Bringing value to light: A distinct perspective on the US value equity landscape

Listen to the Delaware Funds® by Macquarie webinar replay, which discusses US value investing, the various methodologies used to uncover potential reasons why a company is trading at a discount, and what precautions to take to help ensure that the company is not a “value trap.”

Highlights include:

  • the value/growth debate and our view on why value has outperformed growth over the long term
  • how an active, valuation-driven investment style can help generate alpha over passive investment options
  • long-term changes to the sector classifications of value benchmarks and their impact
  • our outlook for 2019 performance drivers in the US value market.

Good afternoon, everyone. My name is Katie Killen, retail channel manager at Macquarie Investment Management. And on behalf of the team, I'd like to welcome you to our first quarter capital markets coaching clinic event today reviewing our perspective on the US value equity landscape. Just a few housekeeping items before we begin today. Feel free to ask us our presentation material from today via the resources widget left of the slide window. Please also submit questions via the questions widget below the slide window. If we do not get to your question today, a member of the Macquarie Investment Management team will follow up with you after the event. Upon successful completion of our full webinar today, CE credit will be reported on your behalf to IWI and the CFP board. If we are missing any of your validation information, you will be contacted to provide those details so that we can accurately get your credit. Finally, in order to help better serve you with the content in the future, we'd appreciate your feedback via our survey to the right of the slide window. Our discussion this afternoon features Chris Beck, chief investment officer of the firm Small and Mid-Cap Value Team, as well as two of his team members, senior portfolio manager Kelly Carabasi, and senior equity analyst Mike Foley. We look forward to hearing the team's perspective on the state of the US value market for the remainder of 2019. And with that, Chris, I will pass it off to you.

Great. Thank you very much. Good afternoon, everybody. Let's go right to slide two where we'll give you a little bit of history of the small-cap value team that we have here and the mid-cap value team at Delaware Funds by Macquarie. I've been with the firm since 1997 and broke into the business in 1981. Kelly McKee, who is Kelly Carabasi, who you'll hear on the call, joined in 2004 and has been with the team 14 years, almost 15 years in the summer. And then, Mike was our latest addition, who joined us in February of 2015. So it's a good seasoned team. Everybody has their CFA. And you can see from the graph here that we all have sector focus specialties in there that we've had for quite a while. Everybody has been through a big upturn and a big downturn – a lot and certainly, some volatile markets going through. And then, you can see that the focus that we have really is – the philosophy is the same for each small-cap and the mid-cap products. The focus is, and everybody believes in this, free cash flow. We want the ability of companies to give money back to us, and it's really how we define a value stock. Can you find companies that give dividends, pay down debt, do share buybacks, that will give money back to us as shareholders? And frankly, in this market, it's been fairly easy to find a lot of companies that are giving free cash flow returns back to shareholders. So it's been a good market for our kind of a style, and we'll go into some of the details from here. Let's go to page three, and this is, frankly, the favorite page that I like to talk about. Because, as I’ve mentioned, our style is focused on free cash flow. And what this chart shows you is in an over 30-year period, beginning in 1986, it really is a perfect sequence in terms of the record of free cash flow yields, and the stocks are returning the best four shareholders. So the ones that have a highest free cash flow yield, quintile one, delivers 17.7 annual returns over 17 years. Obviously, very, very strong. And then, really, what we want to point out is that the ones that do not deliver free cash flow generally fall into the quintile five, some in the quintile four in the area of lowest returns. So clearly, this tragedy has worked well over time, and shareholders do like to get returns in some fashion coming back to them whether it's dividends, as I've mentioned, buybacks, or paying down debt.

Now, the other alternative for some free cash flow firms is M&A, which a chart later on will show how big that has been the last several years. So companies clearly have been using a lot of their cash flow in order to give money back to shareholders or to buy other firms. We do not see that changing any time soon because the company has been very disciplined in terms of what they've been doing with their capital. Now, this strategy has not always worked. Certainly, for those of us who were through the 1999 and early 2000 Internet bubble, free cash flow basically was an afterthought. Back then, all people looked at was the potential of revenue growth, even if the company at the time did not have any revenues. But that was a tough period for value investors. Since then, we've had some spotty markets like in the middle of 2009, which actually was a good year for everybody, but in the middle, it was very tough for companies with free cash flow. And then, 2012, particularly the second half of that, focused on companies that had high debt, and no earnings, and a low market cap, and they actually did the best. So of course, now it doesn't work all the time, but it does work the vast majority of the time. And again, we always view companies that have higher quality, that have the ability to turn a capital share.

