Marketing and innovation

Global Investor
Expert know-how for Credit Suisse investment clients May 2005
Marketing versus innovation Is the balance right?
Chemicals Modernization is key to remaining competitive
Healthcare Innovation resurgent in big pharma?
Automobiles Driving the future
Technology Not yet poised for the next upcycle
Covered Bonds European covered bonds in the spotlight
Swiss Real Estate Stocks ready to take a breather
MARKETING EXPENSES
R&D EXPENSES
93 94 95 96 97 98 99 00 01 02 03
MARKETING AND INNOVATION

GLOBAL INVESTOR 2.05 Editorial—3
Long-term investing as volatility rises
With volatile and often downward movements across many of
the world’s financial markets, investors have tended to seek risk
reduction and capital preservation strategies, and our shorterterm
research has focused on this. But we believe that now is
also a good moment to look at much longer-term issues, so that
investors can start to identify opportunities that may emerge
once the current phase of volatility settles down. Accordingly,
much of this issue of Global Investor is devoted to a big-picture
analysis of the balance between marketing and innovation in
major industries. We argue that an overemphasis on marketing
at the expense of genuine innovation has contributed to
underperformance in recent years of global sectors such as
automobiles and pharmaceuticals, and stunted the growth
prospects of consumer electronics companies. Looking forward,
we suggest that the big pharma companies may be on the
brink of rectifying this imbalance, potentially opening exciting
opportunities for investors. By contrast, most major automobile
manufacturers seem stuck in their old ways. Separately, we
look at Europe-wide covered bonds, and Swiss real estate
assets, as possibly attractive diversification amid an uncertain
market environment for bonds. Here, we conclude that the
underlying collateralization of covered bonds does indeed make
them interesting, while for Swiss real estate assets, investors
should wait for valuations to become less rich.
As usual, the medium-term analysis in the Global Investor will
be complemented by our shorter-term research, which will
advise in detail on the timing and the vehicles for implementing
the bigger themes discussed here. And as with all our
publications, we welcome your comments and feedback –
good or bad.
Giles Keating, Head of Global Research

GLOBAL INVESTOR 2.05 Contents—4
Themes
Marketing versus innovation
Is the balance right? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Chemicals
The European chemicals industry: Innovation is the key
to remaining competitive . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Healthcare
Will innovation regain the upper hand over marketing
in pharma? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Automobiles
Driving the future . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Technology
Technology not yet poised for the next upcycle . . . . . . . . . . . . 31
Topics
Covered Bonds
European covered bonds in the spotlight . . . . . . . . . . . . . . . . 39
Real Estate
Swiss real estate stocks ready to take a breather . . . . . . . . . . 42
Services
Credit Suisse publication landscape . . . . . . . . . . . . . . . . . . . 46
Author index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Imprint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Mass Marketing
GLOBAL INVESTOR 2.05 Marketing versus innovation—5

Limited Innovation?
Mass-marketed brands have guaranteed quality and consistency to consumers since the nineteenth century,
but do they make companies complacent about innovation?

GLOBAL INVESTOR 2.05 Marketing versus innovation—7
Marketing versus innovation: Is the balance right?
Marketing and innovation have been two inseparable parts of capitalist success
since the earliest days of the industrial revolution. Craftsman Thomas Chippendale
published his Furniture Catalogue in 1754. Giles Keating
Mr. Chippendale’s fine products, previously sold only in small
quantities, were transformed into the ultimate interior design
feature for the English middle class, and he became a wealthy
man. The following century, international brands such as Lipton’s
Tea and then Coca-Cola emerged, offering consumers the guarantee
of a product with consistent taste and quality, and making
fortunes for their owners.
Initially, marketing and branding were about taking a product
that had already been invented and making sure that it sold. Gradually,
many successful companies introduced feedback in the
other direction, giving marketing people a say in the way that
products were developed, aiming to leverage their brands and
increasing the chances of commercial success for new products.
This process gathered momentum in the later decades of the
twentieth century as marketing and pricing strategies became
increasingly refined, bringing benefits to both companies and their
customers. But arguably, it has now gone too far for the good of
either, with marketing now dominating R&D in many firms. In
some major pharmaceutical companies, the heads of each of the
main brand lines are now paid multiples of what is earned by the
research chief. And across many of the sectors covered in this
edition of Global Investor, the budget for marketing far exceeds
that for R&D.
This dominance of marketing over R&D is very often associated
with a reliance on ever more incremental product improvement,
rather than the development of truly life-altering innovations. In
the short-term, this is a nice safe and easy strategy for managements,
since instead of the risk of costly development of unknown
novelties, it leverages existing brands, taps into apparently loyal
consumer groups, and may allow new look-alike patents to replace
old ones that are expiring. The sense of comfort is enhanced when
all the major incumbent companies in a sector are doing much the
same. However, in the medium to long term, this kind of strategy
can be a recipe for disaster, as utterly unexpected competitors
appear with genuinely new innovations that sweep the market.
The classic case is the rise of the low-cost airlines, which has left
Southwest Airlines with a higher market capitalization than the
three traditional carriers combined.
Another obvious example is in the consumer electronics sector,
where Sony’s focus on incremental improvements to its
famous Walkman (allowing, for example, ever-larger jolts without
upsetting the music flow) has left it gasping in the face of the

assault from the iPod produced by Apple – a company that previously
had not been a direct competitor to Sony at all. The iPod’s
ability to play and organize large amounts of downloaded music
makes it utterly different from the Walkman. This followed a similar
incident some two years earlier where Sony’s emphasis on its
Trinitron TV technology left it far behind in the development of
flat-screen TVs, where South Korea’s Samsung has raced ahead.
For Sony, there seems to be a pattern of over-reliance on a
powerful brand, backed up by merely incremental innovation. This
is especially striking since Sony had itself, half a century before,
emerged from nowhere on the back of radical product innovation.
In the automobile sector, the annual reports of the major
companies suggest large expenditure on innovation, which is
apparently much more than is spent on marketing (where data
are available). But it is an open question whether this innovation
really offers genuinely new responses to consumer needs, or
whether it is over-reliant on a marketing-dominated strategy that
leverages off consumers’ desire to keep up with the latest models
in a strong brand. DaimlerChrysler’s recent problems with reliability,
largely caused by the unnecessary electronics packed into
its latest automobiles, provide a stark reminder that the core
business model of the US and European manufacturers over the
last two decades has been to add extra gizmos into their cars to
persuade people to upgrade. While driving their business down
this route, they have failed to come up with far more fundamental
innovations under the hood. No one has produced a viable massmarket
fuel-cell-powered automobile or electric car, suggesting
that more than two decades of research has been underfunded
and under-focused by the major companies. Instead, they offer
an ever-increasing number of voice options on sat-nav systems
and yet larger number of pre-set memories for electric seats. The
prospect of sustained high oil prices may eventually cause the
management at the major US and European carmakers to inject
badly needed urgency into this research. But meanwhile, successful
genuine innovation in fuel systems has been realized by
other companies. In Japan, Toyota has achieved world-beating
success with its petrol-electric hybrid car (the Prius), which has
caught the imagination of consumers. And Valeo, a medium-sized
component manufacturer, has developed a system that substantially
boosts urban fuel efficiency through the simple expedient of
shutting off the engine at red traffic lights and re-starting automatically
when the driver hits the gas.
The next big competitive threat could well come from ultra-cheap
urban cars, costing perhaps only two or three thousand euros or
dollars, lightweight and with unnecessary gizmos stripped out.
Companies such as Shanghai Motor Corporation, or Tata Motors
in India, are well positioned to produce these automobiles. So are
the Japanese companies contributing to the one-person transport
in use at this year‘s World Expo in Aichi, Japan. This kind of product
would strike at the heart of the marketing strategy of the
major US and European carmakers, which have focused for decades
on pushing customers up-market to maintain sales values
in the face of falling production costs.
And in the pharmaceuticals sector, the biggest companies
have focused heavily on marketing. Large sales teams targeted
at health professionals, and ad campaigns aimed at the general
public, have pushed marketing budgets up to more than double
R&D budgets. And a major part of the research budgets has
generated products designed to cope with patent expiry by, for
example, offering weekly doses of a drug that previously had to
be taken daily. Very useful for the patients involved – and very
profitable in the short to medium term – but for the long-term
health of both companies and their customers, this kind of
incremental innovation is hardly in the same class as inventing
drugs that really address currently incurable diseases such as
Alzheimer’s.
With researchers playing second fiddle to marketing people
in the corporate culture, and often much less well paid, it is unsurprising
that many of the best and brightest research scientists
have quit big pharma companies to go work in biotech companies
where they can participate in the upside of their work. Unsurprisingly,
a broad index of biotech shares, although volatile, has
substantially outperformed the largest pharma stocks over the
last decade. And a new competitive threat is now appearing, with
India moving toward international patent law, and large Indian
generics companies, such as Ranbaxy, starting to develop the
capability to produce their own original drugs.
If there is good news in the big pharma sector, it is that the
situation has become so bad, that finally a constructive reaction
may be starting to emerge. The takeover by Novartis of the generics
producers Hexal and Eon Labs may yet turn out to have
significance beyond mere business-line diversification, if it allows
the combined company to focus on offering its own generic
response to patent expiry, rather than researching and marketing

GLOBAL INVESTOR 2.05 Marketing versus innovation—9
Three steps on the path of evolution of the Walkman …
Sony created and dominated the mass mobile music market with the Walkman, then lapsed into low-innovation
complacency and lost out to Apple‘s iPod.

follow-on patentable drugs that differ only marginally from those
expiring. This should then free up research resources for genuine
innovation. And in another potentially very positive development,
GSK recently signaled that it is prepared to make a substantial
cut in its marketing budget, with the money to be re-directed to
research, provided its major competitor Pfizer takes the lead. This
move (still uncertain at the time of publication) would represent an
end to the marketing “arms race.” Investors should reap the peace
dividend.
The message from these and other sectors, is that the progressive
takeover by marketing seen over the last few decades is
either already reversing, or is set to do so soon. In our view, this
can only be good for companies, investors and customers, not
because we think marketing is somehow bad, but because we
perceive there is an optimum mixture between marketing and
research within a company, both in terms of money spent and in
terms of corporate power. Moreover, we believe that the pendulum
has swung too far away from research. The companies that move
fastest to bring it back to a better balance will outperform; those
that lag will underperform. In this issue of Global Investor we
provide more detailed analysis on this, and in further publications
over the next few months, we will bring detailed investment
recommendations based on these concepts.
Furthermore, this re-balancing toward R&D, with more genuine
innovation and less marketing-led incremental product development,
could have broader economic and political ramifications. One
of the big debates among economists at the moment focuses on
why people say they are no happier today than they were 40 years
ago, despite the fact that real per capita gross domestic product
has doubled over that period (see chart on page 11, derived from
data cited in a new book titled “Happiness: Lessons from a new
science,” by Professor Richard Layard). Among the various likely
explanations for this, there is much focus on the notion that much
of consumer spending is focused on one-upmanship, i.e., simply
trying to be better than the person next door. This is, of course,
a zero-sum game: If I buy a bigger car purely to get ahead of my
neighbor, then I feel better, but as soon as he or she follows suit,
we are both back where we started in terms of happiness, although
GDP has gone up. By contrast, if we both buy a genuinely new
product that enables us to do something that was impossible
before, or makes us both healthier, than we are both better off.
The increasing emphasis given to marketing by major companies
in the last four decades, with the accompanying tendency
to make marginal product improvements rather than to seek out
quantum leaps, tends to prey off people’s natural inclination
toward one-upmanship. If within companies there is now a return
to focus on genuine innovation, there should be an accompanying
upswing in happiness. That would be a worthwhile change in itself,
representing a major shift in society, and it might be accompanied
by a new dynamism in people’s economic attitudes, which (together
with a re-engagement with politics) is most especially needed
in Europe, in our view. But whether or not this truly represents a
new Zeitgeist, for investors there is a simple message: to invest
in companies that are riding this wave of change. |

GLOBAL INVESTOR 2.05 Marketing versus innovation—11
%
USD
80
40,000
70
35,000
60
30,000
50
GDP per capita (real), r.h. scale
25,000
40
20,000
30
20
Happiness (% very happy), l.h.scale
15,000
10,000
10
5000
Source: Credit Suisse
Note: Data from the book titled “Happiness: Lessons from a new science” by Richard Layard
0
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
0
Corporate emphasis on marketing over innovation implies that much of rising GDP has gone to bigger, shinier
versions of existing products, which doesn’t really make us happier.

