Capital Markets Coaching Clinic: Small caps. Big ideas.

Join Macquarie Investment Management for a webinar tracking the global small-cap market. While small-caps are their shared area of focus, each portfolio manager will represent their unique area of specialty — Growth, Value, Global, and Core — for a well-rounded look at small-cap equity investing. They will discuss their approaches, as well as performance drivers and current issues in the market.

Topics will include:

  • What will drive small-cap markets over the course of 2018.
  • Why active management matters in small-caps.
  • How different investment approaches can be put into practice.

Read more from our investment team at

Good afternoon. My name is Erica Kay, Head of Value Add Programs here at Macquarie Investment Management. And on behalf of our team, I'd like to welcome you to our 2Q Capital Markets Coaching Clinic Event today featuring a panel of our small-cap investors. Just a little housekeeping before we begin. Feel free to access our presentation materials and additional information from our team via the resources widget below our slide window. Please also feel free to submit questions via the questions widget below and to the left of your slide window. and if we don't get to them all today, a member of the Macquarie Investment Management Team will follow up with you after the event. Thank you, especially to all of you who presubmitted questions for our panel. Finally, in order to help better serve you with this content in the future, we'd appreciate your feedback via our survey to the right of your slide window today. Now, we'll get started.

Our discussion this afternoon features a panel of our small-cap investors. Combined, this panel has exactly 100 years of equity investing experience. With us today, we have Frank Morris, Chief Investment Officer of our Small-Cap Core Equity Team.

Alex Ely, chief investment officer of our Small Mid-Cap Growth Team.

Good afternoon.

Kent Madden, portfolio manager and equity analyst for our Small-Cap Value Team.

Hello, everybody.

And Stefan Maikkula, portfolio manager on our Global Ex-US Equity Team.


Adding another 12 years of experience is our moderator today, Zach Per, product manager for Small-Cap Equity Products.

Hello. Thank you, Erica. And thank you everyone for dialing in. I think it's a great time to be talking about both US and developed markets' small-cap equities, given the strength that we've seen this year in small-cap performance, particularly here in the US. I'd like to note that something I find interesting across the 14 equity boutiques that we have here at Macquarie Investment Management, and those start here in Philadelphia, which is where we're hosting this call from, circling all the way around the globe to Sydney, Australia, and then coming back into San Diego, California, which is where Stefan is calling from in today. We have four unique portfolio managers and four unique strategies, but each of them has a breadth of experience that we're going to share with you today, particularly in a facet of the small-cap universe. Starting with small-cap core equities, then ranging from small-cap growth and value, and then rounding out that discussion with an international equity conversation. So with that, I'd like to turn it over to Frank Morris, who's going to get things started talking to you about US small-cap equities and what makes them unique.

Terrific, Zach. Thanks so much. And as the individual with over a third of that 100-year experience, that's why I get to go first, I gather, because they might think I would forget about my name in about five minutes. So if we could move forward to the next slide. So when we look at the small-cap market, and that'll be the primary focus of my discussion today to sort of lay out the background before our other participants talk about their particular specialties, many of the small-cap stocks — many of the larger-cap stocks, once started as small-caps. And as you can see on this slide, you see that Amazon, at one point in time, started with a Russell 2000 designation of under 500 million in its IPO and then rapidly graduated to be a large-cap name from there and is now, as you're all fully aware of, one of the largest market caps in the indices. I always say that our perfect world is to find the next Amazon, find a company that is a $500 million market cap company, and grow with it over time so that it becomes a larger-cap company. And you have that every year as the indices rebalance. And so Proofpoint in the security software side, GrubHub in the Internet space, are examples of names which one were very small market caps which now will be graduating to become large-cap companies. And if you're fortunate enough to exploit those inefficiencies, you can generate nice returns for your clients.

If we could move forward. And that gets to the point of many of your companies that are on this page, you'll know them. They are small-cap companies and yet, you'll know who they are. Cree in the lighting space, Etsy in the ecommerce area, Cracker Barrel in the restaurant space, Avis,, Beacon Roofing, so many, many companies that you'll know through your dealings with every day are small-cap companies. And so it's not really an index or — that is a totally unknown to investors, to companies that are in there. And when you look at it, if we could move forward, how the market cap in the Russell has developed over time, what you'll see is you'll see that the index itself, as the overall market has done, has been increasing. And when you look at where we are right now and when we rebalance here going forward in June of this year, the other end of that range is now projected to be 5.1, 5.2 billion. And so small really isn't that small anymore at the upper end of that range. Now, part of this, we get asked sometimes the differences between the Russell 2000 and the S&P 600®, just to start, and yeah, Russell 2000 is a pure mathematical index. They just take the 2,000 smallest companies. And the S&P 600 tends to impose a higher quality standard around it, companies that have to have earnings to be included in their index.