Now, if we go to page four, here's the quarterly dividends and share buy backs, literally, for the last 15 years. And what I'd like to focus in on is that it's been very, very significant, as you can see, in all periods. Even during the downturn, during the great financial crisis, you had a lot of companies returning a lot of capital to shareholders through dividends and through share buy backs. Now, this chart is of the Russell 3000. It works for both the Russell 2 and the Russell 1 in terms of the ability to have a lot of dividends and a lot of buy backs. What I also want to point out is that the fourth quarter of 2018 had a record level of both dividends and buy backs that we've seen. And you can see a steady increase in the dividends and a steady increase in the buy backs over time. It's gradual, but it is certainly consistent. I'd say one that I wanted to point out was the fourth quarter of 2014 where you see a very large increase in dividends, and then it fell off in the first quarter. And if you remember, the fourth quarter of 2012 was just before they were changing the tax rate on dividends in 2013. So a lot of companies did what they should have done for shareholders, they actually prepaid their dividends that they would have paid in the first quarter, and they paid them in the fourth quarter. So that's why you see the big bump there to 125 billion, and then back down to 93 billion in the first quarter. So companies did what they were supposed to do. But the thing that I want to point out here, again, is that you got a very large buy back and dividend component for returns. They did get a boost from the tax reform act back at the end of 2017 into 2018 when the tax rate went down from 35% for corporations down to 21. They had a lot of excess capital that they could use, and they did a lot of that, as you can see in the buy backs and dividends. So they are being very disciplined, and their cap excess is what we look for, and we think it's a great way to define quality.

Page five, to continue in this theme, I mentioned that there are several ways for companies to return capital, and we had dividends and share buy backs, as well as pay down a debt. And we also had M&A. And if you'll notice on the bottom of page five where we have the total deal valued, in three of the last four years they've been the highest. So 2015, 2016, and 2018 were three of the four highest years of deal value on record. And that's probably going to continue into 2019. Not necessarily at the rate that we've seen, but it still looks like all indications are that it's going to be very substantial. And then, the deal count itself, looks like the average deal is hovering between 4 to 6 billion for the last five or six years, so the deals are not just small-caps and mid-caps, but you do get some large-caps in there, but it's a significant amount. The use of capital, actually during the past year this had the highest rate of the use of capital. Then, it went to buy backs, and then dividends. So again, we expect this to continue for the next several years. Companies on the prowl for ways to grow their revenue, and obviously we've seen the past and the way to grow EPS is through the use of share buy backs, and companies have taken full advantage of that. Now, if we go to page six, here's where we get some real fun in the market in terms of what defines small-cap. Now, for a little bit of background, this probably does more to date me than anything else, when I broke into the business in 1981, a small-cap company was defined as 500 million in market cap. And now, you can see, this is all based on the Russell 2000 index, which does a re-balance end of June of every year, right now, a small-cap company is defined as roughly 5 billion market cap and below. We do have some services that actually have it much higher than that, around the 7 to 8 billion, but when I've went back to the thick of 1981 when I broke in, I mentioned that small-caps were 500 million and below, the Dow was at 940 and the S&P was 120. So the markets have roughly gone up between 25 times and 28 times since that time. So you can see that the-- you would expect the definition of small-cap to go up quite a bit.

Now, look at the very bottom there. You can see what it really shows is the top end of the Russell, and then the bottom end of the Russell. So for instance, in the last year of 2018 the top end was about 4.8 billion, the bottom was 159 million. So really, you're stretching into micro-cap territory when you get down to that bottom part. And then, just for some other reference, look at 2008, and then 2009. So you can see that at the time in 2009, just coming out of the great financial crisis, the top end of the Russell 2000 small-cap index was about 1.7 billion, down about a billion from the previous year, but the bottom end was actually well below 100 million. It was 78 million. So the definition of small-cap does change quite a bit from year to year potentially. But the thing is that over time, you can see that it's generally a gradual increase. And the odds are that when we get to 2019, because of the fourth quarter that we saw in 2018 where we had a decline of roughly 20% in small-caps, the top end may not quite reach full point eight billion, but again, we still have a few months to go before we determine that. Now, to give you some other insight into small-caps and mid-caps, back in 1980, here were your larger stocks. And you'll notice a little difference in what they are today. This is just for information purposes. So the largest stocks, the 10 largest, were IBM, AT&T, Exxon, Amico, Schlumberger, Shell, Mobile, Standard Oil of California, Barco, and GE. So literally, seven of the companies were related to energy, and that's the big change. So back in 1980 there were a lot of small-cap companies that were drillers, oil field services companies, that they were also populating the small-cap indices, which had just started, by the way, in 1979. So, energy became around 30% of the S&P at its high. And right now, it's well into the single digits. So obviously, the Schlumberger’s, and the Amico’s, and the Exxon’s, and the Mobiles have been replaced by the Googles and the Apples, things like that. So there's been a big change in the market. But I just wanted to point out that back then there was a totally different market in terms of what was working what was not. And that certainly was elevated in the small-caps because back then, you had a lot of IPOs that were energy related and that right into the Russell 2000 Value Index — into the Russell 2000 Growth Index.

