. What’s more interesting as part of a discussion on
concentration risk are the Financial sector business models that are presumably more stable: insurance
companies, companies acting as fee-based transaction agents, REITS and asset managers. History
provides quite a few examples of how overly aggressive insurance companies, without access to the
Fed’s Discount Window, can experience substantial distress when the business cycle turns. While many
financial institutions have made substantial changes to their approach to leverage since the credit crisis,
REIT capital structures look pretty similar, with most leveraging via bond markets instead of through
syndicated bank loans. As a result (and given their cash flow distribution requirements), equity and
mortgage REITs implicitly assume that credit and equity markets will remain open, even during a
recession. The REIT stresses during 2008-2009 were in some ways the first big test for the sector, since
they were much less prevalent during the prior commercial real estate recession in 1990-1991.
There are a million flavors of derivatives, and some of Sometimes short-sellers are right: a leveraged,
them taste terrible acquisition-based insurance company makes little
$1,750 sense, and became the 3rd largest bankruptcy in history
$60
$1,500
$50
$1,250 American International
Group, Inc. $40 Conseco Inc.
$1,000
$750 $30
$500 $20
$250 $10
$0 $0
1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 1987 1989 1991 1993 1995 1997 1999 2001 2003
Source: Bloomberg. July 2014. Source: Bloomberg. September 2003.
An overly aggressive investment strategy (i.e., 45% of Diversifying a low-margin business (discount
Executive Life's assets in HY bonds) can attract brokerage) with a cyclical one (home equity lending)
attention of regulators and scare policyholders can be hazardous to your wealth
$20 $600
$500
$16
First Executive
Corporation $400
$12 E*TRADE Financial Corporation
$300
$8
$200
$4 $100
$0 $0
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1997 1999 2001 2003 2005 2007 2009 2011 2013
Source: FactSet. April 1991. Source: Bloomberg. July 2014.
Asset managers who are concentrated by style (Janus) Most REITs came back from 2009 lows, but are still
or with a handful of star managers (like Legg Mason in exposed to credit crises given 90% income
2006-08) can suffer radical changes of fortune distribution, no access to Fed discount window and
$50 preference for bonds > more easily negotiable
syndicated bank loans
$40 $70
Janus Capital Group Inc.
Developers Diversified Realty Corp.
$60
$30
$50 Similar REIT declines
$40
and recoveries: General
$20
Growth Properties,
$30 Duke, Maguire, Cousins
$10 $20
$10
$0
Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Jun-14 $0
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
Source: Bloomberg. July 2014.
Source: Bloomberg. July 2014.
21
18
Healthcare
Within Healthcare, which is one of the most diverse sectors, biotech is revealing, where over
100 companies in the Russell 3000 have collapsed since the boom/bust cycle of 2001 and
2002, and the risk of failure is still as high as ever.
22
Health Care
Health Care includes pharmaceutical companies, biotech, medical devices, hospitals and assorted
service providers. As you might expect, relative business risks differ. On large-cap pharma, generic
drugs took their toll: from 2003 to 2012, generic drug consumption generated $1.2 trillion in savings
for the US health care system, much of which represented lost revenue for branded pharmaceutical
companies. The highest event risk in the sector is of course related to Biotechnology. According to
Harvard’s Gary Pisano, even when a drug finally gets to Phase 3 trials, the probability of failure can still
be as high as 50%. Pisano also found that the R&D process at biotech firms has been no better than at
big pharma companies; a study in the Journal of Health Economics actually found that larger firms had
better performance in drug discovery. One irony about the biotech boom-bust of 2000: part of it was
based on the promise of mapping the human genome, which is now finally paying dividends (timing is
everything). While 2000-2001 was the peak in biotech distress, there have been over 100 catastrophic
failures of Russell 3000 biotech/life sciences companies since 2002 (see Appendix II).
Device companies heavily reliant on one product (drug- Note to CEOs selling a company for stock in a roll-up:
coated stents, in this case) are like concentrated stock due diligence on buyers is important; largest outpatient
portfolios themselves rehab roll-up was fueled in part by accounting fraud
$50 $160
$45 $140
Boston Scientific HealthSouth
$40
Corporation $120 Corporation
$35
$30 $100
$25 $80
$20 $60
$15
$40
$10
$5 $20
$0 $0
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014
Prostate cancer wonder drug? Sometimes FDA Unanticipated sharp declines in Medicare reimbursements
approval is not enough, customer demand has to render GHV (nursing home) capital structure inoperable;
materialize as well contagion spreads to other providers
$60 $40
Dendreon Corporation Company Genesis Health
$35
$50 withdrew Ventures Inc.
FDA approval guidance $30
$40 received
$25
$30 Successful $20
test results
$15
$20 announced
$10
$10
$5
$0 $0
Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12 Jun-14 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Source: Bloomberg. July 2014. Source: Bloomberg. October 2001.
FDA approval tolerance can shift over time, particularly if Advanced scientific breakthroughs (even mapping
approved competitors (Lunesta, Ambien) show signs of human DNA sequences) do not necessarily translate
negative side effects immediately into profitable business models
$70 $120
Neurocrine Human Genome Sciences Inc.
$60 FDA denies
Biosciences, Inc. approval for $100
Largest Biotech companies with
$50 larger dose
$80 catastrophic price declines, 2000-02:
$40 Indiplon Millennium, Celera, Abgenix, Protein
insomnia drug $60 Design Labs, Medarex, Maxygen,
$30 Curagen, Enzon, Cell Therapeutics
$40
$20
$10 $20
$0 $0
1997 1999 2001 2003 2005 2007 2009 2011 2013 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: Bloomberg. July 2014. Source: Bloomberg. August 2012.
23
19
EYE
E ON
ye o n tTHE
he MMARKET
a r k e t  •J . J.P.
P . MMORGAN
ORGAN
Industrials
Most Industrial failures that people remember are airlines, which is understandable since there have
been so many (162 airline bankruptcies from 1978 to 2005 as per the US GAO). There have been
other Industrial distress cases as well. Many thrived for a long period of time, sometimes multiple
decades, perhaps convincing concentrated holders that event risk was minimal. Then, something
changed: Asian growth, asbestos litigation, competitive forces resulting from China’s entry into the
World Trade Organization, declining demand for postage equipment in the internet era (Pitney Bowes),
an unfavorable ruling by the Nuclear Regulatory Commission regarding the use of decommissioning
funds (EnergySolutions), a state government terminating alternative energy subsidies (Foster Wheeler),
etc. Regarding the latter company, there’s a broader paradigm of business risk for industrial companies
involved with the various aspects of renewable energy (photovoltaic equipment, wind turbines, fuel
cells and related services). See A123 Systems below, and pages 37-38 for more details.
Slow responses to low-fare competition and high salary Debt-fueled expansion and reliance on overseas
workers, coupled with a spike in jet fuel costs, forced consumption can be risky: reduction in orders from
the airline to file for bankruptcy Indonesia in 1998 when its GDP fell 17%
$80 $50
Other catastrophic airline stock price $45
$70 declines: American, Branif f , Frontier, JetBlue,
KLM, Mesa, Midway, Northwest, PanAm, $40
$60
SkyWest, Texas Air, TWA, United, $35
$50 US Airways, ValuJet $30 Harnischfeger Industries Inc.
$40 $25
$30 $20
$15
$20
Delta Air Lines Inc. $10
$10 $5
$0 $0
1981 1984 1987 1990 1993 1996 1999 2002 2005 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
Source: Bloomberg. April 2007. Source: Bloomberg. July 2001.
In 90 AD, Pliny the Younger wrote of medical problems Preeminent civil engineering and heavy construction
associated with asbestos mining; 2,000 years later, firm overextends itself financially while aggressively
nearly 100 asbestos producers filed Chapter 11 expanding into non-core areas like mass transit
$50 $60
Owens-Corning
$50
$40 Fiberglass Corporation
$40
$30
$30
$20 Morrison Knudsen Corp.
$20
$10 $10
$0 $0
1981 1984 1987 1990 1993 1996 1999 2002 2005 1981 1983 1985 1987 1989 1991 1993 1995 1997
Source: Bloomberg. October 2006. Source: Bloomberg. August 1997.
One of the world's largest machine tool manufacturers The government can sponsor the idea of electric cars,
struggled to compete with cheaper foreign competition but cannot make people buy them, or the lithium ion
and the slowdown in US manufacturing batteries that A123 made
$400
$400 $25
$350
CincinnatiMilacron
Cincinnati MilacronInc.
Inc. China joins WTO
China joins WTO $20
$300
$250 $15
$200 A123 Systems, Inc.
$150 $10
$100
$5
$50
$0 $0
1980 1983
1983 1986
1986 1989
1989 1992
1992 1995
1995 1998
1998 2001
2001 2004
2004 2007
2007 2010
2010 Sep-09 Sep-10 Sep-11 Sep-12
Source: Bloomberg. February 2013. Source: Bloomberg. July 2013.
24
20
Technology
In the rapidly changing world of technology, some industry leaders were able to adapt to
change, and others, presumably run by some of the smartest people in the industry, were not.
25
E ye o n t h e M a r k e t  J . P . M O R G A N
EYE
E ON
ye o n tTHE
he MMARKET
a r k e t  •J . J.P.
P . MMORGAN
ORGAN
Information Technology
Information Technology
The tech sector has generated some of the most spectacular gains in the history of US equity markets.
The techApple,
Google, sector Qualcomm,
has generated some of the most
salesforce.com, eBay,spectacular gains Oracle,
Adobe Systems, in the history ofsome
etc. are US equity
of themarkets.
most
Google, Apple,
successful publicQualcomm,
companies salesforce.com,
in the world. AseBay, shown Adobe Systems,
on page Oracle, etc.
7, however, onlyare
6%some
of allof the most
tech
successful
companiespublic
turnedcompanies in the world.
out to be extreme As shown
winners; on page
the median tech7,company
however,substantially
only 6% of underperformed
all tech
companies
the market;turned out to be extreme
70% underperformed thewinners; the median
Russell 3000; tech50%
and over company substantially
generated negativeunderperformed
absolute
the market;
returns. 70% underperformed
Furthermore, almost 60%the Russell
of all 3000; and
technology over 50%
companies generated
in the negative
history of absolute
the Russell 3000 Index
returns. Furthermore, almost 60% of all technology
fell by 70% from their peak price and did not recover. companies in the history of the Russell 3000 Index
fell by 70% from their peak price and did not recover.
The story of the tech sector is a long narrative about disruptive technologies which are themselves
The story of
disrupted by the tech sector
changes is a long
that follow. Wangnarrative
Labs,about
Silicondisruptive
Graphics,technologies which Corporation
Digital Equipment are themselves
4
and
4
disrupted
Commodore by changes
are somethat follow.
of the earlierWang Labs, Silicon
casualties, unable Graphics,
to adapt to Digital Equipment
the shift Corporation
away from dedicatedand word
Commodore
processors and are3Dsome of theservers
graphics earlierand
casualties,
towardsunable to adaptbased
PC platforms to theonshift away from
Microsoft’s dedicated
Operating word
System.
processors
Similar fatesand
were3Deventually
graphics servers
in storeandfortowards PC platforms based
Cray Supercomputer, Prime on Microsoft’s
Computer, Operating
Data General, System.
Atari,
Similar
Maxtor,fates
DEC,were eventually
Borland in storeand
International for other
Cray Supercomputer,
tech stalwarts ofPrime Computer,
the 1980’s Data General,
and 1990’s. Atari,
They were all
Maxtor, DEC, Borland International and other tech stalwarts of the 1980’s and
industry leaders at their peak, run by some of the smartest individuals in the business world whom1990’s. They were all
industry leaders at their
would presumably be ablepeak, run bytosome
to adapt of thetechnologies
changing smartest teams
andincircumstances.
the business world that would
presumably adapt to changing technologies and circumstances. Most of them, however, did not.
Dedicated word processing equipment Dedicated 3D graphics servers
Dedicated word processing equipment
$45 Dedicated
$16 3D graphics servers
$45
$40 $16
$14
$40
$35 $14 Silicon Graphics Inc.
$12
$35 Wang Labs, Inc. Silicon Graphics Inc.
$30 $12
$10
$30
$25 Wang Labs, Inc.
$10
$8
$25
$20
$8
$20 $6
$15
$6
$15
$10 $4
$10 $4
$5 $2
$5 $2
$0 $0
$01982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 $01987 1989 1991 1993 1995 1997 1999 2001 2003 2005
1982 FactSet.
Source: 1983 1984 1985
August 1986 1987 1988 1989 1990 1991 1992 1993
1993. 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
Source: Bloomberg. September 2006.
Source: FactSet. September 1993.
Source: Bloomberg. October 2006.
The next phase in the tech sector came in the late 1990’s, when internet use began to rise sharply. The
The next era
dot-com phase
wasinfueled
the tech
by sector came in the
this enthusiasm, aslate
well1990’s, when internet
as by opportunities in use
the began to rise sharply. The
business-to-business
dot-com
space. Asera was fueled
global internetbyusers
this enthusiasm,
rose ten-foldasfrom
well32
as million
by opportunities
in 1995 toin320
themillion
business-to-business
by 2000, markets
space.
assumed Asthat
global internetbusiness
profitable users rose ten-fold
models from
would 32 million
emerge aroundin 1995 to 320 million
it. However, by 2000,
while global markets
internet use
assumed that profitable business models would emerge around it. However, while
did keep growing at a rapid clip, many technology companies weren’t making enough money to global internet use
did keepwhat
survive growing
turnedat out
a rapid
to beclip, many
a mild technology
recession companies
in 2001, weren’teven
and required making
moreenough money to
exponential
survive what turned uptake
internet/broadband out to be
thana mild
whatrecession in 2001,
was occurring and required
in order even more exponential internet/
to be profitable.
broadband uptake than what was occurring in order to be profitable.
Data center provider cannot survive collapse of its tech Provider of optical equipment to the high-tech food
customer
Data centerbase and the
provider eventual
cannot migration
survive from
collapse co-tech
of its chain
JDS' (Alcatel, base
customer Ciena,
forCisco,
opticalCorning, Juniper,
equipment Lucent,
(Alcatel,
location tobase
customer managed
and thehosting
eventual migration from simple Marconi,
Ciena, Motorola,
Cisco, Nortel,
Corning, Scientific
Juniper, Atlanta,
Lucent, Siemens,
Marconi,
co-location to full-service managed hosting
$80 Sycamore),
Motorola, muchScientific
Nortel, of whichAtlanta,
collapsed at the same
Siemens, time
Sycamore)
$80 Exodus all suffered a collapse in demand at the same time
$1,200
$70
Communications Inc.
Exodus
$70
$60 $1,200
Communications Inc. $1,000
$60
$50 $1,000 JDS Uniphase
$800
$50
$40
JDS Uniphase
$800
$600
$40
$30
$600
$30 $400
$20
$400
$20
$10 $200
$10 $200
$0 $0
$0 1998 1999 2000 2001 2002 $0 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
1998 Bloomberg.
Source: 1999
May 2002. 2000 2001 2002 1994Bloomberg.
Source: 1996 1998 2000
July 2014.2002 2004 2006 2008 2010 2012 2014
Source: Bloomberg. June 2002. Source: Bloomberg. July 2014.
4
“The personal computer will fall flat on its face in business”, Ken Olsen, CEO Digital Equipment
4
“The personal
Corporation, whocomputer will fall
was proclaimed flat on its
“America’s face
most in business”,
successful entrepreneur” by CEO
Ken Olsen, Fortune magazine
Digital in 1986.
Equipment
Corporation, who was proclaimed “America’s most successful entrepreneur” by Fortune magazine in 1986.
26 21
21
E ye o n t h e M a r k e t  J.P. MORGAN
Eye on the Market  J.P. MORGAN Eye on the market • J.P. Morgan
As the tech bust rolled on through 2001 and 2002, dozens of technology companies ended up seeing
their
As thehighest stock
tech bust prices
rolled oninthrough
the rearview
2001 mirror (for example,
and 2002, dozens ofoftechnology
212 Internet & Software
companies Service
ended up seeing
companies with stock prices in February 2000, only 17 ever saw higher stock prices at any
their highest stock prices in the rearview mirror (for example, of 212 Internet & Software Service time
between March
companies 2000 prices
with stock and February 2014).
in February 2000, Some
onlyof17
theever
largest
saw declines apppear
higher stock below;
prices at anythe
timefirst three
each had a peak market cap over $100 billion. While some companies survived (EMC,
between March 2000 and February 2014). Some of the largest declines appear below; the first threeIntel, Cisco,
Broadcom), others
each had a peak did not
market adapt
cap overto industry
$100 changes,
billion. While adapted temporarily,
some companies or did
survived not adapt
(EMC, Intel, in time 5.
Cisco,
Broadcom), others did not adapt to industry changes, adapted temporarily, or did not adapt in time5.
The world’s largest telecom equipment company in Lucent's Canadian competitor, drowning in a sea of
1999 with $38 billion in sales; relied excessively on its overpriced, ill-chosen, poorly integrated acquisitions;
The world’sposition
incumbent largest telecom equipment
and did not adapt company in Lucent's Canadian
suffered from competitor,
a "culture drowning
of arrogance andin a sea of
hubris"*
1999
$60
with $38 billion in sales; relied excessively on its overpriced,
$900 ill-chosen, poorly integrated acquisitions;
incumbent position and did not adapt suffered from
Nortel a "culture
Networks of arrogance and hubris"*
Corporation
Lucent Technologies Inc. $800
$60
$50 $900
$700
Lucent Technologies Inc. $800 Nortel Networks
* according Corporation
to a study
$50
$40 $600 released in 2014 by the
$700
$500 *University
accordingoftoOttawa
a study
$40
$30 $600 released in 2014 by the
$400 Departments of Law,
$500 University
Electrical of Ottawa and
Engineering
$30
$20 $300
$400 Departments
Managementof Law,
$200 Electrical Engineering and
$20
$10 $300
$100 Management
$200
$10
$0 $0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 $1001981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014
$0 $0
Source: Bloomberg. November 2006. Source: Bloomberg. July 2014.
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014
Source:
IndustryBloomberg.
shifted November 2006.Sun on hardware (to x86
away from Source:
SupplyBloomberg. July 2014.
chain management software leader runs into
processor machines), and on software (away from Germany's SAP, which decides to compete and abandon
Industry shifted
proprietary away from Sun on hardware (to x86
licensing) Supply chain
JV; 2008 management
IP judgment software
against SAP wasleader
tooruns
little,into
too late
processor machines), and on software (away from Germany's
$2,500
SAP, which decides to compete and abandon
$250 JV; 2008 IP judgment against SAP was too little, too late
proprietary licensing); see footnote #5
Sun Microsystems $2,500 I2 Technologies Inc
$250
$200 $2,000
Sun Microsystems I2 Technologies Inc
$200 $2,000
$1,500
$150
$150 $1,500
$1,000
$100
$100 $1,000
$500
$50
$50 $500
$0
$0
1987 1990 1993 1996 1999 2002 2005 2008 1997 1999 2001 2003 2005 2007 2009
$0 $0
Source: Bloomberg. December 2009. Source: Bloomberg. January 2010.
1987 1990 1993 1996 1999 2002 2005 2008 1997 1999 2001 2003 2005 2007 2009
Source: Bloomberg. January 2010. Source: Bloomberg. January 2010.
As for computer hardware, cheaper component parts and migration to smartphones and tablets
eventually
As pulled hardware,
for computer down several manufacturers’
cheaper componentstocks.
parts and migration to smartphones and tablets
eventually pulled down
Too slow moving severalcomputers,
into portable manufacturers’ stocks.
and from World's #1 computer system provider experiences
retailslow
Too to enterprise customers
moving into portable computers, and from declining
World's #1need for customized
computer hardware
system provider and a bruising
experiences
$80
retail to enterprise customers price war, need
declining can't for
execute on transition
customized to mobile
hardware and a bruising
$80
$70 $60
price war, difficulty executing on transition to mobile
Gateway 2000 $60
$70
$60 $50
Gateway 2000 Dell Computer
$60
$50 $50
$40 Corporation
Dell Computer
$50
$40 $40
$30 Corporation
$40
$30
$30
$20
$30
$20
$20
$10
$20
$10
$10
$0 $10
$0
1994 1996 1998 2000 2002 2004 2006 1989 1992 1995 1998 2001 2004 2007 2010 2013
$0 $0
Source:
1994 Bloomberg.
1996 October
1998 2007.
2000 2002 2004 2006 Source:
1989 Bloomberg.
1992 October
1995 2013.
1998 2001 2004 2007 2010 2013
Source: Bloomberg. October 2007. Source: Bloomberg. October 2013.
5
Sun Microsystems CEO Scott McNealy in 2011, on the conundrum of proprietary vs open-source code: "The
mistake
5 we made was putting it on our own hardware. If we hadn't metal-wrapped it, it would have been more
Sun Microsystems CEO Scott McNealy in 2011, on the conundrum of proprietary vs open-source code: "The
widely adopted. If we had put Solaris early on an Intel box, Linux never would have never happened. We would
mistake we made was putting it on our own hardware. If we hadn't metal-wrapped it, it would have been more
have been the operating system for all those startups." [Information Week, February 25, 2011].
widely adopted. If we had put Solaris early on an Intel box, Linux never would have never happened. We would
have been the operating system for all those startups." [Information Week, February 25, 2011]. 27 22
22
EYE
E ON
ye o n tTHE
he MMARKET
a r k e t  •J . J.P.
P . MMORGAN
ORGAN
After the dust cleared, the steady drumbeat of substantial tech stock price declines continued over the
next few years, even on stocks linked to rapidly growing wireless and video communications (each
example shows the company; the date of its peak price before the decline; and the magnitude of the
stock price decline through July 31, 2014 or the last quoted price, according to Bloomberg):
• Travelzoo (largest publisher of travel, entertainment and local deals): December 2004, -82%
• Avid Technology (commercial audio and video production software): February 2005, -89%
• Intermec (automated identification and data capture, barcode scanners): September 2005, -71%
• Sirf Technologies (GPS for consumer applications): February 2006, -89%
• Trident Microsystems (digital processors for LCD TVs): March 2006, -99%
• Brightpoint (distributor of mobile phones and other wireless products): April 2006, -68%
• Digital River (e-commerce sites for software and other tech companies): November 2006, -76%
• Imation Corp. (DVDs, flash drives and magnetic tapes): December 2006, -93%
• THQ (video games such as Dawn of War and Company of Heroes): March 2007, -100%
Fast forward to today. Some people view the Technology sector as changed, and believe that
companies brought to market via initial public offerings are more robust. Can this be substantiated?
It depends how you define your parameters. As shown in the next chart, the median age of tech IPOs
has been rising since the height of the dot.com era;
the median age has risen from 4 to 10 years. This Technology IPO trends: firm age and valuation at IPO
Median price/sales Median firm age in years
does suggest a maturation of tech companies going
15x 15
public, perhaps a result of deeper pre-IPO financing
capital pools which allow companies to stay private 12x 1999: 26.5 13
longer. As for valuations, nothing will probably ever 2000: 31.7

