SMALL-CAP VALUE STAYS STRONG

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1 Legg Mason Thought Leadership SMALL-CAP VALUE STAYS STRONG Charles M. Royce Chief Executive Officer, Portfolio Manager Francis Gannon Co-Chief Investment Officer, Managing Director Earnings, high ROIC (returns on invested capital), and valuation have mattered a lot more over the last year than they did in the previous five or six. Chuck Royce We still believe strongly that we are in the early stages of a long run for small-cap value. Recent data showed that at the end of March small-caps were the cheapest they ve been versus large-caps in the last 13 years, that value is cheap relative to growth, and that cyclicals are cheap compared with non-cyclicals. Credit spreads remain wider than they were a year ago at this time, even with the 10-year Treasury rate falling again, so the cost of capital remains higher, which should help profitable, lower leverage businesses. Past performance is no guarantee of future results. All investments involve risk, including possible loss of principal This material is only for distribution in those countries and to those recipients listed. Please refer to the disclosure information on the final page. 2Q 2016 IN THE U.S. INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 Q. Both the Russell 2000 Value and Growth Indexes 1 were enjoying solid results until the Brexit vote what does all the wild activity in the second quarter tell you about how small-caps may perform in the second half of this year? A. Chuck Royce: Before we think about where small-caps may be headed, we need to look at where they ve been. The Russell 2000 Index reached a peak on June 23, 2015 and fell 25.7% from that high through the 2016 low on February 11. This was kind of a stealth bear market people didn t talk about it much outside the small-cap world, but it was a significant decline. Large-caps fell far less sharply over the same period. This bear phase therefore gave small-caps more ground to make up versus their larger peers, which drove the rebound for the Russell 2000 until the Brexit vote interrupted the rally. And that s very much how we see Brexit as an interruption and not a disruption of the current cycle that we think will continue to favor small-cap value. At the end of the day, we see it as more of a political than an economic event, one that looks unlikely to have a meaningful or lasting effect on U.S. small-caps. Prior to the vote, we d seen a recovery for biotech as well as rebounds for internet and software companies, the industries that were hit hardest earlier in the year. We don t see either of those areas resuming anything close to the sustained runs they made in in the second half of this year, even in light of a spate of renewed strength during the last week of June. Within small-cap value, Financials led, driven in part by REITs 2, which also did well in But the valuations on these stocks still look high to us, so we don t see them necessarily leading either, at least not over the long run. Our thought is that companies in more cyclical sectors are more likely to lead primarily because of the shift in investors expectations that began off the small-cap peak last June. Earnings, high ROIC (returns on invested capital 3 ), and valuation have mattered a lot more over the last year than they did in the previous five or six. Although there are some potential obstacles in the way, such as the strengthening U.S. dollar and the possibility of further contraction in credit spreads 4, we think the current cycle is one that value will continue to lead. 1 The Russell 2000 Value Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their value orientation. The Russell 2000 Growth Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their growth orientation. 2 Real Estate Investment Trusts (REITs) invest in real estate or loans secured by real estate and issue shares in such investments, which can be illiquid. 3 Return on invested capital (ROIC) is the amount, expressed as a percentage, earned on a company s total capital. It is calculated by dividing total capital into earnings before interest, taxes, and dividends. 4 A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in credit worthiness. 2

3 Q. So the volatility at the end of June didn t change your mind about the long-term advantage for small-cap value? A. Francis Gannon: Not at all. We still believe strongly that we are in the early stages of a long run for smallcap value. This is due to two factors the relatively attractive valuation and earnings picture for many cyclical stocks and the emerging advantage for small-cap value relative to growth. Perhaps the most intriguing development we ve seen so far this year has been the strength of small-cap value through the recovery that began off the mid-february low. I think most market observers anticipated that value would do well in the decline and that growth would respond well off the bottom. But value has been more competitive than almost anyone would have imagined during this mostly bullish phase. From February 11, 2016 June 30, 2016, the Russell 2000 Value gained 19.5% versus 19.4% for the Russell 2000 Growth. Coupled with value holding on much better through the winter decline (as well from the June 23, 2015 small-cap peak), this span of outperformance gave it a substantial edge in the first half, up 6.1% versus a loss of 1.6%. This is not surprising when stocks come out of a bear market, leadership almost always rotates. So while we may see some brief periods when growth does better, which is what happened in the recovery following the Brexit-led decline, overall we see value maintaining small-cap leadership. We think it s also important to remember how critical it is to try to take advantage of volatility. We looked at the calendar-year price increases and intra-year declines for the Russell 2000 over the last 20 years the results show just how important it is to stick to one s discipline when the markets are falling. For example, the data shows that the Russell 2000 had double-digit positive returns in 21 out of 36 calendar years. In 16 of those 21 years, the index also endured a double-digit decline. Q. Do you have comparable confidence in the prospects for small-cap cyclical stocks with earnings? A. Chuck: We re still confident that an extended period of even slow economic growth should be enough to boost the shares of many companies in sectors such as Industrials, Financials, Information Technology, Materials, and Energy all of which are home to cyclical businesses with earnings and, in some cases, high ROIC. Those that also have reasonable to attractive valuations are the companies that we expect to lead small-cap going forward. Even with the peak last June shifting investor preferences eventually sparking the turnaround for many companies we favor expectations for many of these businesses remain low. In many cases, stocks were oversold back in the winter to the point that, even after experiencing some recovery, their valuations still look attractive to us. Several looked even cheaper in late June. Francis: Some recent data from Furey Research Associates reinforces Chuck s point. It showed that at the end of March small-caps were the cheapest they ve been versus large-caps in the last 13 years, that value is cheap relative to growth, and that cyclicals are cheap compared with non-cyclicals. So we feel like we have a lot of reasons to feel good about the long-term potential for both profitable smaller companies and small-cap value. 3

