Capital Markets: Observations and Insights Searching for Yield and Asking for Trouble? As of June 30, 2016
Key Observations Strong bond performance has supported bond-like equities and hurt growth stocks Fundamentals for growth equities continue to be very strong relative to value stocks Valuation of growth stocks are very appealing relative to bond-like equities A framework for evaluating future returns leads us to be more optimistic on the long-term potential for growth-oriented equities Page 2
2Q16 Review Asset Class Performance Commodities bounced back and the dollar declined, helping boost emerging markets, and when combined with the large rally in bonds, drove outperformance in value stocks Source: FactSet as of 06/30/2016. Page 3
Telecom Utilities Energy Consumer Staples Materials Industrials Consumer Discr Health Care Info Technology Financials Energy Telecom Utilities Health Care Consumer Staples Materials Financials Industrials Consumer Discr Info Technology 2Q16 Review Sector Performance Lower interest rates helped drive outperformance in defensive, bond-like sectors (highlighted below) 24.8 23.4 YTD S&P 500 Sector Performance (%) 11.6 Q216 S&P 500 Sector Performance (%) 16.1 10.5 7.5 6.5 0.7 0.4 7.1 6.8 6.3 4.6 3.7 2.1 1.4-0.3-3.0-0.9-2.8 Source: FactSet as of 06/30/2016. Page 4
Dividend Yield Revenue/Price Trading Activity Debt/Equity Log of Market Cap Earnings Variability Relative Strength Earnings/Price Price Volatility EPS Growth Rate Book/Price Dividend Yield Price Volatility Relative Strength Log of Market Cap Book/Price Trading Activity Debt/Equity Earnings Variability EPS Growth Rate Revenue/Price Earnings/Price 2Q16 Review Factor Performance The most dominant factor for stock performance has been dividend yield as investors focus on bond-like equity characteristics rather than fundamentals 5.7 YTD Excess Return (%) 2.4 2Q16 Excess Return (%) 1.0 0.9 0.8 0.1-0.2-0.5-0.9-0.9-0.1-0.1-0.3-0.6-1.9-2.5-3.0-3.0-3.4-1.3-1.4 Source: FactSet as of 06/30/16 using Northfield defined quantitative factors for the Northfield broad U.S. market database. Page 5
Jan-83 Dec-83 Nov-84 Oct-85 Sep-86 Aug-87 Jul-88 Jun-89 May-90 Apr-91 Mar-92 Feb-93 Jan-94 Dec-94 Nov-95 Oct-96 Sep-97 Aug-98 Jul-99 Jun-00 May-01 Apr-02 Mar-03 Feb-04 Jan-05 Dec-05 Nov-06 Oct-07 Sep-08 Aug-09 Jul-10 Jun-11 May-12 Apr-13 Mar-14 Feb-15 Jan-16 Searching For Yield Bond Yields Are Extremely Low U.S. bond yields recently hit their lowest level on record and, generally, global interest rates are at their lowest level in 5,000 years!* $11 trillion of global government debt currently yields less than 0%. Investors are paying to lend their money! 16 14 12 10 10-Year Government Bond Yields U.S. China Japan Germany U.K. Canada Australia S. Korea 8 6 4 2 0-2 Source: FactSet. *Bank of England, Global Financial Data, Homer and Sylla A History of Interest Rates, and BofA Merrill Lynch. Page 6
Searching For Yield Asset Flows Continue to Chase Income Investors have poured money into bond funds and redeemed from equity funds The search for yield is apparent in equity fund flows equity income funds have seen modest inflows compared to large outflows for equity growth funds 80,000 YTD Fund Flows ($m) 65,205 10,000 YTD Fund Flows ($m) 616 40,000 (10,000) - (40,000) (43,752) (30,000) (80,000) Bonds Equities (50,000) Equity Income (40,894) Equity Growth Source: Morningstar through May 2016. Bonds include taxable & municipal, and equities are the U.S. equity category. Equity income and growth based on prospectus objective. Page 7