11
match the pricing of tech IPOs in 1999 and 2000 9x Median firm age
9
when average price/sales ratios were 27x and 32x, 6x
respectively. More recent valuations have been 7
creeping up again, however, and are roughly where 3x 5
Median price/sales
they were before the onset of the financial crisis.
0x 3
There’s one area showing clear signs of rising investor 1980 1984 1988 1992 1996 2000 2004 2008 2012
risk appetite: the falling percentage of tech IPOs that Source: "Initial Public Offerings: Technology Stock IPOs". Ritter (Univ. of
Florida). July 2014.
are profitable at issuance. In the last couple of
years, this measure has declined almost back to where it was during the dot.com era. From
this perspective, there’s a lot of business risk being brought to market via companies whose profitability
has not yet been established. All things considered, the business risk of today’s tech IPO may be only
moderately lower than it was 15 years ago. For more on IPOs and their performance relative to a
diversified basket of stocks, see page 41.
Remembrance of things past: low percentage of technology company IPOs with profits
Percent of technology companies with positive net income at IPO
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013
Source: "Initial Public Offerings: Technology Stock IPOs". Ritter (University of Florida). July 2014.
28
23
To complete the tech sector review, we conclude with a few recent cases where there have been
substantial reversals of fortune. To reiterate a theme, the fact that a certain segment of the industry is
skyrocketing (e.g., the 220% growth in mobile search and display advertising since 2012) does not lift
all boats. On gaming, many mobile game developers have struggled to establish the kind of brand
loyalty that exists in traditional gaming (Madden NFL, World of Warcraft, Call of Duty) which keeps
players coming back for more. There’s also “piggy-backing” risk: companies like Zynga and Demand
Media rely to a great extent on how Facebook and Google integrate them; changes in the latter can
have very large impacts on the former. We conclude with BlackBerry. Innovation in handheld devices
and mobile phones garners a lot of interest, but these companies can be rapidly eclipsed by
competitors and changing technology. Palm, the company that pioneered personal digital assistants
and first popularized the smartphone, collapsed in 2001; then Motorola could not maintain the
advantage it had in 2006 with its revolutionary Razr phone; BlackBerry is just the latest casualty.
Google finally gets wise to "content farms" like Demand Big data flash storage leader's customer base too
Media, and changes algorithms to avoid them concentrated (loss in pricing power); low barriers to
$50 entry invite intense competition
$45 $40
$40 Fusion-io, Inc.
Demand Media, Inc.
$35 $30
$30
$25
$20
$20
$15
$10 $10
$5
$0 $0
Jan-11 Jan-12 Jan-13 Jan-14 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14
Buying the next big hit proves to be much harder than Pioneer of mobile advertising gets squeezed out once
developing it; acquisition writeoffs, falling subscribers, the mega-platforms (Google, Facebook) compete with
bloated management and lots of competition them; not every little fish gets bought
$14 $25
$12 Millennial Media, Inc.
Zynga Inc. $20
$10
$8 $15
$6 $10
$4
$5
$2
$0 $0
Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Mar-12 Sep-12 Mar-13 Sep-13 Mar-14
Extreme revenue concentration for smaller technology Stale technology (no touch screen), operating system
companies (in this case, software-defined networking) problems, worldwide outages, too much focus on corp
causes problems when big customers cut back customers; mine is constantly re-booting for no reason
$16 $150
$14
Cyan, Inc. $125
$12
BlackBerry Ltd.
$10 $100
$8 $75
$6
$50
$4
$25
$2
$0 $0
May-13 Aug-13 Nov-13 Feb-14 May-14 1999 2001 2003 2005 2007 2009 2011 2013
29
24
EYE
E ON
ye o n tTHE
he MMARKET
a r k e t  •J . J.P.
P . MMORGAN
ORGAN
Materials
The Deng reforms in China and the Rao reforms in India are among the most momentous shifts in
relative economic power in centuries. In both countries, capital and energy-intensive industries like iron
and steel benefited from very generous government subsidies (see Appendix I). As these state-sponsored
companies became more profitable, their earnings were reinvested, creating expansion of capacity and
production well beyond their domestic markets’ ability to absorb. This resulted in a structural change in
global export markets, and intense competition for US firms. Other secular, permanent shifts: the
decline in US newspaper readership from 62 million daily (1990) to 52 million (2006), a problem for
newspaper companies and the Materials companies that sell newsprint to them. As for cyclical risks,
many Metals & Mining companies were not well positioned for the 20% collapse in global trade which
took place in 2009, the largest decline in 50 years (e.g., Alcoa, US Steel, AK Steel, Intrepid Potash all
suffered sharp declines and have not yet substantially recovered).
Deng reforms in China reshape steel export market, Low margin packaging business with too much
management did not reduce labor costs or increase leverage suffers from a collapse in trade during the
plant productivity in time global recession
$35
$35 $25
Bethlehem Steel Corp.
Bethlehem Steel Corp. Annual Chineseiron
iron
$30 Annual Chinese
$30 and steel exports
exports
and steel $20
$25
$25 jump from $1.6B
jump from $1.6Bto to
$5.2B
$5.2B $15
$20
$20
$15
$15 $10
$10
$10 Smurfit-Stone Container Corp.
$5
$5
$5
$0
$0 $0
1981 1983
1981 1983 1985
1985 1987
1987 1989
1989 1991
1991 1993
1993 1995
1995 1997
1997 1999
1999 2001
2001 2003
2003 1995 1997 1999 2001 2003 2005 2007 2009
Source: Bloomberg.
Source: Bloomberg.January
January2004.
2004. Source: Bloomberg. June 2010.
No statute of limitations: environmental misdeeds, even "Rare earth demand is insatiable since the entire
2-3 decades after they take place, can threaten a electronics and renewable energy industry depends on
company's solvency them!!" That is, until workarounds are found
$35 $80
$70
$30
$60
$25
Solutia $50
$20 Molycorp, Inc.
$40
$15
$30
$10 $20
$5 $10
$0 $0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2011 2012 2013 2014
Source: Bloomberg. February 2008. Source: Bloomberg. July 2014.
An indirect internet casualty: declining newspaper Alcoa's fortunes hurt by global over-expansion of
demand leads to collapse in the demand for newsprint capacity which drags down producer profits; a leveraged
$20 reflection of global growth and capex
$18 $45
Aluminum Company of America
$16 $40
$14 $35 Similar profiles in metals/
mining due to collapse in global
$12 $30 trade: US Steel, AK Steel,
$10 $25 Walter Energy, Intrepid Potash,
$8 $20 Century Aluminum, Thompson
Abitibi-Consolidated Inc. Creek
$6 $15
$4 $10
$2 $5
$0 $0
1990 1992 1994 1996 1998 2000 2002 2004 2006 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013
Source: Bloomberg. October 2007. Source: Bloomberg. July 2014.
30
25
Telecom & Utilities
Our study reveals that a changing regulatory environment can increase the risks for
concentrated holders in both the Telecommunications and Utilities sectors.
31
EYE
E y e ON
o n THE MARKET
the M a r k e t  •J .J.P.
P. MMORGAN
ORGAN
Telecommunications
While the period from 1999-2001 is often referred to as the dot-com bust, the telecommunications
industry accounted for much more equity market capitalization both gained and then lost. The lesson:
regulatory shifts can make it difficult to forecast supply and demand. The catalyst for change was the
Telecommunications Act of 1996, which was designed to bring competition to the local exchange level
(by 1996, long distance service was already subject to competition, although the Act also allowed
incumbent local carriers to compete in long distance markets). The combination of deregulation and
advances in fiber optic technology resulted in the belief that a single firm could provide all of a given
household’s or company’s telecom needs. Demand for bandwidth proliferated; from 1994 to 1996,
internet traffic in the US increased from 16 to 1,500 terabytes per month. Meanwhile, the Act was
constantly tied up in the courts since the FCC left many of the Act’s clauses open to interpretation or
dispute (in particular, disputes over the FCC’s jurisdiction regarding forced co-location and other rules
requiring incumbents to make room for new competitors).
A gold rush of investment followed: at the peak of the cycle, telecom capital spending was
skyrocketing and industry profitability was negative. In hindsight, a buoyant IPO market and the
willingness of telecom equipment sellers (Lucent, Nortel, Motorola, Alcatel and Cisco) to provide
vendor financing were signs of industry weakness. In the early 2000’s, end-user demand for long-haul
fiber did not rise as quickly as telecom companies projected. As a result, a glut of excess capacity,
lower tolling rates and too much debt caused a collapse in telecom stock prices by 2003 and a wave of
bankruptcies (see box, below). Video streaming and other data-heavy trends that the telecom giants
expected eventually appeared, several years later; however, leveraged capital structures could not wait
that long. The importance of this episode for concentrated stockholders is not that a telecom boom-
bust will necessarily repeat itself, but that the paradigm might take place elsewhere.
Private fixed investment in communications Communication industry after-tax profits
Billions of 2009 USD (both axes) USD, billions
$90 $30 $30
Communications
$25
$80 structures
$20
$70 $25 $15
$10
$60
Communications $5
$50 equipment $20 $0
-$5
$40
-$10
$30 $15 -$15
1995 1997 1999 2001 2003 1995 1996 1997 1998 1999 2000 2001
Source: Bureau of Economic Analysis. December 2003. Source: Bureau of Economic Analysis, J.P. Morgan Asset Management. 2001.
2000-2003 Telecom bankruptcy wave (partial)

