SMALL-CAP VALUE: THE CASE FOR DEFENSIVE QUALITY

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1 INVESTMENT INSIGHTS March 216 SMALL-CAP VALUE: THE CASE FOR DEFENSIVE QUALITY DEFENSIVE QUALITY IDEAL FOR INVESTORS OVER A CYCLE Lower quality, highly-levered stocks led the bulk of post-crisis market gains through 214. However, amid increased volatility in and the market gyrations at the start of 216, we see a rotation underway favoring higher-quality stocks in the small-cap value segment. We believe a more accurate description of these securities is defensive quality, as these stocks appear well positioned to benefit from current market dynamics based on their attractive defensive attributes and stronger long-term return potential. WHY INVESTORS SHOULD CONSIDER SMALL-CAP VALUE NOW EXHIBIT 1: MARKET CAP PERFORMANCE (1/2/21-1/1/216) Although small-cap value stocks have underperformed their mid- and large-cap value counterparts during the last three years (see Exhibit 1), we think quality small-cap value stocks are better positioned to weather current market volatility. 5 4 Russell Midcap Value Index Russell 2 Value Index Russell 1 Value Index In this increasingly uncertain and turbulent environment, one attractive aspect of small-cap stocks is their tendency to be domestically-focused, thereby lessening their exposure to potentially volatile global financial markets and economies. The segment also has more reasonable valuations compared to the market. While expensive relative to large-cap stocks as recently as late 21, small caps now trade at a slight discount relative to large caps for the first time since 2. As shown in Exhibit 2, the valuation spread in forward priceto-earnings (P/E) ratios between small-cap and large-cap equities was down to.7x at the end of. INDEX RETURN (%) 2 1 Jan-1 May-1 Sep-1 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 Source: Bloomberg. As of 1/1/216.

2 EXHIBIT 2: DIFFERENCE IN FORWARD P/E BETWEEN RUSSELL 2 INDEX AND RUSSELL 1 INDEX (1Q Q ) Volatility for the broad market has been elevated since the second half of for a host of reasons that are unlikely to dissipate anytime soon. A key source of increased volatility is China s slower economic growth and, in particular, the slowdown in its industrial economy and the reverberations these disappointments are creating for the global financial markets. These concerns won t likely abate anytime soon as China undergoes a long-term transition from a manufacturingdriven economy to a consumption-driven economy, and it s expected that growth will slow during this evolution. China s economy and financial markets should continue to impact global markets as investors scrutinize the country s growth and its broader impacts on the global economy. Stubbornly low crude oil prices are another source of market volatility. Investors question whether sub-$4/barrel prices are simply due to oversupply, slowing global growth weighing on demand, or some combination of both. Regardless of the reason, global financial markets are vigilantly monitoring any change in price positive or negative and reacting accordingly. Since there are few signs that the oversupply of crude oil is lessening or that global growth is about to accelerate, we must assume that there is an outsized chance that prices will remain low and volatile for the foreseeable future Source: Russell Investment Group; BofA Merrill Lynch Small Cap Research. As of 12/1/. 21 Given the concerns about China, global economic growth, oil prices, foreign currency weakness and leverage around the globe, we believe volatility in equity markets will be with us for the foreseeable future. Value stocks are potentially also poised for stronger performance. Value has lagged growth during the recent low-growth environment in which investors were willing to pay a premium for growth; the Russell 2 Growth Index outperformed the Russell 2 Value Index by roughly 8.8 percentage points in 21, 1.4 percentage points in 214 and 6.1 percentage points in. The mix of lofty multiples and lackluster earnings growth may presage a change in leadership. We believe we re now witnessing a market rotation which will favor value stocks, especially the high-quality stocks favored by Perkins. DEFINING QUALITY Perkins measures stock quality based on strict evaluation criteria around: > > Balance sheet strength > > Competitive position > > Earnings stability > > Management skills > > Recurring free cash flow > > Strong return on invested capital WHY QUALITY MATTERS TODAY Although we ve recently experienced a period of low-quality stocks outperforming, we believe the environment that provided the fuel for this low-quality rally has changed to one that favors high-quality stocks. Generally, higher-quality stocks tend to outperform lower-quality stocks during periods of elevated volatility, as their balance sheet strength and earnings stability provide important defensive attributes that can help mitigate downside risk. 2