Now, let's go to page seven and page eight. This shows the long-term track record of small-cap value over 40 years. And as I mentioned, the Russell small-cap indices actually started on January 1st of 1979. So that's why it goes back to the end of 1978. So just for the start. You can see that in this case Russell 2000 value by far has the best returns over that time frame. Russell 2000 growth is actually the lager among those. So it's not that small-caps out performed all the time, it was that the small-cap value out performed for a great majority of the time. Then, Russell 2000 value was the second-best performer, and then you went to the S&P 500. So, value has definitely outperformed growth, whether it's small-cap or large-cap, during the previous 40 years. So that's starting in that first chart on page seven. Now, let's go to page eight, and here's your 20-year chart. A little different in the sense that the composition of the bottom four are a little bit different, but small-cap value, once again, definitely wins hands down in the 20-year time frame. In this case, it's actually followed by small-cap growth, and then the Russell 1000 value. So, in this case, it's small-caps over large, not necessarily uniform value over growth. And then, I want to highlight, look at the very left part of that chart where you have that orange line, which is Russell 2000 growth. You can see the big upward tilt in 1999 into very early 2000. So, for those of us who remember the internet bubble in a big way, in 1999 the Russell 2000 growth out performed Russell 2000 value by 45 percentage points. So, a huge out performance. And then, when you went to the Lipper, small-cap growth was up 62% in 1999, and Lipper small-cap value was up 1%. So a huge out performance. That continued into the first two months of 2000 when the Lipper small-cap growth was up 27% in just two months and the small-cap value was down 1%. And then, March 10th came in 2000, which really initiated the Nasdaq rolling over, and I guess, from a value manager standpoint, we would consider the beginning of the good new days, as opposed to the bad old days.

So that's when all the internet stocks really decided to go down because the revenue projections were certainly inflated, were not going to be met. But really, what I'm trying to point out here is that even with that time period of Russell growth certainly out performing in a major way that we haven't seen since, the Russell 2000 value over the 20-year and the 40-year time frame has certainly done better than the Russell growth, and certainly better in the large-cap. Now, one of the things that I did want to point out is that certainly, as I mentioned, it doesn't always work. And the last 10 years we've actually seen the Russell growth indices beating the Russell value both in the small and the mid-cap in most of the years over the last 10. But even with that, as I mentioned, you can see the long-term track record certainly favors small-cap values. So, we think it's a great asset class. It's a population of stocks that are certainly defined by companies giving back a lot of money to their shareholders. We do not see that ending. We generally get to see lower PE multiples in the value stocks. And one thing that's been really pleasantly surprising in this environment, we are in the 10th year of this recovery, and we still have a lot of companies that are giving a lot of money back to their shareholders. And again, is I want to emphasize, we do not see that ending. So, with that, I'm going to turn it over to Mike Foley to pick up on some of his topics.

Thanks, Chris. This is Mike Foley. I cover financials and REITs for Delaware's small-cap value and mid-cap value team. I'm going to talk to you about what makes investing in financials and REITs different from other sectors and the outside influence that financials and REITs have on the value style indices as compared to the growth style indices. Starting on page 10, the accounting evaluation metrics for financials and REITs are different for most other industry sectors. Unlike other companies, the value and earnings power of a financial services company or a REIT begins with its balance sheet and not necessarily its income statement. Therefore, many of the financial performance ratios for REITs and financial services companies are specialized, and only some of the traditional valuation metrics that we are familiar with apply to these companies. Looking at the valuation multiples on the left side of page 10, financials do trade on their price-to-earnings multiples, and some REITs do trade on an EV-to-EBITDA basis. But analysts in these sectors also look at price-to-tangible book value for financials and price-to-funds from operations and price-to-net asset value for REITs. The words cash flow are seldomly used by REIT analysts and are almost never used by financials analysts. And as Chris mentioned earlier, the foundation of our investment process is to identify companies that can generate sustainable free cash flow going forward. Because my sectors don't trade on cash flow metrics, we use proxies for cash flow for each sector to determine our estimate of the fair value of these companies. For financials, we focused on the amount of excess capital that a company can generate, which if the size of the balance sheet of the company is unchanged, that will equal the company's earnings. And for a REIT, we favor funds available for distribution, which is a REIT's earnings or FFO multiple adjusted for recurring capex requirements.