Long distance/wholesale fiber carriers: Global Crossing, GTS, 360Networks, Impsat, Network Plus, Star,
Touch America, Viatel, WorldCom
Competitive local exchange carriers: Convergent, Covad, Focal, ICG, McLeod, Northpoint, NTL, Rhythms
Net, Telcove, XO (After FCC rulings that originally favored the new competitive local exchange carriers, an
FCC ruling in 2000 on pricing methodology went against them)
Wireless carriers: GlobalStar, Leap, Metricom, OmniSky, StarBand, Teligent, Winstar
Diversified/Other: Excite@Home
32
26
The box on the prior page lists the companies that filed Chapter 11. Others survived the telecom bust,
but their stock prices look like Sprint (below) which only recaptured a fraction of its lost market cap (in
the case of Sprint, it was acquired in July 2013 by Japan’s SoftBank). Other examples of partial stock
price recoveries include Qwest, US Cellular, Level 3 and Arch Wireless. Only a handful of telecom
survivors look like Bell South, Alltel and SBA Communications, whose stock prices declined during the
telecom crash and then rebounded substantially, reaching or surpassing prior stock price peaks.
Third largest wireless and wireline company barely Examples of recovering telecom stocks
survived telecom boom-bust and a failed 2004 $36 Index = 100 at February 2000
billion merger with Nextel 250
$70
$60 200
$50
SBA Communications
Sprint Communications Bell South
150 Alltel
$40 (acquired)
(acquired)
$30 100
$20
50
$10
$0 0
1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 1996 1997 1999 2001 2003 2005 2007 2009 2011 2013
There were also telecom declines that took place after the telecom boom-bust that are worth
reviewing. Like biotech and internet stocks, while the period of peak business failure was 2000-2002,
telecom companies are still subject to traditional business cycle and management risks.
Differentiated product (unlimited minutes for low-end Not all wireless service created equal: higher frequency
customers) attracts competition from proxies funded by spectrum has shorter coverage areas and weaker
large wireless companies using superior 4G technology penetration strength; eventually surpassed by broadband
$90 $30
$80
$25
$70 Clearwire Corporation
$60 Leap Wireless International Inc. $20
$50
$15
$40
$30 $10
$20
$5
$10
$0 $0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2007 2008 2009 2010 2011 2012 2013
Source: Bloomberg. March 2014. Source: Bloomberg. July 2013.
VOIP*: revolutionary idea gets old fast when Skype Iridium failure ten years prior was the template for
offers basic service for free, cable companies compete satellite phone technology that did not live up to
and wireless companies file patent infringement suits expectations
$14 $30
*VOIP = Voice Over Internet Protocol
$12 $25
TerreStar Corp.
$10 Vonage Holdings Corp. $20
$8
$15
$6
$10
$4
$2 $5
$0 $0
May-06 May-08 May-10 May-12 May-14 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Bloomberg. July 2014. Source: Bloomberg. March 2013.
33
27
EYE
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ye o n tTHE
he MMARKET
a r k e t  •J . J.P.
P . MMORGAN
ORGAN
Utilities (power generation, transmission and distribution)