And then also, when you look at the differences between small and large in terms of sector weights, what you'll see is that, in the Russell 1000, the large-cap index, the information technology sector is about 600 basis points greater than that which is constituted in a small-cap index. That 600 gets distributed in small-caps, in industrials, in healthcare — particularly on the biotechnology side — and in financials, particularly on the community bank side. And so while there are some significant large sector weights within small, it's not as dominated by technology as the large-cap indices are. On the next slide, we'll talk a little bit about how the valuation of small-caps are relative to large-caps. And what you'll see here is that, at the current moment, small-caps are valued based on forward earnings at about 17.5 times, with large-caps somewhere in the upper 16, 17 times earnings. And when you then look at the next slide and you look at how they compare to one another, what you'll see is that small-caps are trading at about a 3 to 4% premium relative to large-caps. However, that represents a discount to where the indices traded on a more historical basis, which is about a 5% premium for large-caps. And that valuation level has attracted investment into the Russell 2000, and I know you've all seen recent newspaper articles about how small-caps have started to do better than large-caps. And the main reason for those that I'll identify — or just five critical ones.

One is valuation, that you see on this slide. Two is the gross domestic product, the US economy, running now 3%, north of 3%. And the sweet spot for small-cap investing tends to be between 2 and 4%. So we've got an economy that's doing pretty well. The dollar, which has been increasing, tends to benefit small-caps because 80% of their revenues are domestically oriented. Tariffs, they impact large-caps to a greater extent than small-caps. And then, finally, tax reform, as you can see on this slide, has a much more beneficial impact to small-caps than it does to their larger-cap brethren. Now, as you look at that upper tax rate, in the Russell 2000, 30% now being lowered to 21%, there's significant earnings leverage to the upside with respect to small-caps from the revision down. Mostly in financials, some in consumer, and some in media. But there's significant earnings benefits to be had. So when you look at the performance of small-caps versus large-caps and you look at the rolling 1-year, right now, small-caps are up a little bit over 20% on the rolling 1-year, large-caps are up 50. Year to date, small-caps are up close to 6.5%; large-caps are up close to 2.5%. And so you're seeing significant outperformance here of the small-cap indices based on more favorable opportunities.

And then, finally, we get asked a lot about M&A activity with respect to small-caps. And if you look at these numbers year to date and you annualize them, what you're looking at then is you're looking at an M&A activity count, which is roughly equal to where it is last year, but a dollar number, which would be significantly higher. And what's driving this M&A are higher equity prices, the ability to use stock to make acquisitions, lower taxes, the ability to use cash to make acquisitions, and historically low tax rates, which are making financing — historically low interest rates, I'm sorry, which are making financing deals for larger-cap companies easier than in all of history. And then, finally, and then also what drives small-caps? And so what drives small-caps, to some extent, is the ability for us to find a diamond in the rough, if you will. Names that are underfollowed. Here, you see on this slide the average analyst coverage for a large-cap name versus that of for a small-cap name. And so small-caps are significantly less followed than their larger-cap brethren. And that provides opportunity. And that provides opportunity if you have a seasoned investment team, as we do here at Macquarie, seasoned investment teams in the small-cap space, if you see the right people who make the decisions in running companies, and you ask them the right questions to ascertain whether it's a particularly good investment for your portfolio. And the inefficiency of that space, small-cap space, really creates the opportunity set. And that's shown on my final slide and why one should be an active investor in small-cap equities.

So if you look at this slide and you look at the numbers, not in the circles, but just in the box, you'll see along the lower part of the boxes the small-cap space. From left to right, small-cap value, small-cap growth. And what you can see, that over the 3-year period, the percentage of active managers outperforming. And it's significantly higher than what you see in the large-cap space. And in the circles are their actual index return over this 3-year period. Part of that is the inefficiency of the space, part of that is the composition of the index, so when you look at the two indices, large versus small, many within the small-cap indices, the largest weights, probably 25 basis points, the top 10 is a little bit over 3%, versus your larger-cap, Russell 1000, where the top 10 is close to 19% and many of your larger weights are north of 3%. And so to have an active position, you really have to commit a large portion of your portfolio to those higher market cap weights. Within small, you can drive a very high active share by owning a significantly higher weight than the 25-basis-point weight in the index, or owning a nice weight in a name that's down-cap, 3, 4 hundred million market cap weight that you own north of 50 basis points in. It's still a significant active position. So active management in small tends to drive returns. We're fortunate here at Macquarie. We've got good teams who are able to drive good value across the spectrum, small value, small growth, small core, small-cap global, and you'll hear from all of those people today. And I would encourage you to ask questions. So let me stop there, turn it back to Zach to introduce our next speaker.

Thank you, Frank. And just to summarize some of the key points that Frank hit on differentiating US small-cap companies from US large-cap companies, we have, one, the market cap difference. Small-cap is small, but not as small as some people are used to seeing. There's plenty of opportunities we see in the small-cap space looking forward. We have really attractive rates in the tax space that are offering opportunities to the companies. We have less analyst coverage, which provides the opportunity for active managers to really exploit inefficiencies in the market. And we have a forward-looking valuation framework that seems to be conducive to small-caps continuing their outperformance that we've seen so far this year. I'd be remiss if I didn't mention the Barron's article that came out at the end of April mentioning the power of value, particularly over growth, and how, long term, the Russell 1000 Value has performed extremely well relative to the Russell 1000 Growth. And while we'll hear from both growth and value managers, I think the one thing that Barron's forgot to mention was the power of small-caps. And that if they would have thrown a chart on there for the Russell 2000, we would have really seen the appreciation of small-caps and how they contributed to outperformance relative to their large-cap brethren. And that's just a testament to why we're here today talking, in particular, about small-cap equities. With that, I want to turn it over to Kent Madden, who is the portfolio manager of Small-Cap Value. I'm sorry, Alex Ely, who's the portfolio manager of Small-Cap Growth. He's going to talk to us today about the growth equity investment in those particular sectors which appeal to him. Alex?

