Taking Stock Third quarter 2010

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1 Turner s Growth Investing Team sizes up a market issue Taking Stock Third quarter 2010 Smid-cap stocks: the Goldilocks asset class Jason Schrotberger, senior portfolio manager/ security analyst and lead portfolio manager of Turner SMID Growth Equity I nvestors may at times empathize with Goldilocks and her dilemma of extremes. Some stock investments are too risky. Others produce returns that are too flat or volatile. Some companies go bankrupt. Others grow rapidly. So what is the just right investment, à la Goldilocks? We think the answer is a smid-cap portfolio, which blends the stocks of small- and mid-cap companies to ideally capitalize on the high growth rate of small firms and the above-average but more stable growth rate of mid-sized enterprises. We think a smid-cap portfolio, as part of a larger, diversified portfolio, may offer benefits that an investment with a more limited smaller or larger capitalization may not. While the definitions aren t set in stone, companies with a market capitalization (the total market value of a company's outstanding shares) of less than $2 billion are commonly defined as small cap. Mid-cap companies usually fall into the $2 billion to $14 billion range. In contrast, a smid-cap portfolio typically contains stocks of companies with market capitalizations of about $7 billion to $8 billion and below. Small caps risky Investing in small-cap companies is celebrated for being distinctly lucrative. Many small-cap enterprises are start-ups with a lot of growth and stock-market potential. (Think Apple and Starbucks early on.) According to Morningstar, the investment-research firm, one dollar invested in large-company stocks at the end of 1925 would have been worth $2, by the end of 2009, if dividends were reinvested. A dollar held in small-company stocks for the same period would have grown more than four times as much -- to $12, Conversely, the downside of small-cap companies is greater risk: when compared to mid- and large-caps, small-cap companies are more likely to fail, and their stocks may have relatively little liquidity (that is, they can t be easily traded) and are highly volatile. Small stocks have higher highs and lower lows: Morningstar reports that annual total returns of large-cap stocks from 1926 to 2009 ranged from a high of 54.0% to a low of negative 43.3%. In

2 Smid-cap stocks: the Goldilocks asset class / 2 contrast, the performance range for small stocks were bookends to the large-cap results: small-cap stocks rose as much as 142.9% in one year and lost as much as 58.0% in another year. As for mid-cap companies, they generally offer the advantages of increased operating stability and stock-market liquidity, a diversified revenue base, and an earnings-growth rate higher than that of largecap companies and the economy as a whole. In the past two decades Wall Street analysts have generally projected that the Russell Midcap Index companies would produce a growth rate in earnings per share over the next 12 months at least 15% higher than that of large-cap S&P 500 Index companies, our research indicates. Like Goldilocks porridge One drawback of mid-cap companies, however, is that their stocks tend to underperform smaller stocks. That s because mid-cap companies tend to grow at a slightly lesser rate than their smaller peers do. Nevertheless, just like the temperature of Goldilocks porridge, it s all relative: although mid caps may generally underperform small caps, they typically offer greater potential gains than large-cap stocks do. So, given the pros and cons of small- and mid-cap stocks, what s an investor to do? As we see it, smid-cap investing may provide just the right mix of the two asset classes. Our research indicates that smid portfolios have typically exhibited these benefits in comparison with portfolios only owning either small- or mid-cap stocks: higher returns with less risk, an enhanced ability to capture extra return, more liquidity, and lower tax and transaction costs. Also, smid-cap portfolios can offer higher returns without significantly increased risk than their largecap counterparts can. Indeed, seeking to exploit the advantages of smid-cap stocks, we began offering a smid-cap strategy, Turner SMID Growth Equity, in We think Turner SMID Growth Equity fills a key niche in our lineup of stock portfolios spanning the capitalization spectrum, a niche that our clients believe is promising. Smid caps outperform Let s look at the record, as New York Governor Al Smith was fond of saying. The Russell 2500 Growth Index is typically considered a proxy for smid-cap growth stocks, serving as a benchmark against which the performance of smid-cap growth portfolios is typically measured. The Russell 2500 Growth Index contains small-cap companies included in the Russell 2000 Growth Index and a

