Proceed With Caution: Higher Probability for Normalized Market Returns Ahead

September 2015 Matt Neska, CFA, Domestic Equity Specialist Proceed With Caution: Higher Probability for Normalized Market Returns Ahead

The current bull market in U.S. equities is entering its seventh year, and valuations are near all-time highs, but we believe there exists a higher probability of entering a more normalized return environment in which high-quality stocks should outperform. Overview The domestic equity markets have performed extremely well since the financial crisis, with most indices generating annualized returns in the mid- to high teens. Such returns are not unprecedented, but they are also unsustainable. As figure 1 shows, the annualized six-year rolling return of the Russell 3000 Index is approaching its all-time high, and prolonged periods of such positive performance generally reverse. In addition to the duration and strength of the current bull market, a number of other factors increase the probability of returning to a more normalized return environment, including the possibility of multiple compression off high absolute levels, the likelihood of higher interest rates, and the potential for increased market volatility. So, while we remain constructive on the domestic equity markets in general, we believe a return to a positive yet more normalized return environment, or possibly even market consolidation, is likely. Fig. 1: Rolling Six-Year Returns, Russell 3000 Index 25 20 15 10 5 0 12/1/84 1/1/86 2/1/87 3/1/88 4/1/89 5/1/90 6/1/91 7/1/92 8/1/93 9/1/94 10/1/95 11/1/96 12/1/97 1/1/99 2/1/00 3/1/01 4/1/02 5/1/03 6/1/04 7/1/05 8/1/06 9/1/07 10/1/08 11/1/09 12/1/10 1/1/12 2/1/13 3/1/14 4/1/15 Source: FactSet, as of 6/30/15. Performance cited represents past performance. Past performance does not guarantee future results and current performance may be lower or higher than the data quoted. A direct investment in an unmanaged index is not possible. Accommodative Monetary Policy Fueled Low-Quality Rally, but a Reversal May Be Due During the current bull market, an abundance of accommodative monetary policy and an extended period of historically low interest rates benefited lower-quality stocks in a number of ways. For example, the environment allowed lower-quality companies, generally more reliant on the capital markets, to refinance their higher levels of debt at historically low interest rates. Investors were further encouraged to take on the risk of lower-quality stocks given the extended period of extremely low volatility the highly accommodative monetary policy environment fostered. This environment is likely to change as the Fed s accommodative monetary policy comes to an end and interest rates rise. These higher interest rates should put more pressure on the balance sheets and cash flows of lower-quality companies, potentially increasing the bankruptcy risk associated with lower-quality stocks.

Historically, higher-quality stocks have tended to outperform over the long term. To illustrate, we looked for a common measure as a proxy for quality. There are many available, including return on equity or assets, margins, leverage, and earnings variability, but in this analysis we use a company s return on invested capital (ROIC) because it provides an assessment of how efficiently management allocates capital to profitable investments. The universe is the Russell 3000 Index. High-quality stocks are those in the Russell 3000 Index within the top quintile of ROIC; low-quality stocks are those within the bottom quintile. As you can see from figure 2, which shows the quarterly performance difference between the top and bottom quintiles as measured by ROIC, higher-quality companies have historically outperformed lower-quality companies. This has particularly been true when the market has been down, as the light blue shading which represent negative calendar-year returns for the Russell 3000 Index indicates. Looking at the data on a more granular level, when the index has experienced a quarter of negative performance, higher-quality stocks have outperformed lower-quality stocks almost 80% of the time. Historically, higher-quality stocks have tended to outperform over the long term. Fig. 2: Quarterly Performance Difference, High- and Low-Quality Russell 3000 Index Stocks Quarterly Performance Difference Between Top and Bottom Quintiles Based on ROIC Negative Calendar-Year Return, Russell 3000 Index 240 Over the long term, higher-quality companies have historically outperformed lower-quality companies 200 160 120 12/97 6/98 12/98 6/99 6/00 12/00 6/01 12/01 6/02 6/03 12/03 6/04 6/05 6/06 6/07 6/08 6/09 6/10 6/11 6/12 6/13 6/14 6/15 Source: FactSet, as of 6/30/15. Performance cited represents past performance. Past performance does not guarantee future results and current performance may be lower or higher than the data quoted. A direct investment in an unmanaged index is not possible. Negative calendar-year periods are 1/1/00 12/31/02 and 1/1/08 12/31/08. While lower-quality outperformance has occurred, the duration of such occurrences before 2009 was relatively short lived, often lasting only a quarter or two. Beginning in 2009, that changed as we explained earlier, most likely due to the abundance of accommodative monetary policy and a prolonged period of extremely low interest rates, which benefitted lower-quality companies more than higher-quality companies. Looking ahead, however, we believe any tightening of monetary policy should lead higher-quality stocks to again outperform lower-quality stocks. While we are not bearish on future market returns in general, we believe it is prudent to consider that downside risk (the financial risk associated with losses) may be higher given a prolonged period of high absolute valuations, the possibility of interest rate hikes, and low market volatility.

