Capital Markets: Observations and Insights Earnings Resurgence Spring 2017

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1 Capital Markets: Observations and Insights Earnings Resurgence Spring 2017

2 Key Observations After diverging in 2016, fundamentals once again drove performance in 1Q17 There is a resurgence in earnings growth after a couple of years of weakness Leading indicators suggest that economic and corporate profits will continue to expand Some areas of the equity market are attractively valued, particularly relative to fixed income and real estate Table of Contents Performance Fundamentals Valuation Pages 3-11 Pages Pages Page 2

3 Performance Strong Fundamental Data Drove Performance 1Q17 Performance Equities Outperformed Bonds Large Caps Outperformed Small Caps Growth Beat Value 6.1% 6.0% 8.6% 2.5% 3.0% 0.8% S&P 500 Barclays Agg. Bond Russell 1000 Russell 2000 Russell 3000 Growth Russell 3000 Value Source: FactSet as of 3/31/2017. Page 3

4 Technology Consumer Discretionary Health Care Utilities Consumer Staples Materials Industrials Real Estate Financials Telecom Energy Energy Telecom Financials Industrials Materials Utilities Technology Consumer Discretionary Consumer Staples Health Care Performance Growth Sectors Led in 1Q17 As investors refocused on growth and current fundamentals, growth sectors such as Technology, Health Care, and Consumer Discretionary outperformed Growth Sectors 1Q17 Returns (%) U.S. World Returns (%) U.S. World Source: FactSet as of 3/31/2017. U.S. represented by S&P 500 and World is represented by MSCI All Country World Index. Page 4

5 Technology Consumer Disc Health Care Utilities Consumer Staples S&P 500 Materials Industrials Real Estate Financials Telecom Energy S&P 500 Sector Returns (%) Performance Earnings Drove Sector Performance in 1Q17 In contrast to much of last year, sectors with strong earnings performance in 1Q17 had the best stock performance (i.e. Technology, Consumer Discretionary, and Health Care) In the same way, sectors with poor earnings relative to expectations underperformed (i.e. Telecom and Energy) Leading Price & EPS Performance % Companies Beating Estimates Lagging Price & EPS Performance Source: FactSet as of 3/31/2017. Companies beating estimates based on Q416 earnings results relative to consensus, reported during 1Q17. Page 5

6 Market Cap Earnings Variability Earnings / Price EPS Growth Price Volatility Trading Activity Debt / Equity Dividend Yield Revenue / Price Book / Price Relative Strength Dividend Yield Earnings / Price Book / Price Trading Activity Revenue / Price Debt / Equity Earnings Variability Price Volatility Market Cap EPS Growth Relative Strength Performance The First Shall be Last Stocks with strong relative strength (strong performers in 2016) underperformed the most in 1Q17 The trough in interest rates in 2016 helped drive the search for dividend yield amid the rotation to bond-like equities 1Q17 Excess Return (%) 2016 Excess Return (%) Source: FactSet as of 3/31/17 using Northfield defined quantitative factors for the Northfield broad U.S. market database. Page 6

7 Performance The Earnings Growth Resurgence is Boosting Performance Total Return = Dividend Yield + EPS Growth +/- P/E Change S&P 500 MSCI All Country World Index ex-usa 25% Dividend EPS Growth P/E Change 40% Dividend EPS Growth P/E Change 20% 30% 15% 10% 5% 0% -5% -10% EPS Growth Reversal 20% 10% 0% -10% -20% EPS Growth Reversal -15% Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17-30% Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar Month Total Return: 16% 9% 14% 22% 13% 2% 17% 12- Month Total Return: 6% -4% 14% 13% 16% -10% 18% Source: FactSet as of 3/31/17. Based on consensus estimates of next 12-month EPS. Actual earnings per share might be materially different than shown. MSCI ACWI ex-us performance based on local currency. Page 7