Thank you, guys. And thank you, Frank, for those insights. I think the percentage of active managers is actually going — that outperform — is actually going to increase going forward and I'll show you why later in the show here. And thank you for everyone that dialed in and I appreciate you taking your time to learn more about small-cap investing and what we're doing here at the Delaware Funds. I have 25 years of experience, as you can see here. I run a small-cap growth and a mid-cap growth products that are out there, and I'll be going through the merits and characteristics of growth investing so you can see how we approach it and how we think about it.

On the next slide, you can see, obviously, growth investing is focused on faster-growing companies. What we're trying to do is find the companies that are in the economy that we believe can consistently grow year after year much quicker than their value counterparts. What we look for specifically are secular changes in the economy, typically, trends or themes that are long-lasting, where businesses are changing, or sometimes, where all-new businesses are being created. So that would be things like social media or streaming media where you didn't have them a decade ago and now they've become much bigger businesses. The characteristics of growth are typically that the valuations are higher, along with the higher growth rates, and that they're volatile. So it's a more difficult route to sort of corral. And the tendency is, obviously, for higher growth rates in respect to earnings and sales, cash flow, book value, EBITDA, whatever metrics you're looking for, it changes industry by industry as for what you want.

On the next slide, you'll see — if they flip it forward — there we go - some of the actual statistics of that growth. So you can see earnings per share growth for the last five years and the Russell 2000 Growth has been much stronger than just the typical Russell 2000 or the value side. The standard deviation or the volatility that the Russell 2000 growth has is somewhat significantly above what you're going to see in the value or regular Russell 2000 index. But you do pay up for it. In terms of the extra growth that you get, the average price-to-earnings is 25 times in the Russell 2000 growth. The reason that it's so much higher is that, ideally, as you look out, that number comes down dramatically more than the others would because of the consistent earnings growth that you'll see within this group.

On the next slide, as it comes forward, along with this, you see stronger return. This is a chart that shows the Russell 2000 Growth versus the S&P and it's not insignificant. It seems a little bit higher on the line but it's more than that. On a $1,000 investment, you're, in essence, getting 35% more return over the last 10 years out of smaller companies. And this is typically held to be the case over time. If you look at 20-year periods, the Russell 2000 Growth has outperformed almost every period versus the larger-cap names. And over 10-year periods of time, it typically almost always outperforms the S&P, is what you'll find. So small-caps will be rewarded to those people that have a longer-term outlook and to the effect that you have clients that are looking to retire and maybe they're in their 20s, their 30s, their 40s, or what have you, and they're not retiring for a long period of time, certainly, there's more opportunity in small-cap than there would be in other areas.

So, as we look forward, what kind of trends are we seeing right now within the economy? What kind of companies are we seeing that we think have a lot of secular growth? In the consumer area, specifically, better living. People are looking for a better lifestyle, whatever it may be. These are three examples. One is higher-quality food. It works from the grocery stores to restaurants, in that in the grocery stores, organics are growing 10% a year while traditional food categories are flat. Fast-casual restaurants are on the rise, so kids would rather go to Chipotle or Shake Shack than McDonald's these days. We're seeing a movement towards that higher quality experience across the board. Huge market, all of our food, so the fact that we're seeing a 10% growth in any category is really dramatic for a consumer staples industry.

Second would be mobile services. Mobile services, I mentioned before looking for all-new businesses. These are companies that didn't even exist in the way they do today just 10 years ago because the advent of having apps and great Wi-Fi and wireless broadband services didn't really exist. We hadn't really had 4G yet in terms of what telecom service companies provided, so you couldn't have the kind of content that you can have today. And mobile services are really ideal for certain things, whether it be banking or dating or trying to find new people or diet and exercise or healthy living. All of these things are finding big, new markets on mobile services and a lot of opportunities that certain companies are able to exploit.

And then, finally, secular migration. This is an area that I think is misunderstood by many. Many people look at the overall housing market as being mixed, but they're including all of the different areas of the country. If you look at specifically at certain smaller cities, typically that are southern, we feel we're seeing a secular migration to these cities, whether it be Austin or Nashville or Charleston or Jacksonville, Tampa, Denver, Seattle, Portland, what have you, people are moving there in droves because they're confident that they can get a job and now there's a higher level of confidence in the economy. They're moving there because of money. It's cheaper to live there, the taxes are lower, you can buy a bigger house for a lot less money. Typically, it's warmer climates or better climates than an area like New York City or what have you. But they're also doing it because they can. In essence, the landscape is being changed by the Internet. In essence, the same way that it was by elevators and air conditioning generations ago, that enabled you to have buildings in southern cities and so forth. Today, the network makes it that you can do your job wherever you may be. You don't have to be on Wall Street to work on Wall Street or in Hartford for insurance or on Madison Avenue for advertising. You can do those jobs in those other cities. And when you go there, people typically look for shelter. And the housing companies that are providing that shelter, providing houses in those areas, are having a secular buildout of housing in those particular areas.

