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July 8, 2010
Blah-Shaped Recovery Not Priced in – Downgrading to Sell
Meyer Shields, FCAS (443) 224-1331 [email protected] M. DeAugustino (443) 224-1330 [email protected]
Arash Soleimani, CPA (443) 224-1377 [email protected]
Company Update
We’re downgrading the shares of Berkshire Hathaway to Sell from Hold asour weak macroeconomic outlook implies poor 2H10 earnings. In this notewe outline the signs we see for a 2H10 economic retreat, and why BRKshould outpace market declines.
• We think declining consumer confidence will slow consumer spending, asemployment very slowly recovers. Additionally, a shrinking appetite forincreased public spending should limit the size of any future economic
stimulus packages. Middle Eastern political instability could also drive realoil prices above $85 a barrel, further impacting consumers’ discretionaryexpenditures.
• Aside from Berkshire’s operating units’ exposure to economic weakness,its shares face a “double whammy,” as its equity portfolio and derivativepositions expose it to additional book value pressure. Investors’ focus onBerkshire’s book value for valuation imply that its shares could outpacebroader market’s declines.
• BRK’s YTD outperformance versus the S&P 500 is nearing an apex thatseems poised for a correction based on the shares' history.
• Berkshire’s property/casualty reserve releases have recently ramped up,but we see that as unsustainable in an enduring soft market, implying
additional earnings pressure as releases slow.
We’ve reduced our EPS estimates to reflect the expected challenging 2H10environment, with modest economic growth expected in 2011. Our EPSestimates move to $5,685 from $5,764 (2010E), and to $6,097 from $6,241(2011E). Our sum-of-the-parts valuation method suggests fair value for theshares at about $104,000, about 13% downside from current levels.
Berkshire Hathaway Inc.
BRK.A – NYSESell
Insurance: Standard/Specialty/Brokers
From ToChanges (Previous) (Cur rent)
Rating Hold Sell
Target Price — —
FY10E EPS (Net) $5,764 $5,685
FY11E EPS (Net) $6,241 $6,097
FY10E Revenue (Net)$122.37B $121.91B
FY11E Revenue (Net)$126.84B $125.19B
Stock Data
Price (07/07/10): $119,889.00
52-Week Range: $125,252 –$84,600
Market Cap.(mm): 197,457
Shr.O/S-Diluted (mm): 1.6
Avg Daily Vol (3 Mo): 937
Dividend ($): $0.00Yield (%): 0.0%
Book Value/Share: 89,374
Stated Book: 89,374
Price/Stated Book: 134%
Tangible Book: 59,799
Price/Tangible Book: 200%
S&P Index: 1,060.27
EPS (Net) 2009A 2010E 2011E
Q1 $1,100 $1,390A $1,488
Q2 1,147 1,319 1,437
Q3 1,325 1,459 1,564Q4 1,306 1,518 1,608
FY Dec $4,878A $5,685 $6,097
P/E 24.6x 21.1x 19.7x
Revenue (Net) 2009A 2010E 2011E
FY Dec $112.49B$121.91B$125.19B
Q2 Q3 Q1 Q2 Q360,000
75,000
90,000
105,000
120,000
135,000
2010
1 Year Price History for BRK/A
Created by BlueMatrix
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(1) Economic Pullback Investor and Consumer Expectations Poised for Disappointment: We think the market’s recent 13% pullback anddeteriorating consumer confidence reflect investors’ and consumers’ disillusioned hopes for a robust economicrecovery that looks less likely, primarily because of steadily high unemployment data. Our skepticism stems fromrecent recessions' pattern of slowing employment recovery highlighted in Figure 1.