The European chemicals industry: Innovation is the key to remaining competitive
The golden age of chemicals innovation (i.e., dyes, fertilizers, plastics
and many other products) ended in the 1960s and was followed by
decades of limited, incremental development. Now at last, that is changing
as interdisciplinary research promises a new era of genuine innovation. Dr. Maria Custer
Chemistry is all around us. Industrial chemicals enrich daily life,
whether in food production, agriculture, medicines, cosmetics,
textiles, electronics or cars. The industry produces a vast array
of diverse products, originating from raw materials derived from
oil, natural gas, minerals and air, and it supplies practically all
sectors of the economy. Until around the 1990s, specialty chemicals
were high-margin products produced in small volumes and
sold at high prices, justified by the products’ capacity to fulfill
specific functions. These businesses sat reasonably comfortably
alongside pharmaceuticals, which were also high-margin, intellectual-property-driven
activities. However, at that time parent
companies decided to concentrate on pharmaceuticals, spinning
off their specialty chemicals businesses into separate firms. For
example, Sandoz demerged its specialty chemicals business by
floating Clariant before creating Novartis with Ciba-Geigy, while
Astra-Zeneca and Novartis hived off their agrochemicals divisions
to create Syngenta. Nevertheless, the newly formed specialty
chemicals companies were rapidly confronted with the commoditization
of many of their products.
While the global specialty chemicals market has traditionally
been dominated by the USA and Europe, Asian countries – particularly
China and India – are becoming important players too.
These countries benefit not only from low-cost manufacturing, but
from the strong demand for chemicals in the region as well.
Roughly 70% of the plastic toys worldwide, for instance, are produced
in China, where the market for plastics is growing at a rate
of 15% per annum. Other segments with high demand for chemicals
in Asia are footwear (accounting for 74% of global demand
for chemicals) leather (50%) and textile processing (53%).
Europe’s leading position as chemicals producer threatened
The European chemicals industry has enjoyed a leading global
position in past decades, though this position is weakening rapidly.
In 1992, the EU produced 32% of available chemicals worldwide.
According to the European Chemical Industry Council
(CEFIC), this market share dropped to 28% in 2002. By 2015, the
CEFIC expects Europe’s share of global chemicals production to
be between 23% (best-case scenario) and 16% (worst-case
scenario) (see Figure 1). In a study titled “Horizon 2015, Perspectives
for the Chemical Industry,” published in 2004, CEFIC explains
that the main factors negatively affecting competitiveness in
Figure 1
The EU’s share of global chemicals production
is declining
Source: CEFIC
34
32
30
28
26
24
22
20
18
16
14
12
10
8
%
32
32
30 30 30
20.5
19.0
13.2
14.815.817.1
27 28 23.7
23?
16?
90 92 94 96 98 00 02 04 06 08 10 12 14 16
EU USA Asia excluding Japan Japan

GLOBAL INVESTOR 2.05 Chemicals—13
Innovation feeds ideas
Ciba SC offers a broad range of innovative products for packaging, enhancing product protection and conservation.
Ciba’s Shelfplus UV filters block ultraviolet light, extending the shelf life of the product.

Europe are 1) the decreasing attractiveness of investments in
Europe due to low demand growth in the region, delocalization
of customer industries, high production costs and highly regulated
environment; 2) the decline in R&D spending in the region
(see Figure 2); and 3) an eroding skill base (according to
CEFIC, the number of graduates in the field of chemicals in the
EU is estimated to decrease by 10% per annum between 1996
and 2007).
Strategies of European companies to remain competitive
p Expansion to Asia … The importance of the Asian markets for
the chemicals industry is well known, and for virtually all companies
under our research coverage, expansion to Asia is a key point
in their strategy. Between 2001 and 2005, BASF, for example, is
investing approximately 20% – 25% of the group’s total capital
expenditure, or USD 5.6 billion (including USD 2 billion in China),
in Asia. European companies follow diverse strategies in Asia, but
it is clear that their activities in the region are not confined to
production, in order to reduce costs or to be closer to the chemical
consumer markets. They also include the formation of R&D
centers. Ciba Specialty Chemicals, for example, has just opened
a new R&D center in Shanghai.
p … and differentiation through innovation. The other pillar of
the strategy currently followed by the industry to remain competitive
is product differentiation through innovation and improving
customer relationships. We observe a strong trend in the sector
toward innovation, driven by the need of providing solutions to
customers. Clariant, for example, is able to offer color systems
for every element in the interior of a car. The “Clariant Color Concept”
for the automotive industry enables the harmonization of
colors of textiles, leather, plastics and aluminum inside the car.
This process takes place mainly in collaboration with customers,
which means that R&D and marketing efforts come together to
ensure the market relevance of new products and services. Specialty
chemical companies aim to have a proportion of approximately
25% new products (products less than five years old) in
their portfolios.
Despite the focus on innovation, R&D expenses as a percentage
of sales have remained more or less stable during the past
ten years (see Figure 3). The fact that the focus on innovation as
a key for competitiveness does not translate into higher R&D
expenses as a percentage of sales is due to several factors. First,
R&D expenses do not necessarily correlate with productivity of
R&D. Second, the most important trend in R&D seems to be the
necessity of focusing on a smaller number of projects with potential
for quick commercialization, rather than following a large
number of projects in parallel.
Besides in-house research and collaborations with companies
with new technologies and academic groups, a possibility to
drive innovation is the acquisition of technologies or smaller firms
with expertise in specific fields (see Figure 4). BASF, for example,
invests in start-up companies through its BASF Venture Capital
GmbH subsidiary.
Figure 2
R&D expenditures as percentage
of sales by region
Source: The European Chemical Industry Council (CEFIC)
4.5
4.0
3.5
3.0
2.5
2.0
1.5
25
20
15
10
5
%
95 96 97 98 99 00 01 02
EU USA Japan
Figure 3
Despite more focus on innovation, R&D
expenses as a percentage of sales
remain stable, at approximately 5% on average
for the sector
Source: CSFB HOLT
%
R&D focus on extending product lines, improving processes
The golden age of innovation in the chemicals sector was in the
1930s to 1950s, when the industry brought to the market life-changing
products such as plastics and man-made fibers. During the
last 20 years, there have been only a few really “revolutionary”
products.
0
94 95 96 97 98 99 00 01 02 03
R&D as % of sales
SG&A as % of sales

GLOBAL INVESTOR 2.05 Chemicals—15
Fertilizers
Nanotechnology, biotechnology
Dyes
Nylon, plastics
Real innovation:
plastics, dyes …
Development and
commoditization
Interdisciplinary
innovation
opportunities
1865 1925 1950
1970
1990
2005
Source: Credit Suisse
The golden age of innovation in the chemicals sector was in the 1930s to 1950s, when the industry brought to
[Topic_Quote] the market life-changing products [Topic_Quote_Autor]
such as plastics and man-made fibers. Looking ahead from now,
innovation will mainly come from new research areas such as nanotechnology and biotechnology, and these
interdisciplinary approaches offer significant potential for growth over the coming decade.

p Packaging, performance and appearance: Ciba SC offers a
broad range of innovative products for the production of paper
and plastic packaging. These specialty chemicals enhance product
protection and conservation, packaging integrity, product
promotion and manufacturing ease. Fast food packaged in paper
for microwave cooking (e.g., popcorn, french fries, fried chicken)
requires a stain-resistant barrier. Ciba’s LODYNE ® is a repellent for
oil, grease and water that helps to keep the package stain-free. Light
can cause colors to fade and loss of vitamins in products packaged
in plastic bottles. Ciba’s Shelfplus UV filters block ultraviolet
light, extending the shelf life of the product (see page 13).
Really innovative new products will emerge from interdisciplinary
research combining knowledge of chemicals with new technological
developments such as biotechnology and nanotechnology:
p Biotechnological processes are used for the synthesis of
chemicals. The advance of scientific knowledge in areas such as
biotechnology and nanotechnology have opened new opportunities
for the chemicals industry. The traditional chemicals-based
methods are often more awkward than the biotechnological processes.
Biotechnology uses microorganisms or cell cultures as
“production machines.” One example is chiral compounds. BASF
uses an enzymatic process for the production of chiral intermediates.
These products are sold under the brand name ChiPros.
Syngenta has extensive expertise in plant biotechnology and a
dedicated scientific team working closely with academia to develop
biopharmaceuticals that can be produced by plants.
p Nanotechnology will most likely play an important role in future
innovation: Many chemical companies are investigating the application
of nanotechnology to areas such as plastics, electronics
and pharmaceuticals. Nanotechnology opens up new opportunities
for the chemicals industry. At the nano level, materials show
different properties (e.g., color, magnetic properties, electrical
properties, etc.) than at the macroscopic level, allowing the design
and construction of innovative materials with better or distinct
electrical, optical or thermal properties.
Innovation versus marketing
The chemicals industry has a distinctive feature in that a substantial
part of the supply chain involves companies in the same or
related industries (automotive, electronics, food, etc.), rather than
consumers, so marketing is not considered as an industry strength.
This is not the case, however, in some specialty chemicals areas,
where customer relationships and product development, in close
collaboration with consumers in order to provide solutions for their
needs, is increasingly playing an important role.
In summary, the European chemicals industry of the future
will rely on both innovation and marketing to remain competitive
amid a tough environment. The role of marketing will be to improve
customer relationships in order to understand client needs and
to develop new, innovative and market-oriented products. Innovation
will mainly come from new research areas such as nanotechnology
and biotechnology, and these interdisciplinary approaches
offer significant potential for growth over the coming
decade. |
Figure 4
M&A activities in the industry;
acquisition of technology
Source: Company data, Credit Suisse
Materials
Biotech/Food
Genencor
(enzymes)
Eastman high
performance
christaline
plastics
DuPont
Danisco
(Food Ingr.)
ICI Quest’s
Food
Ingredients
Chemicals
Kerry
Food
Monsanto
Emergent
genetics
Syngenta
Merck
KGaA
Avecia’s
OLED and
polymers
Biotech/Seeds
Golden Harvest
Seeds
Technology/
Nanotechnology

GLOBAL INVESTOR 2.05 Healthcare—17
Will innovation regain the upper hand over marketing in pharma?
Hope looms for a turnaround in big pharma as strategies begin to shift toward
meaningful innovation – rather than progressing in small increments – to provide
long-lasting value creation. Dr. Luís Correia, Dr. Maria Custer
The pharmaceuticals sector has fallen out of favor with many
investors. We believe this mainly reflects pricing pressure, patent
expirations and slowing research productivity. We think that this
can be traced back to overemphasis on marketing compared with
innovation. Many big pharma companies now spend more on
marketing than some of the large consumer goods companies,
and their sales forces have grown rapidly. Although this marketingdominated
approach proved very profitable for some time, we
believe that it has sapped the large pharmaceutical companies’
ability to deliver true innovation. This damages profitability in the
long run, and we argue that this is a key driving force behind the
recent poor performance of pharmaceuticals shares. Looking
ahead, we feel that there is hope for a turnaround in big pharma
as strategy begins to shift toward meaningful innovation – rather
than advancing in small increments – providing long-lasting value
creation.
The rise of marketing in the pharmaceuticals industry
Over the last two decades, the importance of marketing in the
pharmaceuticals industry has risen sharply, and now surpasses
that of many consumer goods companies (see Figure 1). Several
factors have driven this development:
p The realization that primary care products were promotion
sensitive and that greater product sales meant more profits. The
undisputed leader of this marketing/blockbuster strategy is Pfizer,
which managed to achieve the industry’s highest operating margins
– close to 40%. As competitors tried to keep pace, this
inevitably led to a race: i.e., a sharp increase in the size of sales
forces (see page 18).
p The introduction of direct-to-consumer advertising. Over the
last 10 years, spending on direct-to-consumer advertising has
risen sharply (see Figure 2). While this spending still represents
a small fraction of overall marketing costs, it can mean allocations
of significant proportions for specific mass-market products (such
as allergy treatments or oral contraceptives). The objective of the
pharmacy industry was to generate demand driven by patients,
rather than relying exclusively on promotion to physicians.
p Crowded therapy classes driving the need for intense spending
in clinical trials, with the aim of differentiation. In this regard, the
state of things has not changed much as analyses such as those
shown in Figure 3 suggest. As a rough approximation, we regard
the number of products in development as a measure of R&D
Figure 1
Selling, general & administrative (SG&A)
expenses as % of sales for pharma and
consumer goods companies
Source: GS (Note: As a proxy for marketing costs, we use data on SG&A expenses)

