U.S. Small-Cap Stocks: Why This Cycle Is Not So Different Presenters: Hugh Evans, Steph Jackson, Jack Laporte, Greg McCrickard, and David Wagner
15% 12% Annualized Asset Class Returns since 1926 1 12.8% 12.5% 10.5% 9% 6% 3% 5.5% 4.6% 3.6% 0% U.S. Small-Cap Equities U.S. Mid-Cap Equities U.S. Large-Cap Equities Bonds Precious Metals Cash 190 165 140 115 90 Relative Performance of Small-Caps vs. Large-Caps Small-Caps Outperform Small-Caps Underperform '50 '54 '58 '62 '66 '70 '74 '78 '82 '86 '90 '94 '98 '02 '06 s Small-Cap/Large-Cap Relative Strength 12-Month Moving Average Small-caps have outperformed other asset classes over extended time periods, while exhibiting periods of extended outperformance and underperformance versus large-caps. (1) Precious metals returns only since 1947 All Returns are annualized returns from 1926 to June 30, 2009 except precious metals which is from 1947- September 30,2009. Equity returns are based on Center for Research in Security Prices, University of Chicago Data, Large-cap: Deciles 1, Mid-cap: Deciles 2 and 3, Small-cap: Deciles 4 and 5. Precious metals returns are based on CRB CCI Precious Metals Index. Bonds based on US IT Government Index from 1926-1972, Lehman Bros. Government Corporate Index from 1973-1975, Barclays Cap. U.S. Aggregate Index from 1976-Present. Cash based on the 30-day T-bill yield. Past performance does not guarantee future results. Charts in this presentation are for illustrative purposes only and not intended to represent any specific security. Source: CRSP Center for Research in Securities Prices-University of Chicago, T. Rowe Price, The Leuthold Group September 2009 2
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Percent of Periods Outperforming Large-Caps Over Various Time Horizons Small-Caps Mid-Caps 54% 55% 53% 55% 58% 61% 66% 75% 76% 83% 84% 90% 0% 1 Year 3 Years 5 Years 10 Years 15 Years 20 Years The smaller-capitalization equity asset classes outperform largecaps on a relative basis with a higher success rate when investors hold the asset class for a longer time period. Source: Merrill Lynch Small-Cap Research 3
World Indices Market Capitalization Total Market Value (U.S. $ Trillions) MSCI EM Index 2.9 DAX Index CAC 40 Index 0.7 1.0 FTSE 100 Index Nikkei 225 Index Russell 2500 Index 2.1 2.2 2.0 Russell 3000 Index 11.4 S&P 500 Index 9.3 MSCI World Index 20.8 $0 $5 $10 $15 $20 $25 Trillions Along with other international indices, U.S. small- and mid-caps make up a large part of the world s investable universe. Source: Factset, T. Rowe Price, Bloomberg 4
Number of Companies in Various Market Cap Buckets Total Market Value ($ Billions) of all Companies in Market Cap Bucket $0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 $8,000 $9,000 Market Cap Bucket ($ Millions) Smallest 0-1,000 Mid 1,000-10,000 Largest Over10,000 Number of Companies Total Market Value ($ Billions) Average Number of Analysts 25 20 15 10 5 0 Average Number of Analysts Covering a Stock by Size 18 0 500 1,000 1,500 2,000 2,500 3,000 3,500 Number of Companies 12 Large Mid Small Micro Merrill Lynch Size Composites The sheer number of companies in the small-cap opportunity set is large, leading to less analyst coverage and potential for outsized rewards through value-added research. 8 4 Source: FactSet, Merrill Lynch Small-Cap Research, T. Rowe Price 5
Risk/Return Relationship 1974 2009 Annualized Total Return 15% 100% Large-Caps 50% Small/ 50% Large 100% Small-Caps 10% 15% 20% Annualized Standard Deviation More Adding Uncorrelated Assets Increases Benefit to Diversification 1.0 Correlation Between Small- and Large-Cap Stocks Benefits of Diversification Less -1 Correlation 1 Return 0.9 0.8 Correlation of 20 Year Monthly Returns Correlation of 10 Year Monthly Returns 0.7 '36 ' '50 '57 '64 '71 '78 '85 '92 '99 '06 Small-caps provide portfolio diversification benefits over a portfolio consisting of only large-cap stocks, and can increase portfolio return potential with only moderate increase in risk. Source: Merrill Lynch Small-Cap Research 6