Utility catastrophic stock price declines are less frequent than in other sectors (there were no private
sector utility defaults between the Great Depression and a New Hampshire utility failure in 1988).
However, when they happen, they tend to be large. The largest was of course Enron, the catalyst for
Sarbanes-Oxley and other regulations that followed. The distraction of Enron in a concentrated stock
discussion is that accounting fraud is generally not the biggest risk for utilities. Instead, there are
parallels with telecommunications: (a) deregulation led to a variety of unanticipated market
outcomes and business failures, and (b) there was a poorly timed capacity glut financed with leverage.
At times, mismatches between reimbursement mechanisms and changing commodity prices and
electricity demand were the cause of severe declines (e.g., PG&E bankruptcy in 2001, when the state of
California required the company to sell power at fixed prices regardless of its rising out-of-state
electricity acquisition costs). The separation of generation from transmission in many states also took
away a degree of income stability from formerly diversified utilities.
The first chart shows the increase in natural gas capacity at the end of the 1990’s. Much of it was
fueled by the view that coal plant de-commissioning would accelerate, either due to voluntary decisions
by utilities that owned them, or due to EPA regulations. However, when natural gas prices rose from
their lows in 2001, utilities did not de-commission coal plants that quickly. Furthermore, electricity
price spikes in the year 2000 led many companies to make massive additions to future natural gas
capacity, financed with debt; this was a mis-read of underlying supply/demand conditions, as electricity
prices soon corrected, particularly in California. The glut of unused plants and a sharp decline in
electricity prices in the summer of 2001 (due to increased capacity, mild weather and weaker demand)
led to sharply declining utility stock prices. The subsequent rise in natural gas input costs from 2001 to
2006 eventually pushed some companies into bankruptcy (Calpine, NRG, Mirant, NEGT) and heavily
damaged others (Dynegy) when their contracts did not adjust sufficiently for rising gas input prices.
Natural gas powered capacity additions Spike in California wholesale spot electricity prices
Gigawatts of electricity generating capacity additions was not a reflection of a permanent supply shortage
60 Dollars per MWh
$1,000
50 $900
$800
40 $700
$600
30
$500
$400
20
$300
10 $200
$100
0 $0
1990 1993 1996 1999 2002 2005 2008 2011 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01
Source: Energy Inf ormation Administration. 2013. Source: Western Price Survey, Energy NewsData Corporation. October 2001.
US natural gas prices