Dec-95 Jul-96 Feb-97 Sep-97 Apr-98 Nov-98 Jun-99 Jan-00 Aug-00 Mar-01 Oct-01 May-02 Dec-02 Jul-03 Feb-04 Sep-04 Apr-05 Nov-05 Dec-13 Feb-14 Apr-14 Jun-14 Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 Feb-16 Apr-16 Jun-16 Searching For Yield The Trouble With Passive The vast majority of passive investing allows relative performance to drive relative weighting changes, irrespective of fundamentals This can exacerbate bubbles, such as in tech in the late 1990s Weightings in bond-like equities have been rising recently These increased weightings along with high and rising valuations may elevate the risk of passive investments S&P 500 Technology Sector S&P 500 Bond-Like Equities 40% Weight Rel Perf 300 22% Weight Rel Perf 120 30% 200 20% 115 110 20% 105 10% 100 18% 100 95 0% - 16% 90 Source: FactSet. Bond like equities include consumer staples, telecommunications, utilities, and real estate. Page 8
1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 Searching For Yield Equities Are Inexpensive Relative to Bonds Will TINA * drive the stock market? The earnings yield for equities is 455 bps more than Treasury bonds The median yield spread over the past 50 years has been less than 50bps 16 S&P 500 EPS Yield Treasury Bond Yield 14 12 10 8 6 4 2 0 455 bps Source: FactSet, Federal Reserve, S&P as of 6/30/16. * TINA is an acronym for There is No Alternative [to stocks] Page 9
Apr-96 Apr-97 Apr-98 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14 Apr-15 Apr-16 Apr-96 Apr-97 Apr-98 Apr-99 Apr-00 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14 Apr-15 Apr-16 Growth vs. Bond-like Equities Total Yield Compelling Dividends + Share Repurchases = Total Yield Total Yield is the highest relative to corporate bonds in two decades S&P 500 Dividend Yield S&P 500 Buyback Yield 8% 7% 6% Total Yield Total Yield 5.5% 12% 10% S&P 500 Total Yield Corporate Bond Yield 5% 8% 4% Share Repo. 3.3% 3% 2% Dividends 2.1% 1% 0% 6% 4% 2% 0% Highest Spread Source: FactSet and Alger estimates as of 6/30/16. Corporate Bond Yield is Moody's Baa Corporate Bond Yield. Page 10
Yield Growth vs. Bond-like Equities Growth Is Where the Yield Is Growth has attractive total yields relative to traditional dividend yield sectors, which demonstrates shareholders are getting significant return of capital 7% 6% 5% 4% High share repurchases drive higher total yield for some growth sectors. 6.5% 6.0% 4.9% Traditional dividend sectors have relatively low total yields despite high dividend yields. 4.7% 4.3% 3.9% Share Repurchases Dividend Yield X.X% Total Yield 3% 2% 1% 0% Technology Cons. Disc. HeathCare Telecom Utilities Energy Source: FactSet. Total yield is dividend yield plus share repurchase yield. Share repurchase yield is last 12 month share repurchase through April 2016 divided by shares outstanding, and dividend yield is based on 06/30/16 yield. Page 11
P/E Relative to 20-Year Median Growth vs. Bond-like Equities Growth Sectors Are the Cheapest to Bond-like Equities in 20 Years! Bond-like stocks, such as Utilities and Consumer Staples, are expensive compared to their historic averages Overvalued Bond-Like Equities 32.0% 28.0% 24.0% 20.0% 16.0% 12.0% 8.0% 4.0% 0.0% -4.0% -8.0% Widest Spread in 20 Years! Undervalued Growth Sectors -12.0% Utilities Consumer Staples Materials Financials Telecom Industrials Consumer Disc. Health Care Technology Source: FactSet, June 30, 2016. Note: energy P/E is very high relative to history and not meaningful. Page 12
Jan-79 Jan-81 Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Growth vs. Bond-like Equities Large Cap Growth is Inexpensive Relative to Large Cap Value Large cap growth has historically been at a ~40% P/E premium to large cap value but it is now only a 16% premium Russell 1000 Growth is trading at P/E-to-growth of 1.4x vs. the Russell 1000 Value at 2.5x, which is the largest gap in over a decade Russell 1000 Growth vs. Russell 1000 Value P/E NTM 2.40 2.20 2.00 1.80 1.60 1.40 1.20 1.00 Median ~40% Premium Current 16% Premium Source: FactSet, Bank of America as of 06/30/2016. Page 13