1.5 Relative Forecast P/E 1.1 1.0 Long-Term Average = 1.04 0.5 1Q80 1Q84 1Q88 1Q92 1Q96 1Q00 1Q04 1Q08 Relative Price/Book Relative Price/Sales 1.2 1.2 0.9 0.75 0.9 Long-Term Average = 0.77 0.6 Long-Term Average = 0.76 0.6 0.74 0.3 1Q80 1Q84 1Q88 1Q92 1Q96 1Q00 1Q04 1Q08 0.3 1Q80 1Q84 1Q88 1Q92 1Q96 1Q00 1Q04 1Q08 Small-cap valuations on price-to-earnings, price-to-book, and price-to-sales measures relative to large-caps are near long-term averages. All statistics are relative measures of the Russell 2000 Index versus the Russell Top 200 Index. Source: Merrill Lynch Small-Cap Research 7
M&A Number of Deals 1,600 1,400 1,200 1,000 800 600 400 200 0 M&A Activity and Russell 2000 Index Performance Correlation = 0.72 Number of U.S. M&A Deals Russell 2000 Index Jan-90 Jul-91 Jan-93 Jul-94 Jan-96 Jul-97 Jan-99 Jul-00 Jan-02 Jul-03 Jan-05 Jul-06 Jan-08 Jul-09 900 800 700 600 500 400 300 200 100 0 Russell 2000 Index Level M&A Number of Deals 1,600 1,400 1,200 1,000 800 600 400 200 0 M&A Activity and Russell Midcap Index Performance Correlation = 0.69 Number of U.S. M&A Deals Russell Mid-Cap Index (EOP, Dec/31/78=100) Jan-90 Apr-91 Jul-92 Oct-93 Jan-95 Apr-96 Jul-97 Oct-98 Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 3,000 2,700 2,400 2,100 1,800 1,500 1,200 900 600 300 0 Russell Mid-Cap Index M&A has been a key driver of small- and mid-cap index performance over time. Recent announcements are encouraging for small-/midcap stocks. Source: Citi Investment Research & Analysis 8
Lessons 200% 150% Peak to Trough Drop One-Year Performance Post Small-Cap Trough 100% 50% 0% -50% -100% 83% -9% 65% 35% 35% -14% -19% -36% 33% -11% 44% 53% -52% -50% 94% 75% -27% -29% 56% 59% 39% 38% 5% -39% -34% -37% -37% -37% -60% 78% -150% 1945 1948-1949 1951-1954 1957-1958 1960-1961 1969-1970 1971-1975 1980 Historically, when there has been a positive inflection point in economic indicators, small-cap equities have performed very strongly. 1981-1982 October 1987 Stock Market Crash 1990 1997/98 Financial Crisis 2000-2001 TMT Bubble, 2002 Sell Off 1 2007-2009 Financial Crisis (1) Sell off through 9 Mar 09, recovery 9 Mar 09 to 30 Sep 09 1945-1980: Ibbotson Small-Cap peak-to-trough drops and one-year recoveries (based on month-end closing prices). 1980-2009: Russell 2000 early recession/crisis sell-offs and 12-month recoveries off the bottom (based on daily peaks and troughs). Source: Citi Investment Research, Small-/Mid-Cap Strategy 9
Lessons Date of Bear Market Low Small Growth Small Value Large Growth Large Value June 1932 341% 368% 130% 318% March 1938 40 22 42 32 April 1942 63 136 52 91 June 1949 46 33 33 41 October 1957 57 51 29 49 June 1962 20 36 32 October 1966 106 77 44 46 May 1970 78 62 58 44 October 1974 62 48 In 80% of cases since 1932, smallcaps have led the market off of extreme lows March 1978 August 1982 December 1987 October 1990 August 1998 October 2002 Average 28 99 25 58 42 78 76% 30 94 36 40 18 65 74% 19 67 24 46 34 47% 15 61 32 32 18 40 60% Median 58 Number of Times with Highest Return 8 4 2 1 Early Bull Market Gains March 9 - September 30 Russell 2000 Growth +74% Russell 2000 Value +82% Russell 1000 Growth +54% Russell 1000 Value +66% Off bear market lows, small-caps have typically outperformed over the following 12 months. All returns are based on Fama-French Benchmark Portfolios, Tuck School of Business. Returns based on monthly figures from 1932 to 1962; daily figures are used thereafter. Boxes highlight highest return among the four styles of each bear market low. Source: The Leuthold Group 10
Small-caps have outperformed other asset classes over time. The U.S. small-cap market is an important asset class. The U.S. small-cap space allows potential for alpha generation due to the relative inefficiency of the market segment. When combined with other asset classes, U.S. small-caps can provide diversification benefits and additional return for a small increase in risk. Though not as compelling as in some prior periods, valuations for small-caps appear reasonable. Coming out of bear markets, small-caps tend to outperform strongly, providing a potentially timely opportunity for investment in the space. 11
Questions and Answers
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