Turning to pages 11 and 12, financials and REITs make up a much larger percentage of the value indices as compared to the growth indices. On page 12, our benchmark for our small-cap value strategy, the Russell 2000 Value Index, is comprised of nearly 30% financials and 12% REITs. So these two interest-rate sensitive sectors make up nearly 40% of our benchmark, whereas in small-cap growth, technology and healthcare play a much larger role. In mid-cap value, which is our team's other strategy, financials and REITs make up a slightly smaller percentage of our benchmark at about 33%. Even though interest-rate sensitive sectors play a big part in our portfolio, the risk of interest rates negatively impacting our performance is somewhat limited as REITs and utilities tend to do well when interest rates are low and financials do well when interest rates are high, providing a natural hedge across these two sectors. But in the growth indices, many of the tech and healthcare stocks have very high P/E multiples, or sometimes no earnings at all, particularly in small-cap, and that is an exposure that is really tough to avoid when you're investing in growth stocks. Moving on to pages 13 and 14. When I was asked to talk about what was going on in my sectors, I thought that the most interesting thing that has happened to financials recently had nothing to do with a company's fundamentals and everything to do with the recent volatility in their stock prices. Since the beginning of last summer, regional banks, which make up about 75% of financials in small-cap, declined in price by 29% in a matter of six months, and then appreciated by 22% since the beginning of last year through today. And during this period of pretty significant price volatility, the fundamentals of these companies did not change at all, in our view. The selloff was driven by late-cycle fears based on what happened to banks during the last recession and also the thought that bank profitability couldn't get any better.

During the Q4 sell off, it was our belief that perhaps earnings were close to peaking, giving the waning benefit from rising interest rates and the idea that loan losses couldn't go any lower. However, we didn't believe that risk of peak earnings justified a nearly 30% decline in value, and we decided to add to our weightings and financials in November and December. Our outlook for financials now is neutral. And moving onto '14, this shows the PE multiple of the KBW regional bank index versus the S&P 500. And shortly after the 2016 election, financials were one of the best performing sectors driven by three factors, the prospect for corporate tax reform, a parallel shift up in the yield curve driven by synchronized global growth, and the prospect for deregulation. And as a result, bank multiples expanded, reaching over 19 times during the beginning of 2017. The benefit from tax reform was meaningful and resulted in a 20% increase in earnings on day one for most banks that these companies typically paid the full statutory tax rate of 35%. Increases in interest rates was also a positive for bank earnings. However, the benefit from that is waning as the right side of a bank's balance sheet tends to re-price on a lag basis as compared to the left side of the balance sheet. Anyone who has shopped for a money market account or a CD recently will notice this. And then, finally, deregulation has had a very little quantifiable benefit for small banks, in our opinion. The large regional banks, your PNCs, your U.S. Bancorp’s, your BB&Ts, which are either mid-cap or large-cap companies, did see some benefits from deregulation related to liquidity and capital relief, but those were not nearly as significant as tax reform and higher interest rates. And the smaller community and regional banks saw very little or no quantifiable benefit from deregulation. After all those benefits, we realized bank multiples compress meaningfully, and now banks trade below the long-term averages on both an absolute basis and relative to the S&P 500, which you can see on slide 14.

The attractive valuation multiples combined with our acknowledgement that things can't really get much better for the sector makes us neutral on financials, and I wouldn't expect our financials weight to change meaningfully in the short-term. However, in December, when regional banks were trading at a single-digit PE multiples, we thought the sell off was overdone, and we had a positive outlook for the sector at that time. With that, I'm going to turn the call over to Kelly, who is going to talk to you about a few economic trends that are helping the small-caps, particularly one of our largest holdings.

Great. Thank you, Mike, and thank you, everyone, today for being on the clinic call today. So, my name is Kelly McKee Carabasi. I am a senior PM. And my specific area of focus within the fund is on industrial materials and utilities. In this next section, I'm going to talk about some positive economic trends in the market and how we, on the small-cap value team, are taking advantage of them. Some of the areas that we find attractive are companies that benefit from the capital spending cycle, specifically, materials, industrials, and technology, which are all areas which we are overweight. Despite the recent upturned trend in capital expenditures, the age of US fixed assets has not been this old in over 60 years. When we look at this chart, you see almost 100 years of the age of the installed assets in the United States. These assets help to drive the economy through production growth and productivity. There are four phases shown on this chart. The first was World War II and The Great Depression where money to invest was either non-existent or going towards the war efforts. Not a lot of investment in the domestic economy otherwise, and assets aged during this time frame. Post World War II, we really hit the golden age of manufacturing. Significant investment and manufacturing plants were made, be it in steel, auto, this was a time when power steering was first introduced, refrigerators, air conditioners, electronics, the first microwave was introduced in the 1950s, and even random things that you use every day such as household goods, like Saran Wrap was invented by Dow during this time and was a new technology. And the third part, we really had a steady state of investment from the late '70s through 2000 as the economy slowly grew.