8 Aug-56 Dec-61 Feb-66 Nov-68 Jan-73 Nov-80 Aug-87 Jul-90 Mar-00 Oct-07 Median Current Performance Missing: Exuberance that Typically Accompanies End of Bull Run The voyage of a bull market begins in despair, sails forward in anxiety, catches the winds of enthusiasm, and finally hits the rocks of exuberance Over the past 60 years, equity markets typically have had very large increases preceding their peaks 2-Yr Returns Preceding S&P 500 Peaks 93% 74% 32% 30% 44% 39% 65% 45% 42% 36% 43% 19% Typical exuberance of a market peak is not currently present Source: BofA ML U.S. Equity & Quant Strategy and FactSet. Page 8

9 Duration of Bull Market (Years) Performance Waiting on the Sidelines Can Be Costly Bull markets have been getting longer over time The current bull market is four years younger than the 1990s bull market Those last four years produced >150% total return; even through the trough of the following correction, equities generated a high-single digit annual return s Bull Market Duration of bull markets growing over time 10 8 Current Bull Market (ongoing) Year that Bull Market Ended Source: FactSet and Goldman Sachs. Bull markets over 6-months in duration since Page 9

10 % of Fund Assets Outperforming 5-Yr Performance Has Active Relative Performance Troughed? While there are secular pressures affecting active management, cyclical factors tend to be much more powerful in the short- and medium-term We believe the trough in cyclical active performance may be behind us as small caps, the largest of several factors that drive active relative performance, are likely to perform better in the future (see pg.18) 100% Active Relative Performance is Cyclical 40% 80% 60% 40% 20% 30% 20% 10% 0% -10% Small Cap Relative Outperformance 5-Yr 0% -20% Source: Nomura/Instinet Quantitative Investment Strategy and FactSet through 12/31/16. Fund performance is trailing 5-year data and Small Cap Outperformance is Ibbotson US Small Stock Premium 5-year rolling return. Page 10

11 1 month 1 quarter 6 months 1 year 3 years 5 years 10 years 20 years Performance Put Probability on Your Side The probability of positive returns increases over time Valuations, such as P/Es, can vary widely over short periods of time, driving volatility In the long-run P/Es are mean-reverting, allowing earnings growth, which is typically positive over long periods of time, to drive stock prices higher Historical Probability of Positive Returns Based on Holding Period 62% 70% 72% 80% 85% 89% 95% 100% Longer holding periods typically increase probability of positive returns Source: FactSet and Alger calculations using S&P 500 monthly total return data from January 1970 March Page 11

12 S&P 500 Price (Log Scale) Fundamentals The Stock Market Engine Runs on Earnings Growth In the short run, the market is a voting machine, but in the long run, it is a weighing machine. Ben Graham EPS growth has averaged approximately 6% annually over the past 50 years 10,000 1, $1,000 $100 $10 $1 S&P 500 EPS (Log Scale) In the short term, sentiment/valuation drives returns; in the long term, stock prices grow exponentially with earnings $ Source: FactSet, S&P, Robert Shiller. Data through March 31, Page 12

13 Leading Economic Index Fundamentals Leading Indicators Suggest Earnings Will Continue to Rise The Conference Board Leading Economic Index (LEI) typically leads earnings by 6-18 months and usually peaks one to two years prior to a recession Given that the LEI is increasing solidly year-over-year and hit a record high in 1Q17, we believe the economy and earnings have room to run 130 $ Month Lead $125 $100 S&P 500 EPS Leading Economic Index indicates further EPS growth 100 $75 90 $50 Source: FactSet, Conference Board. Page 13

14 Fundamentals Leading Cycle Indicators Are Not Flashing Red Every major recession in the past 75 years has been preceded by substantial Fed Funds rate tightening or inflation acceleration, or both On average, the U.S. has not entered a recession until about three years after material Fed tightening, which we believe is beginning this year Recession Fed Funds Effective Rate Inflation Today, short-term interest rates and inflation are less than 1% and 2% respectively Source: FactSet as of 3/31/17. Inflation represented by PCE Price Index ex-food and energy (year over year). Page 14