Number of sales representatives in the US pharmaceuticals market (1994 – 2003)
Source: Verispan
thousands
100
90
80
70
60
50
40
30
20
10
0
94 95 96 97 98 99 00 01 02 03
Big pharma new product approvals in the USA (1998 – 2004)
Source: FDA, LB, Credit Suisse
40
35
30
25
20
15
10
5
0
98 99 00 01 02 03 04E
While marketing expenditures have risen, the number of new product approvals in big pharma has declined.

effort. The figure indicates that companies continue focusing their
efforts on the largest commercial opportunities. In our view, they
do not seem to be taking into account the fact that if they all do
the same, they will be paving the way for tough competition and
decreasing value at a later stage!
GLOBAL INVESTOR 2.05 Healthcare—19
The marketing/lifecycle management game cannot last forever
Before patents expire and in the absence of a truly novel molecule
to replace the old one, companies attempt to launch so-called
line extensions, or second-generation drugs, which correspond
to minor improvements over the older product. While the old
product is charged at 30% of the price in the USA once it goes
generic, a line extension can retain a price similar to the original
price of the old drug. It is this sort of strategy that annoys healthcare
payers and damages the reputation of the pharmaceutical
industry.
The combination of lifecycle extension tactics with the blockbuster
strategy described previously has been almost consensual
in big pharma. In our view, it explains the developments of
recent years of increased pricing pressure already before patents
expire. Healthcare payers have resorted to tools such as increasing
patient co-payments for the more expensive drugs within a class,
so that they are encouraged to use generics or the cheaper drug.
A further downside to the blockbuster strategy is the dependecy
it creates on few drugs. This can pose high risk of a sharp decline
in earnings once patents expire and there are no substitutes.
Best innovators moved away from supremacy of marketing
Under this new, more competitive environment, analysts have
started to evaluate companies’ portfolios to identify the better
placed companies, i.e. the ones with more unique products that
are subject to less pricing competition (see Figure 4).
The rise in importance of marketing has meant that marketing
departments have gained such a high profile in pharmaceutical
companies that the key decision makers and best-paid workers
are the marketers. Dissatisfaction with this state of things has led
many scientists and medical developers to start their own businesses.
We believe this was a main driving factor beyond the
emergence of the biotechnology industry. As biotechnology companies
matured over the last 20 years, their importance has
become evident in terms of the weight of their products and R&D
pipelines. A good case in point is Genentech.
Genentech
Genentech is a very innovative company within the healthcare
sector. Since its founding in 1976, it has remained at the forefront
of innovation based on its scientific strengths. Scientists at
Genentech have focused on the understanding of the molecular
basis of disease. The strong expertise in oncology allowed the
development of several cancer drugs with novel and more specific
mechanisms of action. Although these drugs are commonly
used in combination with existing chemotherapeutic agents, they
represent an important step into targeted and less aggressive
therapies. Rituxan, the first therapeutic antibody to treat cancer
in the USA, was approved in 1997. Rituxan works by binding to a
particular protein on the surface of healthy and malignant B-cells,
making them susceptible for the body’s natural defenses. After
treatment, new normal B-cells regenerate from the bone marrow
and return to normal levels within months. Avastin, approved in
2004, is the first therapy that inhibits angiogenesis (the process

Figure 2
Amount spent on direct-to-consumer
advertising in the US pharmaceuticals market
1993 to 2003 (USD millions)
Source: Verispan
Figure 4
Product portfolio analysis by degree
of innovativeness
Source: LB
USD millions
3500
3000
2500
2000
1500
1000
500
0
93 94 95 96 97 98 99 00 01 02 03
% of pharma sales in 2004E
100
90
80
70
60
50
40
30
20
10
0
More novel portfolio
Less novel portfolio
Amount spent on direct-to-consumer advertising
in the US pharmaceuticals market 1993–2003
Eli Lilly
Roche
GlaxoSmithKline
Bristol Myers Squib
Schering Plough
Novartis
Sanofi-Aventis
AstraZeneca
Johnson & Johnson
Abbott
Merck
Wyeth
Pfizer
Novel
Genericized
Discountable
Other products
Figure 3
Net present value by therapeutic class versus
number of products in development
Source: GS analysis
Figure 5
Number of projects in R&D by phase 1
Source: Company data and LB analysis. P1 P2 P3 refer to the phases of clinical development.
Please note that P1 companies only partially disclose their projects.
NPV (USD billions)
24
20
16
12
8
4
0
Diabethes/Metabolism/
Endocrinology
20.5 bn
Cardiovascular/Thrombosis
13.3 bn
6.3 bn Arthritis/Immunology
Respiratory/
Allergy 5 bn
4.5 bn Others
3.9 bn Anti-infectives/Virology
0.8 bn Reproductive/WH/Fertility
15.8 bn Oncology
15.8 bn CNS
Number of drugs
160
140
120
100
80
60
40
20
0
Number of
molecules
0
5 10 15 20 25 30 35 40 45 50 55 60 65 70 75
P1
P2 P3 Filed
1998 1999 2000 2001
2002 2003 2004
Late-stage projects have been declining,
but signs from the early pipeline are encouraging
1
(AZN,AVE,GSK,NVS,ROG,SASY)

y which new blood vessels develop needed for a tumor to grow)
and interferes with the blood supply to tumors.
Beyond the cancer portfolio, the company has pursued highly
novel product opportunities outside the area of cancer. These
products have highly novel mechanisms of action and can be considered
first in class: e.g., Raptiva (psoriasis), Xolair (asthma).
Psoriasis occurs when the skin replaces itself too quickly.
This process begins when T-lymphocytes, also called T-cells,
become activated and travel to the skin leading to inflammation.
Raptiva, the first biologic therapy for psoriasis, prevents T-cells
from being activated and entering the skin.
Interestingly, Genentech’s majority owner, Roche, has decided
not to exercise its opt-in rights on these non-cancer products.
Instead, Genentech has partnered them with other companies. A
possible reason that Roche decided not to license these products
is that they did not satisfy a minimum level of commercial potential.
GLOBAL INVESTOR 2.05 Healthcare—21
Decline in R&D productivity is mainly a big pharma problem
In recent years, big pharma has had an effective decline in products
in phase III trials and flat trend in new product filings, as
illustrated in Figure 5.
This has several possible reasons, in our view. Mergers have
typically led to streamlining of R&D projects. More stringent
requirements by the authorities have led companies to resize and
redesign their late-stage clinical trials. The pharmacological targets
that could be exploited for new drug discovery with the knowledge
of ten years ago reached a saturation point. The first fruits of new
research methodology based on genomics and proteomics could
start to bear fruit.
New technologies in research should start delivering soon
During the 1950s and 1960s, the strategy for drug development
was screening of known compounds and new molecules in animal
models. Although several important drugs were discovered using
this approach (e.g., benzodiazepines), the method was limited in
that the number of molecules with structural diversity was not
enough, and that the mechanism of action of many drugs was
unknown.
With the development of knowledge in cell biology during the
1960s and early 1970s, it was possible to use a more rational
approach. Scientists would identify proteins (receptors) relevant
to conditions such as asthma or diseases such as glaucoma, and
then find a drug to inhibit its action (in some cases, the problem
would be the other way round, where a receptor was meant to do
something desirable but was failing to do so, and in such cases
the aim would be to find a drug to enhance the action of the
receptor). For example, beta-blockers (i.e., drugs that block the
β-adrenergic receptors) have around 30 different indications,
such as treating irregular heartbeats, addressing high blood pressure,
and relieving migraines, to cite just three.
From the mid-1980s, new solutions based on biotechnology
began to appear. The earliest major example was the development
of biotechnologically produced insulin, which has transformed
the lives of diabetics around the world.
With the start of the new millennium, biotechnology has
taken another big step forward, helped by three key factors. First,
scientists’ understanding of the biochemical factors causing
diseases has been greatly enhanced by advances in genetics,
including the sequencing of the human genome. Second, modern
combinatorial chemistry greatly facilitates the creation of large
Figure 6
Number of new product approvals
in the USA (1998 – 2004)
Source: FDA, LB, Credit Suisse
40
35
30
25
20
15
10
5
0
98 99 00 01 02 03 04E
Pharmaceuticals
Biotechnology

Generica
Line extension
Before patents expire and in the absence of a truly novel molecule to replace the old one, companies attempt
to launch so-called line extensions, or second-generation drugs, which correspond to minor improvements over
the older product.

numbers of possible drugs. Third, mass screening techniques
allow this plethora of possible drugs to be subjected to at
least a preliminary testing of their effectiveness in a very short
time span. Processes of this kind are only preliminary, but they
prevent a large number of dead-ends very quickly so that the
much more expensive and time-consuming phase of full testing
focuses on putative drugs, for which the chance of success is
reasonably high. The result is that the number of diseases for
which a cure may be found has risen substantially and continues
to grow.
Reflecting these advances, an increase in the number of
early stage R&D projects (phase I and II, see Figure 4) provides
some reasons to be hopeful in the coming years. GlaxoSmithKline
could be the focal point for the industry on this front. The company
expects to report phase II results for 15 new drugs as soon
as 2005.
GLOBAL INVESTOR 2.05 Healthcare—23
The future belongs to innovators
Typical analyses of the industry tend to focus on the decline
of new product launches, but we believe that these analyses
very often exclude biotechnological products. If we include the
approvals of products from biotechnology and smaller pharma
companies, we arrive at a positive trend over the last years (see
Figure 6). What is more, the importance of biotechnology companies
is gaining significance in terms of new product output.
In summary, we believe that innovation is still the lifeblood of
the pharmaceutical industry. Overall, the biotechnology industry
has generated higher returns (see Figure 7), which seems only a
fair reward for the greater risk taking and willingness to genuinely
innovate. Can the pharmaceutical industry balance the power
between research and marketing in a better way? This is an issue
that is even more concerning since many of the large blockbuster
products will lose patent exclusivity over the next three
years, and it is difficult to see enough pipeline opportunities to
make up for the lost sales. Some views in the financial markets
point to the inevitability of a reduction in sales force for companies
with significant patent expirations, which would avoid a sizable
earnings shortfall in the near term. Some in the industry have
said that an initiative by industry leader Pfizer to reduce its sales
force would be greatly welcomed. However, the same circles
emphasize that cost savings from such a move would be reinvested
in R&D. It may still be only wishful thinking, but we see it
as an encouraging sign. |
Figure 7
Performance of biotechnology versus
pharmaceuticals over ten years
Source: Datastream
1400
1200
1000
800
600
400
200
0
12/93
12/94
12/95
12/96
12/97
12/98
12/99
12/00
12/01
12/02
12/03
12/04
World DS Biotechnology price index
World DS Pharaceuticals price index