Figure 1: Employment Recovery Takes Increasingly Longer Each Time
55
57
59
61
63
65
67
69
71
73
75
1 9 7 0 M
1
1 9 7 2 M
1
1 9 7 4 M
1
1 9 7 6 M
1
1 9 7 8 M
1
1 9 8 0 M
1
1 9 8 2 M
1
1 9 8 4 M
1
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1
1 9 8 8 M
1
1 9 9 0 M
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1 9 9 2 M
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1 9 9 4 M
1
1 9 9 6 M
1
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1
2 0 0 0 M
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1
2 0 0 4 M
1
2 0 0 6 M
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1
2 0 1 2 M
1 E
E m p l o y m e n t R a t i o
$10
$100
$1,000
$10,000
S P X
( L o g S c a l e )
Employment to Population Ratio (12MMA) SPX Price
?
Source: FactSet Research and BLS, Stifel Nicolaus analyst Barry Bannister’s format
Figure 2 traces the employment headcount trajectory for the current and recent recessions (i.e., headcounts indexedto the point of initial employment decline), which illustrates the severity of the current employment environment, and thelikely protracted recovery timeline.
Figure 2: Employment Recovery Trajectories during Past Recessions
93%
94%
95%
96%
97%
98%
99%
100%
101%
1 3 5 7 9 1 1 13 1 5 1 7 19 2 1 2 3 25 2 7 2 9 31 3 3 3 5 37 3 9 4 1 43 4 5 4 7 49 51
Months Since Recession Start
2008
2001
1990
1981
1974
1970
2001
Current excl. census
1970 1974 1981 1991
Source: BLS, Stifel Nicolaus analyst Michael Widner’s Format
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Given that we think the current employment situation will take longer than most consumers and many investors areexpecting, consumer confidence will probably suffer as expectations reconcile with reality. Figure 3 tracks the inverserelationship between unemployment and consumer confidence.
Figure 3: Slower-than-Expected Employment Recovery Likely to Drag on Consumer Confidence
3%
5%
7%
9%
11%
13%
J u n - 8 0
J u n - 8 2
J u n - 8 4
J u n - 8 6
J u n - 8 8
J u n - 9 0
J u n - 9 2
J u n - 9 4
J u n - 9 6
J u n - 9 8
J u n - 0 0
J u n - 0 2
J u n - 0 4
J u n - 0 6
J u n - 0 8 U
n e m p l o y m e n t R a
t e ( S A )
-4%
-2%
0%
2%
4%
6%
8%
E x p e n d i t u r e
s
Unemployment Rate Expenditures
Source: BLS and Consumer Conference Board, via FactSet Research, Inc.
In turn, weak consumer confidence tends to go hand-in-hand with weak personal expenditures ( Figure 4), which wouldotherwise be the key to a sustained economic recovery, as the “shot in the arm” of increased government spendingsubsides.
Figure 4: Consumer Confidence and Personal Spending
-4%
-2%
0%
2%
4%
6%
8%
1 9 8 0 M 6
1 9 8 2 M 6
1 9 8 4 M 6
1 9 8 6 M 6
1 9 8 8 M 6
1 9 9 0 M 6
1 9 9 2 M 6
1 9 9 4 M 6
1 9 9 6 M 6
1 9 9 8 M 6
2 0 0 0 M 6
2 0 0 2 M 6
2 0 0 4 M 6
2 0 0 6 M 6
2 0 0 8 M 6
Y / Y
E x p e n d i t u r e s
020406080100120140160
C C I
Personal Consumption Expenditures, (Bil. $, SAAR) CCI
Source: BLS and Consumer Conference Board, via FactSet Research, Inc.
The Chicken and the Egg: We think consumers are waiting for an employment recovery, while the employmentrecovery is waiting on increased consumer spending. We’re concerned government spending won’t provide the samerelative stimulus strength as a temporary proxy for consumer spending this time around, for two reasons. First, eventhough the drop in personal expenditures, and consequently GDP, is much deeper than in other recent recessions, theincrease in government spending is trailing off (Figure 5). Second, we don’t see much political appetite for additionalstimulus spending without either offsetting budget reductions, or at least definitive repayment plans. Although fiscalresponsibility is (temporarily) great for voter support, zero-sum spending initiatives do little to stimulate increasedspending (the recently failed Senate extension of unemployment benefits is a good example of a faltering appetite forincreased stimulus spending, in our view).