On the next slide, it refers to healthcare and what we're seeing there. Specifically, we see it being ignited by the fact that the genome could be mapped, and that just started about 15 years ago. At that time, it took years and millions and millions of dollars to map one genome. Now, you can map hundreds on a desktop computer sold by Illumina for just $20,000. So that's a lot of opportunities in terms of identifying specific new drugs in the future. Also, this enables doctors and researchers to look into targeted therapies, which are very important. By targeting specific gene pools or gene variations of a disease, you're able to have a better efficacy or success rate, and therefore, much more likely to get approval on a new drug.

Another area of concentration is the opiate crisis. Specifically, obviously, we have lots of people dying in the country, it's an awful thing that we see. But we do feel that there are new kinds of treatments which can help prevent opiate addiction. Specifically, we look at opiate in terms of when people have procedures or surgeries. And the reason we look at that is 40% of all addicts start by having some procedure done and then they're given opiates and then they get hooked. For goodness sake, they're giving 18-year-olds Percocets and Vicodins when they get their wisdom teeth taken out and it's a bad scenario to have. So one company that we have in this area makes a non-opiate anesthesia that makes it so that you never have to take opiates when you do the procedure in the first place. We're seeing support for this right now in a bill that's coming together in Congress which we believe will be approved in the next month and should be supportive of the companies that help to prevent opiate addiction.

And then, finally, medical devices, we're seeing lots of new innovations across the board, whether it be for new kinds of braces or new kinds of heart valves or different ways to monitor your heart. There's new medical devices and new monitoring that is helping to improve people's lives. On the next slide, it's really just about tech and the fact that tech is permeating so many different areas of the economy. Content is one, which I mentioned before. My kids watch streaming media and social networking, interactive gaming. My daughter said to me the other day that regular TV is boring. And in a lot of ways, I can agree with her. So huge, new markets that are undergoing change. Fintech, this is a big thing in the banking area, whether it be payments or blockchain and how things are changing there, or how people bank and the fact that people will bank on their phone as opposed to ever going and seeing a teller. That's significant and really, actual cryptocurrencies, you can't have a bigger market than all of our currency and what's provided there.

And then, finally, Internet of Everything. We're seeing the Internet permeate into so many areas of our lives and, in essence, there's connectivity opportunities that are out there that the Internet is creating. So whether it's in your grocery store or whether it's in your home or your factory or your building or on your sports equipment or what have you, there's going to be chips on everything in order to monitor the data and be able to use algorithms to manipulate the movement of that data to improve what we're doing. So, of course, we're seeing autonomous vehicles and other things that are creating those opportunities.

Next, we'll go into just a quick history lesson in respect to why growth is in a unique place, particularly in small-cap, right now. And I'll run through these pretty quickly. We know that in 1929, the market peaked out. It took 20 years for the market to break out again. It was drawn down in a very poor period by high unemployment and the Great Depression and war. After that, major trends created huge amounts of value in the marketplace where the S&P went up 500% in the 18 years of 1950 to 1968. Airlines came about, the interstate highway system created logistic improvements, container shipping was invented during this time as well. Everyone gets a car, everyone gets a phone, big new trends are created and new value is created during that time. On the next slide, we have the same thing happen again. We have 14 years where the market didn't go anywhere, marked again by war and other macro-issues that made it tough for active managers during that time. We had 20% mortgage rates. I even bought a CD that had a 14.5% yield in 1982. So incredible what it changed. After that, we had the globalization of American brands like Coke and Nike and Johnson & Johnson. Certainly, PC penetration with Microsoft and Internet. And then again, tech in things you don't think of, things like big box stores, companies like Home Depot and Lowe's and Costco and Walmart. All of these were major leaders in terms of creating a 1,400% increase from 1982 to 2000.

Then we had our generation's lost decade or decade of fear, so to speak, again, marked by war, but also the tech rack and the consumer debt bubble. We believe we've just broken out of that range and are now in an area where the market could do very well in an expansionary period for a long period of time. I mentioned some big trends that were out there, things like mobile services, all-new content, Internet permeating all areas of our lives, cancer cures. There's a lot of opportunity that's out there and this is what growth managers look for. They look for trends. And, as I started in the beginning of this discussion, it makes it easier for active managers. In the '90s, 75% of small-cap managers outperformed. 75%. And it's because we're not the only ones that see these things happening. Other people can identify them, see what's happening, and work onto it. We should be coming into a newer area of asset management, of greater confidence in the economy, and I believe there's been too much money that's been pushed into passive and alternative solutions over the last decade, which won't be set up for what we're seeing ahead in growth going forward. And I believe that's my last thought. I appreciate, again, the opportunity to talk to you guys. I think I'm handing it off to Chris Beck next, who I'm sure who will have some good information for you. Thank you again and we'll talk to you soon.

Thank you, Alex. This is Zach. And I really appreciate the key concepts there that we heard there from you regarding the growth side of investing. In particular, better living, medical breakthroughs in technology, and how you apply your earnings growth framework to investing. Now we'll hear from Kent Madden, who works with Chris Beck on the Value Team here in Philadelphia. He's going to talk to us about some of the value-oriented sectors within the small-cap universe.

