Small Caps: The Case For Active And Value

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1 Small Caps: The Case For Active And Value SMALL CAP VALUE: ACTIVE HAS OUTPERFORMED OVER THE LONG TERM Much has been written on the relative domestic focus of small cap scks in these times of volatile trade and tariff headlines. Through July 2018, small cap scks have led the way among equity indices, with the Russell 2000 Index climbing 9.5% on a tal-return basis, outperforming the S&P 500 by more than 300 basis points. 1 This short-term focus belies a long-term trend. Small cap scks have outperformed large cap over the last 20 years. When looking by facr, small cap value has outperformed small cap growth, despite recent performance. 2 Invesrs are gaining exposure this space more and more through passive investing (e.g., ETFs) at the expense of active strategies. Since the beginning of 2015, small cap value ETFs have seen $13.2B of inflows while small cap value mutual funds have seen -$6.2B of outflows. 3 At face value, this point might not mean much. There has been a long-term trend across market caps out of actively managed equity funds and in passively managed funds. However, active small cap value managers have hisrically outperformed the passive Russell 2000 Value Index. 4 Passive has the edge in the shorter 3-year period, which we attribute persistent outflows from active funds that began in 2015, which have made cash management difficult for value managers in a rising market. Active has outperformed over the longer 5-, 7- and 10-year periods (see next page). This highlights the patience required invest in small cap value, as it can take a company years have its fundamental value realized by the market. 20-Yr Performance (Indexed Aug-98) SMALL HAS OUTPERFORMED LARGE LONG TERM, SMALL VALUE HAS OUTPERFORMED SMALL GROWTH S&P 500 Value S&P 500 Growth Russell 2000 Value Russell 2000 Growth Cumulative Monthly Flows ($B) INVESTORS CHOOSING PASSIVE OVER ACTIVE SMALL CAP VALUE 3 $16 $12 $8 $4 $0 -$4 -$ Small Cap Value Mutual Funds Small Cap Value ETFs 1 Morningstar. 1 August FactSet. Monthly performance data from August 1998 through July August Morningstar. Monthly flows through July August evestment. Annualized net returns through Q2 2018, the latest data available. 28 August 2018.

2 CAPITALIZING ON SMALL CAP DISTORTIONS Taking a step back, one key difference from the large cap universe is that small cap companies often derive a bigger percentage of their revenues domestically, meaning they are less exposed currency fluctuations overseas and tend be more insulated from global earnings headwinds. 5 This domestic focus also means small caps typically have more gain from any corporate tax reform, and are better insulated from any trade disputes or renegotiations. Further, small cap names are less covered by market analysts, which creates more market inefficiencies as research is thinner and trading volumes are less. 6 As an asset class, therefore, there may be more opportunities for active managers find attractive scks and navigate this difficult environment. We see several potential areas where small cap managers could find value: > The increased flow of capital in passive may be creating some disrtions in the marketplace, particularly in small caps. Flows in broad market ETFs are spread across all secrs and industries, providing technical support despite their respective fundamental outlooks. There are also more narrowly-focused ETFs, where inflows provide (further) technical support a specific secr, industry, etc., again despite respective fundamental outlooks. Such disrtions could create gaps between the price of certain scks and the value of those companies. These disrtions could be exploitable investment opportunities for astute active managers. > Small caps have hisrically paid higher effective tax rates than large caps and, therefore, more small caps will likely benefit from recently passed corporate tax reform. However, 34% of Russell 2000 companies, representing more than 25% of the index s market cap, had negative pre-tax income last year and did not pay any taxes, per Cambridge Associates. 7 In other words, the benefits of tax reform would seem accrue a smaller subset of small cap scks. These disrtions could also be exploitable investment opportunities for astute active managers, especially as this anomaly begins reversing itself in 2018 given current earnings estimates (see next page). > Small caps are more exposed rising rates and refinancing risk than large caps, with floating rate debt making up approximately half of the outstanding debt for Russell 2000 issuers. 8 Floating rate borrowers have likely hedged out at least some of their exposure. For those who have not, rising interest rates may offset benefits net profit margins and free cash flows from the recent tax cuts for certain small cap scks. Once again, these disrtions could be exploitable investment opportunities for astute active managers. 13% LONGER TERM, ACTIVE SMALL CAP VALUE MANAGERS HAVE OUTPERFORMED THE PASSIVE INDEX 9 12% 11% 11.2% 10.5% 11.2% 12.0% 11.1% 12.1% 11.4% 10% 9.9% 9% 7% 3Y 5Y 7Y 10Y Russell 2000 Value TR evestment Small Cap Value Universe - Median Net Return 5 FactSet, PPM. We used the S&P SmallCap 600 Index for continuity, comparing weighted average domestic revenue (most recent fiscal year) across it and the S&P 500. S&P SmallCap 600 companies derive 79% of their revenue domestically, while S&P 500 companies derive 70%. 28 August Bloomberg, PPM. We used the S&P SmallCap 600 Index for continuity, comparing the average number of analysts covering each sck by the averages for the S&P 500 and S&P MidCap August Cambridge Associates. 10 July FactSet and BofA US Equity & US Quant Strategy, via WSJ. 50.6% of Russell 2000 debt was floating rate as of 31 December 2017, the latest data available. 13 August evestment. Annualized net returns through Q2 2018, the latest data available. 28 August 2018.