Dollars per MMbtu, generic front month US natural gas price
$16
$14
$12 Rising prices, a problem
for unhedged buyers
$10
$8
$6
$4
$2
$0
2000 2001 2002 2003 2004 2005 2006
Source: Bloomberg. December 2006.
34
28
In the charts below, Calpine and Reliant are proxies for utility distress that took place as a result of the
1999-2003 capacity expansion in natural gas plants. There were other reasons for utility distress
outside this period, such as under-appreciation of emerging market risks (AES). In the case of Exelon,
changing energy policies and commodity supply created a formidable headwind: its nuclear-heavy
generation portfolio is in less demand since the natural gas boom and renewable energy production tax
credits make other forms of generation cheaper. In addition, renewable portfolio standards drive grid
operators towards more wind/solar. As for Constellation Energy, we might have included it in the
Financials section given its January 2007 launch of an energy trading business that created huge
problems: the company had to arrange a fire sale when a pending downgrade could have required a
collateral posting of $4 billion. This was not the first time that utilities suffered from outsized energy
trading operations: problems earlier in the decade at Dynegy, Williams, Aquila and El Paso were similar.
Over-reliance on leverage (85%) despite a transition First leg: rising fuel input costs combined with $5bn debt
from fixed price contracts to merchant pricing; at one increase from 2002 to 2003; Second leg: asset sales not
point, 115% of capacity under construction completed fast enough before recession/liquidity crisis
$60 $40
$35
$50
$30
$40 $25
$30 $20
$15
$20 Reliant Energy Inc.
Calpine Corp. $10
$10 $5
$0 $0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: Bloomberg. February 2008. Source: Bloomberg. December 2012.
Massive overseas expansion (esp. Latin America) Exelon portfolio: 55% nuclear at a time of rising nuclear
backfires after 65%-75% currency declines, adverse maintenance costs, and falling prices of natural gas
regulatory rulings in Brazil and falling global demand and wind-powered electricity
$70
$100
$60 $90
$80
$50
$70
$40 $60
$50
$30 AES Corporation Exelon
$40
$20 $30
$20
$10
$10
$0 $0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014
Consequence of energy trading becoming a primary Wholesale ownership and distribution of water was an
strategic focus, rather than the generation of wholesale immature market, limited ability to recapture capital
power spending outlays
$120 $25
$100 $20
$80
$15
Constellation Energy
$60
$10
$40
Western Water
$5
$20 Company
$0 $0
1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 1993 1995 1997 1999 2001 2003 2005
Source: Bloomberg. March 2012. Source: Bloomberg. February 2006.
35
29
Alternative Energy
While it’s clear the world is on a path toward renewable energy, which business models work
and which ones don’t is far from certain.
36
Subsector focus on alternative energy stocks

In our 2014 annual energy paper, we write about the practical certainty of the world’s eventual
transition to renewable energy. This transition will be the fourth of the last few hundred years, with
the first three being coal (early 1800’s), oil (early 1900’s) and natural gas (mid 1900’s). However, the
journey to a renewable energy world will be long, and subject to fits and starts regarding what works
and what doesn’t. The next chart is one way of visualizing the risks and opportunities for concentrated
holders. It shows how the returns on two diversified clean energy indexes have usually underperformed
the S&P Small Cap Index. The peaks and valleys are huge, with more valleys than peaks; new ideas
often generate tremendous excitement, but only a few work out in the long run.
Renewable energy stocks fall in and out of favor
Rolling 1-year excess return of clean energy vs. S&P small cap
70%
50% NYSE Bloomberg AME

Clean minus S&P Small
30% Cap Index
10%
-10%
-30%
-50% Wilderhill Clean Energy Index

minus S&P Small Cap Index
-70%
2002 2004 2006 2008 2010 2012
Source: Bloomberg. July 31, 2014.
The table below shows a few more comparisons. Clean energy stocks have struggled versus both the
broad market and versus the oil & gas stocks which make up the majority of energy-specific S&P sub-
indices. The relative returns are similar when starting the analysis in 2002, 2005 or 2008, or when
using different clean/alternative energy indices.
The underperformance of alternative energy stocks
Annualized Total Returns
Index Since 2002 Since 2005 Since 2008
Clean Energy Indices:
Wilderhill Clean Energy Index -3.04% -10.08% -4.11%
NYSE Bloomberg Americas Clean Energy Index ** 4.61% 11.82%
FTSE Environmental Opps. Renewable & Alternative Energy Index ** ** 1.90%
Benchmark Indices:
S&P Small Cap 12.01% 8.60% 18.39%
S&P Small Cap Energy 20.01% 12.49% 25.04%
S&P Mid Cap 12.04% 9.03% 19.98%
S&P Mid Cap Energy 12.19% 5.59% 18.41%
S&P 500 9.21% 7.47% 17.06%
S&P Large Cap Energy 14.64% 9.87% 13.71%
Source: Bloomberg. July 31, 2014. ** represents indexes prior to their inception.
37
30
EYE
E ON
ye o n tTHE
he MMARKET
a r k e t  •J . P
J.P.
. MMORGAN
ORGAN
There may be no sector whose stocks have more true believers than alternative energy and related
services/products. This category includes companies developing wind and solar equipment, fuel cells
and biofuel processes. It also includes companies in search of superconductor materials, which would
save the world enormous amounts of energy by reducing the 6%-10% of electricity that is lost on
alternating current transmission lines and across other synapses. Unfortunately, while each of the ideas
below may one day become integral and indispensable, there are issues related to pricing, subsidies,
government regulations, overseas competition, raw materials costs, carbon emission taxes (or the lack
thereof), capacity factors/efficiency and the practical limits of science that can get in the way. We
chose some of the better known examples below; each was seen in its day as a “magic bullet”, only to
see dramatic reversals of fortune.
Wind turbine manufacturing and services Manufacturer of thin film photovoltaic solar panels,
$300 provider of PV power plants/services
$300
$250
Broadwind Energy, Inc. $250
$200 First Solar, Inc.
$200
$150
$150
$100 $100
$50 $50
$0 $0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2007 2008 2009 2010 2011 2012 2013 2014
Hydrogen fuel cells Superconductors

$120 $80
American Superconductor Corporation
$70
$100
Ballard Power Systems Inc. $60
$80
$50
$60 $40
$30
$40
$20
$20
$10
$0 $0
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Next generation renewable biofuels Environmentally friendly fast-food containers

$20 $180
$160
$15 KiOR Inc. $140

Earthshell Corp.
$120
$100
$10
$80
$60
$5 $40
$20
$0 $0
Jul-11 Jul-12 Jul-13 Jul-14 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Bloomberg. July 2014. Source: Bloomberg. August 2007.
38
31
A look at the winners (The Ecstasy)