3 Smid-cap stocks: the Goldilocks asset class / 3 Over the one-, five-, and 10-year periods ending June 30, 2010, smid-cap growth stocks, as represented by the Russell 2500 Growth Index, outperformed their smaller and larger counterparts Annualized total returns Periods ended June 30, 2010 Past performance is not a guarantee of future results. Source: Russell Investments selection of growth-oriented mid-cap companies from the Russell Midcap Growth Index. What the record shows is this: for the one-, five-, and 10-year periods ended June 30, 2010, the Russell 2500 Growth Index recorded consistently higher returns than other capitalization segments did, as represented by the small-cap Russell 2000 Growth Index, the Russell Midcap Growth Index, and the large-cap Russell 1000 Growth Index (see display, above). For instance, the Russell 2500 Growth Index s annualized five-year return ended June 30, 2010 was 1.81%, versus a 1.14% gain for the Russell 2000 Growth Index, a 1.37% gain for the Russell Midcap Growth Index, and a 0.38% gain for the Russell 1000 Growth Index. In the shorter term, for the one-year period ended June 30, the Russell 2500 Growth Index s performance was almost identical to the results of mid-cap growth stocks, but it returned notably more than small-cap growth stocks did (specifically, 3.48 percentage

4 Smid-cap stocks: the Goldilocks asset class / 4 points more) and large-cap growth stocks did (7.82 percentage points more). As time goes by Smid-cap investing also enables an investor to stick with a small company as it evolves from a start-up and grows to mid-sized dimensions, thus reaping a potentially bigger return over time. Here s why: if a company s capitalization exceeds the limits of an institutional small-cap portfolio, the stock typically must be sold, resulting in the portfolio missing out on any further gains. In contrast, in a smid portfolio, with its broader market-cap range, returns of individual stocks have the luxury of compounding over a longer time. Our research shows that a company s stock tends to generate the greatest returns when that company is growing most rapidly, when it falls into the smid-cap category -- that is, when a company s market capitalization is between $700 million and $8 billion. That finding has been confirmed by other studies. In terms of return potential, smaller companies have generally produced higher returns than large ones historically -- a phenomenon that Morningstar calls the size effect. Morningstar, in analyzing the size effect, has classified the returns of stocks by their capitalization size, in 10 deciles, ranked in descending order from the largest to the smallest. Morningstar has found that the average return in the long run tends to increase as one moves from the largest decile to the smallest. From 1926 to 2009, the large stocks in decile #1 have returned an average of 9.1%. Decile #4 stocks -- mid-cap stocks -- have gained even more, an average of 10.7%. And decile #10 stocks -- the smallest -- have soared the most, 13.1% on average. Example: Intuitive Surgical As an illustration of high-return potential, take an exceptional smidcap stock in the health-care sector, Intuitive Surgical, which currently has a market capitalization of about $13 billion and a share price of more than $330 (see display, page 5). In December 2002, Intuitive s market cap was a mere $225 million, and its price was about $12. When the stock crossed the $2 billion threshold in mid- 2005, qualifying it as a mid-cap stock, the price was about $50. So a small-cap portfolio that bought Intuitive Surgical in December 2002 and was compelled to sell it in mid-2005 because of its rising capitalization would have captured a fat capital gain by most standards: 416%. However, if Intuitive Surgical had been owned in a smid-cap portfolio that held onto the shares until the stock reached a capitalization of $8 billion, the reward would have been even fatter. By then, the stock was worth more than $215, representing a whopping 1,791% gain -- more than four times the return that would

5 Smid-cap stocks: the Goldilocks asset class / 5 Holding onto Intuitive Surgical shares as they advanced from the small-cap segment to the mid-cap segment was highly rewarding Market capitalization and stock price: Intuitive Surgical June 2000-June 2010 Source: YCharts have been realized in mid Again, Intuitive Surgical may be the exception rather than the rule, but it demonstrates vividly the extent a superior stock can grow if held for an extended period, while graduating from the small-cap to the smid-cap ranks. In addition to such possibilities to achieve outsized returns, smidcap investing may offer lower fees and greater liquidity. Holding stocks in the small and mid ranges can translate into less portfolio turnover, resulting in reduced capital-gains taxes and transaction fees. Also, smid-cap stocks tend to be more liquid, making them easier for investors to buy and sell when they want to. Smid stocks more liquid To be sure, the low liquidity of some small stocks can be costly; investors may forfeit an investment opportunity or extra return if they have trouble buying or selling small stocks at a desired price. That s much less of a problem for smid-cap stocks: the liquidity of the Russell 2500 Growth Index is almost twice that of the Russell 2000 Growth Index, due to the Russell 2500 Growth s inclusion of more-liquid mid-cap shares. The typical mid-cap stock has an