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Figure 5: Y/Y Personal Consumption and Government Spending (Treasury Outlays)
-15%-10%-5%0%
5%10%15%20%25%30%
2 0 0 5 Q 1
2 0 0 5 Q 2
2 0 0 5 Q 3
2 0 0 5 Q 4
2 0 0 6 Q 1
2 0 0 6 Q 2
2 0 0 6 Q 3
2 0 0 6 Q 4
2 0 0 7 Q 1
2 0 0 7 Q 2
2 0 0 7 Q 3
2 0 0 7 Q 4
2 0 0 8 Q 1
2 0 0 8 Q 2
2 0 0 8 Q 3
2 0 0 8 Q 4
2 0 0 9 Q 1
2 0 0 9 Q 2
2 0 0 9 Q 3
2 0 0 9 Q 4
2 0 1 0 Q 1
Treasury Outlays Personal Consumption & Gross Investment
Source: BLS, Department of Treasury
Further, in no recent recessions have households deleveraged to the same degree (Figure 6) as they have in thisrecession. Even if we were to assume the U.S. government can keep issuing paper at ultra-low rates (in fact, we don’t)
to effectively jump-start the economy, we think consumers won’t take the lead in driving GDP growth, as favorablefinancing terms and a housing bubble likely won't work this time around. We believe consumers' spending growth willslow as they gradually work off the last decade of added leverage (regardless of low interest rates), which we thinkwidens the gap between investors’ expectations and economic reality.
Figure 6: Y/Y Debt Balance Changes
-15%
0%
15%
30%
45%
2 0 0 5 Q 1
2 0 0 5 Q 3
2 0 0 6 Q 1
2 0 0 6 Q 3
2 0 0 7 Q 1
2 0 0 7 Q 3
2 0 0 8 Q 1
2 0 0 8 Q 3
2 0 0 9 Q 1
2 0 0 9 Q 3
2 0 1 0 Q 1
F e d . G o v t . D e b t B a l a n c e
C h
a n g e , Y / Y
-5%
0%
5%
10%
15%
H o u s e h o
l d D e b t B a l a n c e
C h a n g e , Y / Y
Federal Government Households
Source: BLS
The Oil Wild Card: While the U.S. is not directly dependent on Iranian oil, any Iranian/Israeli conflict intensification
could induce a worldwide oil supply shock. We think such a scenario could push real oil prices well above $85 a barrel.Figure 7 illustrates that rising oil prices have foretold recessions, with oil above $85 per barrel leading to particularlydeep recessions (late 70’s and current recession). Rising oil prices deter GDP growth even without a shock, but thesituation could get far worse if geopolitical tensions worsen.
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Figure 7: Real Crude Oil Prices vs. GDP Growth
$-
$20
$40
$60$80
$100
$120
$140
$160
J a n - 7 5
J a n - 7 7
J a n - 7 9
J a n - 8 1
J a n - 8 3
J a n - 8 5
J a n - 8 7
J a n - 8 9
J a n - 9 1
J a n - 9 3
J a n - 9 5
J a n - 9 7
J a n - 9 9
J a n - 0 1
J a n - 0 3
J a n - 0 5
J a n - 0 7
-6%
-4%
-2%
0%2%
4%
6%
8%
10%
Real Crude Oil $ per Barrel Real GDP Y/Y%
Source: EIA, and BLS
(2) Double-Dip's Double-Whammy Impact to Book Value We’ve taken our EPS estimates down to $5,685 from $5,764 (2010E) and $6,097 from $6,241 (2011E). Using thesum-of-the-parts calculator built into our model (available for clients to alter per their assumptions), our moreconservative earnings outlook and float-based valuation assumption changes produce an estimated fair value of$104,000 (Table 1) - implying 13% downside from current levels.