GLOBAL INVESTOR 2.05 Automobiles—24
Driving the future
For the car industry, developed countries are replacement markets, where new
customers can only be acquired by gaining market share from the competition.
Marketing and sales incentives are key elements of this strategy, but in mature markets
like Europe and North America, they rapidly become a zero-sum game. Markus Mächler
Penetration into fast-growing emerging markets is one response
to this problem, but the competition is fierce here too. The other
response would be to try to re-invigorate the developed markets
through radical innovation, for example, in new fuel systems or
utterly new market segments such as ultra-lightweight urban
vehicles. Instead, the major automobile manufacturers have
focused on relatively marginal innovation, which is rapidly copied
and ultimately is little better than marketing spending in terms of
the benefits it brings to companies and consumers.
US and European car registrations reached their peak in 2000,
followed by a sharp correction of the economy (due to post 9/11
shock, the economic slowdown and end of the so-called technology
bubble). As consumer confidence diminished, especially in the USA,
the automobile industry increased sales incentives and marketing
led strategy did achieve its narrow objective of sustaining sales
volumes. As Figure 1 shows, this marketing-led strategy did
achieve its narrow objective of sustaining sales volumes. However,
it did so at the expense of margins. This was a deliberate
choice by the US mass-market manufacturers, which were not
flexible enough to cut volumes substantially due to their pension
and healthcare costs. Measured as a percentage of sales, average
incentives per automobile have risen steeply in the last six
years, while R&D spending has fallen (see Figure 2).
The US and the European market are both over-saturated car
markets. Despite greater spending on marketing, only a few car
manufacturers have managed to grow during the last few years.
Consumer response to higher incentive spending is decreasing.
Pressure from raw-materials prices has become an issue and
does not allow carmakers to further cut prices either. The question
is how to keep consumer spending at least stable. In our view,
only serious innovation can help bring the automobile industry out
of this current predicament (see Figure 3).
Increasingly, the major automobile manufacturers have concentrated
on what we would describe as “pseudo-innovation,” i.e.,
changing the size and shape of cars as part of a marketing-led
strategy to appeal to image and perception, without fundamentally
altering their functionality. The rapid growth of the sports
utility vehicle (SUV) market is an example of this. In the short term,
this can be highly successful, allowing early movers to capture
significant market share. But over time, it becomes a zero-sum
game as others enter the new market segment and drive margins
Figure 1
US consumer confidence and new passenger
car registrations
Source: Autodata
150
130
110
90
70
50
30
01/76
07/78
01/80
07/82
01/84
07/86
01/88
07/90
01/92
07/94
01/96
07/98
01/00
07/02
01/04
US consumer confidence index SADJ (l.h. scale)
US new passenger car and light truck sales (r.h. scale)
millions of units
18
17
16
15
14
13
12
11
10
9
8

China is currently the third-largest car market after the USA and Japan
The Middle Kingdom experienced phenomenal growth in demand for automobiles following the WTO entry in
December 2001. China has a large number of local car producers facing increasing competition from
Western car manufacturers in their home market. Will they be able to export their products to the Western world?

down again. Spending on research and development (R&D) was
dispersed across a wider product range and more technical gizmos
to cover every possible niche, instead of being focused on developing
genuine innovations. As a result, there has been miserably
slow progress on new technologies that could have really breathed
new life into the industry, such as fuel cells (see below). In addition,
the life cycle of existing model lines shortened on increasing
competition.
While the life cycle of a car model is getting shorter and
shorter, the average car in use is getting older and older. In Germany,
a country where the automobile plays a significant role, the
average age of a car increased from 6.8 years to 7.6 years
between 1999 and 2003. The same trend can be seen in the USA,
where the average age of a car rose from 4.9 years back in the
1970s to 8.6 years in 2004. Notwithstanding marketing campaigns,
such as 0% financing, this trend has only eased in the
short term (see Figure 4).
Due to cost pressure, development of key technology features
has been carried out in cooperation with suppliers or in joint
ventures with other manufacturers. The search for innovations
was not always successful, as seen from an investment point of
view. Despite more than 20 years of research and several successful
tests, fuel-cell technology is far from being introduced
into the mass market. Hydrogen-powered engines are also known
as zero-emission power. The best way to picture the evolutionary
development of fuel cells is with the graph of Ballard Power. The
Canada-based company, under control of Chrysler (now Daimler-
Chrysler) and Ford, has focused on fuel-cell technology for more
than a decade now (see Figure 5).
The technology is available and running, but one big problem
is cost. Fuel-cell units are ten times more expensive to make than
petrol or diesel engines. Another problem is the lack of a refueling
infrastructure, which requires huge investments. Optimistic estimates
for commercial sales of hydrogen-powered cars are made
for 2010, while realistic forecasts predict mass-market penetration
no earlier than 2020. BMW, DaimlerChrysler, Ford and Opel
(GM) currently have test vehicles running in Germany, while BMW
uses the technology of liquid hydrogen for conventional car
engines (bi-fuel). However, realizing the goal of making hydrogenpowered
cars available for everyone is between two and three
(car) generations away.
Another very promising but unsuccessful technology – the
electric-powered automobile – has fallen far short of market
expectations. The electro car has not disappeared from the scene,
but the lack of development of new-generation batteries has
hampered the success in this segment. Electric-powered cars
use lead acid or nickel metal hydrid batteries, but scientists say
lithium ion batteries are more promising, though still insufficiently
developed for use in automobiles. Lithium ion batteries are
currently more appropriate for use in low-voltage equipment such
as cell phones and hand-held electronic devices. In terms of
environmental compatibility, the success of electric-powered passenger
cars depends a lot on the means of electricity generation
and battery recycling. Taking this and significantly higher buying
costs into account, the environmental balance for the time being
is similar to other technologies already in place, such as diesel or
hybrids. Furthermore, after 80 to 100 kilometers, the batteries
need to be recharged, which takes considerable time.
Even with existing electric propulsion technology, it would be
possible to build medium or lightweight urban cars with reason-
Figure 2
Annual US incentives compared
with total marketing and R&D spending
Source: Autodata, CSFB HOLT, company data
3500
3000
2500
2000
1500
1000
6
5
4
3
2
1
0
%
94 95 96 97 98 99 00 01 02 03 04
US incentives (l.h. scale)
BMW
1994
1998
2002
DCX
Peugeot
Renault
1995
1999
2003
Volkswagen
Fiat
Marketing as % of sales
(estimate)
R&D as % of sales
Figure 3
R&D spending by OEMs (original equipment
manufacturers) as % of sales
Source: Company data, broker research
Ford
1996
2000
GM
Toyota
1997
2001
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
Average
%

able range, and indeed a few examples are available from specialist
manufacturers. But their costs are relatively high, which is
unsurprising given that they are built on tiny production runs. What
is noticeable by its absence is a viable medium or lightweight
urban electric vehicle produced and marketed in large numbers
by one of the major automobile manufacturers – a product which
has the potential to open up whole new market segments.
We cannot be sure whether greater focus on R&D spending
in the key areas such as fuel cells or electric propulsion would
have produced better results. But it is not unreasonable to believe
that we could be far closer to success, if these projects had benefited
from the R&D resources that were instead devoted to adding
a few extra features to adjustable electric seats, or to designing
the shape of yet another SUV, or creating yet another voice
variation for the SatNav system.
Next innovation driver will be ecological compatibility
Safety has become a key issue in the automobile industry, but
environmental friendliness is garnering more attention too. With only
few exceptions, most obviously the United States, all major countries
signed the Kyoto Protocol, which is now in place. With the
current technology, it will be very difficult to reach the set targets
of 6%–8% lower emissions by 2012 compared with 1990.
Safety and technological features are very often developed
by one of the supplier companies. The latest example comes from
Valeo, which produces a start/stop alternator that automatically
shuts down the engine when a car is stopped at traffic lights
and re-starts it when the driver presses the gas pedal. This offers
up to 10% fuel savings for mini and small cars. The system is
already available in the Citroen C3 and will soon be available
from Ford in its latest Fiesta model. Continental has a start/stop
system available as well, but it is only used in a single GM light
truck model so far. Safety features such as airbag systems and
seat belts are dominated by Autoliv. The two large US suppliers
Johnson Controls and Delphi are very active in safety and
comfort equipment. Delphi has a special interest in the development
of fuel cells and batteries technology. These constitute
good examples underpinning our premise that innovation is
currently originating from suppliers and to a lesser extent from
OEMs. The exceptions are Japanese manufacturers, where
Toyota and Honda heavily invest in hybrid technology. In general,
OEMs try to use synergies resulting from cooperative agreements
in key areas of technology such as engines and power-trains.
This harbors the advantage that new developments become
available to a number of OEMs within a short period of time,
though this first-mover advantage from OEMs does not last very
long. The implication for investors is that the more innovative
parts suppliers may offer better medium-term prospects than the
auto majors.
Diesel boom in Europe; still no interest from rest of world
Diesel engines are a real success story in Western Europe, where
market share reached 43.7% of new car registrations in 2003.
One reason for this success comes from improving technology,
where suppliers such as Bosch and Beru once again supported
the development significantly. French manufacturers, especially
Peugeot, are the key driver behind the trend, overwhelming the
competition by introducing a diesel catalyst system. Peugeot has
offered this technology for four years now, and it seems to
become a set standard for the European market as a whole.
Figure 5
Ballard Power and S&P 500
Source: Bloomberg
GLOBAL INVESTOR 2.05 Automobiles—27
Figure 4
Average age of light vehicles in the
USA since 1970 and average age of cars
in Germany since 1994
Source: Polk (USA); VDO (Germany)
9
8.5
8
7.5
7
6.5
6
5.5
5
4.5
1600
1400
1200
1000
800
600
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04
Average age of cars in the USA
Average age of cars in Germany
01/97
01/98
01/99
01/00
S&P 500
Ballard Power (r.h. scale)
01/01
01/02
01/03
01/04
200
180
160
140
120
100
80
60
40
20
0

Several countries intend to make catalysts compulsory for new
diesel engine-equipped cars in order to reduce particle emissions.
The problem seems to be supply since only a few producers are
able to deliver diesel catalysts at present. One key supplier is
Faurecia, a 71% subsidiary of Peugeot.
Recently, several German car manufacturers had to recall
diesel cars and reduce or even close production of several model
lines because supplier Bosch delivered a low-quality injection
pump. OEMs are highly dependent on their suppliers and the
quality that they deliver. Automobile suppliers are currently very
powerful; they can pass on higher raw-materials costs to OEMs
and even increase their own margins. German car manufacturers
concentrate their diesel research on inner-engine solutions for
the particular problem, but have failed to deliver a system in due
time. The first generation of new diesel engines just hit the market.
Diesel market penetration in North America is still below 1%,
which is attributable to the poor history and lack of acceptance
by customers as well as to the poor quality of diesel fuel in the
past. The big question is whether diesel engines will eventually
become a success story in the USA too. (see Figure 6)
The current success story comes from Japan, where hybrids
attract key attention for development. It took three years and a
second-generation hybrid car to successfully launch this technology
for the mass market. The latest-generation hybrid cars do
not differ from other automobiles on the road with respect to
shape, look or performance. The innovation is taking place behind
the scenes, with an additional electric engine (or even two in the
new Lexus 400h), a trunk of batteries and the latest electrical
technology to coordinate the performance between the two different
engines. Even hybrid cars have just started to undergo
innovation. Toyota has been the first-mover in this field of technology,
followed by Honda. Both companies are offering their technology
to third parties, which will enable the industry to further
develop this new standard. Several countries support this technology,
with incentives similar to, or even exceeding, those for diesel
catalyst cars in some European countries. Besides this support,
hybrids provide a real alternative for anyone living in urban areas.
Next-generation hybrid cars will be equipped with diesel-powered
or natural-gas-powered engines, in combination with improved
battery technology or even fuel cells later on.
Natural gas on the edge
Natural-gas technology is drawing more attention as the discussion
for ecological compatibility seriously evolves. Argentina has
the largest fleet of natural-gas-powered cars, with 750,000 units,
followed by Italy with more than 400,000. More cars are available
with bi-fuel tanks, where conventional gasoline and natural gas
can be used together, providing the same power and performance
as gasoline engines. A number of cars are now available with bifuel
tanks. Besides the ordinary gasoline tank and engine, an
additional fuel tank needs to be added and some electronics. With
natural-gas technology, the number of fuel stations as well as tax
advantages will be key for this environmentally friendly alternative
to penetrate the market. Several countries in Europe support
natural gas and the development of a fuel-station grid. Today,
around 60 fuel stations for natural or biogas are already in place
throughout Switzerland, 555 in Germany and 24 in the UK. A full
grid should be in place by 2007 given that political support for tax
cuts on fuel continues. Several gas stations for bio-fuel are
already in place. Bio-fuel is produced without any CO 2 emissions.
Figure 6
Market share of diesel engines in Europe
by country
Source: ACEA
70
60
50
40
30
20
10
0
%
94 95 96 97 98 99 00 01 02 03
France Germany Italy
United Kingdom Switzerland Western Europe

GLOBAL INVESTOR 2.05 Automobiles—29
Projects to produce a simple low-cost car in large volumes and on a profitable basis have failed so far.
Every part of a car features the latest technology developments, but know-how ownership increasingly belongs
to supplier companies.