Thank you, Zach. And thank you everybody for joining us today. I'd like to spend a few minutes talking about how we think about investing in small-cap value and a couple minutes on valuation metrics that we do find useful, talk a little bit about the current macro-environment and how that relates to small-cap value and positioning, and wrap up with a couple of stock examples that we bought in the past 12 to 18 months here at Macquarie.

So the traditional definition of value investing is finding a company that is trading at a discount to its intrinsic value. There's definitely different flavors of value investing, ranging from deep value; deep value typically involves buying a company that may have shaky fundamentals, may have a distressed balance sheet, and the reward may be great on these companies but the risk is also very high as well. At Macquarie, our small-cap value strategy typically focuses on more of the quality of value buys. We typically look through the lens of the more traditional or relative valuation framework. We're trying to find companies that are trading at discounts to their long-term historical averages. And we're also looking at companies trading at discounts to their peers as well. So we will do this through doing comparable company analyses. We'll do discounted cash flow analyses. But the most important thing that we do is in-depth fundamental research. We really try to get to know the companies as best we can. We will go through the 10Ks, the 10Qs, speak with the management team, speak with analysts on the sell side, really understanding what the potential catalysts are for the company that may drive that outperformance and may drive that valuation gap to the peers to close over time.

A very important part of that strategy is focusing on companies that do have very strong free cash flow. We find that that free cash flow focus, along with finding companies at discounted valuations, that combination can be very, very powerful. So along with those cash flow focused metrics, we do focus on capital spending trends, making sure companies are using their shareholders' capital judiciously. Moving onto the next slide, on some of the important valuation metrics that we like to look at, a lot of these should be familiar to you. Enterprise value to EBITDA, price and cash flow, which typically includes working capital changes, price to free cash flow, which is essentially free cash flow yield, forward and trailing to P/E ratios, price-to-book is also in there as well. We like to also focus on quality metrics, which we think is important as well. A return on equity as well as return on invested capital. Return on invested capital is essentially measuring how much efficiency or return a company is getting for each dollar of capital invested into the business. And what we'll typically see in the marketplace is companies that have high return on capital, typically, will garner a higher multiple in the marketplace. And when we're looking at valuations, we're not only looking at looking for the cheapest stocks, we're also looking for companies that have quality metrics through high cash flow or high return on equity or high ROICs.

The next slide is one of my favorites. This shows the free cash flow yield going back to 1986 by quintile. So the companies in quintile one are the companies with the highest free cash flow yield. Essentially, the companies that are generating the most free cash flow. And the companies in quintile five are the companies with very low free cash flow or potentially no free cash flow. And you can see that disparity between quintile one and quintile five is pretty dramatic. So when we're looking for stocks to buy, we want to focus on those stocks in quintiles one and quintiles two. And I think this works not only for value investing, but I think this works quite well for investing overall; focusing on those companies with free cash flow is a very powerful metric.

Moving to the next slide, not only do we want companies to generate free cash; what those companies do with free cash is also very important. We don't want companies to squander their cash through bad acquisitions or bad projects. We want companies to invest in meaningful projects that have appropriate returns and with that excess capital, we want them to return that cash to shareholders through either dividends, share buybacks, or paying debt down. And this chart shows dividends and buybacks going back to 2008, and you can see a nice, consistent pattern here. Companies have been very generous with their excess cash and returned those to shareholders through both dividends and buybacks going past 10 years plus. We think that trend can continue. CapEx has upticked modestly in the recent quarter or two, but we do think there's going to be plenty of excess cash flow to go around for companies to return to shareholders going forward.

Moving onto the next slide of consumer confidence, something I'm sure you've all seen recently. And what I really want to take note of is we are back past the previous peaks back in 2006, 2007, and we are approaching the peaks in the year 2000. And I think what's interesting is really the big uptick we've seen in the last two years. I think a lot of that has to do with tax reform. Consumers finally are starting to feel a bit better after what felt like a three or four years of fairly anemic consumer spending. We're finally starting to see consumers follow through with their pocketbooks. They are spending more money. Retail traffic is coming back. Still negative, but retail spending is getting better. Consumer spending at restaurants is also getting better. So we're finally starting to see consumers spending more money and that's definitely reflected in those confidence figures.

The following chart shows new home sales going back to 1978. And this is also one of my favorite charts because it's still pretty amazing to me that we are not even back to long-term median levels of new home sales in the US. This shows single-family new homes sales. Really, it shows you the peak of the market and then the size of the downturn was huge. So we do think that, going forward, homebuilding can be the tailwind for the US economy. We think that, even as rates do rise, we think there's going to be room at the entry level of the market. We're finally starting to see millennials come back into the marketplace. Home ownership rates have bottomed and are starting to increase again. And we're starting to see a lot of homebuilders cater more towards those entry-level buyers at affordable price points, especially in regions of the country where they, homebuilders, can buy affordable land; we're definitely starting to see those builders cater towards those entry-level buyers at those purchase price points and I think that may be somewhat at the expense of higher-level homes, which may see a bit of pressure as appreciation as continued in those homes gets a bit expensive. So we are seeing small-cap homebuilders trading at pretty close to book value right now. And given the point we are in the economic cycle, I do think there's opportunity for small-cap builders to do well despite the increase in rates that we've seen over the past several months.

