Capital Markets Coaching Clinic: Get the core facts

Capital Markets Coaching Clinic: Get the core facts

Erica Kay 00:03

Good afternoon, my name is Erica Kay and on behalf of Delaware Investments I would like to welcome you to our Capital Markets Coaching Clinic today. Exploring small-cap core equities and their behavior across common sectors.

Whether it's keeping you ahead of the curve when it comes to technology and social media trends, helping make your work day more efficient or learning more about the markets from our team of exports, Delaware investments strives to be your partner in growing your business and serving your clients.

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We'll now get started and today our discussion features our small-cap core equity team. While we do our best to manage risk here at Delaware Investment we were not able to prevent our team leader Frank Morris coming down with a seasonal bug. We'll be talking about health care a little bit later today, but the rest of his team will be joining us; Senior Portfolio Manager Mike Morris, Chris Adams and Don Padilla.

To get things started I am going to turn it over to Mike.

Mike Morris - 01:50

Thank you Erica, and thank you for joining us today. I will first revise with a brief overview. I will lead off with an introduction to small-cap stocks. I will then turn it over to Don Padilla who will discuss the consumer and some trends that are impacting that space. Dom will then turn it back over to me and I will discuss small-cap banks and investing in small-cap banks and then Chris Adams will conclude with his outlook, his secular outlook, on the healthcare space.

I thought I would start by providing a historical perspective on the performance of small-caps. If you look at the small-cap index, as opposed to the Russell 1000 index, the Barclays US aggregate bond index, which is an investment grade index that incorporates mortgage backed agencies and corporates, so it is a very broad based fixed income index, and the EAFE index which is the developed markets index, and you look at those four indices and you were to invest a million dollars in each of those at the start of 2000 you would see that small-caps have out-performed the other indices by a fairly healthy margin over that time frame. And if you think about that period, the beginning of that period was the bursting of the tech bubble and the credit cycle, we had a housing boom in the middle of that period followed by the great recession, and a pretty nice recovery off of those great recession lows. So with a very volatile environment small-caps delivered pretty good performance in an absolute sense and also relative to those different asset classes, with somewhat higher volatility but nevertheless a very good performance.

If you look at some of today's large-caps you know those companies began as small-caps. If you look at Amazon, Amazon IPO'd in 1997. That was during the midst of the development of the tech bubble and literally one year later the company graduated from the Russell 2000 and graduated into the Russell 1000 with its market cap going from less than half a billion to almost 5 billion in the course of a year.

A lot of other small-cap companies that are out there are names that are easily recognizable. They are places that all of you shop, eat, use for news sources, use for financial services and use for your utilities. So it is a variety of companies, so of them are listed there for you. Bloomin' Brands is the owner of Outback Steakhouse, Flemmings and Goldfish Grill. You will see a variety of other companies there, there are higher growth companies like a Bloomin' Brands, IMAX and Burlington Coat factory. And there are also lower growth factories like The New York Times, Valley National Bank or Piedmont Utility but a wide variety of companies within that universe that are all recognizable names.

The next slide looks at the growth of the market cap of the Russell 2000. If you look at it today the market cap range of the companies within the index ranges from 200 million to a little over 4.3 billion. That has not surprisingly grown over time, as the market has grown. I think this is important to note that as you look at providing small-cap allocation to your client I think when you are looking at the small-cap products that are being utilized, I think for those products to fully represent the size characteristics of the Russell 2000 they would have to have market caps ranging from 200 million to 4.3 billion today. You know 15 years ago that number would have been from 200 million to 1.5 billion. So that has evolved and I think that is an important point to make.

Sector weights within the Russell 2000 have changed over time. If you look at aXXX (06:34) today, the largest sectors within the Russell 2000 are the technology space, the healthcare space and the finance space. This representation is based on our sector mapping proprietary that we use. If you were to aggregate the three consumer sectors they would aggregate into close to 12%. So if you look at those four sectors combined those are the four largest sectors of the Russell 2000. As I mentioned it has evolved over time. If you look at the start of this period, so the darker blue line which is the end of the second quarter of 2000 that was when we were still in the midst of the technology bubble bursting, so at that time technology was almost a little over a quarter of the index but today it is a little less than 16%.

Similar changes have been secular. If you look at the increasing healthcare weight within the space that is in large part driven by secular growth in that business, which Chris will discuss in a little bit.