High Valuations Increase Concerns About Downside Risk Consider the substantial market appreciation over the past several years, which is reflected in current multiples. Absolute valuations look expensive across the market-cap spectrum. Indeed, they are approaching 30-year highs, as shown in figures 3 and 4. The recent prolonged period of low interest rates and inflation may justify higher valuations, but we believe there is likely little upside given current levels. While expensive valuations do not guarantee that domestic equities will sell off in the year ahead, such levels heighten concerns about downside risk. Stocks could be vulnerable to negative catalysts. Investing in higher-quality companies (namely, those with higher ROIC) may help investors weather periods of market consolidation should valuations begin to moderate. The recent prolonged period of low interest rates and inflation may justify higher valuations, but we believe there is likely little upside given current levels. Fig. 3: Standard Deviations of Small-Cap Valuations (Russel 2000 Index) 2.00 1.50 1.00 0.50 - (0.50) (1.00) (1.50) (2.00) (2.50) (3.00) 12/85 12/86 12/88 12/89 12/91 12/92 12/94 12/95 12/97 12/98 12/00 12/01 12/03 Source: CS U.S. Equity Strategy, Russell, S&P Capital IQ/Clariff as of 6/30/15. Shows Russell 2000 Index unweighted median LTM P/E ex negative EPS, P/B, LTM P/S, NTM P/E ex negative EPS. Fig. 4: Standard Deviations of Large-Cap Valuations (S&P 500 Index) 2.50 2.00 1.50 1.00 0.50 - (0.50) (1.00) (1.50) (2.00) (2.50) 12/85 12/86 12/88 12/89 12/91 12/92 12/94 12/95 12/97 12/98 12/00 12/01 12/03 Source: CS U.S. Equity Strategy, Russell, S&P Capital IQ/Clariff as of 6/30/15. Shows Russell 2000 Index unweighted median LTM P/E ex negative EPS, P/B, LTM P/S, NTM P/E ex negative EPS.

In addition to an increased probability of multiple compression as a result of high absolute valuations, relative valuations indicate that higher-quality stocks are more attractive than lower-quality stocks. Figures 5, 6, and 7 show the relative valuation difference (as measured by price-to-book [P/B], price-to-sales [P/S], and forward price-to-earnings [P/E] ratios) between the Russell 3000 Index stocks in the top and bottom quintiles of ROIC. As shown, on a relative basis, higher quality is trading at a discount to lower quality, and is therefore more attractive. Similar to the earlier absolute valuation comments, a discounted relative valuation does not imply future outperformance, but we believe it should be taken into consideration when evaluating investment alternatives. Fig. 5: P/B Difference Between Highest- and Lowest-ROIC Stocks 3.75 3.25 2.75 2.25 1.75 1.25 0.75 0.25 Lower-quality is relatively more attractive Higher-quality is relatively more attractive Source: Russell Investment Group, BofA Merrill Lynch Small Cap Research, as of 6/30/15. A direct investment in an unmanaged index is not possible. Fig. 6: P/S Difference Between Highest- and Lowest-ROIC Stocks 3.75 3.25 2.75 2.25 1.75 1.25 0.75 0.25 Lower-quality is relatively more attractive Higher-quality is relatively more attractive Source: Russell Investment Group, BofA Merrill Lynch Small Cap Research, as of 6/30/15. A direct investment in an unmanaged index is not possible. Figure 7: Forward P/E Difference Between Highest- and Lowest ROIC Stocks 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 0.00 Lower-quality is relatively more attractive Higher-quality is relatively more attractive Source: Russell Investment Group, BofA Merrill Lynch Small Cap Research, as of 6/30/15. A direct investment in an unmanaged index is not possible.

