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S&P Fair Value and Increase in Risk

May 14th, 2010

We have received a number of emails regarding our perception of the increase in risk overwhelming the rise in free cash flow.

There are many factors which contribute to credit risk, with Sovereign debt and foreign exposure being just two. Please do not forget the rise we are seeing in free cash flow is made possible, in good measure, from cost cutting, to the extent when we adjust for normalized changes in working capital, the increase, while, positive, loses about 40% of its magnitude.

This is not unusual for the initial stage coming out of recession, but must be compared to the very large rise, over the same period, in valuation multiples.

Additionally, our credit metrics, especially our consistency measures, have increased over the past month, while other measures, such as health care, taxes ( not just federal income), and foreign pension burden, have all been rising.

All in all, the S&P is about 5% over-valued. Typically, as stocks can fluctuate wildly around fair value, a 5% over-valuation is within normal range-and can even result in a rally. If that were to occur, we would recommend, as we have been, to sell into such rally.

There are, however, stocks that are as much as 40% undervalued, based on free cash flow growth and valuation, cash based ROIC compared to a credit-based cost of capital, and financial flexibility, and it is there where we continue to focus.

For additional information, contact either myself or Simon Adams

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