An Overlooked Opportunity Why Global Mid-Caps Make Sense Now and for the Longer Term PERSPECTIVE FROM FRANKLIN EQUITY GROUP

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1 Topic Paper August 15, 2016 An Overlooked Opportunity Why Global Mid-Caps Make Sense Now and for the Longer Term PERSPECTIVE FROM FRANKLIN EQUITY GROUP Coleen F. Barbeau Senior Vice President, Director of Global Growth Portfolio Management Franklin Equity Group John P. Remmert Senior Vice President, Senior Portfolio Manager Franklin Equity Group Donald G. Huber, CFA Senior Vice President, Portfolio Manager Franklin Equity Group Introduction After years of outperformance, mid-cap stocks mainly in the United States appear to us to have gotten lost in the pull between risk-on and risk-off that has driven the performance of global financial markets since the financial crisis in Low rates and abundant liquidity have largely overshadowed corporate fundamentals, and, as a result, mega-cap US names have benefited when markets are seeking out quality and safety as risk rises; small-caps such as biotechnology have gotten the attention when investors are feeling a bit more secure about the broader economic and financial environment. The increase in passive investing also has benefited US large-caps indiscriminately. With interest rates in the United States starting to rise, more expensive valuations at the larger-end of the equity market may make it more advantageous for investors to cast a wider net when looking to generate better returns. We anticipate US mid-cap stocks as well as non-us mid- and perhaps some large-cap stocks, particularly those high quality sustainable growth names, could reemerge since they should offer better growth prospects in a still sluggish economic recovery. We anticipate this shift could create greater opportunities for us given our consistent bias toward non-us mid-cap stocks historically. Mind the Performance Gap Historically, global mid-cap stocks, or those with market capitalizations of between US$2 billion and US$15 billion, have outperformed their large-cap counterparts as measured by the MSCI World Mid Cap and MSCI World Indexes, respectively, while lagging their riskier small-cap peers (the MSCI World Small Cap Index) only modestly. Mid-cap names in many cases were successful small-cap companies that survived the early stages of their growth to become more established. As such, they have tended to have a well-regarded product or service that may be just beginning its longer-term growth phase. In our view, that should allow them to grow more quickly than their mature large-cap counterparts with less risk of failure than their small-cap brethren over an extended period. Additionally, mid-caps may potentially be prime acquisition targets for slower-growing large-cap companies. Over the 20-year period through April 30, 2016, the MSCI World Mid Cap Index has returned 6.86% on an annualized basis, according to data from FactSet, while the MSCI World Index has returned just 5.46% and the MSCI World Investable Market Index (IMI) has returned 5.97%.

2 Exhibit 1: A Performance Aberration? MSCI World IMI Cumulative Returns by Market Cap in US Dollar Terms % 55.32% 50% 40% 30% 20% 10% 42.79% 43.32% 0% Source: FactSet. Past performance does not guarantee future results. This trend has generally held up over the 10-year period as well. On an annualized return basis, the mid-cap constituents of the MSCI World IMI have returned 5.4% over the decade through April 30, 2016, versus just 4.1% for mega-cap constituents with market caps above US$50 billion and 5.2% for large-cap constituents with market caps between US$15 billion and US$50 billion, according to data analyzed from FactSet. Mid-caps have also generally outperformed with less risk, according to FactSet data. Over the 10-year period referenced above, the group posted a Sharpe Ratio, a measure of risk-adjusted returns, of 0.21 versus 0.16 for mega-caps and 0.19 for large caps, according to FactSet. While an economic rationale for strong relative and absolute midcap performance exists, since 2010 we have seen a shift. USbased mega-caps have outperformed significantly as companies fundamentals have mattered less to investors in an era of ultralow interest rates and abundant liquidity. Over the past five or so years, mega-caps and large-caps drove the market s advance and outperformed their mid-cap peers. The strong performance of US mega-cap names has meant that on a global basis mid-caps have lagged their large-cap peers. From 2011 through the end of 2015, mega-cap constituents in the MSCI World IMI returned 55.32% on a cumulative basis, outpacing the mid-cap segment s 43.32% return. In the United States, cumulative returns for US mega-cap stocks within the MSCI USA IMI, have been over 82.89% since January 2011, while mid-cap names based in the United States have returned just 73.95%. As illustrated below, 2011, 2014 and 2015 accounted for the bulk of the mega-cap outperformance, with the trend starting to reverse in early Exhibit 2: Large US Stocks Drove Global Returns Cumulative Performance by Market Cap: MSCI USA IMI vs. MSCI EAFE IMI % 80% 70% 60% 50% 40% 30% 20% 10% Exhibit 3: Mid-Caps Begin to Reemerge in 2016 Cumulative Performance by Market Cap January 1, 2016 April 30, % 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 0% MSCI USA IMI MSCI EAFE IMI -2.0% MSCI USA IMI MSCI EAFE IMI Source: FactSet. Past performance does not guarantee future results. Source: FactSet. Past performance does not guarantee future results. An Overlooked Opportunity Why Global Mid-Caps Make Sense Now and for the Longer Term 2