GLOBAL INVESTOR 2.05 Automobiles—30
Mercedes, Fiat, Citroen, Ford, Opel, Volkswagen and Volvo offer
cars that are standard equipped with bi-fuel tanks already.
Emerging markets: Growth and low-cost production
To reduce cost pressure, OEMs and suppliers have started to shift
production to the emerging markets, where wage costs are lower
and investments in production facilities are supported by the government.
Meanwhile, new market entrants from emerging markets
are progressively starting to increase competition in the developed
markets. And we believe this effect will become much more powerful
over the next few years, notably as Chinese auto production
capacity starts to outstrip domestic demand by a wide margin.
For the time being, emerging markets are growth areas for
domestic producers as well as for foreign companies willing to
move their production for cost reasons. Since average incomes
in the new markets are rather low, the need for low-cost cars has
increased. With a price tag of EUR 5,000, the Dacia Logan from
Renault is opening up a new market segment. It offers a full-size
car for the price of a second-hand import car. Renault uses the
advantage of low-cost production in Romania, where the Dacia
Logan is mainly handmade since workers in Romania are cheaper
than high-tech robots to build this car. Since the EU has some
stricter rules for safety, content and recycling, the very basic
technology coupled with an attractive model car will be available
for around EUR 7,500 in the developed countries as well. Plans
are to produce the Logan in various locations around the world
(Iran, India, China, Columbia, Brazil and Russia). Renault intends
to produce one million units per year at its peak. In our view, this
target is very ambitious since the competition is working on
similar projects. It looks like Volkswagen plans to cooperate with
Proton of Malaysia to build an even cheaper entry-level car, but
no plans have been confirmed yet. Small-size entry-level cars,
with a price tag of around EUR 8,000 in developed markets are
available from various producers. China is the third-largest automaker
in the world. It experienced phenomenal growth in demand
for automobiles following its entry into the World Trade Organization
(WTO) in December 2001 (see Figure 7)
Chinese car production is currently focused on the local
market, with 4.4 million units a year. Despite the market’s huge
growth potential, expansion of production plants seems to exceed
the needs of the local market over the long run. China aims to
boost its automobile and component exports from USD 8 billion
in 2003 to USD 15–20 billion in 2005, and even more to USD
70–100 billion by 2010. China’s competitive advantage is in the
areas of labor-intensive parts and material-intensive parts, such
as auto glass, tires, wheel hubs, brakes and universal joints.
There is still a technology gap to fill with the foreign companies.
Local content ratio is estimated at around 65% for the time being.
Due to high import taxes on spare parts, total vehicle production
costs in China are still 15%–20% higher than in Europe or the
USA. So far, only Honda, Volkswagen and some large local
manufacturers intend to export complete cars from China to
other countries. We expect China to play a mayor role in the supply
parts business, with a less stringent regulatory environment:
100% foreign ownership is allowed versus a maximum of 50% for
OEMs. Besides some Chinese suppliers, familiar names including
Delphi are using this advantage for low-cost production. Emerging
markets such as China will be important for the pricing of the
supplier industry in the next few years.
Suppliers and OEMs face a very challenging future, with new
market entrants in their core market areas, while they have to
grow in the emerging markets too. We see key technology ownership
as the best way to invest in the car market. While massmarket
producers will face more pricing pressure in the future, it will
be mainly suppliers that own key technology and innovations –
such as Valeo and Continental – who will be able to maintain
higher margins and growing sales volumes. Automobile manufacturers
such as Renault, Proton or Tata, which are able to produce
low-cost cars for the mass market, have good opportunities to
reap rewards from the opening up of the emerging markets. |
Figure 7
Monthly growth in sedan sales in China
Source: CAAM, Merill Lynch
140
120
100
80
60
40
20
0
%
China’s WTO entry –
import tariff/quotas
started changing in
January 2002
Jan/Feb 01
Jun
Oct
Mar
Jul
YoY growth (l.h. scale)
Monthly sales (r.h. scale)
Nov
Apr
Aug
Dec
May
Sept
thousands
250
200
150
100
50
0

GLOBAL INVESTOR 2.05 Technology—31
Technology not yet poised for the next growth cycle
Robotics offers exciting potential five to ten years down the road, while
marketing and “pseudo-innovation” imply modest, cyclical growth
for the time being. Ulrich Kaiser, Uwe Neumann
At present, the global technology sector is very much driven
by replacement demand rather than innovation, resulting in pronounced
cyclicality. We believe consumers are unlikely to see any
real life-changing innovations for another five or perhaps ten
years, but then we do expect to see new products such as intelligent
vacuum cleaners and kitchen appliances – or even robots
that can manage conventional appliances. As these innovations
become an accepted way of life, making people’s lives easier and
giving them more time off, demand should surge and growth
prospects for the industry will be transformed.
In the meantime, success in marketing will remain crucial in
driving corporate profitability. This means investors can expect
only modest, cyclical growth in profits, while consumers will have
to be content with “pseudo-innovation,” (i.e., new products that
basically just enhance old ones, with new features or different
designs). The large majority of new products in the audio, video,
data processing and telecommunications segments improve only
marginally on old models (see page 33).
Within this rather unexciting short-term outlook, we do expect
occasional bright spots. These can occur where companies create
a product, which, although not incorporating radically new technology,
does offer a genuine quantum leap in terms of ease of
use and associated services. Apple’s iPod, with its link to one of
the first legal music download websites, is one of these inventive
marvels. In our view, companies that are in a position to create
added value in this way, from existing technologies (process
innovation) will enjoy temporary success in the interim term, until
the new phase of real innovation kicks in.
Markets for early consumer electronics totally unsaturated
In the past, the consumer electronics industry was confronted by
different underlying conditions. The rise in prosperity after the
Second World War sparked the innovative prowess of Western
industrial nations, in particular, and provided an ideal selling environment
for consumer electronics companies. The range of products
was originally mainly limited to radios and cameras. Thereafter,
black and white televisions, and audio devices, such as
stereos and tape recorders, increasingly found their way into
consumers’ living rooms. Generally, the products made by individual,
mostly regional manufacturers hardly differed in functional
terms. For consumers, quality was the main factor, which
was manifest in the life span of the products.
Figure 1
Balance between R&D, marketing and
margins at Sony (1984 – 2003)
Source: Sony
18
16
14
12
10
8
6
4
2
0
%
84
85
86
87
88
89
90
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Other SG&A in % of sales
R&D in % of sales
92
93
94
95
96
97
98
99
00
EBITDA margin
EBIT margin
01
02
03

Evolution has edge over innovation in consumer electronics
When we talk about product innovation, we are referring to inventions
that have significantly changed people’s lives. Here, we would
include consumer electronics products such as radios, televisions,
record players, tape recorders, as well as photo and movie cameras.
While the first generation of audio/video appliances satisfied
people’s basic needs, subsequent consumer electronics
products would be better classified as replacement products.
Hence, we saw the evolution from tubes to transistors, and from
the first battery-operated appliances to the forerunners of today’s
portable electronic devices. Color TVs replaced black-and-white
TVs, cassette recorders replaced tape machines, CD players
replaced record players, and video replaced 8 mm movie cameras.
One could call this the birth of second-generation consumer
electronics products. Based on previous products, companies
came up with increasingly sophisticated, user-friendly models,
releasing them faster and faster into the market. Today, as the
life cycles of products diminish, the ability to launch a new product
as quickly as possible (time-to-market) is now an increasingly
important and often crucial success factor. Companies justify
their extremely high marketing budgets on these grounds.
The future has already begun
The next generation of consumer electronics devices will involve
further cross-linking or combinations of existing products. We
should see new products progressively entering the market; for
example, remote control mobile telephony, voice-controlled PCs
without keyboards, and so on. Remote control by mobile phone
will allow people to manage their lives electronically. For example,
they will be able to check the amount of food in the refrigerator
or freezer without being at home, or program the DVD player or
bake a pizza while they are on their way home.
Company reports provide no conclusive evidence
If we look at the income statements of leading manufacturers
such as MEI, Sony and Philips to test our supposition that marketing
costs are rising faster than spending on innovation, we end
up with two basic observations: First, research and development
costs amount to only a third or half of marketing costs. Second,
marketing costs are much more volatile in relation to sales, while
research and development costs are relatively stable. How do we
explain this? We believe the marked decline in profitability of
these companies (see Figure 1) is one of the main reasons. Companies
are sometimes compelled to undertake major cost-savings
programs, and that often means cutting back on marketing spending
for a while. This ongoing pressure on costs forces consumer
electronics firms to adopt different business models, with varying
degrees of flexibility.
Evolution changes conditions for consumer electronics
With market saturation at an advanced stage, the main consideration
is no longer the satisfaction of basic needs, but more and
more the satisfaction of individual needs. In their efforts to cater
to as many market segments as possible, manufacturers have
expanded their range of products, and at the same time disproportionately
increased their costs. To counter this, they began to
outsource part of their production. In addition, they were able to
benefit from the fast-growing, rapidly developing semiconductor
technology. In this way, a kind of modular construction system
has arisen and, in the most extreme cases, the role of consumer
electronics companies has become purely one of design and
assembly.
Because the components of modular systems are often the
same, manufacturers face an increasingly difficult task of differentiating
their products from those of competitors. Where this
may have been achieved in the past by applying a specific manufacturing
technology or know-how to achieve superior quality,
today’s customers are won with price concessions, unique designs
and/or manufacturing concepts. Branding, supported by high
marketing budgets and to some extent design, has become crucial
in this environment.
Semiconductors driving force behind consumer electronics
As consumer electronics companies have focused more on
assembly, branding and marketing, the cutting edge of research
has, to some extent, shifted to the semiconductor industry. The
steady flow of ever-smaller microchips in line with Moore’s Law
(which predicts that the processing power of microchips will double
every 12 months) enables manufacturers to produce smaller and
more convenient consumer electronic devices. Moreover, smaller
chips mean that more of them can be used in consumer electronics
devices and an increasing number of functions can be built in.
Texas Instruments is one example of a company where we can
see the increasing importance of research and development in
the semiconductor industry. The ratio of R&D spending to sales
has risen disproportionately in the last few years. In contrast,
marketing costs play only a secondary role. Compared with consumer
electronics firms, however, semiconductor companies
generate higher operating profit margins. On the one hand, this
supports the notion that the real value added in consumer electronics
products takes place at the semiconductor level. On the
other, it also explains the relatively modest research and development
costs of consumer electronics firms.
Figure 2
Balance between R&D, marketing and
margins at Texas Instruments (1984 – 2003)
Source: Texas Instruments
35
30
25
20
15
10
5
0
–5
–10
% %
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
Other SG&A in % of sales
R&D in % of sales
25
20
15
10
EBITDA margin (r.h. scale)
EBIT margin (r.h. scale)
5
0

GLOBAL INVESTOR 2.05 Technology—33
2020
2010
2000
1990
1980
1970
1960
1950
1940
1930
1920
1910
1900
voice
transmission
audio
recording
television
display
word
processing
In the wake of 30 years of continuous innovation, life is becoming more difficult for technology companies.

Nanotechnology should open the door to truly exciting innovation in five to ten years, in the areas of consumer
electronics as well as pharma.