3 VALUE IN A TIME OF GROWTH OUTPERFORMANCE Much has also been written on the outperformance of growth scks over value scks since the global financial crisis (GFC). By itself, this trend is not unusual, as the sck market has hisrically moved in growth/value cycles. One unusual aspect of this specific trend, however, is the current growth cycle has been much longer than hisrical examples. The current cycle began in January 2007 and has now spanned nearly 12 years, while previous growth cycles have been two years or less. 10 Focusing on the difference between small cap growth and value shows that growth cycles have varied in terms of outperformance. Growth cycles have seen a hisrical outperformance range since 1979 of 29% 121%. The current growth cycle has seen the Russell 2000 Growth Index outperform by 75% on a tal-return basis, within the hisrical range despite its much longer duration. Value cycles, however, have hisrically shown stronger outperformance, ranging from 111% 196%. 10 Scarcity of growth has been a contributing facr in the latest growth cycle. At the macro level, the economic expansion post-gfc has been the slowest going back At the corporate level, across market caps, companies had struggled grow revenue and earnings post-gfc. 12 This period included an earnings recession in , and sparked a surge in M&A activity as companies attempted purchase the growth they could not produce organically. 13 We believe this influence is no longer working in growth s favor, given the recent, tax reform-driven spike in earnings. Current expectations for the Russell 2000 call for 53% EPS growth in 2018 and 2 growth in SMALL CAP VALUE CYCLES HAVE HISTORICALLY SHOWN STRONGER OUTPERFORMANCE THAN GROWTH CYCLES % 200% 191% 196% 150% 111% 121% 100% 67% 75% 50% 29% 0% Jan-79 Nov-80 Dec-80 Nov-88 Dec-89 Dec-91 Jan-92 Aug-98 Sep-98 Feb-00 Mar-00 Dec-06 Jan-07 Jul-18 Growth Value 10 FactSet, PPM. 28 August J.P. Morgan Asset Management. 30 June FactSet. 15 August Bloomberg. 15 August FactSet. 7 August 2018.

4 OUR OUTLOOK The relative domestic focus of small cap scks in these times of volatile trade headlines is not the only facr driving recent outperformance. It has been driven by multiple catalysts: regulary relief, ongoing tax-reform benefits/improving company fundamentals, strong GDP growth expectations, the US small business optimism index being at its second highest level in its 45-year hisry and, now, US dollar strength and small caps being a relative haven from trade. 15 We see continued strong performance for small caps, as trade and tariff headlines will put the focus on more domestically-oriented companies and they stand benefit most from US growth, even if global growth seems stutter. We are also seeing small cap earnings growth estimates outperforming those of large cap names, which has not happened in a few years. 16 If earnings growth is realized, we could see a continued reversal away from large cap outperformance. Given recent growth outperformance, we believe small cap value is currently more attractive from a valuation standpoint. Barring a trade escalation, we see an opportunity in value names, despite their underperformance year--date. 17 Strong earnings growth, a healthy economic backdrop and firmer commodity prices keep our outlook positive on value scks. In terms of risks our outlook, these facrs are all coming gether at a time when there are fears around the longevity of the economic cycle. Fundamentals are strong, but markets are being driven by headline risk, at the same time as singular secrs and even individual names have been outsized drivers of returns. Further, we are hesitant overemphasize how trade tensions/fears have benefited small caps. Long term, a trade war could hurt all caps since small cap companies supply large caps in many cases and a slowdown in the broader economy would be a negative for consumers and companies alike. CONCLUSION The combination of small caps and value names requires expertise and experience, and a long-term investment horizon. Small cap scks are inherently more likely suffer from market inefficiencies than large cap, but finding fundamental value can be more challenging with less data and coverage. This approach, therefore, requires patience as it can take a company years have its fundamental value realized by the market. We believe investing discipline, team work and proper construction of the portfolio are key realizing success. SMALL CAP EARNINGS GROWTH ESTIMATES OUTPERFORMING LARGE CAP 18 60% 53% 40% 20% 21% 0% S&P 500 Russell Expected Earnings Growth 2018 Expected Revenue Growth WE BELIEVE SMALL CAP VALUE CURRENTLY MORE ATTRACTIVE FROM VALUATION STANDPOINT Small Cap Value Small Cap Small Cap Growth Forward P/E (Current) Forward P/E (20Y Avg.) 15 Atlanta Fed GDPNow. The current estimate for Q3 GDP growth is 4.1%. 30 August NFIB. 14 August FactSet. 14 August Morningstar. 1 August FactSet. 7 August Factset and Russell Investment Group, via J.P. Morgan Asset Management. 30 June 2018.

