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Matter Of Debate: A Return To Small Cap Quality?

By Robert D’Alelio, Portfolio Manager, Small Cap Value Team and Benjamin Nahum, Portfolio Manager, Small Cap Intrinsic Value Team After a period of small cap underperformance, the focus may shift to fundamentals. Small-capitalization equities have underperformed larger stocks over the past year, and experienced a particularly rough stretch of negative performance in the second half of 2015 and into early 2016. The Russell 2000 Index, a popular benchmark for smaller stocks, declined more than 25% from its peak last June through a low in February of this year. To assess risks and opportunities in small caps, we tapped into the insights of two of Neuberger Berman’s small-cap equity managers, Benjamin Nahum and Robert D’Alelio. Benjamin Nahum: Contrasting today’s market for small-cap stocks with June of 2015, we see significantly more value but with greater volatility. A year ago it was the inverse. Arguably the current environment presents more challenges, including economic deceleration and uncertainty with regard to China and central bank policy, but for long-term investors, we see a far more appealing value equation in small-cap equities today than there has been in quite some time. Robert D’Alelio: When prices get lower, stocks can become more attractive, provided your time horizon is sufficiently long. It’s worth noting, however, that lower prices don’t necessarily equate to an attractive small-cap market. Roughly one-third of the companies in the Russell 2000 are projected to lose money over the next 12 months, so selectivity is important. This is one reason we think small-cap equities are an area that stands to benefit from active management. Nahum: To put our thinking on the attractiveness of current valuations into context, our strategy’s “intrinsic value” discount metric exceeded historical averages in February. In our view, a “cheap” or truly distressed market would mean an intrinsic value discount north of 40%. This happened three times in the past 18 years, during periods of global financial panic or systemic risk. We believe our strategy’s current intrinsic valuation discount represents an attractive entry level of value. If you think there is a crisis lurking out there, then there could be more downside based on what we’ve seen in the past. Absent a crisis, the current discount to intrinsic value is appealing. D’Alelio: To us, the overall market does not look particularly cheap on an absolute basis, but we don’t buy the overall market. We buy individual securities, and we focus on high-quality companies with strong balance sheets, high levels of free cash flow and high returns, with barriers to entry. Until recently, in the post-financial crisis recovery, high-quality businesses like the kind we prefer have lagged. Low rates have helped highly leveraged companies and hurt companies with net cash balance sheets. In this sense, corporate savers are no different than individual savers that have been punished by Fed policy. Clearly cash is a “non-earning” asset today; however, it can always be converted into an earning asset via share repurchase, acquisition and so on. It follows that companies with net cash balance sheets have untapped earnings power. So while the market today does not appear to be attractive on an absolute basis, quality looks relatively cheap. Identifying Attractive Opportunities Nahum: We are taking a measured approach to adding new ideas to our portfolios and are demanding a higher-quality investment, not simply an inexpensive stock. We look for companies whose share prices have underperformed the market and where there is a compelling value argument in terms of cash flow, earnings or price-to-sales. If our analysis suggests a discount of more than 30% to intrinsic value, we’ll investigate further. The idea is to look for out-of-favor companies with strong value attributes, along with capable management teams and credible catalysts for a turnaround in the next three to five years. D’Alelio: Quality has been out of phase recently but, over a full market cycle, we believe the quality approach works. Small is thought to equate with sexy, new kinds of companies, but we buy established and perhaps even boring businesses with clear-cut barriers to entry. They tend to keep competitors out and generate substantial free cash flow. Because these are not the kinds of companies that need to access the capital markets, they often don’t get a lot of attention from Wall Street analysts. Advantages and Considerations of Small-Cap Equities Nahum: The small-cap marketplace has been inefficient and volatile, but over the long-term, small-cap value, in particular, has attractive relative returns versus large-caps, as measured by the performance of the Russell 2000 Value versus the Russell 1000 indices since 1979. One reason, in our view, is that managements of smaller companies are often owner-operators, rather than bureaucrats. They tend to be entrepreneurial and creative, and are often more innovative and faster to market than their counterparts in larger companies. We believe these are the people you want to partner with over long periods of time. D’Alelio: I agree. Also, the inefficiency in the small-cap markets is great for active managers. Why would you want to index inefficiency? Are U.S. Small Caps Insulated from Global Risks? Nahum: Small-cap companies are sometimes thought to be insulated from global risks, but we think this is a bit of a red herring. The financial sector accounts for nearly 40% of the Russell 2000 Value Index, and about one-third of those companies are real estate investment trusts, one-third are banks and one-third are non-bank finance companies. U.S.