3 The historical relationship between mid-cap and large-cap performance has held up better outside the United States but the magnitude of returns indicates non-us stocks may still have more room to run in general. Non-US mega-cap equities constituents of the MSCI EAFE IMI returned less than 20% over the period, while mid-cap names returned nearly 30%, according to FactSet data. However, on an absolute basis, the US market has returned much more than international equities between January 2011 and April 2016, creating what we believe are opportunities in the non-us mid-cap space despite its outperformance relative to large- and mega-cap names. Examining the US Outperformance When looking at the US versus non-us performance, the relative health of the US economy to that of Japan or Europe is a reason investors have favored US names over the past five years. Among US mega-cap stocks, it has tended to be the quality, dividendpayers that have done remarkably well as investors seek out US companies with bond-like characteristics, offering both an attractive dividend yield and relative safety in an environment where risk-on or risk-off has dominated. As a result, the higher quality and more defensive sectors such as consumer discretionary, health care and consumer staples have done particularly well over the past few years. Additionally, large-caps have tended to offer higher dividends than their mid-cap counterparts historically, which have tended to reinvest for growth as opposed to returning greater capital to shareholders. Stock buybacks in the United States have also had an impact on domestic equity market performance. Over the past six years, companies in the MSCI US Index have been buying back nearly 3% of their market cap on average each year, while companies outside the United States have been buying back closer to 1% in the MSCI EAFE Index. Buybacks have generally had the effect of reducing share counts to flatter corporate earnings per share, while bolstering demand for stock in general. Flowmageddon and Its Aftermath A rise in passive investing has further distorted market performance at the larger-end of the market cap spectrum within the United States. The overwhelming influence of macroeconomic factors on market returns instead of company fundamentals have increased correlations, generally favoring a more passive approach. Additionally, with central banks in the United States, Europe and Japan generating extraordinary amounts of liquidity since the global financial crisis in , money has found its way into equities, and ETFs and passive investments in particular. According to data from Morningstar illustrated in Exhibit 5, cumulative net inflows from 2011 through 2015 for passive investments totaled US$1.49 trillion while active funds saw US$77.5 billion in cumulative net outflows. In general, as a result of this so-called flowmageddon, we believe money has been under-allocated to non-benchmark US companies and companies outside the United States, providing a long-term opportunity, in our view. We believe this trend runs at odds with efficient market Exhibit 4: Buybacks as a Percentage of Market Capitalization % 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Exhibit 5: Cumulative Estimated Net Flows for Equity Funds Globally $USD Millions Estimated Net Flows $1,600,000 $1,400,000 $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $200,000 $0 -$200,000 -$400, % US Non-US Source: FactSet. -$600,000 Q1 '11 Q2 '12 Q3 '13 Q4 '14 Active Passive Source: Morningstar. Q4'15 An Overlooked Opportunity Why Global Mid-Caps Make Sense Now and for the Longer Term 3

4 theory, which suggests capital needs to discriminate between companies based on valuation and fundamentals. The rise of passive ETF investing is in some ways a replay of the late 1980s and early 1990s when emerging-market investing came to the fore. Many emerging markets may not have been a fundamentally attractive place to invest when they first garnered investors attention, but their relative newness meant emerging markets would continue to attract money from first-time investors in the asset class. In our view, ETF investing is similar. They are the relatively new product and so long as central banks continue to print money and equity indexes march higher, we believe that ETFs and passive strategies should remain in demand as an abundance of liquidity looks for a home. Valuations Have Favored Mid-Cap Names Combined, these trends have left mega- and large-cap equities globally looking much more expensive than the rest of the equity market on a price-to-earnings-to-growth (PEG) basis, as stock price appreciation has generally outpaced earnings growth. As of April 30, 2016, global mega-cap stocks were trading at about 2.2 times versus 1.7 times for mid-cap names, a 30% premium, according to data analyzed from FactSet. Mega-cap stocks are also trading well above their eight-year average of 1.5 times a 25% premium. Large-caps in the US$15 billion to US$50 billion range also look more attractively valued than their mega-cap constituents, trading at 1.6 times. Exhibit 6: A Widening Valuation Gap May Present Opportunities MSCI World IMI PEG Ratio January 1, 2009 March 31, /09 3/10 6/11 8/12 10/13 1/15 3/16 Source: FactSet. While mid-caps have gotten pricier in the recent run-up through April 30, 2016, this valuation gap between mid-cap and mega-cap names looks unsustainable to us. Efficient market theory holds that capital should be discerning, allocating to undervalued securities at the expense of overvalued names. Passive investing, in our view, has made no distinction in recent years. As money pours into a certain ETF or passive strategy, most if not all index constituents benefit proportionally based on market weighting in the index, further pushing up large-cap stocks. Because the passive trend has been most pronounced in the United States, it has helped large-cap US index constituents while under-allocating to smaller, non-benchmark US companies and those outside the United States. As a result, we believe many attractive mid-cap companies both in the United States and internationally, particularly those that are not part of the major benchmarks, were left behind in the current market environment. We believe that the historically strong performance of mid-caps has the potential to reassert itself as interest rates begin to rise, excess liquidity dries up and economic growth begins to gain traction globally. As that occurs, corporate fundamentals should matter more for investors when evaluating stocks for their portfolios. In our view, a return to more rational equity markets would likely mean the broader markets could struggle as rates normalize and expensive mega-caps struggle, thereby penalizing passive investors, but potentially finally rewarding careful stock selection. High-Quality, Sustainable Growth for the Longer Term In positioning for such an environment, we believe that highquality mid-cap companies with solid growth prospects should do particularly well and actively seeking out opportunities could create significant value over the longer term. Unlike global megacap stocks, sell-side analyst coverage of the mid-cap universe has been more limited. This fact is important because it means that dedicated analysts focused on fundamentals such as earnings growth, free cash flow and profitability have, in our view, a better chance of finding overlooked quality stocks with good growth prospects at attractive valuations. Finding these hidden gems requires a disciplined and welldeveloped investment approach. When considering any potential investment opportunity, we believe it is important to identify a stock s fundamental drivers, or economic exposure. This analysis should look beyond standard industry classifications or country listings to consider factors driving a company s earnings stream. Its revenue and expense drivers, customers and competitors must also be researched to fully understand the potential opportunity. We also advocate including other factors in the analysis such as a company s competitive landscape, capital structure, prospects for merger and acquisition activity, and external factors. An Overlooked Opportunity Why Global Mid-Caps Make Sense Now and for the Longer Term 4