The sector allocation really does matter and what we are showing you here is based on 2014. If you look at the Lipper small-cap core category and that category active waste which is represented in the darker blue bars. So for example in 2014 the category was under weight in the REITs sector by a little over 360 base points. And the lighter blue lines depicts the performance of those very sectors in 2014. So the category was underweight in REIT's and healthcare for the two best performing sectors in 2014 and conversely the category was overweight in the energy and capital goods space and those two sectors were down in 2014. 2014 as a whole for the category did not do a good job of identifying attractive sectors, as was reflected in their sector weight. So how a manager chooses to address that sector allocation question we think is an important consideration when you are looking at small-cap stock.

Small-cap stock performance does vary widely. We have bucketed the Russell 2000 into four different market capped buckets and they are shown here in increments of roughly a billion dollars. And what you will see is the difference in returns, not only within each bucket, so if you look at the 3 to 5 billion dollar bucket on the far right you see a fairly nice explosion of returns. But then what you also see is that as you go down in market caps that dispersion widens out. So if you look at the smallest bucket under a billion you will notice a fairly wide dispersion of returns based on 2014 performance in the sector. So I think that to the extent that you want to deliver a small-cap core exposure to your client you need representation in that lower bucket of market cap. But it is a volatile riskier sector so from a risk standpoint I think that is an important consideration as you are investing in small-cap stock how are your managers managing risk and what is their philosophy around risk management.

The next chart shows valuation for both the Russell 1000 and Russell 2000. The Russell 1000 currently trading around 17 times earnings, the Russell 2000 at a little over 18 times, 18.4 times. Both indices are off of their recent lows of earlier this year but still not out of line with where they traded from a longer term perspective. If you look at a small-cap stock valuation relative to large typically the Russell 2000 trades at a 4 to 5% premium to large caps. We are modestly above that today. But still not near the highs that we have experienced over the last couple of years. Given the fact that we are on the cusp of a Fed tightening cycle we thought it would be constructive to look at how small-caps have performed during period of rising rates. We showed you here the last four periods of rising rates and what you will see here is that the Russell 2000 has delivered positive performance throughout those periods. Granted there may be some near term weakness at the onset of those tightening cycles but from a historical perspective small-caps have performed a deliver positive performance during those rising rates periods. So that is an overview of the small-cap space I would like to turn it over now to Don Padilla to discuss the consumer area.

Don Padilla - 12:18

Thanks Mike, as Mike said I am going to discuss some uberXXX (12:23) spending trends also highlight some structural changes that are occurring within some of the sub groups in consumer particularly retail and the restaurant group. Turning to slide 16, just before we get started on that discussion, I thought it was important to highlight what the percent of US State sales were in the small-cap consumer space. As you can see over 85% of the sales generated by small-cap consumer companies is in the US and that is a high number and it is even higher than the overall Russell 2000 and the reason I highlighted that is that I think it is particularly important as international economies and markets are becoming increasingly volatile. So getting started on the spending trends, on the next chart it's a little bit of a busy chart but it is very interesting. Basically what this chart is showing is various categories of personal consumption expenditure and it breaks them down into categories that are gaining and losing share. The bubbles above the horizontal X axis are categories that are gaining share in the short term year to date 2015. While the bubbles to the right of the vertical Y axis are gaining share over a longer period of time from 2011 through 2014. Obviously the ideal positioning on this chart is the upper right hand quadrant, indicating that you are gaining share of spending both in the long term and the shorter term.

So what I would like to do is focus on two of the larger areas within the Russell 2000 consumer sector and that would be the restaurant group and clothing and footwear. This chart is government categories, they label clothing and footwear as a category. Within the Russell 2000 the vast majority of companies are clothing and footwear companies so they can be used interchangeably. So as the chart shows on the restaurant side spending has outpaced overall spending both in the short and long term. And in the retail or clothing and footwear category this category has actually been losing share over both of those periods of time. The main drivers of that trend is really a re-allocation of spending to larger ticket items such as automobiles but it is also a very big trend in increased spending on experiences such as eating out and entertainment and travel. So within that group in addition to gaining a larger share of spending there are several industry dynamics, primarily technology driven, that made restaurants more attractive than retailers going forward.

