U.S. Small-Cap Stocks: Why This Cycle Is Not So Different

Presenters: Hugh Evans, Steph Jackson, Jack Laporte, Greg McCrickard, and David Wagner Case for Small-Cap Equities

As of September, 30 2009 Annualized Asset Class Returns since 19261 15% 12.8% 12.5% 12% 10.5% 9% 6% 5.5% 4.6% 3.6% 3% 0% U.S. Small-Cap Equities U.S. Mid-Cap Equities U.S. Large-Cap Equities Bonds Precious Metals Cash Relative Performance of Small-Caps vs. Large-Caps 190 Recessions 165 Small-Caps Outperform 140 Small-Cap/Large-Cap Relative

115 Small-Caps Strength Underperform 12-Month Moving Average 90 '50 '54 '58 '62 '66 '70 '74 '78 '82 '86 '90 '94 '98 '02 '06 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 . 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 Case for Small-Cap Equities

As of September, 30 2009 Percent of Periods Outperforming Large-Caps Over Various Time Horizons 100% 90% 90% Small-Caps 83% 84% 80% Mid-Caps 75% 76% 70% 66% 58% 61% 60% 54% 55%53% 55% 50%

40% 30% 20% 10% 0% 1 Year 3 Years 5 Years 10 Years 15 Years 20 Years

The smaller-capitalization equity asset classes outperform large- caps 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 Case for Small-Cap Equities

As of September, 30 2009 World Indices–Market Capitalization Total Market Value (U.S. $ Trillions)

MSCI EM Index 2.9

DAX Index 0.7

CAC 40 Index 1.0

FTSE 100 Index 2.1

Nikkei 225 Index 2.2

Russell 2500 Index 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 Case for Small-Cap Equities

As of September, 30 2009 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

Smallest 0-1,000 Number of Companies Mid 1,000-10,000 Total Market Value ($ Billions) ($ Millions) ($ Largest Over10,000 Market Cap Bucket Bucket Cap Market 0 500 1,000 1,500 2,000 2,500 3,000 3,500 Number of Companies Average Number of Analysts Covering a Stock by Size

f 25 20 18 15 12 10 8

Analysts 4 5

Average Number o 0 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.

Source: FactSet, Merrill Lynch Small-Cap Research, T. Rowe Price 5 Case for Small-Cap Equities

As of September, 30 2009 Risk/Return Relationship 1974–2009

50% Small/ 15% 50% Large 100% Small-Caps

100% Large-Caps Annualized Total ReturnAnnualized 10% 15% 20% Annualized Standard Deviation

Adding Uncorrelated Assets Increases Correlation Between Small- and Benefit to Diversification Large-Cap Stocks Mor e 1.0

0.9 Return 0.8 Correlation of 20 Year Monthly Returns Correlation of 10 Year Monthly Returns Benefits of DiversificationBenefits of Less 0.7 -1Correlation 1 '36 '43 '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 Case for Small-Cap Equities

As of September, 30 2009

Relative Forecast P/E 1.5 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

0.75 Long-Term Average = 0.77 0.9 0.9

0.6 0.6 Long-Term Average = 0.76 0.74

0.3 0.3 1Q80 1Q84 1Q88 1Q92 1Q96 1Q00 1Q04 1Q08 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 versus the . Source: Merrill Lynch Small-Cap Research 7 Case for Small-Cap Equities

As of September, 30 2009 M&A Activity and Russell 2000 Index Performance 1,600 900 1,400 Correlation = 0.72 800 1,200 700 1,000 600 500 800 400 600 300 400 Number of U.S. M&A Deals 200

M&A Number of Deals of M&A Number 200 Russell 2000 Index 100 Russell Index 2000 Level 0 0 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

M&A Activity and Russell Midcap Index Performance 1,600 3,000 1,400 2,700 Correlation = 0.69 2,400 1,200 2,100 1,000 1,800 800 1,500 600 1,200 900 400 Number of U.S. M&A Deals 600 Russell Mid-Cap Index M&A Number ofDeals 200 Russell Mid-Cap Index (EOP, Dec/31/78=100) 300 0 0 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 M&A has been a key driver of small- and mid-cap index performance over time. Recent announcements are encouraging for small-/mid- cap stocks.

Source: Citi Investment Research & Analysis 8 Case for Small-Cap Equities

As of September, 30 2009 Recession Lessons 200%

150% Peak to Trough Drop One-Year Performance Post Small-Cap Trough 94% 100% 83% 75% 78% 65% 53% 56% 59% 44% 50% 35% 35% 33% 39% 38% 5% 0% -9% -14% -19% -11% -27% -29% -50% -36% -39% -34% -37% -37% -37% -50% -52% -60% -100%

-150% 1 Crash Recession Recession Recession Recession Recession Recession Recession 1981-1982 1948-1949 1951-1954 1957-1958 1960-1961 1969-1970 1971-1975 Crisis Recession TMT Bubble, 2002 Sell Off 2002 Sell 2000-2001 Stock Market Stock 2007-2009 October 1987 1990 Recession 1980 Recession 1945 Recession Financial CrisisFinancial 1997/98 Financial Historically, when there has been a positive inflection point in economic indicators, small-cap equities have performed very strongly.

(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 Case for Small-Cap Equities

As of September, 30 2009 Recession 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 43 October 1966 106 77 44 46 May 1970 78 62 58 44 October 1974 62 43 48 43 In 80% of March 1978 28 30 19 15 cases since August 1982 99 94 67 61 1932, small- December 1987 25 36 24 32 caps have October 1990 58 40 43 32 led the August 1998 42 18 46 18 market off of October 2002 78 65 34 40 extreme lows Average 76% 74% 47% 60% Median 58 43 43 43

Number of Times with 2 1 Highest Return 8 4 Early Bull Market Gains— Russell 2000 Growth Russell 2000 Value Russell 1000 Growth Russell 1000 Value March 9 - September 30 +74% +82% +54% +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 Case for Small-Cap Equities

• 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.

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