Table 1: Sum-of-the-Parts Valuation$ in millions, except per share data
Step Float Valuation Input Result
(1) Estimated "float" (Insurance Float at 3/31/10, Derivative Float at 12/31/09) 69,800.0
(2) After-tax "look-though" investment return on float 7.50%
(3) Projected "look-through" investment growth 2.0%
(4) Risk-free rate (Rf) 3.85%
(5) Beta ( ) 0.90
(6) Equity Risk Premium (ERP) 6.75%
(7) Required rate of return (Rf+ *ERP) 9.93%
(8) "Float" perpetuity = ((1)X(2))/((7)-(4)) 66,057
Operating companies 2011E After-tax Earnings Peer P/E Valuation
GEICO 472 10.0x 4,716
Other insurance/reinsurance (90) 7.0x (629)
Investment income (excluding float) 2,427 15.0x 36,405
Railroads, Utilities and Energy 3,334 12.8x 42,671
Manufacturing, Service and Retailing 1,356 13.0x 17,630
Finance and Financial Products 445 10.0x 4,453
Total valuation, operating companies 7,944 13.2x 105,246Total valuation, float 66,057
Total 171,303
Shares outstanding (est. 2011) 1.651
Valuation, Class A 103,742
Valuation, Class B 69.16
Source: Stifel Nicolaus estimates
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In particular, we think that widespread institutional ownership of BRK's Class B shares means that the stock willbehave less like a cult stock, and more like a "normal" stock following earnings beats and misses - in other words, weexpect a much higher 'beta' than in the past.
Given Berkshire’s sizable investment portfolio and derivative positions, many investors use book value as a valuationbasis. In that vein, we adjust Berkshire’s investment portfolio (and book value) for an expected 8% market pullback in2H10. Table 2 includes a +/-10% scale for its equity and derivative portfolios, while we assume its fixed incomeportfolio remains unchanged, reflecting expected sustained low yields.
Table 2: Book Value Impact from Declining Equity Markets$ millions except per share amounts
E qu it y R el ate d I nv est me nt s: 2Q 10E V al ue -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%
Equity securities $51,863 -$5,186 -$4,149 -$3,112 -$2,075 -$1,037 $0 $1,037 $2,075 $3,112 $4,149 $5,186
Derivatives (Assuming no F/X change) -$7,947 -568 -429 -291 -152 -14 0 263 401 540 678 817
GS Warrants 707 -571 -457 -342 -228 -114 0 114 228 342 457 571
Fixed Income (No Price Change):
Fixed Income and Other 60,121 0 0 0 0 0 0 0 0 0 0 0
Total BVPS Impact 112,691 -2,496 -1,987 -1,478 -969 -460 0 558 1,067 1,576 2,085 2,594
Price Change w/ 1.3x P/BVPS -3,245 -2,583 -1,921 -1,260 -598 0 726 1,387 2,049 2,711 3,373
% of Current -2.8% -2.2% -1.7% -1.1% -0.5% 0.0% 0.6% 1.2% 1.8% 2.3% 2.9%
Equity Market Price Change Assumption Range
Base Case
Source: Stifel Nicolaus estimates
(3) Relative Performance Correction We think BRK's 13% outperformance since early June leaves the shares poised for a correction. YTD, the shares haveoutperformed the S&P by about 26%; over the past 20 years, 30% annual outperformance has typically been a turningpoint for a correction (Figure 8). Additionally, while we've speculated that Berkshire should be a perpetual Hold basedon its size and diversification, Figure 8 contradicts this thesis, highlighting that the shares either outperform orunderperform the S&P 500 by at least 10% about 75% of the time.