5 Using this framework to focus on high quality, sustainable growth companies can generate potential value over the longer term, we believe, particularly once markets begin to reward robust fundamentals more consistently. Companies that have good growth prospects, in our view, possess sustainable business models and a long-term competitive advantage in their individual markets. Moreover, these companies should have a record of successfully reinvesting free cash flow in order to create additional potential long-term value for shareholders. We also consider quality, such as a history of proven value creation and a focus on shareholder returns, to help reinforce these strong growth characteristics. Furthermore, we believe the current environment calls for taking a concentrated, unconstrained approach to investing. Concentrated portfolios can offer a number of benefits, which we believe should enhance the ability to add potential value across market cycles. With a limited number of holdings, analysts can spend more time conducting in-depth research on each stock in the portfolio. In our view, a focused approach and deeper understanding of the individual securities support a higher degree of conviction in portfolio holdings, helping the manager to realize the full value of an opportunity despite volatile markets. As the recent trend toward passive investing peaks, selecting individual mid-cap stocks that may not be benchmark constituents can also add greater potential value over time. Global mid-caps have been a mainstay of our portfolios historically and we anticipate that over the longer term those possessing strong growth and quality characteristics should outperform. While this segment of the market has struggled somewhat, as the cycle turns, it is these mid-cap companies that we believe should offer growing earnings, robust free cash flow and a solid business model that ultimately should return to favor. Finding them will require in-depth individual stock research. OUR APPROACH Since 2004, the Franklin Global Large Cap Team has employed a disciplined, bottom-up, investment philosophy that we believe has the potential to deliver alpha over a full market cycle. Our approach focuses on building a concentrated portfolio of high-quality sustainable growth companies with a bias toward mid- and large-cap equities. Research-Driven Approach Results in a Concentrated, Yet Diversified Portfolio Our rigorous investment approach targets a concentrated, best ideas portfolio of approximately 40 stocks. Our unwavering focus on what we believe to be the most attractive high-quality sustainable growth opportunities makes us indifferent to the underlying benchmark constituents during portfolio construction. We seek portfolio diversification and strive to maintain a reasonable level of risk by focusing on limiting holdings overlapping economic exposures, such as among competitors or those exposed to common growth drivers. We believe that purchasing companies whose fundamentals are uncorrelated typically should result in a natural diversification across sectors, industries, countries and regions. In-Depth, Bottom-Up Analysis Focused on High Quality Sustainable Growth Companies We look across all industries and countries for companies with sustainable business models that meet our growth, quality and valuation criteria. We seek specific attributes that we believe have the potential to translate into viable long-term growth, including attractive free cash flow characteristics, solid return on equity, proven management attuned to creating shareholder value and an industry or competitive environment that should help enable superior growth. Finally, we seek to buy companies that our analysis indicates are well priced, utilizing a consistent valuation approach across sectors. Demonstrated Long-Term Focus We assume a long-term perspective, researching stocks that we believe we can hold for three- to five-year periods as a company executes its growth model. As long-term investors with an emphasis on bottom-up research, we view short-term inefficiencies in the market as potential opportunities to purchase fundamentally sound companies that meet our investment criteria. Our approach is built on the belief that independent and in-depth research is vital to finding these opportunities. WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Historically, mid-size company securities have been more volatile in price than larger and mega-size company securities, especially over the short term. Mid-size companies may be more susceptible to particular economic events or competitive factors than are larger, more broadly diversified companies. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. An Overlooked Opportunity Why Global Mid-Caps Make Sense Now and for the Longer Term 5

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