The following chart shows US consumer spending. This is personal consumption expenditures. I really highlight this chart for a couple reasons, but just to give you the background first, the bottom axis shows prior 12-month growth rates and the Y-axis which corresponds with the size of the bubbles, is the annual spend in billions. So the big bubble in the middle is healthcare, and it's such a huge piece of the economy right now, it continues to grow at a faster clip in overall consumer discretionary spending. And that healthcare spending has siphoned off spending from other areas of healthcare, of consumer spending. So we think that trend will continue. Healthcare spending has slowed to some degree, but I think it really highlights the importance of healthcare in the consumer economy.

To highlight a couple other areas, so entertainment is definitely growing faster, decent-sized bubble there, growing close to 5% as consumers do still seem to favor experiences. See medicine and drugs there growing nicely as well. Then a couple areas that have been out of favor. Restaurants have been getting better. Clothing is still relatively slow-growing, but a decent-sized bubble and that has accelerated recently as well. And then, just to the right of clothing, you can see new vehicle sales, that has decelerated some. I don't think new vehicle sales are going to fall off a cliff, I think they'll probably plateau to some degree, but that's also, obviously, a very important part of consumer spending going forward.

And finally, just to wrap up my section, I wanted to talk about a couple names that we bought for the Small Cap Value Fund at Macquarie within the past 12 to 18 months that really highlight what we're looking for when we're buying new stocks. The first one is Sonic Corporation, the drive-in burger chain. The reason we like Sonic, is that it is a 95% franchise concept, which means they have very little of their own capital to invest in the business. Their franchisees invest substantially all of the capital that is required. That means Sonic has a very strong free cash flow profile and they've been great about returning that cash to shareholders, buying back over half their stock in the past, roughly, 11 years. And they have a nice dividend deal as well. We were able to buy Sonic at roughly 25% discount to its franchise peers. We think that Sonic has the opportunity to close that discount over time.

Choice Hotels is the second name. You may not know the Choice brand but you certainly know some of their sub-brands, which include Comfort Inn, Quality Inn, as well as Sleep Inn. This is also a highly franchised concept, catering more towards the leisure traveler at the economy and mid-scale price points. And given the high ROIC of this business, they've also been generating very strong cash flow and been great about returning that cash to shareholders as well. This has enabled us to buy at a discount to its long-term historical average.

Just to summarize my segment on small-cap value, I think looking at companies that have discounted valuations on a long-term basis to their peers as well as their own history, finding those absolute values is also a key. Combining that with strong free cash flow profiles, we think that's a pretty powerful combination for investing in small-cap value stocks. All right, thanks for your time today, and I'm going to turn it back to you, Zach.

Thank you, Kent. And really I appreciate your highlighting the valuation methodologies that you're using in small-cap value spaces, all the economic indicators that you follow, and then finishing off with some good stock examples. We now want to change the pace a little and move things over to a discussion from our San-Diego-based International Small-Cap Equity team, where Stefan Maikkula will talk today about how he views the world, particularly outside of the US, and where those opportunities are lying today for the fund that he manages. And Stefan has over 15 years of experience, over 20 years in the industry, particularly covering the ex US space here for Macquarie today and then some predecessor firms before. But with that, I'll turn it over.

Great. Thanks for the introduction, Zach. And thanks to all of you too for the opportunity to talk about international small-caps. As Zach mentioned, I'm a senior portfolio manager on our Global Ex-US team. I've been with the team since 2007. So if we get started on the next slide, in terms of the outlook for the asset class, we're excited about international, and international small-caps in particular. And this chart basically highlights that we're finally starting to see an improvement in terms of performance, starting to see some funds flow back into international, really, after a prolonged period of underperformance of international relative to the US. And this chart just highlights that, showing 1-year rolling returns of MSCI EAFE versus the S&P 500. If we turn to the next slide, we've basically seen the same thing when it comes to US small-caps relative to international small-caps. And here, you can see that relative performance. And really, we've seen that underperformance since the global financial crisis. And it does feel like it's maybe starting to stabilize a little bit. But as a result of this dynamic, when we go out and we talk to investors, we find that a lot of people are underallocated to international, and international small-caps in particular, and really felt it was important to discuss international small-caps here today.

If we turn to the next slide, in terms of the international small-cap asset class, I really want to focus on some of the structural drivers for the asset class. From a strategic standpoint, international small-caps as an asset class have a number of key drivers in their favor. First of all, it's an inefficient asset class. So as we saw earlier too with respect to US small cap, there's just simply not as much coverage of the individual companies. So larger-cap names on the international side, for example, they'll have 15, 16 sell-side analysts covering them, on average. In the international small-cap space, that number is going to be closer to five or six, on average. And there are a lot of companies that are yet to be discovered. And you can see on this slide, I mean, a large part of the universe has very little sell-side coverage. So you can see here that a significant percentage of the universe in that zero- to two-analyst bucket, and in the three- to five-analyst bucket. So what we see is that it takes long for that price discovery process to play out. And that information inefficiency really provides opportunities for experience, for active managers that are researching and investing in these companies to add alpha.