From the investor standpoint, the following questions arise: Will
innovation continue to contribute to the success of technology
companies? Which products are likely to be similar success stories
to Apple’s iPod? Will there be new technologies such as nanotechnology
that make their way into industry and trigger a new
surge of growth? Or have we entered a long, sustained sideways
trend that, at most, offers us short upcycles and downcycles?
GLOBAL INVESTOR 2.05 Technology—35
Optimistic long-term view thanks to nanotechnology
In most of the large innovative companies like IBM, Microsoft,
General Electric, Siemens, Ericsson or Sony, R&D is increased
over time, broadly in line with sales. This should result in new
technologies and, in turn, new growth. In particular, nanotechnology
could trigger a new phase of technological progress in consumer
electronics, by reducing the energy consumed by electrical
devices, using biochemical processes and new materials.
Better energy consumption technology is crucial for the
electronics industry. Intel recently announced that newly developed
procedures should keep Moore’s Law valid for another
10 – 15 years. However, to take advantage of this, a new revolution
is required to cut back energy consumption, reductions in which
have not kept up with the pace of miniaturization.
In our view, since the start of the new millennium, this situation
has led the technology sector into a blind alley for the time being in
terms of real innovation. Smaller semiconductors could, in theory,
allow more complex features to be built into mobile phones, for
instance. But in practice, the energy needed tends to make the
components overheat, so the potential of miniaturization cannot yet
be realized. The same applies to computers, which mostly come
equipped with fans to stop the semiconductors from overheating.
At present, researchers are concentrating on applications and
manufacturing processes for so-called nanotubes or quantum
dots, aimed at improving energy consumption of memory chips
and chip capacity. In the future, chip sets should be able to perform
more complex processes (similar to the way the human brain
works) and thus save energy. This would, in turn, open the door
to mass-production of intelligent robots at prices affordable for
ordinary consumers. Intelligent robots performing various functions
would come closer to our definition of real innovation
because they would change people’s lives and behavior significantly,
just as the first televisions, personal computers and mobile
phones did. We could even see double-digit growth rates similar
to those in the 1990s.
The first nanotube was discovered in 1991 by a researcher at
the NEC Corporation in Tsukuba, Japan, and laboratories all over
the world have been exploring the potential applications of nanotubes
at top speed ever since (government spending on nanotechnology
and the number of secured patents have increased
sharply around the globe, see Figure 3). Still, we believe it will
take at least ten years before widespread affordable commercial
applications appear due to the difficulties of economically producing
nanotubes on a large scale. Hence, it will take at least five
years, or perhaps much more, before the stock markets factor in
this scenario.
Figure 3
Government spending on nanotechnology
Source: Lux Research
5
4
3
2
1
0
USD billions
More cautious short-term view, with limited growth for years
With several years to go before we are likely to have a clearer
idea whether nanotechnology can really create a breakthrough
toward mass robotics, the short-term outlook is focused on relatively
modest improvements to existing products in the consumer
97 98 99 00 01 02 03
Western Europe
United States
Japan
Other
04

Telecom house of the future
Innovation down the road will focus on process optimization.

electronics industry. For example, the luminance and clarity of flat
screens or mobile phone displays can be improved, or new materials
can help to enhance the durability, mobility, functionality, as
well as the look and feel of devices. In short, advanced technology
will mainly be used to support replacement cycles.
In this environment, large corporations such as Nokia, which
have built up a high market share in a particular technology segment
(mobile phones in Nokia’s case), are starting to take a defensive role
and are concentrating mainly on replacement cycles. Nokia is inclined
to cut back on research spending in the next three years and focus
more on finding the best possible way to serve existing market
segments. The latter course has more of a marketing character.
In fact, the last series of mobile phones (7260–7280, etc.) was
designed to match the latest fashions in women’s shoes and accessories
and was successfully launched in the market. As long as large
companies exhibit this behavior, we think the technology sector
will tend to remain cyclical in the big picture. For all that, some TMT
subsectors could reap the benefits of small technological advances.
New developments with regard to batteries are one example.
New batteries for consumer electronics?
The performance of mobile-phone batteries still leaves something
to be desired, especially with the new high-performance third-generation
(3G) phones. This is a serious deficiency, if customers of
telecom providers cannot make optimal use of the new technology.
For this reason, NTT DoCoMo will have invested USD 300 million
up to March 2006 to develop a new battery for mobile phones. The
use of nanotubes should help batteries last ten times longer and
make it easier to exchange them. This development could make
a difference with regard to penetrating the market with 3G mobile
phones. Telecom providers would clearly reap the benefits.
Technology companies focus on process optimization
The iPod is a good example of process optimization. Besides its
appearance and Apple’s targeted marketing campaign, iPod’s
ease of handling was clearly one of its key success factors. Interoperability,
universality, ease of use and safety of consumer
electronics devices are today’s buzzwords in the technology world.
Innovation is thus focused on process optimization. Nokia’s recent
announcement of a tie-up with Microsoft aimed at standardizing
the transfer of files from fixed networks to mobile phones and
vice versa is a move in this direction. However, this is unlikely to
result in above-average growth. This merely represents a better
way of utilizing the technological advances achieved to date.
On the other hand, service providers are likely to profit from
the additional income generated by improved and easier-to-use
products. Besides telecom service providers, this also includes
Internet companies such as Yahoo, Google or E-Bay. Moreover,
software companies involved in the security aspects or, such as
Cognos, in the area of business intelligence, can look forward to
an increase in demand for their services. This also goes for information
service providers, such as Amdocs, that offer segmentation
and settlement systems, for example, and which are likely
to attract more attention from investors.
Conclusion: Investors need to be flexible in their investment
We tend to lean toward a cautious outlook for the next two years.
The innovations expected during this time will not be pioneering,
in our view. While the sector still offers opportunities, the search
for investment success stories based on new technologies is
GLOBAL INVESTOR 2.05 Technology—37
unlikely to bear much fruit in the short run. Even companies
known for their marketing prowess, such as Nokia or Philips,
could turn out to be “lame ducks” because of their defensive
strategies aimed at securing market share. For the time being, we
would advise investors to concentrate on companies that focus
on process optimization and the creation of user-friendlier products
(Apple or Research in Motion are examples of companies that
have had success in this area). With markets tending to move
sideways in general, mergers and acquisitions are also likely to
drive prices of technology stocks. At any rate, flexibility is called
for with regard to the technology sector because of its ongoing
cyclical character.
Still, investors should constantly keep a close eye on developments
in the field of nanotechnology – an area where research
has been carried out for 15 years. If the vision of radical improvements
in microprocessor energy consumption can be achieved, it
would remove the major roadblock that currently inhibits further
miniaturization. That, in turn, would open the door to truly exciting
innovations, such as mass robotics. Companies such as IBM or
Intel put their emphasis on nanotechnology research, while Japanese
firms like Sony are frontrunners in applications such as
robotics. These companies could turn out to be among the winners
in the industry. It could easily be five years or more before the
way forward in this area becomes clear, but when it does, a range
of exciting new opportunities will emerge. And investors should
stand ready. |
Figure 4
Selected nanotechnology patents in the USA
Source: Lux Research
1000
800
600
400
200
0
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
Selected nanotechnology patents
in the USA

Topics

GLOBAL INVESTOR 2.05 Covered Bonds—39
European covered bonds in the spotlight
Covered bonds are fixed-income securities, with the benefit of being collateralized
by either public-sector debt, or by mortgages. Dr. Jeremy Field, Cédric Spahr, CFA
Covered bonds are fixed income securities, issued by banks and
other financial institutions and retained on their balance sheets,
but with the protection of being collateralized by either publicsector
debt, or by commercial or household mortgages. In 2004,
the European covered bond market was worth about EUR 1.5
trillion. By comparison, the European government bond market
was worth about EUR 2.9 trillion, so the covered bond market is
very significant for fixed-income investors. Although the market
is mainly denominated in euros, covered bonds have also been
increasingly issued in US dollars, British pounds and Swiss francs.
Ten years ago, the European covered bond market was dominated
by the issuance of Pfandbriefe from German banks. Since
then, most other countries – with the exception of the UK – have
either introduced, or are currently working on new or improved
legal frameworks for covered bonds.
The European covered bond market has exhibited solid growth in
recent years, with new markets such as Spain and Ireland contributing
to issuance volumes. In July 2005, the German Pfandbrief
market will be opened up to all German banks. Italy and
Portugal are expected to pass covered bond legislation in 2005.
Norway and Sweden are likely to access the euro covered bond
market for the first time this year. Mortgage covered bonds have
increased their importance relative to public-sector covered
bonds, with Spain making an increasing contribution to overall
issuance volumes. At present, there is no common European
legislation governing covered bonds, although there are clear
similarities between countries. Table 1 lists some of the major
issuers of European covered bonds and German public Pfandbriefe.
So-called structured covered bonds have been issued in
the UK, for example by HBOS, but due to the absence of specific
covered bond legislation, these securities incorporate
accepted techniques to enhance their credit quality, as well as
structural features that are accepted under English law.
Despite the fact that there is no common European legislation,
in most European countries covered bonds comply broadly
with Article 22 (4) of the UCITS (Undertakings for Collective
Investments in Transferable Securities) directive and are structured
around the following broad principles:
p Covered bonds must be issued by a recognised credit institution
in an EU member state.
p The bond issuance is regulated either by a specific legal framework,
or on a contractual basis. The issuer is subject to national super-
Figure 1
Efficient portfolio frontier
Source: Credit Suisse
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
Volatility in % 0
Expected return in %
2 4 6 8 10 12 14 16 18 20
Efficient portfolio with covered bonds
Efficient portfolio without covered bonds

vision designed to provide protection to the covered bondholders.
p The amount of money derived from the issuance of covered
bonds must be invested in conformity with the law in assets that
are able to cover the obligations attached to the bonds throughout
their lifetimes.
p In the event of financial distress on the part of the issuer, the designated
assets must be used on a priority basis to pay the accrued
interest and reimburse the principal to the covered bondholders
European covered bonds that comply with the aforementioned
criteria enjoy various preferential regulatory treatment. In
particular, covered bonds qualify as Tier 1 collateral for banks in
the EU for their refinancing operations with the European Central
Bank. Banks, taking about 40% of new issues, represent the
largest single group of covered bond investors.
Surprisingly, what is not addressed in the aforementioned
features is the type and quality of the collateral assets. The German
authorities are preparing new Pfandbriefe legislation that is
expected to come into force in July 2005. One of the main aims
of the proposed law is to open up the issue of Pfandbriefe backed
Table 1
Major European covered bond and German public Pfandbrief issuers
Source: Bloomberg, Credit Suisse
Issuer BB ticker Country Rating/Outlook Fitch Rating/Outlook Moody’s Rating/Outlook S&P
HBOS Treasury SRVCS PLC HBOS Great Britain AAA/n.a. Aaa/Stable AAA/n.a.
DEPFA ACS Bank DEPFA Ireland AAA/Stable Aaa/Neg AAA/Stable
AYT Cedulas Cajas III AYTCED Spain AAA/n.a. Aaa/n.a. AAA/n.a.
Cedulas TDA 1 CEDTDA Spain AAA/n.a. Aaa/n.a. AAA/n.a.
CIE Financement Foncier CFF France AAA/n.a. Aaa/n.a. AAA/n.a.
CIF Euromortage CIFEUR France AAA/n.a. Aaa/n.a. n.a./n.a.
DEXIA Municipal Agency DEXMA France AAA/n.a. Aaa/n.a. AAA/n.a.
Allg. Hypobank Rheinboden AHBR Germany AAA/Develop Aa1/n.a. AAA/Neg
DEPFA Pfandbriefbank DEPFA Germany AAA/n.a. Aaa/n.a. AAA/Neg
Deutsche Hypothekenbank DHY Germany n.a./n.a. Aaa/Neg AAA/n.a.
Eurohypo AG EURHYP Germany AAA/n.a. Aaa/Stable AAA/n.a.
Hypothekenbank in Essen HYPESS Germany AAA/Pos Aaa/Stable AAA/Stable
LB Baden-Wuerttemberg LBW Germany AAA/Stable Aaa/Stable AAA/Neg
Muenchner Hypothekenbank MUNHYP Germany n.a./n.a. Aaa/Neg n.a./n.a.
NRW. Bank NRWBK Germany AAA/Stable n.a./Stable AAA/Stable
n.a. = not available
Table 2
Legal Framework for covered bonds in Europe
Source: Barclays Capital, Credit Suisse
Germany UK France Spain Luxembourg Ireland
Typical name Pfandbriefe UK asset-covered securities Obligations Foncières Cedulas Lettres de Gage Irish asset-covered securities
Special legislation framework Yes No Yes Yes Yes Yes
Special bank principle No No Yes No Yes Yes
Operational limitations Yes Yes Yes No Yes Yes
Bankruptcy remoteness Yes Yes Yes No Partial Yes
Priority of claims Yes Yes Yes Yes Yes Yes