6 Smid-cap stocks: the Goldilocks asset class / 6 average daily trading volume of about 500,000 shares, versus 250,000 shares for the typical small-cap stock. The bottom line: smid-cap stocks, due to their trading efficiency, can typically be bought or sold more readily, to the prospective benefit of short-term investment performance, than small-cap stocks can. What s more, a smid portfolio, by owning mid-cap stocks, can help temper the volatility of its holdings in small stocks. In the process, because stocks of different market capitalizations often perform differently at a given time, mid-cap stocks may be doing well when small-caps are performing poorly and vice versa, thus providing another layer of risk control. This isn t to suggest that smid-cap investing is risk free. Smid-cap portfolios can be volatile in their own right, especially when compared to large-cap stocks. But at the same time they can offer a better risk-reward tradeoff. Namely, smid-cap portfolios can provide greater compensation for the risk taken than portfolios restricted to small- or mid-cap stocks can. In other words, smid portfolios have the potential to generate higher returns for the same amount of risk. Risk/reward profile best For example, when risk, expressed as standard deviation, is plotted against the annualized returns of the Russell large-cap, mid-cap, smid-cap, and small-cap growth indexes for the 11-year period ended June 30, the longest period for which reliable data are available -- the smid-cap Russell 2500 Growth Index generated the most favorable results, the best balance of return and risk (see display, page 7). During that time the Russell 2500 Growth Index recorded the best return, 2.39%. Returns of the other indexes lagged behind: the Russell Midcap Growth gained 1.79%, the Russell 2000 Growth rose 0.69%, and the Russell 1000 Growth lost 2.68%. But returns don t tell the whole story, only the end result. Standard deviation represents the path that each index took to get to the total return. Some risk is inevitable, and the higher the return, the more risk a set of stocks may encounter en route. In short, the risks of smaller stocks may make for a bumpier road than some investors want to traverse. Over the 11-year period, the annualized standard deviation of the Russell 2500 Growth, 40.89%, was 2.21 percentage points above that of the Russell Midcap Growth, but was 3.01 percentage points less than that of the Russell 2000 Growth Index. By the same token, with an annualized standard deviation of 31.39%, the Russell 1000

7 Smid-cap stocks: the Goldilocks asset class / 7 Smid-cap growth stocks historically have offered more reward for a given level of risk Risk/reward characteristics June 1999-June 2010 Past performance is not a guarantee of future results. Source: Russell Investments Growth Index was considerably less risky than the Russell 2500 Growth Index. However, as noted, the performance of the Russell 2500 Growth, a 2.39% annualized gain, was much better than that of the Russell 1000 Growth, which lost 2.68% annualized. The point is that the smid-cap index provided the most attractive combination of reward for the risk taken of the four indexes during the 11-year period. I n sum, we think smid-cap investing can offer an advantageous combination of performance characteristics: the return potential of small-cap stocks and the relatively milder volatility but still-high return potential of mid-cap stocks. As a result smid-cap investing can deliver extra return and less risk. And it can provide a higher degree of liquidity and lower costs than other types of stock investing can. We believe that a smid-cap investment can be a valuable component in a diversified portfolio -- a sentiment that we think that even Goldilocks might agree with.

8 Smid-cap stocks: the Goldilocks asset class / 8 The views expressed represent the opinions of Turner Investment Partners as of the date indicated and may change. They are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. Opinions about individual securities mentioned may change, and there can be no guarantee that Turner will select and hold any particular security for its client portfolios. Certain information presented is of a high-level, summary, condensed and aggregated nature and is inherently limited. Earnings growth may not result in an increase in share price. Past performance is no guarantee of future results. Turner Investment Partners, founded in 1990 and based in Berwyn, Pennsylvania, is an investment firm that manages more than $16 billion in stocks in separately managed accounts and mutual funds for institutions and individuals, as of June 30, The small and mid-capitalization companies may be more vulnerable to adverse business or economic events than larger, more established companies. In particular, these small companies may have limited product lines, markets and financial resources, and may depend upon a relatively small management group. Small cap stocks may be very volatile and the price movements of the Fund's shares may reflect that volatility. Such volatility may make selling a large quantity of shares of one issuer more difficult. Please obtain and review all financial material carefully before investing. Past performance can vary over short periods. Past performance is no guarantee of future results. You cannot invest directly in an index. An index does not have an investment adviser and does not pay any commissions, expenses or taxes. If an index had expenses, its performance would be lower. Any comparison of the Fund s performance to an index is for illustrative purposes only. The Russell 2500 Growth Index measures the performance of the small to mid-cap growth segment of the U.S. equity universe. It includes those Russell 2500 Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell Midcap Growth Index measures the performance of those Russell Midcap Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Growth Index measures the performance of those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000 Growth Index measures the performance of those Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values. The S&P 500 Index tracks the performance of 500 widely held large-cap US stocks in the industrial, transportation, utility, and financial sectors. As of July 31, 2010, Turner held in client accounts 1.7 million shares of Apple, 6.5 million shares of Starbucks, and 614,444 shares of Intuitive Surgical.