-based, small-cap financial companies tend to have little global exposure. The same cannot be said, however, of small-cap technology companies. So if you want the entrepreneurial benefits of small-cap American tech or medical companies, as we do, you’ll incur global risks. D’Alelio: I agree with Ben that, while small companies are in fact more domestically oriented than larger caps, simplistic analysis using SEC filings tends to overstate the magnitude. For example, this type of analysis would lead one to believe that small-cap energy companies are 100% domestic. While that’s technically true, where is the price of oil determined? It’s driven by global demand. While it’s true that small companies are still somewhat more focused on domestic markets than larger ones, we don’t think that should be a reason to embrace or avoid the space. Outlook for Mergers and Acquisitions Activity Nahum: We tend to see a lot of acquisitions among our portfolio companies, and we view a company buying one of our holdings as corroboration of our process. Regarding the level of ongoing M&A activity, we think confidence goes hand-in-hand with liquidity and risk premiums, so we find that there is more M&A activity when financial markets and confidence are strong, and that M&A will ebb when markets weaken. Year to date, we have seen healthy M&A activity within our portfolios, suggesting that confidence among corporate buyers and private equity firms appears reasonably solid. D’Alelio: We experience our share of takeovers within our portfolios, but we tend not to like them unless the premium is very large. That’s because we buy into unique, hard-to-duplicate business models. We’d rather own these companies and capture the benefits of earnings growth over the next 10 to 20 years than get a one-time premium and have to redeploy the cash into another company with similar attractiveness, which can be hard to find. As Warren Buffett has stated – the best time to sell a good company is never. Disclaimer: This material is provided for informational purposes only. Nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Any views or opinions expressed may not reflect those of the firm as a whole. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results. Please see disclosures at the end of this publication, which are an important part of this article. © 2009-2016 Neuberger Berman LLC. | All rights reserved

Ivy Portfolio May Update

The Ivy Portfolio spreadsheet tracks the 10-month moving average signals for two portfolios listed in Mebane Faber’s book The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. Faber discusses 5, 10 and 20 security portfolios that have trading signals based on long-term moving averages. The Ivy Portfolio spreadsheet on Scott’s Investments tracks both the 5 and 10 ETF Portfolios listed in Faber’s book. When a security is trading below its 10-month simple moving average, the position is listed as “Cash.” When the security is trading above its 10-month simple moving average, the position is listed as “Invested.” The spreadsheet signals update once daily (typically in the late evening) using dividend/split adjusted closing price from Yahoo Finance. The 10-month simple moving average is based on the most recent 10 months including the current month’s most recent daily closing price. Even though the signals update daily, it is not an endorsement to check signals daily or trade based on daily updates. It simply gives the spreadsheet more versatility for users to check at his or her convenience. The page also displays the percentage each ETF within the Ivy 10 and Ivy 5 Portfolio is above or below the current 10-month simple moving average, using both adjusted and unadjusted data. If an ETF has paid a dividend or split within the past 10 months, then when comparing the adjusted/unadjusted data you will see differences in the percent an ETF is above/below the 10-month SMA. This could also potentially impact whether an ETF is above or below its 10-month SMA. Regardless of whether you prefer the adjusted or unadjusted data, it is important to remain consistent in your approach. My preference is to use adjusted data when evaluating signals. The current signals based on April 29th’s adjusted closing prices are below. This month ( GSG ) is below its moving average and the balance of the ETFs are above their 10-month moving average. The spreadsheet also provides quarterly, half year and yearly return data courtesy of Finviz . The return data is useful for those interested in overlaying a momentum strategy with the 10-month SMA strategy: Click to enlarge I also provide a “Commission-Free” Ivy Portfolio spreadsheet as an added bonus. This document tracks the 10-month moving averages for four different portfolios designed for TD Ameritrade, Fidelity, Charles Schwab and Vanguard commission-free ETF offers. Not all ETFs in each portfolio are commission free, as each broker limits the selection of commission-free ETFs and viable ETFs may not exist in each asset class. Other restrictions and limitations may apply depending on each broker. Below are the 10-month moving average signals (using adjusted price data) for the commission-free portfolios: Click to enlarge Click to enlarge Disclosure: None