y a specific pool of mortgage loans, public authority debt, or ship
mortgage loans to any licensed bank, subject to the approval of
the German financial services regulator.
The covered bond legislation in the various European countries
applies different guidelines on loan-to-value (LTV) ratios,
interest-rate risk and market risk management, and over-collateralization
requirements. Table 2 gives an overview of the legal
framework for covered bonds in Europe.
In 2004, a new Spanish insolvency regime came into force,
which has strengthened the bankruptcy remoteness of Cedulas,
the Spanish covered bonds. Probably the strongest covered bond
legislation in Europe at present, from the standpoint of protecting
the investor, is in France (see Table 2.) The French credit institutes,
Sociétés de Crédit Foncier, which issue covered bonds,
Obligation Fonciér, are special-purpose vehicles, which are bankruptcy
remote from the holding bank. This provides the strongest
degree of protection for the bond investor, with the eligible cover
assets being held by a separate legal entity.
GLOBAL INVESTOR 2.05 Covered Bonds—41
European covered bonds and asset allocation
Table 3 shows the correlation between European equities, represented
by the DJ Euro Stoxx Index, German government bonds,
Bunds, the JP Morgan Euro Cash Index and covered bonds, represented
by the MSCI Euro Credit Covered Bond (CB) Index. The
table shows that Bunds, cash and CBs all have a negative correlation
to equities, which is positive from the diversification
standpoint. Figure 1 shows the efficient frontier for a portfolio of
the above assets, with and without covered bonds. The graph
clearly shows that a higher return for the same risk (volatility) can
be achieved by the inclusion for covered bonds in a portfolio of
the aforementioned assets.
Conclusions and recommendations
Covered bonds, because of their construction, have a lower
default probability and a lower loss in the case of default than
unsecured bonds. According to ABN Amro Bank, no European
covered bond has ever defaulted in more than 100 years. This
allows investors to have greater exposure to a single issuer, which
is an important consideration for private clients who do not have
the possibility to diversify a bond portfolio to the extent that an
institutional investor can. The inclusion of covered bonds in a
portfolio of equities, cash and government bonds significantly
improves the expected return for the same level of risk
We view the rating outlook for the major European covered
bond issuers as stable. Although the German Landesbanks will
lose their state guarantees in July this year, their existing Pfandbriefe
issues will retain the guarantee (i.e., they are “grandfathered”)
and so will only be subject to a rating downgrade if the
corresponding German state is downgraded.
We do not see any potential for tightening of credit spreads at
the current levels, but we anticipate that the yield pick-up of AAA
rated covered bonds over governments will remain attractive.
We anticipate that investor demand for European covered
bonds will remain high. The investor base for European covered
bonds is broadening, with Asian investors starting to take interest.
Various central banks and other semi-government organizations
have been diversifying into high-quality covered bonds because
of the yield pick-up over sovereigns. The upcoming removal of the
German Landesbanks’ state guarantees is also likely to increase
demand for covered bonds. |
Table 3
Correlation between various asset classes
Source: Credit Suisse
DJ Euro
Stoxx
German
Bunds
JPM Euro
Cash
MSCI Euro
Credit CB
DJ Euro Stoxx 1.0 –0.4 –0.1 –0.3
German Bunds –0.4 1.0 0.3 0.9
JPM Euro Cash –0.1 0.3 1.0 0.3
MSCI Euro Credit CE –0.3 0.9 0.3 1.0

Swiss real estate stocks poised to take a breather
In the wake of two years of good share-price gains for real estate companies, we see
little potential for a further outperformance. The looming rise in interest rates
and the persistent oversupply of office space prompt us to anticipate a difficult year
for Swiss real estate firms. Eric Güller
The proportion of real estate assets in investors’ overall portfolios
diminished toward the end of the twentieth century as a result of
the real estate crisis in the early 1990s and the stock-market
euphoria that lasted through the year 2000. However, the subsequent
sharp correction on the equity markets until 2003 prompted
private and institutional investors alike to rethink their strategies
and adopt a more conservative investment policy. The income
stability and intrinsic value solidity offered by real estate are once
again being prized. Real estate assets have thus recaptured
investor interest. This fact is also visible in the robust price performance
over the past couple of years. The increased demand
propelled prices upward, especially for residential properties. As
a result, the achievable return on direct investments declined
materially. Indirect investment vehicles such as real estate funds
and real estate companies likewise profited and posted a pleasing
performance. Both types of securitized investment vehicles significantly
outperformed the broader Swiss stock market (SPI) over
the past three years. In 2004 alone, the share-price performance
for the group of publicly traded Swiss real estate companies
amounted to an impressive 25%.
Meanwhile, the valuation discount has vanished
The strong share-price performance of the past three years is
more a reflection of the heavy demand for real estate investments
and is less attributable to the trend in the underlying property
market. In other words, the share-price performance is far more
imputable to the change in the premium/discount to net asset
value than to asset value appreciation itself. The long-existing
valuation discount has largely disappeared over the last two years.
Only PSP and Züblin are still trading below their net asset value,
while shares of Warteck, Allreal and SPS are changing hands on
the stock exchange at prices well above net asset value. Although
the sector valuation is now at an all-time high, Swiss real estate
companies nonetheless remain attractively valued relative to real
estate funds since the latter carry a valuation premium that is
approximately 20% higher.
Upside potential in the short run primarily depends on demand
Over the long term, investors can expect to reap a total return of
around 6% to 7% on real estate stocks because the companies
are likely to achieve a return on equity of that magnitude over the
Figure 1
Steady outperformance of real estate stocks
versus the broader equity market since 2002
Source: Datastream, Credit Suisse
130
120
110
100
90
80
70
60
50
01.02
04.02
07.02
10.02
SWX real estate funds
SPI
01.03
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07.03
10.03
01.04
04.04
07.04
SWX real estate companies
10-year Swiss bond index
10.04

GLOBAL INVESTOR 2.05 Real Estate—43
“We see no reason to rush to build up new
investment positions in real estate stocks.” Eric Güller

GLOBAL INVESTOR 2.05 Real Estate—44
course of the economic cycle. In the short run, however, share
prices are likely to remain driven more by the change in the premium
or discount to net asset value, and thus by the demand
for real estate investments, than by asset value appreciation (currently
+6% including dividends). In view of institutional and private
investors’ structural adjustments to their asset allocations – and
given the attractive dividend yields in the current low-interest-rate
environment – we expect demand for real estate investments to
continue to bolster share prices, though demand looks set to
increasingly flatten.
Figure 2
Inverse correlation between real estate
and long-term bond yields
Source: Datastream, Credit Suisse
140
130
120
110
100
90
80
70
60
95 96 97 98 99 00 01 02 03 04 05
SWX real estate funds (l.h. scale)
10-year Swiss bond yields (r.h. scale)
%
9.5
8.5
7.5
6.5
5.5
4.5
3.5
2.5
1.5
Rising interest rates may constrain share-price performance
Despite the share-price explosion, real estate companies continue
to sparkle with attractive dividend yields averaging in excess
of 4%. The dividend yield thus not only far exceeds the yield on
ten-year Swiss Confederation bonds (2.4%) and the average
dividend yield paid out by the companies listed on the Swiss Market
Index (1.8%), but also beats the payout yields offered by real
estate funds (3.6%). Swiss real estate stocks also score well
compared with their European counterparts: despite Switzerland’s
much lower yield level on five- to ten-year bond investments,
the dividend yield offered by Swiss real estate companies
lies only slightly below the average for European real estate firms
(4.4%).
The attractive dividend yield in relation to bond yields was one
of the main drivers behind the re-rating of real estate stocks.
However, the support from income-oriented investors is likely to
ebb as interest rates climb. Although rises in interest rates generally
occur when the economy is recovering – and for this reason
tend to coincide with higher revenue, earnings and asset value for
real estate stocks – their attractiveness will nonetheless diminish
as the yield differential narrows and as investors focus on other,
strongly cyclical, stocks. Since most of the Swiss real estate
companies have been listed on the stock exchange only since
2000, the historical data series is not extensive enough to reliably
Figure 3
Vacancy ratio is steadily rising
Source: Credit Suisse annual report
%
20
18
16
14
12
10
8
6
4
2
0
Allreal
Intershop
Maag
PSP
SPS
Warteck
Züblin
Average
2001
2002
2003
2004E (adjusted for portfolio movements)
2004E (published vacancy ratio)

measure the impact of market interest-rate movements on the
share-price performance of real estate firms. However, real
estate funds, some of which have existed since 1938, exhibit a
strong inverse correlation to the trend in long-term bond yields.
The negative correlation between real estate companies and longterm
bond yields is probably weaker because real estate firms
have the characteristics of a stock and hold a higher proportion
of cyclical office properties than real estate funds do. Nevertheless,
climbing interest rates are bound to weigh on share-price
performance, though to a lesser extent than in the case of real
estate funds. Since we expect interest rates to rise in the second
half of 2005, short- to medium-term investors should increasingly
exercise caution when investing in securitized real estate.
The office market situation remains difficult
As already mentioned, the good share-price performance of
Swiss real estate companies does not correspond to the trend
in the underlying property portfolio. Real estate companies are
predominantly invested in office properties, while the booming
and cycle-resistant residential property segment, which dominates
in real estate fund portfolios, plays a secondary role. The cyclical
market for commercial properties has been plagued by a supply
overhang since 2001. The publicly traded real estate companies
have been unable to circumvent this tough market situation, as
reflected by the trend in vacancy rates. Adjusted for portfolio
acquisitions and property disposals, all of the listed real estate
companies – apart from Allreal – exhibit steadily rising vacancy
rates. Moreover, although a huge oversupply has existed for a
good three years running, additional office space is set to come
onto the market during the next two years and will further aggravate
the situation, particularly in Zurich and vicinity. At the same
time, we expect the demand deficit to persist because uncertainty
about the sustainability of the current economic upturn is making
tenants wary, employment growth is weak, and the trend toward
reducing per capita office space usage continues. The vacancy
rate is therefore more likely to rise slightly higher than fall. We do
not foresee a significant improvement until the second half of
2006 at the earliest.
High vacancy rates are not a priori a bad thing. As demand
picks up, vacancies afford potential to boost rental revenue. However,
the persistently high vacancy rates and the completion of
new buildings pose an increasing risk that rent levels themselves
– where only marginal concessions have been made to date –
could come under pressure. Since property prices directly depend
on the rent level, real estate companies’ net asset values will
come under pressure if prices begin to drop, which would probably
cause their share prices to slump. Peripheral sites and older
buildings that no longer meet modern-day specifications face the
greatest risk of rent and price reductions.
No hurry for new investments in real estate stocks
After three consecutive years of strong share-price performance,
the party for real estate stocks now appears to be largely over: the
market environment for real estate companies remains difficult, and
we see only limited upside potential from the current valuation level.
However, the intrinsic value of stability, attractive dividend yields
and defensive risk profile offered by real estate vehicles make
them a sensible long-term addition to investment portfolios, in our
opinion. Moreover, the enduring demand for such investments is
likely to continue to support real estate stocks for the time being,
though an eventual rise in interest rates would probably break the
positive trend. In view of these circumstances, we recommend
remaining invested in real estate companies for now, though
increasing caution should be exercised. As for individual stocks,
we favor PSP, which we think has the most attractive risk-return
profile among the Swiss real estate companies for the medium
term. However, not even PSP is immune to potential setbacks given
its high vacancy rates and large percentage of leases up for renewal.
We therefore see no reason to rush to build up new investment
positions in real estate stocks, not even in our sector favorite. |
Table 1
Overview of Swiss real estate company valuations
Source: Bloomberg, Credit Suisse, company annual reports
Swiss
real estate
companies
Price:
29/03/05
Market
cap.
(CHF m)
P/E
2004E
P/NAV
2004E
Premium/
discount
to NAV
Dividend
yield
ROE
2005E
Vacancy
rate
2004E
Equity
ratio
2004E
Leases up
for renewal
in 2005
Allreal 111.0 902.5 18.2 1.15 15 % 4.1 % 6.9 % 4.0 % 42 % 14 %
Intershop 238.9 501.7 11.9 1.15 15 % 4.2 % 8.2 % 18.4 % 36 % 8 %
Maag 190.0 193.8 -2.1 0.99 -1 % 0.0 % 4.0 % 6.3 % 20 % 5 %
PSP 49.8 2197.1 12.0 0.96 -4 % 4.0 % 5.5 % 11.7 % 53 % 14 %
SPS 293.3 1175.9 20.2 1.12 12 % 4.3% 6.8 % 5.0 % 31% 12 %
Warteck 1635.0 245.3 17.1 1.25 25 % 3.8 % 7.7 % 2.9 % 55 % 16 %
Züblin 10.4 292.2 18.3 0.85 -15 % 3.8 % 5.2% 10.0% 26 % 16 %
Average 13.7 1.06 6 % 3.4 % 6.3 % 8.3 % 37.6% 12.1 %
Average excluding Maag 16.3 1.08 8 % 4.0 % 6.7 % 8.7 % 40.5% 13.3 %