3 It s also important to note that the recent period of outperformance by low-quality stocks was due, in part, to extremely accommodative monetary policies around the world. The Federal Reserve (Fed) depressed interest rates to historically low levels for an extended period of time, resulting in complacency among investors. We don t believe any future Fed efforts could replicate this outperformance in light of many companies balance sheet problems (which we discuss below), subdued earnings power, and the earnings multiple expansion generated the past few years. compound an earnings miss and make it much harder for a company to recover. Moreover, overly-levered balance sheets will likely continue to be a reality that the marketplace will have to deal with for the foreseeable future. EXHIBIT 4: RUSSELL 2 INDEX LEVERAGE IS AT AN ALL-TIME HIGH (9/1986-1/216) Ex-Financials Ex-Energy, Materials & Health Care EXHIBIT : HIGHER-QUALITY VS. LOWER-QUALITY STOCKS (6// /1/).5 Average Ex-Financials Ex-Energy & Materials HIGH-QUALITY / LOW-QUALITY STOCKS RELATIVE STRENGTH RATIO NET DEBT/EBITDA Source: The Leuthold Group. As of 12/1/. Source: FactSet Research Systems; BofA Merrill Lynch Research Small Cap Research. As of 1/1/216. One factor aiding the performance of high-quality companies is the prevalence of companies with overly-levered balance sheets. Leverage in the Russell 2 Index is at an all-time high. Postcrisis, many companies engaged in shareholder-friendly activities such as share buybacks and merger and acquisition activity, often driven by easily accessible and low cost debt, thus increasing leverage on balance sheets. This is a potentially dangerous position to be in, especially in the current economic environment, which has been challenging for earnings, particularly those companies with significant cyclical and commodity exposure. An overly-levered balanced sheet may Deteriorating credit quality, as evidenced by the widening credit spreads shown in Exhibit 5, also helps boost the appeal of high-quality stocks. As Exhibit 4 demonstrates, the increasingly weak credit market has a larger impact on those stocks with significantly more leverage on the balance sheet. We believe investors seeking more stable sources of return may continue to seek out higher-quality stocks with earnings stability, predictable cash flow, and strong balance sheets. These characteristics are ways to construct outperformance in a chaotic market.