We include an exhibit on the following page that shows the historical extreme winners. As explained
earlier, we defined these winners as having generated more than a two standard deviation return over
the Russell 3000 Index since their inception. There are several hundred of them in our database, which
is too many to list here. Instead, we show a subset: stocks that generated the highest excess lifetime
returns over the Russell 3000 Index, which are currently active (i.e., excluding inactive stocks that
generated outsized returns before being acquired, merged etc.), and which have a current market
capitalization over $5 billion.
This is a very heterogeneous list of companies. Some have been quite volatile; many technology
companies suffered substantial declines during the tech bust, and have been on a tear since then (eBay,
Qualcomm, Amazon). Some took decades to generate substantial wealth, while others accomplished it
in a few short years. Some have not generated substantial returns to holders in many years, and
instead experienced rapid appreciation during the 1990’s. Despite their differences, over the long
haul, all of them generated substantial excess returns relative to their initial reported public
stock price (excluding any pre-IPO wealth creation). Consumer Discretionary and Technology
show a large number of success stories; these are the survivors, since both sectors also generated the
largest number of catastrophic declines.
We prepared this list at the time this document was drafted, in the summer of 2014. If history is any
guide, the drumbeat of business distress outlined on pages 3-5 will eventually ensnare some of them.
39
32
EYE
yey eoON
EE o ntTHE
n hteh eMMARKET
a rakrekte t J•. PJJ.P.
M . MORGAN
. PM MROGRAGNA N
O
Historical
HistoricalWinners
Winnerslist (see
list prior
(see page
prior forfor
page details); sector
details); designations
sector as per
designations FactSet
as per FactSet
Consumer Discretionary Energy Industrials
Amazon.com, Inc. Energy
Cheniere Energy, Inc. Industrials
Cintas Corporation Materials
Amazon.com,
AutoZone, Inc. Inc. Cheniere
Core Energy,
Laboratories NV Inc. Cintas Corporation
Danaher Corporation Airgas, Inc.
AutoZone,
Bed Bath & Beyond Inc. Inc. Core Laboratories
Energen Corporation NV Danaher Corporation
Donaldson Company, Inc. Ball Corporation
BedBuy
Best Bath
Co.,& Inc.
Beyond Inc. Energen
EOG Corporation
Resources Donaldson
Equifax Inc. Company, Inc. CF Industries Holdings, Inc.
Best Buy
Comcast Co., Inc.
Corporation EOG
EQT Resources
Corp. Equifax Inc.
Expeditors International of Washington, Inc. Ecolab Inc.
Comcast
Dillard Inc. Corporation EQT Corp.Corp.
HollyFrontier Expeditors
Fastenal International of Washington
Company FMC Corporation
Dillard
Dish Inc. Corp.
Network HollyFrontier
Patterson-UTI Corp.
Energy, Inc. Fastenal& Company
Genesee Wyoming, Inc. Sherwin-Williams Company
Dollar
DishTree Inc. Corp.
Network Patterson-UTI Energy, Inc. Illinois
GeneseeTool &Works Inc. Inc.
Wyoming, Sigma-Aldrich Corporation
Family
Dollar Dollar
TreeStores,
Inc. Inc. Financials Jacobs
IllinoisEngineering
Tool Works Group
Inc. Inc. Valspar Corporation
Fossil
FamilyInc.Dollar Stores, Inc. AFLAC Inc.
Financials Precision Castparts Corp.
Jacobs Engineering Group Inc.
Gap, Inc.Inc.
Fossil Berkshire
AFLACHathaway
Inc. Inc. Roper Industries,
Precision Inc. Corp.
Castparts
Harley-Davidson,
Gap, Inc. Inc. BlackRock,
BerkshireInc.Hathaway Inc. Southwest Airlines Co.
Roper Industries, Inc.
Hasbro, Inc.
Harley-Davidson, Inc. Charles SchwabInc.
BlackRock, Corporation Stericycle, Inc.
Southwest Airlines Co.
Home Depot, Inc. Franklin Resources, Inc.
Hasbro, Inc. Charles Schwab Corporation Stericycle, Inc.
L Brands Inc. Leucadia National Corporation Information Technology
Home Depot, Inc. Franklin Resources, Inc.
Lowe's Companies, Inc. M&T Bank Corp. Adobe Systems Incorporated
L Brands Inc. Leucadia National Corporation Information Technology
McDonald's Corporation Markel Corporation Alliance Data Systems Corporation
Lowe's Companies, Inc. M&T Bank Corp. Adobe Systems Incorporated
Netflix, Inc. Northern Trust Corporation Altera Corporation
McDonald's Corporation Markel Corporation Alliance Data Systems Corporation
NIKE, Inc. Progressive Corporation Amphenol Corporation
Netflix, Inc. Northern Trust Corporation Altera Corporation
Nordstrom, Inc. Raymond James Financial, Inc. Analog Devices, Inc.
NIKE, Inc. Progressive Corporation Amphenol Corporation
O'Reilly Automotive, Inc. SEI Investments Company ANSYS, Inc.
Nordstrom, Inc.
Polaris Industries Inc.
Raymond James Financial, Inc.
State Street Boston Corporation
Analog Devices, Inc.
Apple Inc.
O'Reilly
PVH Corp. Automotive, Inc. SVBSEIFinancial
Investments
GroupCompany ANSYS,Materials,
Applied Inc. Inc.
Polaris
Ross Stores, Industries
Inc. Inc. State Street
T. Rowe Price GroupBoston
Inc.Corporation Apple Inc.
Autodesk, Inc.
PVH Corp.
Starbucks Corporation SVB Financial Group
TD Ameritrade Holding Corp. Applied Materials,
Automatic Inc. Inc.
Data Processing,
Ross Corp.
Target Stores, Inc. T. RoweCorporation
Torchmark Price Group Inc. CAAutodesk,
Inc. Inc.
Starbucks
Tiffany & Co. Corporation W.TD Ameritrade
R. Berkley Holding Corp.
Corporation Automatic
Cisco Data
Systems, Inc. Processing, Inc.
Target
Time Corp.
Warner Inc. Torchmark Corporation CA Inc. Technology Solutions Corp.
Cognizant
Tiffany
TJX & Co. Inc.
Companies, W. R.Care
Health Berkley Corporation Cisco
Cree Inc.Systems, Inc.
Time
Toll Warner
Brothers, Inc.Inc. Actavis PLC Cognizant
eBay Inc. Technology Solutions Corp.
TJX Companies,
Tractor Supply Company Inc. Health
Alexion Care
Pharmaceuticals, Inc. Cree Inc.Arts Inc.
Electronic
TollCorporation
V.F. Brothers, Inc. Actavis
Amgen Inc.PLC eBayCorporation
EMC Inc.
Walt Disney
Tractor Company
Supply Company Biogen IDECPharmaceuticals,
Alexion Inc. Inc. FactSet Research
Electronic Arts Systems
Inc. Inc.
Williams-Sonoma,
V.F. Corporation Inc. C. Amgen
R. Bard, Inc.
Inc. Fiserv
EMCInc. Corporation
Wynn
WaltResorts,
Disney Limited
Company Cardinal
BiogenDistribution,
IDEC Inc. Inc. Intel Corporation
FactSet Research Systems Inc.
Williams-Sonoma, Inc. Catamaran
C. R. Bard, Corporation
Inc. Intuit
FiservInc.
Inc.
Consumer Staples
Wynn Resorts, Limited Celgene Corporation
Cardinal Distribution, Inc. Linear
Intel Technology
CorporationCorporation
Brown-Forman Corporation Cerner Corporation
Catamaran Corporation MasterCard
Intuit Inc. Incorporated
Church & Dwight
Consumer Co., Inc.
Staples DENTSPLY
CelgeneInternational
Corporation Inc. Maxim
LinearIntegrated Products,
Technology Inc.
Corporation
Clorox Company Express Scripts Holding Company Microchip Technology Inc.
Brown-Forman Corporation Cerner Corporation MasterCard Incorporated
Colgate-Palmolive Company Forest Laboratories, Inc. MICROS Systems, Inc.
Church & Dwight Co., Inc. DENTSPLY International Inc. Maxim Integrated Products, Inc.
Constellation Brands Gilead Sciences, Inc. Microsoft Corporation
Clorox Company Express Scripts Holding Company Microchip Technology Inc.
Hershey Company IDEXX Laboratories, Inc. Oracle Corporation
Colgate-Palmolive Company Forest Laboratories, Inc. MICROS Systems, Inc.
Hormel Foods Corporation Incyte Corporation Paychex, Inc.
Constellation Brands Gilead Sciences, Inc. Microsoft Corporation
J. M. Smucker Company Intuitive Surgical, Inc. QUALCOMM Incorporated
Hershey Company IDEXX Laboratories, Inc. Oracle Corporation
Keurig Green Mountain Inc. Medivation, Inc. salesforce.com inc.
Hormel Foods Corporation Incyte Corporation Paychex, Inc.
Monster Beverage Corp. Medtronic, Inc. Total System Services, Inc.
J. M. Smucker Company
Sysco Corporation
Intuitive Surgical, Inc.
Mylan Inc.
QUALCOMM Incorporated
Xilinx, Inc.
Keurig
Tyson Green
Foods, Inc.Mountain Inc. Medivation,
ResMed Inc. Inc. salesforce.com
Yahoo! Inc. inc.
MonsterCo.
Walgreen Beverage Corp. Medtronic,
Salix Inc. Ltd.
Pharmaceuticals, Total System Services, Inc.
Sysco Corporation
Wal-Mart Stores, Inc. St. Mylan Inc. Inc.
Jude Medical, Xilinx, Inc.
Materials
TysonFoods
Whole Foods, Inc. Inc.
Market, ResMed
Stryker Inc.
Corporation Yahoo!
Airgas, Inc.Inc.
Walgreen Co. Salix Pharmaceuticals,
United HealthCare Corporation Ltd. Ball Corporation
Wal-Mart Stores, Inc. St. Jude
Universal Medical,
Health Inc.Inc.
Services, CF Industries Holdings, Inc.
Whole Foods Market, Inc. Stryker
Waters Corporation
Corporation Ecolab Inc.
United HealthCare Corporation FMC Corporation
Universal Health Services, Inc. Sherwin-Williams Company
Waters Corporation Sigma-Aldrich Corporation
Valspar Corporation
Important Note: these
Important Note: arenot
theseare notrecommendations,
recommendations,and andthe
thecompany
companylistlist is purely
is purely based
based onon historical
historical analyses
analyses andand
information which is never a guarantee of future results or success.
information which is never a guarantee of future results or success. 33
40
33
The performance of IPOs vs. the broad market
While results obviously vary by stock, there are some observations one can make regarding the
aggregate performance of IPOs after they are issued. Using over 7,000 IPOs since 1980, one can
evaluate post-IPO performance (i.e., after the first day’s close) for 3 years and compare it to the broad
market, and also to a group of stocks with similar market cap and book-to-market ratios. The charts
below show the results based on the year of the IPO. There are obviously large differences between
individual stocks, but overall, the results do not point to consistently outsized post-IPO
performance when compared to diversified equity market alternatives.
Post-IPO returns vs. the market Post-IPO returns vs. similar style firms
Average 3-year buy and hold IPO return vs. the market Average 3-year buy and hold IPO return vs. the similar style firms
40% 40%
20% 20%
0% 0%
-20% -20%
-40% -40%
-60% -60%
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12
Source: "Initial Public Offerings: Updated Statistics on Long-run Performance". Ritter (Univ. of Florida). April 2014.
Note: Returns for stocks within 3 years of IPO are through 12/31/2013. Ritter defines the broad market using an index from the Chicago
Booth School (Center for Research in Security Prices) which incorporates all stocks on the Amex, Nasdaq and NYSE exchanges.
A closer look at the results shows that small firm IPOs tend to perform worse than larger ones, with the
cutoff for “small” being $50 million in sales (in 2011 dollars). This is particularly true in technology and
biotech IPOs.
On being an insider, and other issues related to concentrated ownership

Concentrated holders have some important decisions to make: the situs where the stock is held, and
the entity in which the stock is held (for example, a grantor or non-grantor trust). There are also
choices between lifetime gifting and a step-up in basis at death that impact family wealth differently.
Non-insider holders seeking to reduce exposure may want to explore options-based strategies as
alternatives to outright selling. When the latter course is chosen, there are a range of decisions that
holders should be familiar with (exchange funds, issues related to charitable giving to family
foundations, and how to structure a selling program in terms of volume, order type and
primary/secondary offerings).
There are often restrictions on insiders selling their positions; however, there are means by which
insiders can reduce exposure over time. For example, rule 10b5-1 allows for carefully planned
trading programs that may protect the insider from a claim of having made an investment decision
while in possession of material inside information. Such a program, once established, allows trades to
be made at any time, thereby freeing insiders from the prohibitions on trading during “closed window
periods” that normally apply. When executed properly, they have the potential to mitigate signaling
issues generally associated with sales by insiders.
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What about taxes?