How Share Repurchases Boost Earnings Without Improving Returns

By Obi Ezekoye, Tim Koller, and Ankit Mittal – McKinsey & Co Some actions that boost earnings per share don’t create value for shareholders. Share repurchases are generally a wash. Of all the measures of a company’s performance, its earnings per share (EPS) may be the most visible. It’s quite literally the “bottom line” on a company’s income statement. It’s the number that business journalists focus on more often than any other, and it’s usually the first or second item in any company press release about quarterly or annual performance. It’s also often a key factor in executive compensation. But for all the attention EPS receives, it is highly overrated as a barometer of value creation. In fact, over the past ten years, 36 percent of large companies with higher-than-average EPS underperformed on average total return to shareholders (TRS). And while it’s true that EPS growth and shareholder returns are strongly correlated, executives and naïve investors sometimes take that relationship too seriously. If improving EPS is good, they assume, then companies should increase it by any means possible. The fallacy is believing that anything that improves EPS will have the same effect on value creation and TRS. On the contrary, the factors that most influence EPS – revenue growth, margin improvement, and share repurchases – actually affect value creation differently. Revenue growth, for example, can increase TRS as long as the organic investments or acquisitions behind it earn more than their cost of capital. Margin improvements, by cutting costs, for instance, can increase TRS as long as they don’t impede future growth by cutting essential investments in research and development or marketing. For example, to improve EPS, managers at one company committed to an aggressive share buyback program after several years of disappointing growth in net income. Five years later, managers had retired about a fifth of the company’s outstanding shares, increasing its EPS by more than 8 percent. Yet the company was merely retiring shares faster than net income was falling. Investors could see that the company’s underlying performance hadn’t changed, and the company’s share price dropped by 40 percent relative to the market index. Share repurchases seldom have any lasting effect on TRS – and that often comes as a surprise to managers and investors alike. Given how often we hear executives advocate share repurchases because of their effect on EPS – and make the occasional argument for taking on debt to execute them – it is worth exploring the relationship between buybacks, EPS, and shareholder returns. We’ll begin by examining the empirical evidence and then look at the logic behind so many decisions to repurchase shares. Misguided math Companies that repurchase shares when prices are low can create value for those shareholders who don’t sell if the share price rises as a result. As our prior research has found, however, most companies don’t time these purchases well. 1 Rather, we find that many executives have come to believe that share repurchases create value just by increasing EPS. The logic seems to be that earnings across a smaller number of shares mathematically increases EPS, and if EPS increases and the price-to-earnings (P/E) ratio stays constant, then a company’s share price must increase. The empirical evidence disproves this. For while there appears to be a correlation between TRS and EPS growth, little of that is due to share repurchases. Much of it can be attributed to revenue and total earnings growth – and especially to return on invested capital (ROIC), which determines how much cash flow a company generates for a given dollar of income. All else being equal, a company with higher ROIC will generate more cash flow than a similar company with lower ROIC. But without the contribution of growth and ROIC to TRS, there is no relationship between TRS and the intensity of a company’s share repurchases (Exhibit 1). 2 Click to enlarge That’s because it’s the generation of cash flow that creates value, regardless of how that cash is distributed to shareholders. So share repurchases are just a reflection of how much cash flow a company generates. The greater the cash flow, the more of it a company will eventually need to return to shareholders as dividends and share repurchases. The error in valuing share repurchases in isolation The idea that share repurchases create value by increasing EPS also errs in its failure to consider other possible uses of the cash, such as paying dividends, repaying debt, increasing cash balances, or investing in new growth opportunities. What matters is the effect of a share repurchase relative to those other actions, not the effect of the repurchase on its own. Repurchase versus dividend Consider the effect of a hypothetical company using cash to repurchase shares relative to using it to pay an equivalent dividend. The company earns $100, has a P/E ratio of 15, and makes no investments, so managers can distribute the earnings as dividends or as share repurchases (Exhibit 2). Click to