15 Fundamentals Economic Outlook Tailwinds Strong consumer balance sheet Rising real disposable income Improving consumer and business confidence Fiscal stimulus Headwinds Tightening monetary policy (U.S. and China) Political risk Rising U.S. dollar Increasing energy prices Page 15

16 Fundamentals Fiscal Policy Could Boost Earnings Materially A 10 percentage point decline in the corporate tax rate would likely boost S&P 500 EPS by about 8% Business spending would likely benefit more than consumer spending given lower corporate tax rates increase in enterprise cash flow higher business spending The Tax Foundation s analysis of the Trump plan suggests that wages should increase 5% but capital stock (i.e. business spending) would be 20% higher! Impact of Trump Plan Relative to Baseline (Over a Decade) 20% Business spending to outpace consumer spending 5% Consumer Business Source: Tax Foundation and Cornerstone Macro. Consumer is higher wages and Business is capital stock. Page 16

17 Fundamentals Margins Set to Drive Earnings Higher Corporate operating margins have been range-bound After being decimated by the Financial Crisis, they are still being dragged down by Financials and Energy Ex-Financials and Energy, however, margins have been in a secular uptrend As the other two sectors recover and the secular trend continues, overall margins could hit new highs, driving earnings to new records Margins have not been able to Breakout Masking Strong Underlying Progress 12% 11% 10% 9% 8% 7% 6% Operating Margin S&P % 11% 10% 9% 8% 7% 6% Operating Margin S&P 500 ex-financials & Energy 5% 5% Source: BofA using current S&P 500 constituents through 12/31/16. Page 17

18 Fundamentals Smaller Capitalization Stocks Poised to Outperform Smaller capitalization tailwinds More levered to fiscal stimulus: Small caps are more U.S. oriented and have higher operating leverage Rising interest rates: Small caps have historically outperformed large caps in rising rate environments and vice versa in falling rate environments Attractive valuation: Small cap sales multiple discount implies opportunity Stronger fundamentals: Estimated EPS growth for 2017 approximately double that of large cap 0% -5% -10% -15% -20% -25% -30% Enterprise Value / Sales Russell 2000 / Russell 1000 Historically Large Discount Earnings Per Share Russell 2000 Russell 1000 Small Caps Growing Faster -35% % 80 Source: FactSet as of March EPS for are consensus estimates and actual earnings per share might be materially different than shown. Page 18

19 EPS Growth Fundamentals Innovative Companies Grow Earnings and Stock Prices Faster Innovation propels economic growth over time Studies have shown, and our research demonstrates, that the most innovative companies grow their sales and stock prices faster* Innovation Drives: 10% EPS Growth and Stock Prices 400 Most Innovative Least Innovative 6% Most Innovative Least Innovative 2006 Classification - Source: FactSet. Most/least innovative based on R&D % of sales. Actual EPS growth measured after classification of S&P 1500 companies into innovation quintiles in Dec- 06. Most/least innovative stock performance based on S&P 1500 quintiles one month returns. * Baruch Lev and Suresh Radhakrishnan, The Stock Market Valuation of R&D Leaders. Page 19

20 Fundamentals The Growth Advantage Three variables drive P/E multiples: growth, returns, and risk As compared to the Russell 1000 Value, the Russell 1000 Growth has higher expected EPS growth, higher returns on equity, and lower risk in the form of better balance sheets Stronger Growth Higher Returns Lower Risk Russell 1000 Growth Russell 1000 Value Russell 1000 Growth Russell 1000 Value Russell 1000 Growth Russell 1000 Value 13.7% 26.8% 1.9x 9.4% 11.6% 0.8x Long-Term EPS Growth Return on Equity Net Debt / EBITDA Source: FactSet as of March Growth represent consensus long-term analyst estimates, and actual future EPS growth rates might be materially different than the forecasts shown Page 20