Our next phase, during post the tech bubble, we have the rise of emerging markets, and companies expanded their supply chains globally and focused on low-cost sourcing. There was a lot of investment going on at this time, but it was outside of the United States. So now, we find ourselves in 2019, and with more competitive tax rates, which I'll talk more on later, a lower US cost of energy when you compare it to the global landscape, resulting from all of the shale production that we found, and a closing gap in wages with China versus what you pay in the United States, and an abundance of skilled labor. And you combine that with a need for investment, we're finally seeing capex increasing and accelerating in the United States. This broad-based investment is needed, and it's not needed for additional capacity. The US capacity utilization has not been above 80% since the global financial crisis in 2008, 2009. But it's needed to increase domestic productivity. And technology is a big driver of this capex. Investments need to be made in more efficient machinery, software, automation. These are areas where companies need to make these investments in order to remain competitive and to maintain or grow margins into the future. An historically tight labor market only reinforces this need for a sustained investment cycle. As labor, the attracting or retaining talent is frequently mentioned as one of the top concerns of companies' CEOs and CFOs. If I pulled out infrastructure alone, the picture would probably look a lot like this as well. While there is a lot of opportunity on the state and local levels, any infrastructure bill at the national level would only add to this capex story into the future. We would love to see it, but obviously, there's a lot of other things moving on Capitol Hill. So whether actually look at completed is a bit of a wild card.

On the next page, I want to talk about that some of the biggest winners in tax reforms were those domestically focused firms and sectors. Domestic companies on general saw their tax rate reduced by 10 and a half percent. Where those that have more of a multi-national footprint only saw a reduction of about 3%. Tax reform should also positively impact capital expenditure, so it is a delayed effect. Profit growth leads investment growth, and with the tax reform package only passing at the very end of 2017, and a lot of things still really kind of up in the air through a lot of 2018 getting clarity around some of the rulings from the treasury, any impact is likely going to be seen in 2019 and beyond. Recent bottom left revisions have shown rising plan capex spending into 2019, which is certainly encouraging. This chart shows a strong link between tax changes and capex momentum, and those sectors that benefited the most from tax reform are those with higher domestic exposure, and they tend to have a high exposure within small-cap sectors, and specifically those within the value spectrum. Energy companies and tech companies, thinking about cloud computing, have pulled back on their spending, but they do remain at high levels. But we're seeing accelerating capex out of financial firms, staples, industrials, and communication services names. This capex momentum is a positive for the US economy and the small-cap value space, in particular.

On the following few slides, I'm going to give an example of a small value company who is benefiting from this increase capex in the communications, oil and gas, and utility space, in particular, and saw a big benefit to their tax bill with over 95% of their revenues coming from the United States. Turning on to 5-3, I'd like to talk to you about a company that we own in our portfolio that we think really exemplifies what we look for. This company highlights those opportunities that we look for in the marketplace, an attractive valuation, a slightly misunderstood and discounted story, a strong management team, a good balance sheet, and a free cash flow generating company that has a history of giving money back to shareholders. Unless you live in the greater Miami area, you probably never heard of MasTec. They are a specialty engineering and construction firm. Now, what do I mean by specialty? I mean that they don't build bridges, or highways, power plants, or buildings. They play in very niche markets. Telecom, pipelines, electricity, and renewable energy, specifically focusing on wind power. MasTec is a clear beneficiary of increasing US capital expenditures. Though there are certainly investments in wind power and investments to improve our electric grid, they were actually a company that won one of the major awards to help rebuild the Puerto Rico electric infrastructure after the hurricane that hit there in the fall of 2017. Its spend in the telecom and the oil and gas pipeline area, which I'll touch on in more detail, that are the big areas of investment in driving the majority of the growth for this company.

This strong growth, which started in the pipeline side a few years ago and is now reliably picking up in the telecom space, has started to generate some real significant cash flow. The lower levels of cash flow that they generated in 2016 and 2017 are due to increased project work that consumed a lot of resources internally and working capital. It was not a function of increasing their own capex in spending. In 2018, and moving forward, this business hit scale, and the company has worked to reduce days of working capital and has started to generate strong free cash flow. Averaging free cash flow of 350 million a year over the next three years, and with an equity market cap of 3.6 billion, this free cash flow yield is 10%, and that's an area where we find very attractive investments. This free cash flow has also been helped, again, by their effective tax rate going from close to 40% in 2017 to an expected 27% rate in 2019. So what are they doing with that cash? They're investing in businesses to take-- in their own business to take advantage of the attractive growth opportunities that they have in front of them in these markets. They've added small bolt-on acquisitions to complement their existing businesses, either adding new geographies or adding additional services in their existing regions, and they've also been repurchasing shares. They have spent over $400 million since 2015 on share repurchases, with a majority of them coming in 2018, and they've reduced their share capital over 12% over that time. And they still have 130 million in authorization for repurchase into the future. They do not pay dividends at this time. The two founding brothers, who are the chairman and the CEO of the company, respectively, own 20% of the outstanding shares. And at this point, it's not something that the broader shareholder base has really pushed them for, as they feel that there are a lot of investments in front of them, and they're giving us cash back in the form of these share repurchases when they feel that the stock is below its intrinsic value.

