Education Brief January 2012

Short-Term Focus: Coping with Near-Term Fluctuations

Instant access to real-time quotes and media reports canmake it difficult for investors with a long-terminvestment horizon to stay focused on their goals. Inreality, these daily market movements may not be asextreme as they seem. As investors look longer term,their perception often changes. Short-term marketfluctuations can be quite volatile, and the probability ofrealizing a loss within any given day is high. However,the likelihood of realizing a loss has historicallydecreased over longer holding periods. The imageillustrates that while the probability of losing money ona daily basis over the past 20 years was 46%, theprobability dropped dramatically when analyzing anannual time period—20%. Periodic review of aninvestment portfolio is necessary, but investorsshouldn’t let short-term swings affect their view of thefuture.

January 2012 Vol.1 Monthly Education Brief

About Keating Capital

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Keating Capital, Inc. is a businessdevelopment company thatspecializes in making pre-IPOinvestments in innovative, highgrowth private companies thatare committed to and capable ofbecoming public. We provideindividual investors with theability to participate in a uniquefund that invests in a privatecompany's later stage, pre-IPOfinancing round — an opportunity

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Economic Outlook for 2012 The U.S. economy grew in 2011, but at a slower

rate than everyone expected. Even moresurprising than the overall growth rate was thepattern of that growth rate throughout the year.Growth plunged to 0.4% in the first quarter andaccelerated throughout the year, with the fourthquarter now likely to produce annualized growthwell in excess of 3%.

More Upside than Downside (Though theDownside Is Scary): Morningstar economists’overall forecast for 2012 sees slightly highergrowth than the consensus of other economists,but not by a lot. However, the odds of an upsidesurprise are substantially higher than those of adownside surprise. Potential sources of an upsidesurprise include increased U.S. oil production, asharper rebound in automotive and aircraftproduction, and a stronger housing market.

Corporations Are Scared Even as ConsumersAccelerate Spending: It looks like U.S. corporatemanagers are far more scared about Europe andthe economy in general than the U.S. consumeris. Recent reports seem to suggest at least someprecautionary spending cuts by corporations inthe software arena. Managers also seem to beparing inventories to the bone. However, itappears that U.S. consumers are acceleratingspending; they seem to be "thrifted out" and canno longer delay certain purchases, especially autos.This leads Morningstar economists to predictgreater production both in the U.S. and in otherworld economies that export to the U.S. in 2012.

Europe Remains at the Top of the Worry List:The main concern here is the potential of theEuropean sovereign debt crisis to wreak havoc onthe worldwide financial system. U.S. exports toEurope represent just 3% of U.S. GDP, and a lotof that is for basic necessities that can't be boughtelsewhere. However, with a web of lending inwhich European banks lend to sovereigngovernments, and those governments lend themoney back to the undercapitalized banks, thefailure of any one link could bring down a healthychunk of the European banking system.

China Slowing Is an Issue for Some, butPotentially Good News for the U.S.: Chinacertainly remains an issue, too, as growth thereslows modestly and the construction industrypulls back from its breakneck pace. Slowing thereis bad news for a lot of high-profile capital goodsmanufacturers in the U.S but, overall, China is aneven smaller part of U.S. GDP than Europe.Furthermore, slowing growth in China couldmean significantly lower commodity prices,especially in the U.S., which would be good newsfor low-end U.S. consumers, who wereparticularly crippled by rising commodity pricesin 2011.

A Savvy Consumer May Limit Profit Growth:Corporate margins could begin to shrink in thefuture as consumers start to gain the upper hand.Consumers are fighting every price increase toothand nail, with the possible exception of the veryhigh end of the market. The most recent examplecomes in the banking industry, where a pushbackby consumers forced several major banks to cancelproposed increases in debit card fees.