5 ABOUT PPM AMERICA PPM America, Inc. (PPM) is a client-focused investment manager. As part of one of the world s leading financial organizations, PPM has the expertise, global reach and substantial resources provide our clients with investment solutions across markets, including fixed income, public and private equity, and commercial real estate. However, like a smaller shop, PPM remains nimble, investment-led and responsive the opportunities that our teams discover gether. Our mission is deliver specific client solutions and service invesrs around the world with the goal of meeting invesrs unique investment objectives. In addition, PPM employees are committed building our community and supporting local nonprofits that strengthen families and increase economic opportunities. Indices are unmanaged and are not available for direct investment. The index returns do not reflect management fees, transaction costs, or other expenses. Performance of any index does not represent actual portfolio performance. A portfolio may differ significantly from the securities included in an index. The index information provided is for comparison purposes only reflect general market conditions for the period shown. The Russell 2000 Growth Index provides a broad, market capitalizationweighted measure of value oriented US small cap scks. It measures the performance of companies within the Russell 2000 Index based on a probability of growth as measured by their Institutional Brokers Estimate System (I/B/E/S) forecast of medium-term growth (2-year), and sales per share hisrical growth (5-year). The Russell 2000 Index provides a measure of US small cap scks. It includes the botm 2,000 scks in the Russell 3000 Index, which provides a broad, market capitalization-weighted measure of the largest 3,000 publicly-held US companies. The Russell 2000 Value Index provides a broad, market capitalizationweighted measure of value oriented US small cap scks. It measures the performance of companies within the Russell 2000 Index which have lower price--book ratios and lower forecasted growth values. The S&P 500 Growth Index provides a measure of US large cap growth scks and is constructed based on the S&P 500 Index. Additionally, the S&P 500 Growth Index includes scks that exhibit strong growth characteristics based on the evaluation of book value--price, earnings-price and sales--price ratios. The S&P 500 Index provides a broad, market capitalization-weighted measure of US large cap scks. It includes approximately 500 publiclytraded scks of the largest US companies. The S&P 500 Value Index provides a measure of US large cap value scks and is constructed based on the S&P 500 Index. Additionally, the S&P 500 Value Index includes scks that exhibit strong value characteristics based on the evaluation of book value--price, earnings-price and sales--price ratios. The S&P MidCap 400 Index provides a broad, market capitalizationweighted measure of US mid cap scks. It includes approximately 400 publicly-traded scks of mid-sized US companies. The S&P SmallCap 600 Index provides a broad, market capitalizationweighted measure of US small cap scks. It includes approximately 600 publicly-traded scks of small US companies. The information presented herein has been prepared solely for informational purposes and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Unless otherwise stated, information or views herein contained are as of the date of this presentation. The views expressed herein, as well as forecast or portfolio strategies, may be changed in the future, reflecting change of various facrs, including economic fundamentals. This presentation is not an offer, or a solicitation of an offer, buy or sell any instrument. Nothing contained herein shall be relied upon as a promise or representation whether as past or future performance. All investments contain risk and may lose value. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. There is no guarantee that referenced investment strategies, including hedging, will work under all market conditions PPM America, Inc. All rights reserved.