21 S&P Year Annualized Return Barclays U.S. Aggregate Bond Index Annualized Return Valuation The Single Greatest Predictor of Future Stock Market Returns There is a strong relationship between starting valuation and ensuing 10-year returns for both stocks and bonds Current valuations suggest equities should materially outperform bonds over the coming decade (mid-to-high single-digit vs. low-single digit annualized returns) S&P 500 P/E vs. 10-Year Returns = month = current BAA Bond Yield vs. U.S. Aggregate Bond Returns 25% 20% R² = % 10% R² = % 8% 10% 6% 5% 4% 0% 2% -5% S&P 500 Price/Earnings 0% 4% 5% 6% 7% 8% 9% 10% 11% 12% Moody s BAA Corporate Bond Yield Source: FactSet, monthly data since Page 21

22 Valuation The Great Rotation Moving from monetary stimulus and quantitative easing to fiscal stimulus and increased deficits should drive a Great Rotation from bonds to stocks The magnitude of the rotation will be fueled by the valuation disparity as equities are inexpensive relative to bonds The earnings yield for equities is more than 300 bps greater than 10-year Treasury notes vs. a 50 bps median over the past half century Yield Over Past 50+ Years 16 S&P 500 EPS Yield Treasury Bond Yield Stocks are attractively valued relative to bonds >300 bps 0 Source: FactSet, Federal Reserve, S&P as of 3/31/17. Page 22

23 Valuation Stocks Compelling Relative to Real Estate In addition to bonds, other asset classes that provide income streams to investors have become expensive as interest rates have declined over the past couple of decades Real estate valuations are now very high, as illustrated by implied capitalization rates reaching their lowest levels in over 20 years Real estate used to yield more than stocks and now yields much less 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Real Estate Yields More Stocks Yield More Stocks are attractively valued relative to real estate S&P 500 EPS Yield Real Estate Implied Capitalization Rate Source: FactSet, NCREIF and Alger estimates. Real estate cap rate index is based on trailing 4-quarter Net Operating Income / appraised value and then weighted by value for U.S. apartments, industrial, office and retail properties. EPS yield based on NTM consensus estimates. Page 23

24 Utilities Materials Cons Staples Industrials Real Estate Financials Cons Disc Technology Health Care P/E Relative to 20-Year Median Valuation Not All Sectors are Expensive Bond-like equities such as Utilities remain expensive due to the search for yield while some cyclicals have become more expensive in the wake of the U.S. presidential election Growth sectors are reasonably valued relative to other sectors and compared to history, particularly given low levels of interest rates 20% 18% 16% Reasonably Valued Growth Sectors 8% 5% 4% 3% -6% -10% Source: FactSet, based on S&P 500 Index, 3/31/17. Note: energy and telecom are excluded; the former because of an extremely high P/E due to depressed earnings and the latter owing to a small number of constituents. Real estate is a new sector classification, so for the historical data shown above, an industry group category that has approximately 15 years of data was utilized. Page 24

25 Valuation Growth Valuations Are Compelling The search for yield, and more recently optimism for economically sensitive Value stocks, has driven Growth stocks to attractive relative valuations Russell 1000 Growth vs. Russell 1000 Value P/E Russell 1000 Growth vs. Russell 1000 Value PEG Ratio (P/E Divided by Long-Term Growth Rate) 1.7x 21% premium is low relative to history 1.4x Russell 1000 Value Russell 1000 Growth Source: FactSet, Bank of America as of 3/31/2017. Page 25

26 P/E Valuation Addressing Interest Rate Risks It s Too Soon to Worry Potential Risk: higher bond yields lower equity valuations? Potential Solution: favor equities over bonds given that increasing interest rates have supported higher P/E multiples at low absolute levels S&P 500 NTM P/E vs. 10-Yr Treasury Note Yield Higher Rates Rising P/E Higher Rates Falling P/E = Year Year Yield Source: FactSet as of 3/31/17. Page 26

