U.S. Equities AGING GRACEFULLY THE U.S. BULL MARKET HAS FURTHER TO RUN

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1 PRICE POINT December 2016 Timely intelligence and analysis for our clients. U.S. Equities AGING GRACEFULLY THE U.S. BULL MARKET HAS FURTHER TO RUN KEY POINTS Larry Puglia Portfolio Manager, US Large-Cap Core Growth Equity Strategy Global equity markets have shown a fair degree of volatility in 2016, initially impacted by fears of weakening global growth and tumbling commodity prices, and more recently unsettled by the surprise outcomes of the UK Brexit decision and Donald Trump s election to the White House. Despite this environment, the performance of the U.S. stock market has proved resilient, shaking off periods of uncertainty and continuing on the path that has seen all-time high levels tested during the year. However, growth stocks have lagged in 2016, underperforming both their value counterparts and the S&P 500 Index generally. 1 With this in mind, we recently spoke to Larry Puglia, portfolio manager of the T. Rowe Price US Large-Cap Core Growth Strategy, about his expectations for U.S. equities going forward. We have seen some rotation out of U.S. equities in 2016, with investors reallocating toward cheaper markets. Given that U.S. equity indices are trading close to all-time highs, can a valuation case still be made for maintaining U.S. exposure? Yes, absolutely. While the return potential may be more limited going forward, the fact remains that stock valuations in the U.S. are still relatively attractive. This is particularly evident when compared with the low returns available from government bonds. The spread between the earnings yield on stocks and the 10-year Treasury yield is attractive compared with any time in history. The free cash flow yield of many companies is in the region of 10%, substantially above the roughly 2% yields currently available from 10-year Treasuries. This metric alone seems to imply ongoing value in U.S. equities. 1 Sources: MSCI and FactSet, as of October 31, MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. FOR INVESTMENT PROFESSIONALS ONLY. NOT FOR FURTHER DISTRIBUTION.

2 In comparison with other major developed equity markets, the U.S. is currently trading at more expensive levels. Indeed, many commentators seem to be fixated on the fact that U.S. indices are trading near historic highs. However, for years, industry experts have been warning about grossly overvalued U.S. equities while watching markets rally to new highs from the sidelines. So it is important to consider relative market valuations in a broader context. Simply looking at the market level or the multiple it is trading at does not give a complete picture of the potential risks and rewards that exist. The European market, for example, is indeed trading at a cheaper level than the U.S., but that does not necessarily mean that it is a better value. It is cheap for a reason growth is still weak, stimulus measures are, as yet, having limited effect, interest rates are negative, and the region is vulnerable to political instability. In comparison, although Donald Trump s election as president adds an element of uncertainty, the U.S. economy is gathering momentum, growth is superior to other major economies, and corporate earnings growth is expected to improve in On this basis, it makes sense that the U.S. is trading at a higher valuation than Europe as the return potential appears greater. So the fact that the U.S. market is trading near all-time highs is almost irrelevant; the more critical question is: Is it under- or overvalued? And as I suggested earlier, U.S. large-cap stocks are currently trading at relatively reasonable valuations, with the price-to-earnings (P/E) ratio on the S&P 500 Index still slightly below the long-term average (Figure 1). Figure 1: U.S. equity market valuations are far from stretched S&P 500 Index Price-to-12-Month Forward Earnings As of September 30, Price/Earnings Ratio Long-Term Average P/E 17.2x Current P/E 16.8x Sources: FactSet. S&P 500 Index as of September 30, The active versus passive debate continues to rage, fueled most recently by headlines suggesting widespread underperformance by active investment strategies. Given the increasing flow of assets being allocated to passive strategies, as an active manager, how do you make your case to clients? The acceleration of passive investing and the proliferation of exchange-traded funds have been one of the most significant changes to the financial market landscape over the past 20 years. However, while we recognize the appeal of passive investing, we also believe that there are inherent limitations in this kind of approach. Passive strategies assume a high level of market efficiency that we simply do not believe exists. A review of any 52-week range of U.S. stock market performance shows regular periods of dislocation occurring in various areas. Index strategies also reinforce momentum, with an increasing flow of money being allocated to those areas that have done well and to individual stocks with large index weightings. This inevitably creates inefficiency over time and, ultimately, to dislocation; and it is during these periods that passive strategies tend to provide suboptimal results. PRICE POINT 2 2 2