It usually does not make sense to let the tax tail wag the dog; in other words, good and bad
investment ideas rarely distinguish themselves based on taxes. In the case of concentrated stock
positions, this is usually (but not always true): taxes need to be considered given the treatment of low-
basis stock upon death (it receives a step-up in basis). As a result, older owners of concentrated stock
interested in reducing exposure have to take into account the potential tax freight involved with
diversification. There are a lot of scenarios one can assume; based on our findings, in most of them,
taxes do not have a large impact on the outcome.
Let’s assume the following. A concentrated holder wants to reduce exposure, has a basis that is 20%
of the current stock price, and has no unrealized losses available to mitigate the gain. Including taxes
related to the Affordable Care Act (Medicare surtax), the total Federal long-term capital gains rate
would be 23.8%. The owner wants to maintain exposure to equity markets, just not in concentrated
form, and intends to invest the sales proceeds in the Russell 3000 Index. To maximize the amount in
the diversified portfolio, the owner sells the stock, invests in the Russell 3000 and borrows the proceeds
to pay taxes due at an interest rate of 4%. The loan is repaid at the end of the holding period.
The grid below shows two variables that affect the outcome: how the stock performs relative to the
Russell 3000 Index after the sale, and the time horizon, which reflects how long the owner would have
held the stock otherwise (until a step-up in basis at death). As shown, the primary driver is how well
the stock performs vs. the market. If the stock outperforms, then with 20-20 hindsight, selling is
negative. On the other hand, if the stock underperforms the market after the sale, there would almost
always be a benefit to selling. Only in a small number of cases (shown in red) would the impact
of taxation on its own negate the benefits of selling, if in fact the stock underperforms the
market. As a result, for most concentrated holders (excluding those at a very advanced age), we do
not believe that the tax issue should drive the diversification discussion.
Annualized gain (loss) from disposition of concentrated stock and purchase of Russell 3000 Index
Holding period until step-up in basis (years)
3 6 9 12 15 18 21 24
-15.0% -21.5% -17.9% -16.7% -16.2% -15.8% -15.6% -15.5% -15.4%
Excess annual return of Russell 3000 Index
-12.5% -19.0% -15.4% -14.2% -13.7% -13.3% -13.1% -13.0% -12.9%

-10.0% -16.5% -12.9% -11.7% -11.2% -10.8% -10.6% -10.5% -10.4%
over concentrated stock position
-7.5% -14.0% -10.4% -9.2% -8.7% -8.3% -8.1% -8.0% -7.9%

-5.0% -11.5% -7.9% -6.7% -6.2% -5.8% -5.6% -5.5% -5.4%
-2.5% -9.0% -5.4% -4.2% -3.7% -3.3% -3.1% -3.0% -2.9%
0.0% -6.5% -2.9% -1.7% -1.2% -0.8% -0.6% -0.5% -0.4%
2.5% -4.0% -0.4% 0.8% 1.3% 1.7% 1.9% 2.0% 2.1%
5.0% -1.5% 2.1% 3.3% 3.8% 4.2% 4.4% 4.5% 4.6%
7.5% 1.0% 4.6% 5.8% 6.3% 6.7% 6.9% 7.0% 7.1%
10.0% 3.5% 7.1% 8.3% 8.8% 9.2% 9.4% 9.5% 9.6%
12.5% 6.0% 9.6% 10.8% 11.3% 11.7% 11.9% 12.0% 12.1%
15.0% 8.5% 12.1% 13.3% 13.8% 14.2% 14.4% 14.5% 14.6%
Note: assuming an annualized return on the Russell 3000 Index of 8%
The number of shaded red cells in the table above would not change much if we were to assume a
lower annual return on the Russell 3000 Index; the inclusion of state capital gains taxes; or the absence
of a loan (i.e., paying the tax on capital gains when due). Finally, there are strategies which involve
diversification via charitable giving, derivatives and other security arrangements which do not entail the
current recognition of taxable gains.
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Some final thoughts on managing concentrated stock positions

Great fortunes have been created by visionaries who seized a unique opportunity and work single-
mindedly to realize their ambition. Concentration is an effective engine of wealth creation: it helped
drive the success of all 10 of the top 10 on the Forbes magazine list of world billionaires in 2014. In the
US, the top 10 of the “Forbes 400” also made their fortunes through concentration.
As difficult as it is to build a company and amass wealth, it is just as difficult to keep fortunes aloft. Our
analysis (and others before it) demonstrates the hard reality that, all too often, continued concentration
may ultimately destroy wealth. Since the early 1980’s, 40% of all companies experienced a severe loss
and never recovered, with higher loss rates in Technology, Biotech and Consumer Discretionary. As
this study lays out, no matter how well you know your industry and your company, no one is
impervious to event risk and industry changes. The factors outside management control shown
on page 11 are a formidable list, and have grown in complexity since we first drafted this
report 10 years ago. This is perhaps the most important epiphany we gained from the study: that
exogenous forces may overwhelm the things we can control.
Despite this, often the natural impulse is to leave well enough alone. After all, if concentration’s
rewards have been so enormous, why not stay concentrated? Some may be concerned that
“diversification” translates directly into “selling the business.” It does not. While you could sell all or
part of your business, you might also consider taking some capital out of your business or use leverage
to create a complementary portfolio. In doing so, a concentrated owner can take out some insurance
against the unknown.
The process of addressing concentration starts with some personal choices about risk and the fate of
future generations. While no plan is ever perfect, taking no action may be worse. The first step in the
journey is to look at the overarching question of what you want to achieve in the long run, now that
the wealth has been created. If you want your fortune to be enjoyed by your family for generations,
you will need to create a plan that encourages guided consumption, as well as wealth preservation. A
charitable legacy requires substantial planning as well.
While each business and owner is unique, certain patterns and truths are universal. During the 170
years J.P. Morgan has been advising wealthy families around the world, we have had the privilege of
assisting business owners in every phase of their operations and through all market conditions. At
whatever stage you may be in the shift from wealth generation to wealth preservation, and whatever
your hopes for your business, fortune and family, it would be our privilege to share the benefit of our
experience with you.
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Appendix I: Chinese government subsidies

Appendix I: Chinese government subsidies
Government subsidies are often an under-appreciated contributor to the challenges that businesses can
Government
face. subsidies
Sometimes, are often
an industry an under-appreciated
leader in the OECD endscontributor
up facing stiffto the challengesfrom
competition thatgovernment-
businesses
face. Sometimes, an industry leader in the OECD ends up facing
supported firms in other countries. Here’s a look at the impact of Chinese subsidies 6: stiff competition from government-
6
supported firms in other countries. Here’s a look at the impact of Chinese subsidies :
• At most Chinese solar, steel, glass, paper and auto parts companies, labor costs only make up 2%
• At mostofChinese
to 7% solar, steel,
total production glass,Nevertheless,
costs. paper and auto partscompetition
intense companies, from laborChina
costs only
oftenmake
comes upfrom
2%
to 7% of total production costs. Nevertheless, intense competition from
small Chinese firms with limited economies of scale, and whose products sell in the international China often comes from
small
market Chinese
at 25%firms to 30%in these sectorstowith
discounts worldlimited
prices.economies of scale, and whose products sell in
international markets at 25% to 30% discounts
• How can this be explained? In all likelihood, by subsidies to world prices.
received from the Chinese government.
• Subsidies
How can this takebe theexplained?
form of free In all
or likelihood, by artificially
low-cost loans; Government cheap raw materials,
subsidies to Chinese components,
firms, 1985-2005
subsidies
energy orreceived from the
land; support Chinese
for R&D; and a heavily managed Annual, $ bn cheap) exchange rate. Land grants
(i.e., Cumulative, $ bn
government. Subsidies take the form of free or $25
for office or factory construction are particularly valuable, since companies can develop excess
$350
low-cost loans; artificially cheap raw
parcels and use the proceeds to pay for R&D. As permaterials, $300
$20a June 2013 article in The Wall Street Journal
components, energy or land; support for R&D;
Chinese government subsidies grew 23% y/y in 2012 (following on 24% y/y growth in 2011), $250
and a heavily
benefiting 90% managed (i.e.,Chinese
of all listed cheap) exchange
companies. $15 $200
rate. Landingrants
• Example: 2000, for
Chinaoffice
wasorafactory
net importer of steel. By 2007, China became the world’s largest
construction areconsumer,
particularlyand valuable, since $10 $150
steel producer, exporter. Energy subsidies to Chinese steel manufacturers were $27
companies
billion fromcan develop excess
2000-2007. parcels its
Even though and use
fragmented
$100
$5steel industry has limited economies of scale
the proceeds
and not muchtoofpay for R&D. Theedge,
a technological bar chart
Chinese steel sells for 25% less than US and European steel. $50
shows estimates of these subsidies through
• A similar outcome is seen in the Chinese paper industry, $0 which received $33 billion in subsidies $0
2005 from the China Statistical Yearbook; the 1985 1989 1993 1997 2001 2005
from 2002 to 2009. As solar PV, the 5 largest Chinese companies
Source: received
“Subsidies to Chinese the equivalent
Industry”, Usha Haley andof $31Haley,
George
series was discontinued in 2006.
billion in low-interest loans from the state-owned China Development
Oxford University Bank,
Press, April 2013. and other subsidies
• from
Another data provider
national estimates
and provincial Chinese These amounts dwarf the amounts provided by the US
governments.
government subsidies to
government to its solar companies. public companies, and according to their findings, these subsidies are still
growing rapidly. As per a June 2013 article in The Wall Street Journal citing this source, Chinese
government
Estimated subsidiessubsidies
government grew 23%toy/y in 2012
Chinese (following on 24% y/y growth in 2011), benefiting
firms
90% of
Annual, $ bn all listed Chinese companies. Cumulative, $ bn
•$25 Example: in 2000, China was a net importer of steel.$350 By 2007, China became the world’s largest
steel producer, consumer, and exporter. Energy subsidies $300
to Chinese steel manufacturers were $27
$20 billion from 2000-2007. Even though its fragmented steel industry has limited economies of scale
and not much of a technological edge, Chinese steel$250 sells for 25% less than US and European steel.
$15
• A similar outcome is seen in the Chinese paper industry, $200 which received $33 billion in subsidies
from 2002 to 2009. As solar PV, the 5 largest Chinese $150companies received the equivalent of $31
$10
billion in low-interest loans from the state-owned China Development Bank, and other subsidies
$100
$5
from national and provincial governments. These amounts dwarf the amounts provided by the US
government to its solar companies. $50
$0 $0
China is not the
1985
only country
1989 1993
that1997
provides2001
subsidies2005
to domestic industry; the US does as well
(particularly to its
Source: “Subsidies auto industry),
to Chinese andHaley
Industry”, Usha the and
entire OECD
George engages in substantial subsidies for agricultural
Haley,
7
firms
Oxf ord. University
But in Press,
our view, the China case has no equal in terms of scope, breadth and impact.
April 2013.
China
Another is not theof
aspect only
thecountry that provides
China competitive subsidies
story: to domestic
copyright and IPindustry; the US does
infringement. as well
According to a 2011
(particularly
report from the to itsUnited
auto industry), and the entire
States International TradeOECD engages US
Commission, in substantial
IP-intensivesubsidies for agricultural
firms conducting
7
firms
business. But 2009the
in ourinview,
in China China losses
reported case has no equal
of $48.2 billionininterms of scope,
lost global sales,breadth
royalties and
and impact.
license fees
due to intellectual property right infringement in China.
Another aspect of the China competitive story: copyright and IP infringement. According to a 2011
report from the United States International Trade Commission, US IP-intensive firms conducting
business in China in 2009 reported losses of $48.2 billion in lost global sales, royalties and license fees
due to intellectual property right infringement in China.
6
6
From “How Chinese Subsidies Changed the World”, Usha Haley (West Virginia University) and George T. Haley,
From “How
Harvard Chinese
Business Subsidies
Review, Changed the World”, Usha Haley (West Virginia University) and George T. Haley,
April 2013.
Harvard Business Review, April 2013.
7
7
According to an article in The Economist in September 2012, countries like Norway, Switzerland, Japan and
According
South Koreato an article
provide in Theto
subsidies Economist in September
their agricultural sectors2012,
equalcountries
to 45% -like Norway,
60% Switzerland,
of gross Japan
farm receipts. and
The EU
South Korea provide subsidies
registers at 20% and the US at 8%.to their agricultural sectors equal to 45% - 60% of gross farm receipts. The EU
registers at 20% and the US at 8%.
44
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Appendix II: Biotech and Life Sciences

