Growth and Small-Cap Segments Perform Well Over Time

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1 Growth Investing Don t Panic! Think longer term.. Dennis Wassung, Jr., CFA Cabot Wealth Management, Inc. October 2014 After a stellar 2013 for growth and smaller-cap segments of the U.S. equity markets, 2014 has so far proven to be a more volatile ride. In recent months, the volatility of these areas of the markets has increased amid macroeconomic uncertainties, potential Federal Reserve actions, and geopolitical uncertainties in places like Russia, Ukraine, and the Middle East along with fears of a broader Ebola outbreak. While the broad, larger-cap equity indexes have remained resilient notwithstanding the recent pullback many growth and small-cap stocks have come under periods of significant pressure in It is important to note that this is normal as investor sentiment ebbs and flows between multiple parts of the global markets. Looking beyond the short-term variability, we continue to believe that growth equity investing and investing in leading companies in strong secular growth themes is a profitable strategy over the longer term. Growth and Small-Cap Segments Perform Well Over Time To illustrate this point with charts and data, I assembled some 10-year comparisons of various segments of the equity markets. Importantly, it is normal to see variance between large caps and small caps, and between growth and value indexes and the variance changes over time. Russell 3000 Growth Index vs. Russell 3000 Value Index: The Russell 3000 index includes large-, mid- and small-cap U.S. stocks although is weighted toward larger cap. This chart shows that in different time periods over the last 10 years, the growth index underperformed the value index, and outperformed in other periods. However, for the longer 10-year period ending September 30, the Russell 3000 Growth index outperformed by about 24 percentage points at 132%. C a b o t W e a l t h M a n a g e m e n t, I n c. P a g e 1 5

2 Russell 2000 (Small Cap) Index vs. S&P 500 (Large Cap) Index: This chart compares small-cap stocks to largecap stocks in the U.S. equity market. Over the last 10 years, once again there have been periods where small cap underperformed large cap, although overall, the small-cap index maintained a lead over the large-cap S&P 500 nearly the entire 10 years albeit with more volatility. (Namely, the white line stayed above the orange line in the chart.) However, with recent small-cap volatility this year, the current 10-year performance is identical. Russell 2000 Growth (Small-Cap Growth) Index vs. Russell 1000 Value (Large Cap Value) Index: This chart combines the Large vs Small and Growth vs Value comparison looking at how Small-cap Growth (typically more aggressive stocks) performed relative to Largecap Value (typically more conservative stocks) over the last 10 years. While Small-cap Growth lagged Large-cap Value in a few periods, there were multiple periods of substantial outperformance, and Small-cap Growth outperformed by about 22 percentage points (131% total return) for the 10-year period. C a b o t W e a l t h M a n a g e m e n t, I n c. P a g e 2 5

3 Recent Small-cap Growth Volatility: Russell 2000 Growth (Small-cap Growth) Index vs. Russell 1000 Value (Large-cap Value) Index Over the Last 12 Months: To illustrate the increased volatility in 2014, this is a shorter-term one-year chart of the same Small-cap Growth vs Large-cap Value comparison. Through the latter part of 2013 and early 2014 (left half of the chart), Small-cap Growth was roughly matching the Large-cap Value index. However, since March, Small-cap Growth has underperformed and has been more volatile (both up and down), while Large-cap Value has more steadily moved higher through most of Over the last year (through October 21), Large-cap Value has outperformed Small-cap Growth by about 11.5 percentage points (12% vs ~1%) a sizable and notable variance. The larger question is whether this recent Small-cap Growth underperformance is a normal short-term variance and thus a buying opportunity or will it lead to a longer period of underperformance. Thematic Investment Approach Beyond targeting Small cap or Growth or Large cap or Value or Foreign or Domestic markets, we tend to take a thematic investment approach. While carefully studying the big picture issues (such as global market dynamics, macroeconomics, geopolitical risks, market fundamentals and valuation, Fed policy, etc.) and acting accordingly, in our growth equity strategies we focus on finding investment opportunities with strong secular growth themes. Volatility in the various segments of the equity markets perhaps what we have seen so far in 2014 often results in buying opportunities, and we continue to believe investing in growth stocks can drive strong, long-term performance, warranting an allocation in our clients portfolios. Several thematic areas where we see significant growth opportunity lie within Technology, Health Care, and Clean Technology. To illustrate how these smaller slices of the markets can perform relative to the broader indexes, I included twoyear charts comparing how relevant theme-based ETFs (exchange traded funds) have performed relative to the same Smallcap Growth and Large-cap Value indexes explored above. C a b o t W e a l t h M a n a g e m e n t, I n c. P a g e 3 5