So, to talk a little bit about some of these areas of the US economy that are really seeing growth, we'll move to the next slide to talk about the telecom, and the oil and gas pipeline markets, and the capex cycles that they're experiencing. In the communications segment, they install telecom equipment and fiber optic cable to support wireless and wire line, which is fiber, companies. So this would the AT&T, Verizon, Comcast, and a lot of the smaller players in the world. We each probably have two to three personal electronic devices, connected TVs, connected security systems. You might have a net thermostat in your house. And that list of connected devices will only grow. And we're spending an increasingly amount of time on these devices that are driving increased data usage and traffic. This part of their business has been growing at a double-digit rate the last few years, and it's set to continue on that upward trajectory and potentially accelerate with a ramp in spending over the next few years, which is going to be driven by FirstNet, which is a network for first responders that AT&T was awarded to build out, which is one of MasTec's largest customers. And also, 5G network, and that spend will only really begin in late 2019, and it will last for years. One industry report estimates that the spend over the next decade could be upward of $250 billion to build out a 5G network and that peak spending is years out. It's not a question of if it will come, it is a question of when it will come, as we will not be grand plans that the auto companies have and maybe some of the green plans to introduce electric vehicles, and more specifically, automated driving vehicles would not be possible without this 5G network. And so far, we don't think that the company is getting any credit for their results or for the potential of this market.

Moving to the pipeline side, which is a slightly more controversial segment both because of the headline risk. I'm sure you've seen articles where pipelines have been in the news, and in negative investor view on the cycle, specifically from the hedge fund community. Traditionally, the pipeline business has been a boom, and then bust, lasting for two to three years. We are already in year four, and from where we sit, the outlook looks promising. There are fewer competitors that are able to build larger complicated pipelines, and MasTec is the number two pipeline construction company actually in North America. And because of this kind of fewer competitors that are in the market, we're seeing increased profitability on the jobs that they take with a lower risk profile. The owners of the pipelines are taking a lot more risk. We're seeing coal power plant retirements that have been replaced by natural gas. We've seen the shale and oil gas and production growth, specifically in the Marcellus, the Bakken, and the Permian basin. We've seen a build out of new petrol chemical and L&G facilities along the Gulf Coasts, which are driving needs for new pipelines to connect these production basins with the new locations of end use and demand, which might not be, perhaps, some of the traditional areas where you've seen the demand, in addition to just increasing demand where existing pipelines are not able to move that capacity. The increased regulatory environment have also elongated the cycle as the permeating process is taking much longer. These two segments, while not immune from the cycles of the economy, have less correlation with the near term economic outlook as they are both playing the long game in improving America's future. Right now, we view it as an attractive investment to capitalize on these two larger trends.

Shifting back to the small-cap market more broadly, it is a fact that the small-cap space gets a lot less coverage from sell-side investors than the large-cap market does. On the sell-side, analysts cover more companies today than ever before, and many of them are being covered more for maintenance purposes sometimes to support the investment banking activities, and only write research report on earnings. Some of them can provide very little value-add research. When analysts drop coverage on names, it tends to be those smaller companies that we look at. The average company in the Russell 1000 index has 18 analysts. Then, if you look at a company like Facebook, it has 35 analysts that publish on the name. The average small-cap company in the Russell 2000 has 6 analysts. MasTec, the company I just spoke of, has 10 people on it. Though we certainly have a few companies in our portfolio that have three or less. There is value, no pun intended, in active management and fundamental analysis when such little sell-side coverage exists. The last slide I'd like to touch on is that the small-cap value has been one of the good places within the domestic style box to be active. This chart takes the annual returns of funds in each Lipper category over the last 20 years, so 1999 through 2018, and it counts the years when greater than 50% of the funds within that category beat their respective Russell benchmark. Small-cap value has the highest hit rate of any of these style boxes.

Hopefully, these prepared remarks on the slides have provided you with some insights into the small-cap space. The importance of free cash flow, and what companies do with that free cash flow, and the performance that those companies feel over time, what the small-cap value landscape looks like compared to their growth and their large-cap counterparts, how it's evolved over time, how we analyze it, a closer look at the their financials, and REIT sectors, and areas where we are finding opportunity in the small-cap space. With that, I'm actually going to turn it back to Chris for a few closing comments.

Thanks, Kelly. Yeah, there a couple of things that I think we should use to distinguish small-cap value and mid-cap value from the growth side. And the first one, I think, is probably fairly obvious to those of you who own funds or assets in both those categories, but if you're in a value space, you will tend to have a larger position in the financials overall, and that's not even including REITs. To include REITs, it's obviously much larger, and you'll tend to have a larger position in industrials. There, you tend to have the companies that derive more of their cash flow, and free cash flow, and actually have lower P/Es. On the growth side, you're probably loaded with technology stocks and healthcare stocks. So there'll be stocks that have higher P/Es and generally have lower returns on equity just because they're still in their growth phase, and the revenues are supposed to be moving ahead and in a very high manner, but that, in a lot of cases, is still to come. So the P/E difference between value funds and growth funds can, in a lot of cases, be very significant. And when you look at the Russell 2000 composite, most times during it's history, somewhere around 20% of the companies do not have earnings. Obviously, in recession years, it could be much higher than that, and in boom years, it could be much lower. But out of the 2000, roughly, stocks in the Russell 2000, you will have somewhere between 3 and 4 hundred companies that do not have earnings. Most of those will be on the growth side. The value side tends to have many more companies that actually do have earnings and do a cash out. So that's going to be a distinguishing characteristic between value funds, small-cap, and then the growth funds in small-cap.