If we turn to the next slide, the next point that I really want to cover is that international small-caps also offer investors the chance to gain access to key growth areas, or industries, that might be more difficult to gain access to through larger-cap companies. And this slide basically demonstrates that. So what we've done here is we've graphed some Japanese retail sales data over the last few years. So the blue bar represents overall Japanese retail sales growth year over year. The light blue bar does the same thing for the fabric, apparel, and accessories sub-category, and then finally, the orange bar plots revenue growth for a Japanese online apparel company that we used to own. So you can see by both the blue bars, the overall industry growth has really been pretty anemic, or even negative, over the last several years. But, like what we've seen in the US and elsewhere, is that online retail has grown strongly in Japan during that time period. So each company is different, but let's say you were investing in a large-cap retailer, you might find a portion of its sales, maybe that number's 15, 20%, are coming from this faster-growth area. But within the small-cap space, however, you often find situations like this where you have a company that's driving all or a majority of its business from a more niche, fast-growing segment. And we see this in other industries as well, too. So in consumer-oriented areas, in technology, in industrial companies, and so on. So, often, small-caps really allow us to identify a pocket of growth within a broader industry or economy, even, where it's aggregate level, growth figures are much lower. So, again, a larger firm, yeah, it might have some of its business coming from a higher-growth segment, but here we have a company that's focused specifically on this faster-growth area.

So moving onto the next slide, international small-caps have also delivered very strong returns within the broader international space. And the key point here, really, is that international small-caps have outperformed, both in terms of magnitude but also consistency. And I really think that's a key point that a lot of people aren't aware of or fully appreciate. So what we've done here is we've plotted the performance of the MSCI EAFE small-cap index relative to the MSCI EAFE index. So you can see how international small-caps are doing compared to international large-caps. And this data goes back to 2001. It's a little bit busy, but basically, what we did is we went to January 1st in 2001 as our starting point and then we plotted rolling 5-year performance periods using a 1-month shift. So the first data point would be January 1st of 2006 looking back five years. Then we would plot one for February 1st, 2006, and so on, and so on, until I think this data goes through the end of November of 2017. So we have small-cap performance plotted on the vertical axis. We have large-caps on the horizontal axis. So that diagonal line that you see is essentially the even line. So we have performance for a given time period, so the same for small- and large-caps. The points above the line show international small-cap outperformance; points below the line show the large-caps doing better. And, interestingly, what we found is that international small-caps have outperformed in 89% of those rolling 5-year periods going back to 2001. And the numbers are very similar too, whether we're looking at 1-year, 3-year, 10-year timeframes. So, again, historically, we've seen very strong performance from international small-caps compared to international large-caps and really feel that's another reason that warrants an allocation to the asset class.

If we turn to the next slide here, we talked about strong performance of international small-caps relative to international large-caps. So one of the areas of pushback we’ll sometimes get — or the initial question will be, "OK, well, what about risk? Aren't international small-cap stocks really risky?" Well, as you can see on this slide, international small-caps have historically delivered strong risk-adjusted returns in comparison to international large-caps. And this chart shows the 5-year risk and return figures, again, using MSCI EAFE Small Cap, that index compared to MSCI EAFE. And the results look very similar over 2, over 3, and over 10 years. That data's in the table below. The small-cap index shows a high return across each timeframe, but with a lower or very similar risk in terms of standard deviation. So the risk-return profile of international small-caps — pretty compelling compared to international large-caps. And people often think of these smaller companies as being quite volatile and so they're surprised to see that type of a chart. And yeah, on average, an individual small-cap stock is probably more volatile than a larger-cap company. But the interesting thing, though, is that once you put together a diversified index or portfolio of small-cap stocks, the overall volatility of that portfolio or index is relatively close to a larger-cap index.

So if we move to the next slide, the next question we'll get is, "Okay, why is that?" And, on average, individual small-cap names tend to behave more uniquely. So they tend to have lower correlations with each other, and we tend to see bigger return dispersions within small-caps. So, essentially, we have more stocks that have returns further from the benchmark. So these companies, again, they tend to operate on a smaller scale, they have fewer products, they tend to be more domestic or regionally-focused, for example. And it can certainly vary a bit sector by sector. But, oftentimes, they're not necessarily as driven by larger global themes. So if we have a small-cap healthcare company in Germany, for example, that may or may not behave the same as a small-cap healthcare stock in Japan. Whereas if you take a large US pharma company, that might act more similar to a large European pharma company just given the global nature of each firm's business.

And, additionally, we're looking for positive change in terms of investment ideas. So that could be a company rolling out a new product, moving into a new geography, maybe a new market, some type of change in the competitive environment. But what we found is when there's that type of change taking place, the market has a tendency to underestimate the magnitude and/or the duration of earnings growth driven by that change. And when we talk about those type of changes, that can have an outsized impact on smaller companies. Depending on the specific change, I mean, it’s something that could be transformational for a smaller firm. So if we turn to the next slide here, just kind of want to bring one final point here and just kind of summarize some of our thoughts. But one final point I'd like to add is that the international small-cap universe, it really provides a broad opportunity set. So we can essentially invest in any country outside the US. We can invest in emerging markets too as part of our strategy. And that really provides a broad and exciting opportunity set.