3 A good example of the extreme outcomes that passive strategies can lead to is during the tech sector bubble that developed in the late 1990s/early In the buildup to the eventual peak of the bubble in early 2000, investors poured into technology-focused passive strategies, grossly inflating sector and stock valuations. A lot of our growth-oriented peers also became very concentrated, partially in response to the rising technology sector weighting within most growth indexes. As an active, growth-oriented manager, we avoided blindly following the index. We simply could not find enough technology companies that met our quality and growth criteria. This was a headwind in the lead-up to the peak of the bubble; however, we subsequently benefited greatly, avoiding much of the fallout when the tech bubble collapsed in In this way, we have been able to deliver value for our clients by actively avoiding pockets of the market we find unattractive. We have also benefited from being able to be opportunistic and build positions in select undervalued companies during the aftermath of such breakdowns. Some of the companies that we bought, or added to, in the post-tech bubble period we still hold today, and many of these have delivered exceptional compounded performance. The first half of 2016 was not an easy time to be a growth investor. In this kind of environment, where a particular style is out of favor, do you look to adapt your process in any way, or is it simply a matter of battening down the hatches until things improve? There are a number of points to make here. As you say, the first half of 2016 was a difficult environment for growth investors. Growth stocks have outperformed their value counterparts in recent years; however, this trend reversed in 2016 as investor sentiment shifted toward stocks that had been left behind, offering attractive valuations but also high dividend yields. Much has been written about investors desperate search for yield in the low interest rate environment we ve been in, and this preference for defensive yield stocks was certainly a headwind for us during the first half of From a personal perspective, our US Large-Cap Core Growth Equity Strategy had a difficult start to the year. Leadership from defensive, yield-oriented stocks drove part of this, as did some disappointing performance from specific portfolio holdings, notably in health care. The very strong portfolio performance recorded in 2015 also meant we were vulnerable to some pullback at the beginning of the year. This said, however, in the four months since the end of June 2016, we have seen a material improvement in performance as sentiment seems to have shifted again and quality growth stocks have started to come back into focus, benefiting our strategy. Our commitment to our clients is to create value over a longer-term time horizon. To this end, we invest in highquality growth companies that have the potential to perform throughout the market cycle and in a range of conditions. When we do experience periods of short-term underperformance, we generally do not react by dramatically changing our strategy. We intentionally avoid building a portfolio that will only do well in certain types of markets. Rather, we focus on constructing balanced portfolios, with a chance of delivering strong returns in a variety of market environments, so that we can deliver long-term value for investors. Also, far from battening down the hatches, periods when growth stocks are out of favor, or when markets are volatile in general, often provide great opportunities to buy quality companies at potentially very attractive prices. The volatile environment we have seen so far in 2016 serves as a reminder not to become too focused on shortterm performance. Active investing is inherently long term in nature as it relies on a combination of vision, skill, and discipline to successfully compound returns. This last point is important given our record of identifying stock opportunities at an early stage and following these companies over the course of their life cycle, and their progression from small- to mid- to large-cap enterprises. Of course, it is easy to talk about creating long-term value for investors, but it is much harder to prove that you are delivering on that promise. As such, it is worth highlighting a recent study focusing specifically on the performance T. Rowe Price s range of active U.S. equity strategies. Encompassing 19 diversified U.S. equity strategies, and spanning a 20-year performance time frame, the results clearly demonstrate that T. Rowe Price has delivered value to clients over the long term. Over the 20-year period in focus, 100% of T. Rowe Price s U.S. equity PRICE POINT 3 3 3

4 strategies generated positive excess returns, net of fees, over rolling 5- and 10-year periods. Indeed, the longer the time horizon, the greater the value that was created for our clients. 2 Morningstar 3 has highlighted that the average tenure of a portfolio manager today is less than five years. Given your own 20+ years managing the US Large-Cap Core Growth Equity Strategy do you see any issues arising from such a high rate of management turnover? Anecdotally, there seems to be some evidence that funds with consistent, long-term management structures have been able to outperform their peers over time. It is also noteworthy that Warren Buffett, for example, has suggested it is only when someone has notched up a 10-year track record that you can reasonably begin to ascribe their performance to some aspect of process or skill. However, I can only really speak from personal experience and of working at T. Rowe Price, where continuity and consistency of investment process are highly valued. While my own management record stands in contrast to the four-and-a-half-year industry average, it is not particularly unique within T. Rowe Price, where the average tenure of portfolio managers is 17 years. Outside the performance aspect, I think manager tenure is very important in terms of providing investors with a level of confidence. For many, experience implies knowledge and skill acquired over time. Personally, I firmly believe the experience of managing assets over a long period of time, in both favorable and unfavorable environments, has been advantageous to overall portfolio returns. The themes of experience and expertise underpin T. Rowe Price s entire investment proposition. This applies not just at the portfolio manager level, but also in the depth of expertise in our research department, with some 140 equity analysts, each one a specialist in their field. The dynamic, collaborative environment that exists between portfolio managers and analysts provides a rich source of new ideas and alpha-generating opportunities for our clients. Finally, having experienced all manner of market twists and turns over the past 20 years, what are some of the most significant developments or trends in markets that you have seen and have had to adapt to? Advancements in technology and the proliferation of data services have changed the landscape considerably, facilitating an ever-faster flow of information available around the clock. The sheer volume of data means that assimilating it quickly is increasingly important for investors, putting ever-greater pressure on active managers. We have responded to this challenge by building a larger, more cohesive global research platform, able to provide more frequent, robust data points. However, the emphasis is always on the quality of decisions, rather than on how quickly they are made. Experience and judgment play a significant role in this every earnings model, for example, has one or two primary attributes/variables that are critical. Identifying and focusing on these factors helps to screen out a tremendous amount of less useful information and allows us to concentrate on the most relevant drivers of stock prices. The pace of innovation has increased, with new technologies and industries being created. Understanding the potential impact from disruptive technologies can be challenging. That s why it is critical to try and stay ahead of the game and to hire and develop analysts who are technical experts in these areas as the new technologies emerge. We encourage our analysts to use initiative and intellectual curiosity to find areas of growth with large, addressable markets. We have been successful at this in the past, identifying innovative game changers in various industries, many of which we continue to hold today. It should also be said, however, that it is not always about identifying the newest, most innovative companies. We are also very happy to own more traditional growth companies, with simpler revenue models and less execution risk. We prize companies with a high degree of recurring revenue and the potential to grow profits and deliver attractive returns to investors over time. 2 U.S. Equities: Long-Term Benefits of the T. Rowe Price Approach to Active Management, April The study spanned the 20 years up to the end of December 2015 for older strategies, or since inception for newer ones, and measured performance net of fees and trading costs. In instances where a portfolio manager managed multiple strategies in a particular sub-asset class style (e.g., U.S. small-cap growth), we used only the strategy with the largest assets under management to avoid double counting. 3 Morningstar U.S. Mutual Fund Industry Stewardship Survey, June PRICE POINT 4 4 4

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