enlarge If the company pays out its earnings as dividends, its value will be $1,500. Shareholders will also have received $100, so the total value to the shareholders is $1,600. On a per-share basis, the share price will be $15. Since each share will also have received $1 in dividends, the total value and cash per share will be $16. If the company pays out its earnings by repurchasing shares, its total value will remain the same, $1,500, and shareholders as a whole will have received the same amount of cash, $100. On a per-share basis, for those shareholders who don’t sell, each remaining share will increase in value to $16 because the earnings are now divided by a smaller number of shares. For an individual share, this is economically equivalent to having a share worth $15 plus cash of $1 from a dividend. The mechanical effect on EPS is irrelevant. If the company pays a dividend, shareholders retain their shares and receive cash. If the company repurchases shares, the selling shareholders receive cash and the remaining shareholders have shares with higher value (but they don’t receive any cash). Overall, there is no change in value, just a change in the mix of shareholders. Repurchase versus debt reduction Comparing the effect of using cash to repurchase shares with using it to pay down debt is more complex. The reason is that when the company pays down debt, its capital structure, cost of capital, and P/E ratio change. Yet, because the enterprise value of the company stays the same, so does the value to shareholders. In this comparison, suppose our hypothetical company has $200 of debt in the base year (Exhibit 3). In that base year, the company’s enterprise value is $1,500 and its equity value is $1,300. Note that the enterprise value divided by after-tax operating profits is now different from the P/E ratio, at 15.0 and 13.8 times, respectively. The P/E ratio is lower because the higher leverage increases the riskiness of the equity, leading to a higher cost of equity. Click to enlarge Click to enlarge If the company repurchases shares, the enterprise value and equity remain the same as in the base year. In addition, shareholders receive $100 in share repurchases, so collectively, the shareholders will have $1,300 in equity value plus $100 of cash, for a total of $1,400. The remaining shares outstanding will be worth $14 per share. If the company pays down debt instead, the enterprise value remains the same, but the equity value increases by $100. Note that the enterprise value doesn’t change because the operating cash flows of the company have not changed. However, the value of the equity increases by the amount of cash retained and used to pay down debt. The value of the company to all the shareholders is the same as the sum of equity value and cash distributed in the share repurchase, or $1,400. A better way to understand internal rate of return – read this article . The equity value of $1,400 divided by a net income of $97 produces a P/E ratio of 14.4. Note that the P/E ratio in the base year, as well as in the share repurchase scenario, was lower, at 13.8. The increase in the P/E ratio is due to the declining leverage, leading to less risky equity and a lower cost of equity. On a per-share basis, repurchasing shares increases EPS, in this case from $0.94 to $1.01, but the increase in EPS is offset by the lower P/E ratio relative to the scenario of paying down debt. On the off chance that a company might borrow cash to repurchase shares, for example, it would increase a company’s EPS because the effect of reducing the share count is larger than the reduction in net income due to additional interest expense. However, with its increased debt, the company’s equity would be riskier and, all else being equal, its P/E ratio would decline-offsetting the increase in EPS. Repurchase versus investing Finally, consider what happens when, instead of repurchasing shares, our hypothetical company invests that same amount of cash, $100, back in the business. Assuming it earns a return of 15 percent, which exceeds its cost of capital, its income would increase by $15 (Exhibit 4). 3 Click to enlarge Assuming the enterprise-value multiple remains constant at 15 times, the enterprise value and equity value will increase to $1,725 – which is more than the sum of the equity value and the cash paid out in the share repurchase case. The EPS is also higher in the investment case. Investing at an attractive return on capital will always create more value than repurchasing shares, but it doesn’t always do so as quickly. In this simple example, we’ve assumed that the company earned an immediate 15 percent return on its investment. That’s often not realistic, since there will be a lag between when a company invests and when it realizes a return. For example, if the company didn’t earn a return until year three, its EPS for the first two years would be higher from share repurchases than it would be from investing. This explains the temptation to repurchase shares instead of investing. With a share repurchase, the effect on EPS is immediate, and with investing, it is delayed. Disciplined managers won’t fall for the short-term benefit at the expense of long-term value creation. Improving a company’s earnings per share can improve its return to shareholders. But the contribution of share repurchases is virtually nil. Disclosure: None.