So our investable universe, the number of stocks that meet our requirements in terms of liquidity, in terms of market cap and so on, we're looking at over 2,500 stocks. You've got a lot of unique and exciting companies out there, so it's a really broad opportunity set and provides us a chance, really, to find strong growth names around the globe. So, with international small-caps, you have a broad opportunity set, it's less information efficient, you have stocks that behave more uniquely and allow you to access faster-growth areas. And we think that's a real powerful combination and one where experienced active managers have the opportunity to deliver strong risk-adjusted returns. And with that, I will turn it back over to Zach.

Thank you again Zach, and to our panel, for sharing this conversation with us this afternoon. I think we heard a very active message from everybody today. Feel free to continue to submit questions if you have any, and we will do our best to follow up with you after the end of the webinar today. We're respectful of everybody's time. For more regular commentary for the teams you heard from today, please visit the Insights section of our website, and you can feel free to subscribe to updates when new content is available via our survey widget. To learn a little bit more about our teams again today, you can access our Resources widget. The presentation materials from today are there along with a few other pieces you may find interesting. And finally, I know the moment you've all been waiting for, information on your CE credit. For those of you who qualify for the CFP, you will receive a notification directly from the CFP when your credit has deposited to your account. It should be within 10 business days of today's call. For those of you qualify for CIMA® or CIMC® through the Investment and Wealth Institute, one hour after the event today, you will be emailed information containing how to self-report your credit for today. So thank you again for your participation and thank you again to our panel.

For Financial Professional Use

Certain stock examples were not holdings within any of our investment portfolios referenced at time of presentation. Others may have been provided for illustrative purposes. There is no undertaking to update the materials on a going forward basis.

Certain opinions expressed by presenters are personal and not necessarily those of Macquarie Group.

Past performance is no guarantee of future results

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

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

The MSCI ACWI (All Country World) ex USA Small Cap Index captures small-cap representation across 22 of 23 developed market countries (excluding the United States) and 24 emerging market countries. The index covers approximately 14% of the global equity opportunity set outside the US

The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization weighted index designed to measure equity market performance of developed markets, excluding the United States and Canada. Index “net” return approximates the minimum possible dividend reinvestment, after deduction of withholding tax at the highest possible rate.

The S&P 500®; Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the US stock market.

The S&P Small Cap 600® Index measures the small-cap segment of the US equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable.

The MSCI USA Small Cap Index is designed to measure the performance of the small cap segment of the US equity market. With 1,769 constituents, the index represents approximately 14% of the free float-adjusted market capitalization in the US.

The MSCI EAFE (Europe,Australasia, Far East) Small Cap Index captures small-cap representation across developed market countries around the world, excluding the United States and Canada. The index covers approximately 14% for the free float-adjusted market capitalization in each country.

The Russell 3000 Index measures the performance of the largest 3,000 US companies, representing approximately 98% of the investable US equity market. The Russell 2000 Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000 Growth Index measures the performance of the small-cap growth segment of the US equity universe. It includes those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000 Value Index measures the performance of the small-cap value segment of the US equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group.

Standard deviation, a measure of total risk, measures the historical volatility of returns.

Sharpe ratio measures the relationship between reward and risk in an investment strategy. The higher the ratio, the safer the strategy.

The information in this document is not, and should not be construed as, an advertisement, an invitation, an offer, a solicitation of an offer or a recommendation to participate in any investment strategy or take any other action, including to buy or sell any product or security or offer any banking or financial service or facility by any member of the Macquarie Group. This document has been prepared without taking into account any person’s objectives, financial situation or needs. Recipients should not construe the contents of this document as financial, investment or other advice. It should not be relied on in making any investment decision.                             

No representation or warranty, express or implied, is made as to the suitability, accuracy, currency or completeness of the information, opinions and conclusions contained in this document. In preparing this document, reliance has been placed, without independent verification, on the accuracy and completeness of all information available from external sources. To the maximum extent permitted by law, no member of the Macquarie Group nor its directors, employees or agents accept any liability for any loss arising from the use of this document, its contents or otherwise arising in connection with it.

Macquarie Investment Management (MIM) is the marketing name for certain companies comprising the asset management division of Macquarie Group. Investment products and advisory services are offered by and referred through affiliates which include Delaware Distributors, L.P., a registered broker/dealer and member of FINRA; and Macquarie Investment Management Business Trust (MIMBT) and Delaware Capital Management Advisers, Inc., each of which are SEC-registered investment advisors. Macquarie Group refers to Macquarie Group Limited and its subsidiaries and affiliates worldwide.

The Funds are distributed by Delaware Distributors, L.P. (DDLP), an affiliate of Macquarie Investment Management Business Trust and Macquarie Group Limited. Macquarie Investment Management (MIM) is the marketing name for certain companies comprising the asset management division of Macquarie Group Limited and its subsidiaries and affiliates worldwide.

Other than Macquarie Bank Limited (MBL), none of the entities noted in this presentation are authorised deposit-taking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these entities do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of these entities, unless noted otherwise.

© 2018 Macquarie Management Holdings, Inc.

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

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