Growth vs. Bond-like Equities Growth Stocks Have Better Fundamentals The long-term expected growth rate of the Russell 1000 Growth is more than double that of the Russell 1000 Value Sales estimates for R1000G stocks are rising while they are falling for the R1000V Long-Term EPS Growth 3-Month Sales Estimate Revision R1000G R1000V R1000G R1000V 13.4% 0.4% 6.4% -1.1% Source: FactSet, June 30, 2016. The long-term expected growth rate represents a consensus estimate as reported by FactSet and does not represent a prediction or forecast by Fred Alger Management, Inc. Actual growth rates might be materially different than those shown. The 3 Month Sales Est Chg is consensus reported by FactSet and refers to 2017 sales. Page 14
Newspaper - 1704 Stove - 1750 Hospitals - 1776 Second. Sch. - 1810 Steam ship - 1810 Railroad - 1830 Telephone - 1880 Roads - 1880 Electric power - 1882 Radio - 1897 Wash. Mach. - 1904 Air Travel - 1914 Dishwasher - 1924 Air Con. - 1933 TV - 1936 Cable TV - 1950 Credit Card - 1950 VCR - 1965 Microwave - 1967 ATM - 1969 PC - 1974 Internet - 1989 Smartphone - 1996 MP3 Player - 1998 Social Media - 2004 Growth vs. Bond-like Equities Newer Innovations Are Diffusing through Society Faster The faster speed of innovation may be exacerbating the disparity in growth rates between the R1000G and the R1000V Innovations are penetrating U.S. markets at an even faster pace 200 160 120 80 40 0 Years from Market Entry to 50% Penetration in the U.S. Source: Asymco Page 15
Q208 Q308 Q408 Q109 Q209 Q309 Q409 Q110 Q210 Q310 Q410 Q111 Q211 Growth vs. Bond-like Equities Growth through Cycles Growth fundamentals have often done quite well in difficult economic conditions During the recent Financial Crisis, U.S. retail trade was flat while innovative industries such as e-commerce and Internet advertising both grew over 30% 140 U.S. Internet Ad Revenue U.S. E-Commerce U.S. Total Retail Trade 130 120 110 Average of +30% growth during crisis time period 100 90 80 Source: Bureau of Economic Analysis, PwC, Census Bureau Page 16
Growth vs. Bond-like Equities Prospective Returns Appear to Favor Growth Stock returns are generally the result of 1) dividend yield, 2) EPS growth, and 3) change in P/E Growth sectors have significant return potential relative to bond-like sectors Framework for Estimating S&P 500 Sector Returns Dividend Yield (last 12 months) + + = EPS Growth (3-5 year consensus, reduced by 20%) P/E Change (20-year median P/E) Five-Year Return (hypothetical) Bond-Like Sectors Utilities 4% 4% -5% Underperformance? Consumer Staples 3% 7% -5% Underperformance? Growth Sectors Technology 2% 10% 2% Outperformance? Health Care 2% 8% 2% Outperformance? Consumer Discretionary 2% 14% 2% Outperformance? Source: FactSet, June 30, 2016. Table contains annualized S&P 500 GICS sector data. Figures for the EPS Growth represent consensus long-term analyst estimates, and actual future EPS Growth rates might be materially different than the forecasts shown. P/E assumes reversion to 20-year historic norm, and actual future P/E change may be materially different than the forecasts shown. Page 17
Growth vs. Bond-like Equities Income from Growth Investors can generate income from growth if future rates of return are similar to the past Hypothetically, withdrawing 4% annually from $100,000 invested in the Russell 3000 Growth over the past 30 years would have generated both income and growth $900,000 $800,000 Illustration of Hypothetical $100,000 Investment in Russell 3000 Growth (1986-2015) $845,405 $700,000 $600,000 $371,148 Income Received $500,000 $400,000 $300,000 $200,000 $100,000 $100,000 $474,256 Growth in Initial Investment $0 Initial Investment 1986 Source: Morningstar and Alger estimates 1/1/1986-12/31/2015. Index performance does not reflect deduction of fees, expenses or taxes. Numbers may not total due to rounding. Please note the amount of investment growth presented is provided for illustrative purposes and assumes that no other withdrawals were made aside from the annual $4,000 withdrawal during the period from January 1986 to December 2015. Such returns shown represent that of the Russell 3000 Growth Index and not actual performance of any account advised by Fred Alger Management, Inc. Investors cannot invest directly in an index, which does not assess fees and expenses that would have the effect of reducing returns. Also note that index performance reflects the reinvestment of dividends. 2015 Page 18