4 Q. Where have you and your team been looking most frequently? A. Chuck: We re always looking for that sweet spot that intersection of an attractive valuation with a terrific, well-managed, and profitable business that s conservatively capitalized. Nothing makes us happier than finding a good business with an attractively low stock price. This excludes a number of defensive areas, such as utilities and REITS, because the company quality and valuations don t fit our criteria. The same is true for a lot of biopharma stocks. So we ve remained most attentive to those cyclical sectors that have been our focus for the last few years Industrials look promising to us, particularly machinery and services companies, as do select areas of Financials such as asset managers, the less speculative, more earnings-driven industries in Information Technology like semiconductors and other components makers, and Materials, where chemicals have been our main area of interest. Certain energy services companies also fit this profile. Q. Are you concerned that, with additional Brexit-bred uncertainty and interest rates still so low, small-cap investors will move to safety and/or high yield at one extreme and speculative growth at the other? A. Chuck: It s definitely a risk we saw some of that in the first half with the recoveries for biotechnology, banks, and REITS following the February low and the Brexit vote. There are three factors, however, that we believe work against this: First, we also saw strength in the second quarter from Industrials, Materials, and Energy all of which were laggards in 2015 as well as from less speculative industries within Health Care and Information Technology. These and other areas are all giving small-cap value its post-bottom lift. Second, credit spreads remain wider than they were a year ago at this time, even with the 10-year Treasury rate falling again, so the cost of capital remains higher, which should help profitable, lower leverage businesses. Finally, there is reversion to the mean 5 the middle of 2015 marked a two standard deviation 6 event in terms of a performance edge for the Russell 2000 Growth. 5 Mean reversion is a theory suggesting that prices and returns eventually move back towards the mean or average. 6 Standard deviation is a statistic used as a measure of the dispersion or variation in a distribution, or dataset, from its mean, or average; it measures the volatility of an investment s return over a particular time period; the greater the number, the greater the volatility. 4

5 Q. The headlines are once again focusing on uncertainty and the possibility of recession, yet equity returns have been climbing since the mid-february lows. What are you hearing from the companies you re meeting with? Is the outlook as fatalistic as the news would suggest? A. Francis: I would say that while the headlines have been fatalistic, even panicky at times, the management teams we re talking to are more cautious and uncertain than pessimistic. To be sure, they re well aware of how fragile things are economic growth is slow, the global situation remains anxiously unsettled, and our upcoming election looks like another polarizing one. However, we re also hearing some measured optimism in terms of growth picking up, however gradually or in fits and starts. One important insight we ve gained is how supply and demand seem to be coming closer to balancing in industries as diverse as steel, in-land barges, onshore oil services, and irrigation equipment. Moreover, global commodity prices have been stabilizing, led by oil. M&A (merger & acquisition) 7 activity has been picking up, which we re seeing from both the acquirer and acquiree side as small- and mid-cap investors. And it s a positive sign that, when many deals have been announced, both companies are seeing an increase in their share prices. Q. Even with the limited remaining monetary policy options remaining to them, the developed world s central banks were making accommodative comments in the wake of Brexit. Do you see this as a problem for stocks and the economy? A. Chuck: In the long run, I d say, no because we are on the road toward a more historically typical environment in which interest rates are more a function of free trading set by markets rather than by central bank fiats. However, with the added uncertainty that Brexit created and we were already facing considerable uncertainty in terms of global growth there is the risk that central bankers will forestall the inevitable and put off subsequent rate increases, which I think would be a mistake. The worst part of the Federal Reserve s 9 decision not to raise rates earlier in June was its interruption of a gradual and long-delayed normalization process for rates, which in turn is helping the equity markets and economy to also normalize. At this stage, fiscal stimulus in the form infrastructure spending strikes me as the sounder path, at least for the U.S. and maybe for the U.K. as well. If the dollar weakens again, that should help many industrial and manufacturing companies while more infrastructure spending would also provide a big boost. In addition, there was evidence into mid-june, admittedly anecdotal, of Capex 8 ticking up, which is long overdue. So it s not a rosy picture by any stretch, but it s far from the more excitable tone of recent headlines. 7 Mergers and acquisitions (M&A) is a general term used to refer to the consolidation of companies. A merger is a combination of two companies to form a new company, while an acquisition is the purchase of one company by another in which no new company is formed. 8 Capital expenditures (Capex), also called capital spending, is an amount spent by a company to acquire or upgrade productive assets (such as buildings, machinery and equipment, vehicles) in order to increase the capacity or efficiency of a company for more than one accounting period. 9 The Federal Reserve Board ( Fed ) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments. 5

6 Investment risks Investments in small-cap and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies. This risk could be greater in emerging markets. U.S. Treasuries are direct debt obligations issued and backed by the full faith and credit of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities. High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues. Real Estate Investment Trusts (REITs) invest in real estate or loans secured by real estate and issue shares in such investments, which can be illiquid. Outperformance does not imply positive results. 6

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