Let's go back about a year and half to the tax reform, actually, now, a little more than a-- well, right around a year and a half. As the market became convinced that taxes were actually going to go down, and that was after the election in 2016, to me, you had the market respond exactly the way that they should have. You will notice the financials did extremely well in the last six to eight weeks of 2016 into the first week of 2017. The consumer stocks also did very well. The reason being, those are companies that generally have higher tax rates. So when the tax rate went from 35% to 20%, those were companies that were going to be direct beneficiaries for a couple reasons. Not only did it look like on the surface that their earnings would increase, but also because they are paying high tax rates, they're going to increase in their cash flow. So think about it that if you're paying a lot of taxes and your tax rate goes down, you get a benefit of not only cash flow, but also of earnings. On the other hand, if you're a company that lists on the income statement that you have a tax rate of 35%, but then when you go to the fund disclose statement it's all deferred, you're really not paying any taxes. So theoretically, you really don't care what the tax rate is because you're not paying taxes to begin with. So that's why, to me, the market acted just the way it should have in the latter part of 2016 and early 2017, and that's with the financials in consumers doing very well. And that was a very good period for small-cap value, as well as large-cap value versus the growth side. Now, as we moved into 2017, the market was becoming somewhat skeptical that the tax reform was actually going to happen, and that's what you saw from about February to August, the value components really didn't do that well. And then, all of a sudden, around August, the market became convinced correctly that tax reform was going to happen, and the stocks did very well again. So that's what you'll see from the ones that are paying taxes.

On another sector that I think has changed their stripes a little bit during the past several years has been in technology. And it used to be not that long ago that if a technology company paid dividends or bought back their stock, the stock market treated it very poorly because they were treating that as an indication that the stocks could no longer grow. We've entered a new period where now technology companies feel free to buy back their stock and or pay their dividends, and it probably was lead by Apple and Microsoft several years ago when they did those huge buy backs. I believe one was 40 billion and one was 30 billion. But it seemed like that gave the okay to some of the smaller companies to start paying dividends as well as doing their buy backs. Because, as mentioned, that was very rare previously. So now, there is a [?] percentage of companies in technology that are returning capital to shareholders, I would expect that, and we would expect that, to increase over the next several years as they get more comfortable with deploying returns to shareholders, as well as making sure they have the best uses of their capital. So that's one that has changed their stripes, and we, as a team, feel that that's where we can look for some technology stocks that have strong balance sheets and are not afraid to return capital shareholders. Finally, another one that we would look at would be energy. And as you heard in my opening remarks, energy, at one point in the cycle, was around 30% of the S&P. Now, this is going back 40 years when you had the second OPEC supply crunch and when oil went from $11 a barrel up to $34 a barrel in about a year and a half.

So back then, everybody wanted energy, it was considered a growth stock. And then, when you actually had supply start to increase, energy stocks started to lose money, and the price of oil went, eventually, from 34 right back down to $10 a barrel in 1986. So they stayed there for awhile. And then, as we all know, in the 2000s, mainly due to China demand, the demand for oil went up significantly, and the price of oil actually peaked in 2008 at over $120 a barrel. Then, in Thanksgiving, when OPEC-- in Thanksgiving 2014 when OPEC announced that they-- well, let me back up. During the financial crisis, the price of oil went down from 120 down to about 30. And then, we had something that really changed the industry, and probably permanently, and that was the fracking revolution. So our production went from just under 5 million barrels a day, and again, these are not considered non-growth equities because nobody thought that they could find barrels of oil. So production went from almost 5 million barrels a day in 2008 to today where it's over 12 million barrels a day, and we are now, meaning the US, the largest producer of oil in the world. So the fracking revolution, whether one is for or against fracking, has been a boon to the production of oil in the United States. And Kelly mentioned certain things from MasTec like the Bakken areas, the Bakken shale area, and the Permian basin. These are huge areas for oil production, and they're going to continue increasing in their oil production for the next several years. Though these are companies now that admittedly they do not meet our free cash flow credentials. These typically have been companies that historically have been users of capital as opposed to generators of capital. So the big test for them in the next couple years will be can they actually have discipline in their capital spending? And do they have the ability to return capital to the shareholders?