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Asset Allocation
Quelle: Credit Suisse Details vgl. Seite 5
Empfohlen Neutral
12% 10%
31% 35%
35% 35%
22% 20%
10% 10%
33% 35%
35% 35%
22% 20%
GLOBAL INVESTOR 2.05 Services—47
Global Investor Focus – Microfinance
Die in den letzten Wochen veröffentlichten
Wirtschaftsdaten signalisieren ein stärker als
erwartetes globales Wachstum. Als Folge baut
sich – allerdings nur langsam – Infl ationsdruck
auf, sodass die Notenbanken die Zügel ausreichend
straff halten müssen. Allerdings ist bei
Zinserhöhungen keine Eile geboten.
Das Umfeld bleibt weiterhin ungünstig für Anleihen.
Da der Infl ationsanstieg gemässigt ausfällt,
ist die Stimmung nur leicht negativ. Wir empfehlen
den Anlegern Bonds mit kürzerer Duration
oder variabel verzinsliche Anleihen (FRNs).
Aktien halten wir auf mittlere Sicht für ein attraktives
Investment. Allerdings müssen vorübergehende
Rückschläge ins Kalkül gezogen werden
– so zum Beispiel diesen Frühling.
Wachstums- und Energiethemen dürften eine
Outperformance zeigen.
Der US-Dollar dürfte die jüngsten Tiefs nicht
oder kaum mehr unterschreiten und sich möglicherweise
zeitweilig leicht erholen.
Balanced kurzfristig (1–3 Monate)
Research Monthly: The themes of this
monthly publication are based on the decisions
and ideas of the Credit Suisse Investment
Committee, augmented by sound investment
advice.
14. März 2005
Research Monthly
Erste Gewinnmitnahmen bei Aktien, Anleihen untergewichten;
Qualität und längerfristige wachstumsorientierte Themen kaufen
Top-Investment-Ideen
Währungen
BUY CAD gegen CHF bei 0.95, mit einem Stoploss
bei 0.92 und einem Ziel von 0.98. Seite 8
Fixed Income
BUY Floating Rate Notes (FRNs) in USD, z.B. Goldman
Sachs 3M-US-Libor + 50 Bp 2015 oder
Kaupthing Bank 3M-USD-Libor + 15 Bp
2009. Seite 10
Aktien
BUY Qualitätswerte wie Canon, Home Depot,
Johnson & Johnson, Sanofi -Aventis und Stryker.
Seite 14
Rohstoffe
BUY Near COMEX Gold-Futures in Schwächephasen,
Kursziel USD 460, Stop-loss bei USD
400. Seite 18
Balanced langfristig (6–9 Monate)
Empfohlen Neutral
Cash
Cash
Bonds
Bonds
Aktien
Aktien
Total Return/alternative Anlagen Total Return/alternative Anlagen
The United Nations Organization has declared this
year as the International Year of Microcredit 2005.
Microfinance, a form of development aid aimed at
supporting micro-businesses in third-world countries
by providing access to basic financial services
under fair conditions, is enjoying growing public
awareness. Credit Suisse Global Research tackles
this exciting and multifaceted issue in the debut
of Global Investor Focus, which will be published in
May. The first publication focuses on the development
of microfinance from various angles as well as
provides analysts’ views on the investment opportunities
and risks. In addition, specialists from
all corners of the world were invited to an intense
roundtable discussion – hosted by Credit Suisse
Chairman of the Board of Directors, Walter Kielholz,
and Head of Global Research, Giles Keating –
featuring distinguished guests Paola Ghillani (previously
with Max Havelaar), Roshaneh Zafar (Kashf),
Hernando de Soto (Instituto Libertad y Democracia)
and Jane Nelson (Harvard University).
The second issue, Global Investor Focus – Nanotechnology,
will be published already in June.
bulletin
Das Magazin der Credit Suisse . Nummer 1 . Februar 2005 . 111. Jahrgang
Thema Aufbruch : Merian – eine Frau geht ihren Weg; Berufe auf Zeit; China lockt
Florierender Wohnungsmarkt, Das Interview: Winterthur-CEO Leonhard Fischer
Global Investor
Expert know-how for Credit Suisse private banking investment clients May 2005
Balance of M&I Marketing versus innovation
Chemicals Modernization is key to remaining competitive
Healthcare Innovation over marketing in big pharma?
Automobiles Driving the future
Technology Not yet poised for the next upcycle
Global Investor Focus
Expertenwissen für Anlagekunden der Credit Suisse
Covered Bonds European covered bonds in the spotlight
Real Estate Stocks ready to take a breather
MARKETING AND INNOVATION
MICROFINANCE
Jane Nelson // Harnessing the potential of Microfinance
Ursula Oser // The attractive business modell
Roundtable // Walter B. Kielholz, Giles Keating, Paola Ghillani,
Jane Nelson, Hernando de Soto, Roshaneh Zafar
Klaus Tischhauser // Challenges for tomorrow
Bulletin: Credit Suisse’s stakeholder magazine
reflects back on its 110-year history and is
regarded as the financial world›s first real
banking magazine. Bulletin is published
five times a year, with the Research Monthly
supplement.
Global Investor: The definitive Credit Suisse
Research magazine offers analyses and
background information on current economic
themes: Global Investor is published
three times a year, with the Research Monthly
supplement.
Global Investor Focus: This new publication
series examines future-oriented trends
and prevailing hot topics from various angles,
and scrutinizes these taking into account
the views of leading authorities in the field.
(Cover shown is a prototype).

GLOBAL INVESTOR 2.05 Authors—48
Giles Keating, Head of Global Research . . . . . . . . . . . . . . . . . . . . . . . . . . 5–11
Markus Mächler, Equity Sector Research . . . . . . . . . . . . . . . . . . . . . . . 24–30
Dr. Maria Custer, Equity Sector Research . . . . . . . . . . . . . . . . . . 12–16, 17–23
Ulrich Kaiser, Equity Sector Research. . . . . . . . . . . . . . . . . . . . . . . . . . .31–37
Dr. Luís Correia, Equity Sector Research . . . . . . . . . . . . . . . . . . . . . . . .17–23
Uwe Neumann, Equity Sector Research . . . . . . . . . . . . . . . . . . . . . . . . .31–37

GLOBAL INVESTOR 2.05 Research team—49
Global Research
Giles Keating, Managing Director, Head of Global Research . . . . . . (44) 332 22 33
Research Switzerland
Bernhard Tschanz, Managing Director, Head of Research Switzerland (44) 334 56 27
Eric Güller, Equity Sector Research . . . . . . . . . . . . . . . . . . . . . . . . . . . 42–45
Dr. Jeremy Field, Fixed Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39–41
Cédric Spahr, Equity Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39–41
Fixed Income and Credit Research
Dr. Thomas Trauth, Director,
Head of Global Fixed Income and Credit Research . . . . . . . . . . . . . (44) 333 34 62
Manfred Büchler, Public Sector and Corporate Bonds . . . . . . . . . . (44) 333 37 35
John Feigl, Swiss Corporate Bonds . . . . . . . . . . . . . . . . . . . . . . . (44) 333 13 70
Dr. Jeremy Field, Vice President, Public Sector and Corporate Bonds . (44) 334 56 29
Sylvie Golay, Credit Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) 333 57 68
Elena Guglielmin, Financial Institutions . . . . . . . . . . . . . . . . . . . . (44) 333 57 67
Karsten Linowsky, Fixed Income Strategist . . . . . . . . . . . . . . . . . . (44) 333 24 15
Walter Mitchell, Vice President, Emerging Markets . . . . . . . . . . . . (44) 334 56 67
Dr. Ursula Oser, Vice President, Global Credit Strategist . . . . . . . . (44) 334 56 92
Ernst Zbinden, Swiss Corporate Bonds . . . . . . . . . . . . . . . . . . . . . (44) 333 67 10
Equity Sector Research
Robin Seydoux, Director, Head of Equity Sector Research . . . . . . . (44) 333 37 39
Dr. Luís Correia, Vice President, Global Pharmaceuticals . . . . . . . . (44) 334 56 37
Dr. Maria Custer, Vice President,
Global Biotechnology and Medical Technology Europe . . . . . . . . . . (44) 332 11 27
André Frick, Energy, Basic Resources. . . . . . . . . . . . . . . . . . . . . . (44) 334 66 71
Eric Güller, Vice President, Insurance and Financial Services . . . . . (44) 332 90 59
Ulrich Kaiser, Vice President, Media, IT Hardware and Software . . . (44) 334 56 49
Markus Mächler, Vice President, Automotive, Capital Goods, Transport (44) 334 56 41
Olivier P. Müller, Nordic and Italian Banking. . . . . . . . . . . . . . . . . . (44) 333 01 46
Uwe Neumann, Vice President, Telecommunications . . . . . . . . . . . (44) 334 56 45
Maritza Ribeiro, Assistant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) 334 56 44
Christine Schmid, Vice President, Banking Europe. . . . . . . . . . . . . (44) 334 56 43
Basil Sohrmann, Assistant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) 334 88 38
Henry Stalder, Assistant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) 334 56 47
Claude Vautier, Assistant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) 334 88 38
Equity Strategy
Christian Gattiker-Ericsson, Director, Head of Equity Strategy . . . . (44) 334 56 33
Cédric Spahr, Vice President, Equity Strategy, Emerging Markets . . (44) 333 96 48
Economics & Forex
Dr. Anja Hochberg, Director,
Head of Global Economics and Forex Research . . . . . . . . . . . . . . . (44) 333 52 06
Thomas Herrmann, Assistant . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) 333 57 97
Sven Friebe, Forex Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) 334 56 91
Marcus Hettinger, Vice President, Forex Strategist . . . . . . . . . . . . (44) 333 13 63
Roland Kläger, Swiss Economist. . . . . . . . . . . . . . . . . . . . . . . . . . (44) 332 09 69
Tobias Merath, Commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) 333 13 62
Sven Schubert, Emerging Market Forex Analysis . . . . . . . . . . . . . . (44) 333 52 28
Zoltan Szelyes, International Real Estate . . . . . . . . . . . . . . . . . . . . (44) 334 83 22
Technical Research
Rolf Bertschi, Director, Global Strategy, Fixed Income, Commodities . (44) 333 24 05
Beat Grunder, Assistant Vice President,
Equities Switzerland and Asian Pacific . . . . . . . . . . . . . . . . . . . . . (44) 333 53 58
Sigisbert Koch, Assistant Vice President
Europe Equities excl. Switzerland . . . . . . . . . . . . . . . . . . . . . . . . . (44) 333 94 64
Mensur Pocinci, Assistant Vice President, US Equities, Currencies . . (44) 333 20 69
Equity Trading Research
Lars Kalbreier, Director, Head of Equity Trading Research . . . . . . . (44) 333 23 94
Sadik Akkoka, Quantitative Analysis . . . . . . . . . . . . . . . . . . . . . . . (44) 334 78 07
Hervé Prettre, Vice President, Trading Strategist. . . . . . . . . . . . . . (44) 334 88 57
Roger Signer, Trading Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . (44) 335 72 98
Harald Zahnd, Vice President,
Consumer and Luxury Goods, Retail, Emerging Markets. . . . . . . . . (44) 334 88 53
Asia Research
Arjuna Mahendran, Director,
Chief Economist and Strategist, Asia-Pacific . . . . . . . . . . . . . . (+65) 6212 6727
Uetlibergstrasse 231, CH-8070, Zurich Dialing Code (Country/Area): +41

GLOBAL INVESTOR 2.05 Imprint—50
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An investment in the funds described in this document should be made only after
careful study of the most recent sales prospectus and other fund regulations and basic
legal information contained therein. The sales prospectuses and other fund regulations
may be obtained free of charge from the fund management companies and/or from
their agents.
Alternative investments, derivative or structured products are complex instruments,
typically involve a high degree of risk and are intended for sale only to investors who are
capable of understanding and assuming the risks involved. Investments in Emerging
Markets are speculative and considerably more volatile than investments in established
markets. Some of the main risks are Political Risks, Economic Risks, Credit Risks,
Currency Risks and Market Risks. Furthermore, investments in foreign currencies are
subject to exchange rate fluctuations. Before entering into any transaction, you should
consider the suitability of the transaction to your particular circumstances and independently
review (with your professional advisers as necessary) the specific financial risks
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April 2005
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