4 9 7 EXHIBIT 5: BARCLAYS U.S. CORPORATE HIGH YIELD INDEX AVERAGE OPTION ADJUSTED SPREAD (1//211-1/1/216) EXHIBIT 6: PERKINS SMALL CAP VALUE COMPOSITE PERFORMANCE AS OF 12/1/ Perkins Small Cap Value Composite (Gross) Perkins Small Cap Value Composite (Net) 1 Year Year 5 Year 1 Year -1.84% 11.65% 8.4% 8.6% -2.71% 1.67% 7.44% 7.9% Russell 2 Value Index -7.47% 9.6% 7.67% 5.57% Source: Bloomberg. As of 1/1/216. FOCUSING ON DOWNSIDE PROTECTION OFFERS GREATER LONG-TERM RETURN POTENTIAL After a long run off the market bottom in 29, and given the current market environment, investors searching for small-cap value exposure may want to consider a more defensive and quality-oriented manager. Perkins investment methodology focuses on evaluating downside exposure and risk before analyzing upside potential. As always, we are more concerned about protecting assets in difficult markets and performing well in choppy, directionless market environments, even if it means slightly lagging during lower-quality momentum-driven markets. By striving to minimize downside losses while participating in upside market gains, we seek to compound returns at a higher rate throughout a full market cycle. This risk-disciplined approach to small-cap value investing has delivered steady, long-term outperformance for Perkins Small Cap Value relative to the Russell 2 Value Index across full market cycles. Our research typically leads us to higher-quality companies with healthy balance sheets, strong and consistent free cash flow, earnings stability, and attractive competitive positions. Recent history has been difficult for the small-cap value asset class, but Perkins Small Cap Value, with its focus on mitigating downside risk and performing well in volatile markets fared better than the index Past performance cannot guarantee future results. Investing involves risk, including the possible loss of principal and fluctuation of value. Returns greater than one year are annualized. Returns are expressed in U.S. dollars. Composite returns are net of transaction costs and gross of non-reclaimable withholding taxes, if any, and reflect the reinvestment of dividends and other earnings. The gross performance results presented do not reflect the deduction of investment advisory fees and returns will be reduced by such advisory fees and other contractual expenses as described in the individual contract and Form ADV Part 2A. Net performance results do not reflect the deduction of investment advisory fees actually charged to the accounts in the composite but they do reflect the deduction of model investment advisory fees based on the maximum fixed fee rate in effect for the respective time period. Actual advisory fees may vary among clients invested in the strategy shown and may be higher or lower than model advisory fees. Composites may include accounts with performance-based fees. Returns for each client will be reduced by such fees and expenses as negotiated in any client contract as discussed in Form ADV Part 2A. Source: Janus. As of 12/1/. CONCLUSION The current environment is favorable for the Perkins Small Cap Value strategy as we believe we are in the early to middle innings of outperformance by defensive quality stocks. Cycles come and go but quality and downside protection endure. We believe the current environment serves as a powerful reminder of the power of the Perkins investment philosophy. Should the choppy investment climate remain for some time, investors should be well served by Perkins emphasis on defensive quality stocks. By focusing on equities with strong balance sheets and solid, recurring free cash flows, our research process has historically helped protect assets better in volatile periods while capturing attractive long-term outperformance over full market cycles. 4

5 This publication is for investors and investment consultants interested in the institutional products and services available through Janus Capital Management LLC and its affiliates. Various account minimums or other eligibility qualifications apply depending on the investment strategy or vehicle. Investing involves risk, including the possible loss of principal and fluctuation of value. The views presented are as of the date published. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security or market sector. No forecasts can be guaranteed. The opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. It is not intended to indicate or imply in any manner that any illustration/ example mentioned is now or was ever held in any Janus portfolio, or that current or past results are indicative of future profitability or expectations. As with all investments, there are inherent risks to be considered. There is no assurance that the investment process will consistently lead to successful investing. Perkins Small Cap Value portfolios, benchmarked to the Russell 2 Value Index, invest primarily in US companies whose market capitalization, at time of initial purchase, is less than the 12-month average of the maximum market capitalization for companies included in the Russell 2 Value Index. Prior to 2, the composite was known as the Berger Small Cap Value Equity Composite. Prior to 2, the composite included both institutional accounts and mutual funds. In 2 and 24 the composite included only separately managed institutional accounts. Effective January 1, 25 the composite definition was changed to include sub-advised pooled funds as well as separately managed institutional accounts. Effective January 1, 29 the composite definition was expanded to also include proprietary mutual funds. A minimum asset size requirement of $1 million for composite participation was used prior to January 1, 26. The composite was created in June Index returns are provided to represent the investment environment existing during the periods shown. The index is fully invested, including the reinvestment of dividends and capital gains. Index returns do not include any transaction costs, management fees or other costs, and are gross of non-reclaimable withholding taxes, if any. To receive a complete list and description of composites and/or a presentation that complies with the requirements of the GIPS standards, please call or visit perkinsinvestmentmanagement.com to contact a Perkins Investment Management institutional team representative. Perkins Investment Management LLC is a subsidiary of Janus Capital Group Inc. and serves as the sub-adviser on certain products. Janus and Perkins are registered trademarks of Janus International Holding LLC. Janus International Holding LLC. Perkins Investment Management 11 S. Wacker Drive, Suite 6, Chicago, IL For More Information Contact Janus 151 Detroit Street, Denver, CO C