4 1. Technology Cloud Computing, Cyber Security and Big Data: Technology always offers areas of innovation and growth, and the proliferation of the Internet has opened a new set of opportunities. Companies that deliver their software in the cloud (a.k.a. through the Internet) are seeing strong demand. Security of these applications, and all of the data generated through a range of mobile devices and the cloud, has become ever more critical. Dealing with, securing, analyzing, and leveraging the massive amounts of data being generated today ( Big Data ) is critical. This chart compares the First Trust Cloud Computing Index Fund (ticker: SKYY) to the same Small-cap Growth and Large-cap Value indexes illustrated in the prior section. Over the last two years, SKYY has performed in-line with the indexes although has outperformed in certain periods. 2. Health Care Biotechnology, Genomics and Medical Devices: Advances in biotechnology and medical devices can offer strong growth opportunity. Today, a wave of important new drugs are making their way to the market, fighting rare diseases as well as epidemic diseases like Hepatitis C and cancer. New devices helping to fight diabetes and major advancements in the world of gene sequencing and customized medicine (Genomics) are all important focus areas of the medical community. This chart compares the PowerShares Dynamic Biotechnology & Genome Portfolio (ticker: PBE) to the same Small-cap Growth and Largecap Value indexes. Over the last two years, PBE has sizably outperformed both indexes returning ~105% versus about 42% for both Small-cap Growth and Large-cap Value, respectively. C a b o t W e a l t h M a n a g e m e n t, I n c. P a g e 4 5

5 3. Clean Technology Solar Energy, LEDs and Electric Vehicles: After a rough few years for stocks in the Clean Tech area, a resurgence is underway driven by increasing market adoption of new technology. Solar energy continues to grow in the U.S. and globally, LED lighting is seeing rapid adoption in residential and commercial applications, and electric vehicles are getting more attention than ever. This chart compares the Market Vectors Global Alternative Energy ETF (ticker: GEX) to the same Small-cap Growth and Large-cap Value indexes. Over the last year, GEX also has significantly outperformed both indexes doubling their performance with ~85% return for the last two years even when accounting for the recent market pullback. Conclusion What is clear from looking at various parts of the equity markets and various time periods is that the markets are always dynamic, and different market segments go in and out of favor. While investing in smaller-cap and growth-oriented stocks can offer higher volatility in certain periods of time, the risk of higher volatility can be rewarded with higher returns in the longer term. A higher risk tolerance helps to weather such volatility, but we believe growth investing deserves a place in our clients asset allocation. Periods of shorter-term volatility often can result in attractive buying opportunities in our favored areas of the market. The themes we illustrate above are examples of growth areas in which we have significant interest and that have delivered strong returns and offer the potential to remain interesting growth opportunities going forward. We are always on the lookout for important secular growth themes and those innovative companies leading the way that have the potential to become excellent investment opportunities for our clients. Our advice during normal periods of volatility.don t Panic! Think longer term. Note: Source for all charts used herein is Bloomberg Any advice or suggestions are provided for informational purposes only and is not a solicitation to purchase any investments or services described herein. Please consult your advisor to determine if an investment strategy is appropriate for you. Past performance of either the domestic or international markets or any specific investments is not predictive of future results nor will diversification alone protect from loss. For more information about our investment management and wealth management services, visit: Essex Street, Salem, MA Franklin Street, Boston, MA (by appointment only) MGMT contact: info@ecabot.com C a b o t W e a l t h M a n a g e m e n t, I n c. P a g e 5 5