Summary Strong bond performance has supported bond-like equities and hurt growth stocks Equities are attractive relative to bonds, and within U.S. equities, growth stocks are even more attractive Growth equities have the potential to shine as the demand for bond-like equity characteristics wanes and strong, dynamic fundamentals are rewarded Page 19
Supplemental Information Evaluating Stock Market Returns
What Drives the Stock Market? In the short run, the market is a voting machine, but in the long run, it is a weighing machine (Ben Graham) Market return = EPS growth + dividend yield +/- P/E change If the starting P/E is reasonable (i.e. average) then the long-term return should approximately equal earnings growth plus the dividend yield Source: FactSet, Robert Shiller. The second chart is in log. Page 21
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Real 10-Yr Rolling Growth Earnings Growth Has Been Consistent 10-year real (inflation adjusted) EPS growth has been between 3% and 7% more than three-quarters of the time over the past 25 years, with the worst result still being slightly positive 8% 10-yr Rolling Growth in S&P 500 Real EPS 7% 6% 5% 4% 3% 2% 1% 0% Source: FactSet, S&P, and Alger estimates. Page 22
Valuations are Very Important in Determining Future Returns There is a strong relationship between starting valuation and ensuing 10-year returns for both stocks and bonds Current valuation corresponds to a high single-digit annualized 10-year return for stocks and a low-single digit 10-year return for bonds Source: FactSet Page 23
Jan-86 Dec-86 Nov-87 Oct-88 Sep-89 Aug-90 Jul-91 Jun-92 May-93 Apr-94 Mar-95 Feb-96 Jan-97 Dec-97 Nov-98 Oct-99 Sep-00 Aug-01 Jul-02 Jun-03 May-04 Apr-05 Mar-06 Feb-07 Jan-08 Dec-08 Nov-09 Oct-10 Sep-11 Aug-12 Jul-13 Jun-14 May-15 Apr-16 Valuation is Relatively In-line with Historical Averages and Cheap to Bonds Valuation Measure Current 20-Year Median 30.0 25.0 20.0 S&P 500 12-Month NTM P/E P/E 16.6 16.1 P/FCF 18.8 19.0 EV/EBITDA 12.1 12.2 EV/Sales 2.3 2.3 P/B 2.6 2.8 E/P BAA Yield 1.3 0.0 15.0 10.0 Average 5.0 0.0 Source: FactSet. The valuations presented above are based on consensus estimates for future 12-month periods. Actual valuations for such periods might be materially different than those shown. Page 24
Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 P/E (NTM) Global Valuation Emerging markets continue to trade at a historically large discount to developed markets based on NTM P/E S&P 500 MSCI Europe MSCI Japan MSCI EM 25 23 21 19 17 15 13 11 9 7 5 Source: FactSet Page 25
Annual Total Returns Risk Relative to Time Horizon Equity returns look much less volatile over a longer time period than shorter time periods Using 20-year rolling returns, the relative standard deviation is actually lower for stocks than for bonds 60 50 52.3% Range of Stock and Bond Total Returns Stocks Bonds 40 30 29.1% 28.6% 20 10 17.0% 18.6% 12.8% 17.9% 10.0% 0-10 -5.1% -2.4% 1.0% -1.7% 1.8% 6.5% 3.2% -20-30 -40-37.0% 1-Year 5-Year Rolling 10-Year Rolling 20-Year Rolling Source: Morningstar. Stock data is the S&P 500 total return and bond data is the Ibbotson Associates US IT Govt total return. The data spans 1950-2015. Page 26