Tightening Favors Higher-Quality Companies The domestic economy appears to be making progress toward sustainable growth, with the end of the Fed s quantitative easing program and interest rate hikes coming closer into view. We believe a moderately improving economy, or one that necessitates Fed tightening to help restrain inflation, favors companies with higher ROIC, as figure 8 shows. Unlike lower-quality companies, such companies are generally less reliant on the capital markets because they are able to generate enough cash and access enough capital to fund initiatives as interest rates rise. If volatility does increase, we believe investors would likely benefit from a portfolio of higherquality companies. Fig. 8: Tightening Favors Higher-Quality Companies 300 250 200 150 100 50 0 Cumulative Performance Difference Between Top and Bottom Quintiles Based on ROIC (Left Axis) Federal Funds Rate Target Seven Quarters Later (Right Axis) 7 6 5 4 3 2 1 0 12/97 12/98 12/00 12/01 12/03 Source: FactSet, as of 6/30/15. Performance is indexed to 100. A direct investment in an unmanaged index is not possible. Increasing Volatility Favors Higher-Quality Companies The last few years of the current market rally have been marked by a prolonged period of low volatility, as measured by the CBOE Volatility Index (VIX), shown in figure 9. But this prolonged period of low volatility may be coming to an end, thanks to a sell-off in oil and other commodities, concerns about a slowdown in global growth, a strong U.S. dollar, and geopolitical risks. If volatility does increase, we believe investors would likely benefit from a portfolio of higher-quality companies. As figure 10 shows, using monthly data points, there is a strong historical correlation between volatility and the performance difference between high- and low-quality stocks. With higher volatility risk to the upside more than to the downside, we believe there is an increased probability that higher-quality companies will outperform. Fig. 9: CBOE Volatility Index (Price) 90 80 70 60 50 40 30 20 10 1/90 1/91 1/92 1/93 1/94 1/95 1/96 1/97 1/98 1/99 1/00 1/01 1/02 1/03 1/04 1/05 1/06 1/07 1/08 1/09 1/10 1/11 1/12 1/13 1/14 1/15 Source: FactSet, as of 6/30/15. Performance cited represents past performance. Past performance does not guarantee future results and current performance may be lower or higher than the data quoted. A direct investment in an unmanaged index is not possible.

Fig. 10: Strong Correlation Between Volatility and the Performance Difference Between High- and Low-Quality Stocks 70 60 50 40 30 20 10 0 VIX (Left Scale) Quarterly Performance Difference Between Top and Bottom Quintiles Based on ROIC (Right Scale) Correlation: 0.68 250 230 210 190 170 150 130 110 90 We believe that downside protection including a focus on investing in higher-quality companies is of utmost importance. Source: FactSet, as of 6/30/15. Performance is indexed to 100. A direct investment in an unmanaged index is not possible. Conclusion The bull market is now entering its seventh year, valuations are near all-time highs, the Fed is poised to tighten, and there is a higher likelihood of increased volatility. In this environment, the markets are primed to return to a more normalized return environment or experience a period of consolidation. Adding to these concerns are fears of a global economic slowdown and a constantly evolving geopolitical landscape. During such periods of uncertainty, we believe that downside protection including a focus on investing in higher-quality companies is of utmost importance.

About the Author M. Matthew Neska, CFA, is the domestic equity specialist for the firm s U.S. value equity strategies. He joined William Blair in 2013 to work with the firm s domestic equity value teams. Previously, Matt was a manager research consultant with Mercer. Before Mercer, he was an equity research analyst with RBC Global Asset Management. Matt is a member of the CFA Institute and the CFA Society of Chicago. Education: B.B.A., finance, University of Minnesota, Duluth; B.A., economics, University of Minnesota, Duluth. About William Blair Investment Management William Blair is committed to building enduring relationships with our clients and providing expertise and solutions to meet their evolving needs. We work closely with private and public pension funds, insurance companies, endowments, foundations, and sovereign wealth funds, as well as financial advisors. We are 100% active-employeeowned with broad-based ownership. Our investment teams are solely focused on active management and employ disciplined, analytical research processes across a wide range of strategies, including U.S. equity, non-u.s. equity, fixed income, multi-asset, and alternatives. As of June 30, 2015, William Blair manages $68.3 billion in assets. William Blair is based in Chicago with investment management offices in London and Wilmington and service offices in Zurich and Sydney. William Blair Investment Management, LLC and the investment management division of William Blair & Company, L.L.C. are collectively referred to as "William Blair."

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