Right now, history would say that it's a very mixed bag as far as whether they'll be able to do it. But the recent indications are that most of the companies are trying to stick to their capital discipline and at least either pay down some debt or think about initiating a dividend probably sometime in the future. But these are now becoming more value stocks. You'll find very few of these in the growth indices mainly because you don't get the cash flow growth, at least you haven't, especially with oil being so volatile. So when people ask us what have been the biggest changes in the sectors over the last 10 to 15 years? Obviously, technology is one because of the way they've treated their capital with shareholders, energy would be a second. Because there are not too many of us in the room that would have thought 5 years ago or 10 years ago that the US would be the largest producer of oil in the world. That's a sector that has changed. It's one that potentially could get more of a value space depending on how they treat their capital. We have been encouraged by companies saying that they're going to be very disciplined in their cash flow and how they spend it. And if they do start return capital to shareholders, then the odds are this will be a pretty good sector going forward. And it's something that, in our lifetimes, we never felt we'd see in terms of how the US is the predominant producer of oil and energy in the world.

Thank you, Chris. There were a few questions that came in as we were making our presentation today. We wanted to try to answer some of those in the time we have left. One while Mike was talking about the financial sector and REITs, he was speaking about price to tangible book value, and we did have a question come in asking about the intangible asset increase over the last 10 years or so and how that's potentially impacted the relevance of price-to-book ratio valuation.

Thanks, Zach. So the question was if the price-to-book value had lost its advocacy due to the increase in intangible assets in the industry. And for financials, and particularly banks, which are most of the financials that we look at, about 75% of the small-cap index in the financial sector is banks, and the remaining 25% are insurance companies, for the most part. And banks are typically valued using a price-to-tangible-book value as opposed to price-to-book value. So that would account for that increase in intangible assets. However, we do look at both multiples. And when we evaluate either a price-to-book value or a price-to-tangible-book value ratio, we look at it in relationship to the company's return on common equity or return on tangible common equity. So the higher the return on equity, the higher the price-to-book value multiple, and the higher the return on tangible common equity, the higher the price to tangible book value multiple. And what you'll see is if a company has a lot of intangible assets, it might have a really high return on tangible common, but a mediocre ROE, and that's typically viewed as a red flag for us, but it's not a non-starter. Intangible assets in the financial sector are typically created from M&A. And I mean, this is an industry that's been consolidating for 30 years, so it's part of the business, but we do have a preference for companies that have organic growth and aren't over relying on M&A because sometimes they will overpay. And when you create an intangible asset from M&A, it's excluded from regulatory capital, so it's sometimes can indicate that a financial services company is not allocating capital in a prudent manner.

That's perfect.

Hopefully, that helps address that question.

And if there's additionals, you can always write them in, and we can have someone internally follow-up if you want answers. We have one last question that I wanted to touch on for the sake of time, and it was, I guess, some of the advisors were looking at Morning Star and the performance, and wanted to know, for example, what type of market environments, or what type of conditions would the small-cap value fund that we manage, Delaware small-cap value, performed the best or outperform in an ideal environment, when would you want to invest, potentially, before that environment occurs? And when would you outperforms?

So at a high level, I think that through our cash flow driven focus that generally, over time, we've been able to out perform the market. And when you look at things from a broader time frame, valuation does matter in the market. Quality outperforms junkier stocks in the market, and that's in the area that we play in. I think sometimes it's easier to talk more about the times when you don't perform well in the market. And for us, that is when you'd see we've tend to lag in areas where you have low-quality rallies. An example of one occurred recently this past year in the second quarter of 2018. It was a very powerful, small-cap market where the small-cap value space index was up 8 and a half percent, and we were only up about 4%. That was because companies that had no earnings at all, no cash flow, were the companies that performed the strongest. Part of that was driven by ETF flows that obviously they have no discrimination as to the kinds of names that they invest in and raise the entire vote. In addition, use and a lot of that was driven by investors wanting to be more domestically focused because we were on the brink or started conversations about whether trade wars were going to occur. And so those are the kind of environments when you have those kind of low-quality, those non-earners, the kinds of companies that we don't invest in that tend to be the one that perform. When investors are really focusing on the valuations of the market, focusing on higher-quality companies, that is when we tend to do well. And thankfully, looking at history, there have been more times where we've had those kind of markets than when we've had these more momentum and low-quality driven markets.

Great. Well, thank you so much to the team today for this conversation. For more information for what we discussed today, please visit the resources widget. There you'll find links for most updated digital content on the value market. For more regular commentary from our investment teams, please visit the insight section of our website and subscribe to receive updates for new content as it's available. Thank you again to everybody for your participation, and we will talk to you all soon.

The views expressed represent the Manager's assessment of the market environment as of December 2018, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views. This webinar is for educational purposes and for financial professional use only.


Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Value investing focuses on buying stocks that are trading at bargain prices based on fundamental analysis, then holding them until they become fully valued.

Typically, value investors select securities with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.

Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.

The risk that all or a majority of the securities in a certain market — like the stock market or bond market — will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.

All third-party marks cited are the property of their respective owners.

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