Disclosure The views expressed are the views of Fred Alger Management, Inc. as of July 2016. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Fred Alger Management, Inc. These views should not be considered a recommendation to purchase or sell securities. Individual securities or industries/sectors mentioned, if any, should be considered in the context of an overall portfolio and therefore reference to them should not be construed as a recommendation or offer to purchase or sell securities. References to or implications regarding the performance of an individual security or group of securities are not intended as an indication of the characteristics or performance of any specific sector, industry, security, group of securities, or a portfolio and are for illustrative purposes only. Risk Disclosures: Investing in the stock market involves gains and losses and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as the prices of growth stocks tend to be higher in relation to their companies earnings and may be more sensitive to market, political and economic developments. Investing in foreign securities involves risks related to the political, social, and economic conditions of foreign countries, particularly emerging market countries. These risks may include political instability, exchange control regulations, expropriation, lack of comprehensive information, national policies restricting foreign investment, currency fluctuations, less liquidity, undiversified and immature economic structures, inflation and rapid fluctuations in inflation, withholding or other taxes, and operational risks. Special risks associated with investments in emerging country issuers include exposure to currency fluctuations, less liquidity, less developed or less efficient trading markets, lack of comprehensive company information, political instability and different auditing and legal standards. Foreign currencies are subject to risks caused by inflation, interest rates, budget deficits and low savings rates, political factors and government controls. Some of the countries may have restrictions that could limit the access to investment opportunities. The securities of issuers located in emerging markets can be more volatile and less liquid than those of issuers in more mature economies. Investing in emerging markets involves higher levels of risk, including increased information, market, and valuation risks, and may not be suitable for all investors. Fred Alger Management, Inc. 360 Park Avenue South, New York, NY 10010 800.992.3863 www.alger.com Page 27
Disclosure The S&P 500 Index is an unmanaged index generally representative of the U.S. stock market without regard to company size. The Russell 1000 Growth Index is an unmanaged index designed to measure the performance of the largest 1000 companies in the Russell 3000 Index with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth Index is an unmanaged index generally representative of common stocks designed to track performance of small-capitalization companies with greater than average growth orientation. The Russell 2000 Value Index is an unmanaged index generally representative of the small-cap value segment of the U.S. equity universe and measures the performance of Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 3000 Growth Index is an unmanaged index designed to measure the performance of those Russell 3000 Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index is an unmanaged index generally representative of stocks from the Russell 3000 Index with lower price-to-book ratios and lower expected growth rates. The indices presented are provided for illustrative purposes, reflect the reinvestment of dividends and do not assess fees and expenses that would have the effect of reducing returns. Investors cannot invest directly in any index. The index performance does not represent the returns of any portfolio advised by Fred Alger Management, Inc. and actual client results might differ materially than the indices shown. Note that past performance is no guarantee of future results. Comparison to a different index might have materially different results than those shown. Fred Alger Management, Inc. 360 Park Avenue South, New York, NY 10010 800.992.3863 www.alger.com Page 28