Europe Will Hurt Big Firms More Than U.S.GDP: Although U.S. GDP growth may escapethe worst of the effect of a slowing Europe, U.S.multinationals may not. Many of these firmsderive 20%-40% of their revenues from Europe.Since many of those goods are produced inEurope or in other non-U.S. markets, they are notcounted in the U.S. GDP calculations, and theydon't directly add to U.S. employment.Therefore, a weak Europe could significantlyaffect U.S. companies even if it doesn't make adent in the U.S. GDP growth rate.

Looking forward to 2012, the U.S. economy isprobably better positioned than most of the restof the world economies, showing acceleratinggrowth even as Europe falls into a recession andas growth in Asian economies slows to a moremodest pace.

Monthly Education Brief January 2012 2

What Is an Economic Moat?Commentary

Historical data shows that stocks might be thebest investment to help you build wealth overtime. However, with so many stocks available outthere, how do you decide which one to pick? Whatmakes a stock a good or a bad investment? Theanswer lies in carefully scrutinizing the company.

A company’s stock is likely to generate attractivereturns if the company outperforms itscompetitors. The advantage a company buildsover its rivals in the marketplace is calledcompetitive advantage. Morningstar hasdeveloped a rating to measure this competitiveadvantage, the “economic moat.” There are fourmain types of economic moats, examined below.

1. Intangible assets: Intangible assets like brands,patents, and regulatory licenses can provide acompany with a unique position in themarketplace and a significant advantage over itscompetitors. A powerful brand like Apple or Nikecan bring in more revenue and increase customerretention. Patents are especially important fortechnology companies and companies inindustries where innovation is critical(pharmaceuticals, for example). Regulatorylicenses provide a competitive edge in the sensethat they can prevent competitors from enteringa market.

2. High customer switching costs: Basically, if acompany makes it difficult (and, ideally,impossible!) for customers to switch to acompetitor, that company will have a much easiertime growing revenues and expanding. Examplesof industries with high switching costs includebanks and software companies.

3. The network effect: The network effect is basedon the simple premise that the more users aproduct or service has, the higher its value will be.The most popular example of this type of moat isMicrosoft: its success is highly dependent on itsenormous user base. In fact, this network effectoccurs mainly in businesses based on sharinginformation and connecting people (eBay is agood example).

4. Cost advantages: This type of competitiveadvantage is probably the simplest, and yet themost difficult to achieve. Companies can build acost-based economic moat by improving theirbusiness processes (Dell and Southwest Airlines),optimizing their supply chains (Wal-Mart), or byoutsourcing in order to reduce labor costs (“madein China,” anyone?). Cost-cutting can be a two-edged sword, however, and, once the competitiveadvantage is achieved, it may prove difficult tomaintain.

In Morningstar’s database, stocks are assigned aneconomic moat rating: wide (denoting a strongcompetitive advantage), narrow (weaker), or none(no competitive advantage). The image showsthat wide-moat stocks have outperformednarrow- and no-moat stocks, as well as the S&P500 index, over the five time periods analyzed.


Chasing Performance

Investors often endure poor timing and planningas many chase past performance. They buy intofunds that are performing well and initiate a sellingspree following a decline. This becomes evidentwhen evaluating a fund’s total return comparedwith the investor return. Overall, the investorreturn translates to the average investor’sexperience as measured by the timing decisions ofall investors in the fund.

The image illustrates the investor return relative tothe total return for a given fund. Over the shortterm, both the total and investor returns werepositive, with the investor return ending slightlylower. Over a 10-year period, however, total returngreatly exceeded investor return. Investors whoattempted to time the market ran the risk ofmissing periods of exceptional returns.


©2012 Morningstar, Inc. All Rights Reserved. The information contained herein (1) is intended solely for informational purposes; (2) is proprietary to Morningstar and/orthe content providers; (3) is not warranted to be accurate, complete, or timely; and (4) does not constitute investment advice of any kind. Neither Morningstar nor thecontent providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. "Morningstar"and the Morningstar logo are registered trademarks of Morningstar, Inc. Morningstar Market Commentary originally published by Robert Johnson, CFA, Director ofEconomic Analysis with Morningstar and has been modified for Morningstar Newsletter Builder.

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Education Brief January 2012