Figure 8: Annual BRK Relative Performance
-50%-40%-30%-20%-10%
0%10%20%30%
40%50%
1
2 / 3 1 / 1 9 9 1
1
2 / 3 1 / 1 9 9 2
1
2 / 3 1 / 1 9 9 3
1
2 / 3 0 / 1 9 9 4
1
2 / 2 9 / 1 9 9 5
1
2 / 3 1 / 1 9 9 6
1
2 / 3 1 / 1 9 9 7
1
2 / 3 1 / 1 9 9 8
1
2 / 3 1 / 1 9 9 9
1
2 / 2 9 / 2 0 0 0
1
2 / 3 1 / 2 0 0 1
1
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1
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1
2 / 3 1 / 2 0 0 4
1
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1
2 / 2 9 / 2 0 0 6
1
2 / 3 1 / 2 0 0 7
1
2 / 3 1 / 2 0 0 8
1
2 / 3 1 / 2 0 0 9
2 0 0 9 Y T D
R e l a t i v e P e r f o r m a n
c e
$0
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$140,000
$160,000
B R K . A P r i c e
BRK Relative Performance +10% Threshold
-10% Threshold BRK.A Price
75% of Years' Relative Performance > +/- 10%
Source: FactSet Research Systems, Inc.
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Table 3 shows Berkshire’s performance vs. the S&P since several key dates. Most recently the shares haveoutperformed the S&P since the beginning of June without much of a catalyst, putting it at risk for a correction, in ourview.
Table 3: Relative Performance from Key Dates
Event Date BRK.A SPX Diff
Start of Relative Outperform ance Resurgence June 7th, 2010 14.2% 0.9% 13.3%
Recent Market High April 23rd, 2010 1.3% -12.9% 14.2%BRK Addition to S&P Announcement January 26th, 2010 17.8% -2.9% 20.8%
Year Ago July 7th, 2009 37.5% 20.3% 17.2%
BRK Bear Market Low March 5th, 2009 65.6% 55.3% 10.3%
Source: FactSet Research Systems, Inc.
Estimate Changes Table 4 includes a summary of our earnings model and estimate changes.
Table 4: Model and Estimate Change Summary($ in millions, except per share data) Previous Estimates % Change
2008 2009 2010E 2011E 2010E 2011E 2010E 2011E
Revenues
Insurance and Other: $95,698 $92,780 $92,572 $93,172 $92,649 $94,118 0% -1%
Utilities and Energy: 13,971 11,443 2 4,448 27,535 24,809 28,217 -1% -2%
Finance and Financial Products: (1,883) 8,270 4,891 4,483 4,907 4,500 0% 0%Total revenues 107,786 112,493 121,910 125,190 1 22,365 126,835 0% -1%
Cost and expenses
Insurance and Other: 85,044 87,219 82,531 84,290 82,515 85,052 0% -1%
Utilities and Energy: 11,008 9,915 2 0,175 22,406 20,432 22,899 -1% -2%
Finance and Financial Products: 4,160 3,807 3,759 3,765 3,774 3 ,780 0% 0%
Total Costs and Expenses 100,212 100,941 106,465 1 10,461 106,721 111,731 0% -1%
Pretax operating income 15,035 10,765 13,716 14,729 13,915 15,104 -1% -2%
Income tax on operating income 4,794 2,812 3,698 4,242 3,767 4,378 -2% -3%
Minority shareholders' interests 602 386 479 420 479 420 0% 0%
Operating income 9,639 7,567 9,540 10,067 9,669 10,306 -1% -2%
W eighted average common shares outstanding (Class A basis) 1.549 1.551 1.636 1.651 1.636 1.651 0% 0%
Operating EPS $6,223 $4,878 $5,685 $6,097 $5,764 $6,241 -1% - 2%
Non-operating EPS ($2,999) $313 $973 $121 $973 $121 0% 0%
Net EPS $3,224 $5,190 $6,658 $6,218 $ 6,737 $6,363 -1% -2%
Book value per share $70,530 $84,487 $90,883 $96,914 $93,702 $99,871 -3% -3%
TTM Operating ROE 6.5% 6.5% 6.4% 6.5% 6.4% 6.5% 1% 1%
TTM Net ROE 6.9% 6.9% 7.5% 6 .6% 7.5% 6.6% 1% 1%
Source: Company reports and Stifel Nicolaus estimates
Consistent with our unenthusiastic 2H10 outlook, and slower anticipated 2011 economic growth, we’ve adjusted ourestimates for many of Berkshire’s non-insurance subsidiaries' revenues and earnings. While its insurance businessesare typically more insulated from macroeconomic fluctuation, recent reserve release increases (Figure 9) are probablyunsustainable (reserve redundancies tend to fade as soft markets persist), leading to additional earnings pressure asreserve releases slow.