As mentioned in the Health Care section on page 23, while 2000-2001 was the peak distress period
for biotech and life science companies, there has been a steady drumbeat since, with over 100 biotech
and life science catastrophic loss events since 2002 (see bar chart). We referenced earlier research
showing that even when a drug finally gets to Phase 3 trials, the probability of failure can still be as
high as 50%. One possible emerging challenge for the biotech industry: patent trolls. For funding and
other reasons, some universities are under pressure to monetize their patents by transferring rights to
“assertion entities”. As per a 2014 paper from the University of California Hastings College of Law, as
these patent sales take place, the risk to biotech and pharmaceutical companies with existing products
on the market increases dramatically. Such patents can cover active ingredients of drugs, methods of
treatment, screening methods to identify new drugs, manufacturing methods and dosage forms.
In the table, we show some of the more recent catastrophic losses (companies reaching the 70%
decline threshold in 2012 or 2013). Biotech companies can experience periods of depressed stock
prices as trials fail or have to be rerun, with some surging when/if success eventually occurs, or when
they are bought by larger companies. As a result, the table below captures catastrophic loss at a point
in time (Spring 2014), and does not represent a final assessment of each firm’s future prospects.
Health Care companies that reached the 70% loss threshold A Partial List of Russell 3000 Index Biotech and Life
in a given year, 1980-2014, Number of stocks Science Companies reaching catastrophic loss thresholds
60 in 2012 and 2013
Pharmaceuticals
Lif e Sciences Tools & Services Company Product / Treatment Disease / Condition
50
Health Care Equipment & Supplies Affymax Omontys Chronic kidney disease
40 Biotechnology Anthera Varesplaib, Blisibimod Heart disease, Lupus
AVEO Tivozanib Kidney cancer
30
BG Medicine Galectin-3 Test Heart failure
20 Coronado TSO Crohn's disease
Cytori Athena Coronary heart disease
10 Dynavax Heplisav Hepatitis B
Infinity IPI-145 Blood cancer
0
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Myrexis Azixa Brain cancer
Source: JPMAM, FactSet. February 2014. Source: FactSet, J.P. Morgan Asset Management.
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Sources
Ailawadi K, Zhang J, Krishna A, and Kruger M, "When Walmart Enters: How Incumbent Retailers React
and How This Affects Their Sales Outcomes," Journal of Marketing Research, June 2009.
“Agricultural subsidies”, The Economist, September 22, 2012.
“Boom and Bust in Telecommunications”, Couper, Hejkal and Wolman, Federal Reserve Bank of
Richmond, 2003.
“Chinese Industrial Subsidies Grow 23%”, Wall Street Journal, June 23, 2013.
“Generic Drug Savings in the US”, Generic Pharmaceutical Association, 2013 Report
“The Growth of Chinese Exports: An Examination of the Detailed Trade Data”, Board of Governors of the
Federal Reserve System International Finance Discussion Papers, November 2011, Berger and Martin
“How Loyal Are Your Customers? A View of Loyalty Sentiment Around the World”, The Nielsen
Company, November 2013.
“The Impact of the Internet on Advertising Markets for News Media”, Athey, Calvano and Gans,
University of Toronto and NBER, 2013.
“Patent Trolling: Why Bio and Pharmaceuticals are at Risk”, Feldman (University of California Hastings
College of Law) and Price (Petrie-Flom Center for Health Law Policy at Harvard Law School), February
2014
Pisano, G. Science Business: The Promise, the Reality, and the Future of Biotech, Harvard Business School
Press, Cambridge, MA; 2006.
United States International Trade Commission, Investigation No. 332-519, “China: Effects of
Intellectual Property Infringement and Indigenous Innovation Policies on the US Economy”, May 2011.
46
39
Acronyms
BEA: Bureau of Economic Analysis
CLEC: Competitive local exchange carrier
CLTV: Combined Loan to Value
CRSP: Center for Research in Security Prices
DTI: Debt-To-Income; E&P: Exploration and Production
EIA: Energy Information Administration
EPA: Environmental Protection Agency
FCC: Federal Communications Commission
FDA: Food and Drug Administration
FDIC: Federal Deposit Insurance Corporation
FHA: Federal Housing Administration
GAO: Government Accountability Office
GDP: Gross Domestic Product
GICS: Global Industry Classification Standard
GSE: Government-Sponsored Enterprise
HUD: US Department of Housing and Urban Development
IP: Intellectual Property
IPO: Initial Public Offering
JPMAM: J.P. Morgan Asset Management
LCD: Liquid Crystal Display
MMbtu: Million British Thermal Units
MWh: Megawatt-hour
OECD: Organisation for Economic Co-operation and Development
OPEC: Organization of the Petroleum Exporting Countries
PV: Photovoltaic
R&D: Research and Development
REIT: Real Estate Investment Trust
S&P: Standard & Poor’s
SEC: Securities and Exchange Commission
47
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MICHAEL CEMBALEST is Chairman of Market and Investment Strategy for J.P. Morgan
Asset Management, a global leader in investment management and private banking
with $1.6 trillion of client assets under management worldwide (as of December 31,
2013). He is responsible for leading the strategic market and investment insights across
the firm’s Institutional, Funds and Private Banking businesses.
Mr. Cembalest is also a member of the J.P. Morgan Asset Management Investment
Committee and a member of the Investment Committee for the J.P. Morgan Retirement
Plan for the firm’s more than 250,000 employees.
Mr. Cembalest was most recently Chief Investment Officer for the firm’s Global Private
Bank, a role he held for eight years. He was previously head of a fixed income division
of Investment Management, with responsibility for high grade, high yield, emerging
markets and municipal bonds.
Before joining Asset Management, Mr. Cembalest served as head strategist for Emerging
Markets Fixed Income at J.P. Morgan Securities. Mr. Cembalest joined J.P. Morgan in
1987 as a member of the firm’s Corporate Finance division.
Mr. Cembalest earned an M.A. from the Columbia School of International and Public
Affairs in 1986 and a B.A. from Tufts University in 1984.
48
JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained
herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the
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The material contained herein is intended as a general market commentary. Opinions expressed herein are those of
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Further, the views expressed herein may differ from that contained in J.P. Morgan research reports. The
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EYE ON THE MARKET

THE RISKS AND REWARDS OF A CONCENTRATED STOCK POSITION

Table of Contents Page

Sector case studies

The steady drumbeat of creative destruction in the S&P 500

Our study on the creative

Falling from grace: catastrophic losses on Russell 3000 companies

Total % of companies experiencing

Financials: catastrophic loss rates vs. the Russell 3000

> 100% > 100%

> 50% > 50%

> 1000%> 1000%

Annualized stock price return

Optimal mix of a concentrated stock position with the

• commodity price risks that cannot be hedged away

$50 $25 Premier Parks Inc. (Six Flags)

Auto Components Household Durables (continued) Media (continued)

Marshall & Ilsley

longer. As for valuations, nothing will probably ever 2000: 31.7

Telecom & Utilities

2000-2003 Telecom bankruptcy wave (partial)

Utilities (power generation, transmission and distribution)

US natural gas prices

Subsector focus on alternative energy stocks

50% NYSE Bloomberg AME

-50% Wilderhill Clean Energy Index

Hydrogen fuel cells Superconductors

Next generation renewable biofuels Environmentally friendly fast-food containers

$15 KiOR Inc. $140

A look at the winners (The Ecstasy)

The performance of IPOs vs. the broad market

On being an insider, and other issues related to concentrated ownership

What about taxes?

-12.5% -19.0% -15.4% -14.2% -13.7% -13.3% -13.1% -13.0% -12.9%

-7.5% -14.0% -10.4% -9.2% -8.7% -8.3% -8.1% -8.0% -7.9%

Some final thoughts on managing concentrated stock positions

Appendix I: Chinese government subsidies

Appendix II: Biotech and Life Sciences

© 2014 JPMorgan Chase & Co. All rights reserved. 0814-0619-01

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