27 Valuation Total Yield Compelling Dividends + Share Repurchases = Total Yield Equity Total Yield is attractive relative to corporate bonds 2% S&P 500 Total Yield vs. Corporate Bond Yield S&P 500 Dividend Yield S&P 500 Buyback Yield 1% 8% 7% 6% 5% Total Yield Total Yield 4.8% 0% -1% -2% Average Wide Spread Relative to History 4% Share Repo. 2.9% 3% 2% Dividends 1.9% 1% 0% -3% -4% -5% -6% -7% Source: FactSet and Alger estimates as of 3/31/17. Corporate Bond Yield is Moody's Baa Corporate Bond Yield. Page 27

28 Valuation Prospective Returns Appear to Favor Growth Growth sectors have significant return potential relative to value and bond-like sectors Framework for Estimating S&P 500 Sector Returns Value or Bond-Like Sectors EPS Growth (3-5 year consensus, reduced by 20%) + + = Dividend Yield (last 12 months) P/E Change (reversion to 20-year median P/E) Five-Year Return (hypothetical) Utilities 4% 3% -4% Underperformance? Consumer Staples 7% 3% -3% Underperformance? Materials 9% 2% -3% Underperformance? Growth Sectors Health Care 8% 2% 2% Outperformance? Consumer Discretionary 15% 1% -1% Outperformance? Technology 11% 1% 1% Outperformance? Source: FactSet as of 3/31/17. Table contains annualized S&P 500 GICS sector data. Figures for the EPS Growth represent consensus long-term analyst estimates, and actual future EPS Growth rates might be materially different than the forecasts shown. P/E assumes reversion to 20-year historic norm, and actual future P/E change may be materially different than the forecasts shown. Page 28

29 Disclosure The views expressed are the views of Fred Alger Management, Inc. as of March Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Fred Alger Management, Inc. These views should not be considered a recommendation to purchase or sell securities. Individual securities or industries/sectors mentioned, if any, should be considered in the context of an overall portfolio and therefore reference to them should not be construed as a recommendation or offer to purchase or sell securities. References to or implications regarding the performance of an individual security or group of securities are not intended as an indication of the characteristics or performance of any specific sector, industry, security, group of securities, or a portfolio and are for illustrative purposes only. Risk Disclosures: Investing in the stock market involves gains and losses and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as the prices of growth stocks tend to be higher in relation to their companies earnings and may be more sensitive to market, political and economic developments. The S&P 500 Index is an unmanaged index generally representative of the U.S. stock market without regard to company size. The Russell 1000 Growth Index is an unmanaged index designed to measure the performance of the largest 1000 companies in the Russell 3000 Index with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth Index is an unmanaged index generally representative of common stocks designed to track performance of small-capitalization companies with greater than average growth orientation. The Russell 2000 Value Index is an unmanaged index generally representative of the small-cap value segment of the U.S. equity universe and measures the performance of Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 3000 Growth Index is an unmanaged index designed to measure the performance of those Russell 3000 Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index is an unmanaged index generally representative of stocks from the Russell 3000 Index with lower price-to-book ratios and lower expected growth rates. The MSCI ACWI Index (gross) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices. The indices presented are provided for illustrative purposes, reflect the reinvestment of dividends and do not assess fees and expenses that would have the effect of reducing returns. Investors cannot invest directly in any index. The index performance does not represent the returns of any portfolio advised by Fred Alger Management, Inc. and actual client results might differ materially than the indices shown. Note that past performance is no guarantee of future results. Comparison to a different index might have materially different results than those shown. Frank Russell Company ( Russell ) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell s express written consent. Russell does not promote, sponsor or endorse the content of this communication. ALCAPPRESSPR-0417 Fred Alger Management, Inc. 360 Park Avenue South, New York, NY Page 29