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Figure 9: Recent Reserve Releases Likely to Decelerate as Soft Market Persists$ in millions
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(229)
60 20
1,453
(126)(20)
(296)
(96)
(287)
193
55 46
1,026
(88)(196)
(1,270)
(314)
(11)
(211)(204)(205)
(388)
(204)
(391)(418)(311)
(139)
(587)
(449)(502)
(163)
(406)
(892)
(1,500)
(1,000)
(500)
0
500
1,000
1,500
2,000
1 Q
0 2
2 Q
0 2
3 Q
0 2
4 Q
0 2
1 Q
0 3
2 Q
0 3
3 Q
0 3
4 Q
0 3
1 Q
0 4
2 Q
0 4
3 Q
0 4
4 Q
0 4
1 Q
0 5
2 Q
0 5
3 Q
0 5
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1 Q
0 6
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0 6
3 Q
0 6
4 Q
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1 Q
0 7
2 Q
0 7
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0 7
4 Q
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0 8
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0 8
3 Q
0 8
4 Q
0 8
1 Q
0 9
2 Q
0 9
3 Q
0 9
4 Q
0 9
1 Q
1 0
Source: Highline data and Stifel Nicolaus analysis
Company Description
Berkshire Hathaway Inc. is the holding company of a diverse group of businesses including personal and commercialinsurance and reinsurance, energy generation, transmission, and distribution, consumer and commercial lending, andan extensive array of manufacturing, retail, and service businesses. Its primary strategy is to grow earnings throughacquisitions.
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Important Disclosures and Certifications
I, Meyer Shields, certify that the views expressed in this research report accurately reflect my personal viewsabout the subject securities or issuers; and I, Meyer Shields, certify that no part of my compensation was, is,or will be directly or indirectly related to the specific recommendation or views contained in this researchreport.
Q1 Q2 Q3 Q1 Q2 Q3 Q1 Q2 Q3 Q1 Q2 Q350,000
75,000
100,000
125,000
150,000
175,000
2008 2009 2010
10/01/09I:H:NA
Rating and Price Target History for: Berkshire Hathaway Inc. (BRK/A) as of 07-02-2010
Created by BlueMatrix
Rating Key
B - Buy UR - Under Review
H - Hold NR - No Rating
S - Sell NA - Not Applicable
I - Initiation RS - Rating Suspended
D - Dropped
For a price chart with our ratings and target price changes for BRK.A go tohttp://sf.bluematrix.com/bluematrix/Disclosure?ticker=BRK.A
Stifel, Nicolaus & Company, Inc.'s research analysts receive compensation that is based upon (among other factors)Stifel Nicolaus' overall investment banking revenues.
Our investment rating system is three tiered, defined as follows:
BUY -We expect this stock to outperform the S&P 500 by more than 10% over the next 12 months. For higher-yieldingequities such as REITs and Utilities, we expect a total return in excess of 12% over the next 12 months.
HOLD -We expect this stock to perform within 10% (plus or minus) of the S&P 500 over the next 12 months. A Holdrating is also used for those higher-yielding securities where we are comfortable with the safety of the dividend, butbelieve that upside in the share price is limited.
SELL -We expect this stock to underperform the S&P 500 by more than 10% over the next 12 months and believe thestock could decline in value.
Of the securities we rate, 43% are rated Buy, 54% are rated Hold, and 3% are rated Sell.
Within the last 12 months, Stifel, Nicolaus & Company, Inc. or an af filiate has provided investment banking services for 17%, 11% and 8% of the companies whose shares are rated Buy, Hold and Sell, respectively.
Additional Disclosures
Please visit the Research Page at www.stifel.com for the current research disclosures applicable to the companiesmentioned in this publication that are within Stifel Nicolaus' coverage universe. For a discussion of risks to target priceplease see our stand-alone company reports and notes for all Buy-rated stocks.
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