Turning to chart 18 one of the bigger impacts and more obvious impacts that technology is having on retailers is a reduction in traffic. We were able to find this snap-shot of a prime-time period during Black Friday at the Mall of America and you can barely see people there. What has happened is that technology advances in online spending experience continues to improve and that drives even more purchases online. And also the improvements that have been occurring lately have enabled purchases using hand held devices as opposed to lap-tops and computers which also accelerated the process, the movement to online spending.

Turning to the next slide, restaurants on the other hand are actually using technology to differentiate the experience for their customers and drive traffic. The left hand side of this chart is a small-cap sports theme restaurant and quiet obviously they have sporting events which are built in traffic drivers. But they also, since they are a chain, they are able to have much more advanced viewing systems to make the overall experience better which helps them compete much better with local mom and pop restaurants. In addition to the traffic drivers the restaurants are increasingly using table top tablets to enhance customer experience. The snapshot on this chart shows a table in the same restaurant to the left which uses personal gaming, competitive gaming between tables and music to enhance the dining experience and give the customers a reason to return to the restaurant.

On the next page, this is one area on the retail side which is becoming an increasing problem. For restaurants and retailers there is big impact that technology is having on margins. Unfortunately on the retailer side it's a negative impact. On restaurants it's actually having a positive impact. The primary issue for retailers is price transparency, with the advent of digital marketing and shopping apps the price transparency is becoming a huge issue for retailers. Basically for any particular item anyone can go online and find out where the cheapest price for that particular item is. What we show here is a screen shot of an Amazon service which is just one example of this type of app. Basically what this does is you can go into a store and scan a barcode, even take a picture of an item with your phone and Amazon will do a search for you to find that item at a cheaper price somewhere else. So basically in these cases even if the retailer does get you into the store there is no guarantee that you are actually going to purchase the merchandize there with shopping apps like this. You could actually just walk out and find it somewhere else cheaper. And in reality what's happening is that people are doing this homework before they are even leaving the house and either buying it on-line or going directly to the store with the cheapest price.

Now restaurants on the other hand are using technology to make their operations more efficient and in fact lowering their labor cost. This is an example but the more wide spread use currently is table top tablets which are being used from the table. Obviously this makes the restaurant operate more efficiently. There is less need for staffing to constantly visit the table to take orders and it also has had a second benefit that people tend to order more, since it is easier you are likely to order another item if you don't have to wait for the waiter or waitress to come back to the table. The next part of the table top, which has not rolled out completely yet, it's much earlier stages, it's table top payment. Table top payment will again obviously make the labor side much more efficient and again require less individuals to actually run the restaurant.

And finally the square footage growth opportunities a much different for restaurants versus retailers. Chart 21 on the left hand side shows retail square footage per capita in the US versus some of the other countries. Obviously the United Kingdom is the next highest country at 26 sq ft. So the US is over double built than the next highest country out there. This over building problem is compounded obviously by the other two items that I discussed earlier which is the shopping transparency and online shopping as well. And as a result of that in 2014 there was over 6,000 closings announced of chain stores throughout the United States. On the right hand side, I thought this was an interesting comparison to bring it home to what we are seeing in small-cap, showing some obvious larger cap restaurants, the smallest of the group being Wendy's which is a large-cap company at 6 ,500 restaurants. Where as in the small-cap space the average restaurant base is only 1,800. So if you are a restaurant with approx. 1,800 stores obviously your concept is working and clearly you have a lot of room for growth going forward so it presents itself with a lot of opportunity for investment in the small-cap space.

I believe now I am going to turn it back over to Mike to talk about small-cap banks.

Mike Morris - 21:32

Thank you Don. I am going to talk about small-cap banks and particularly investing in the space. I'll first talk about profitability and then growth and then talk about some of the consolidation activity and an outlook on that front, and then wind it up with valuations. So from a bank profitability standpoint, and granted that this is a fairly busy slide, but I think it is very instructive and provides a good framework from which to consider the fundamental position of the group. What the percentages in the table represent are those items along the top as a percentage of average earning assets.

So if you were to look at the second column 'Net Interest Income' that is what you may know more commonly as net interest margin. So that represents the spread between what a bank would earn on the money that it's lending out compared to what it has to pay to fund that loan or what it is paying for its deposits. The fee side for a small-cap bank is going to represent mortgage banking, it's going to represent deposit fees, in some cases investment management and insurance. It will not represent a lot of capital markets which would distinguish the small-cap universe from the large-cap universe. 'Net charge-offs' represents the credit cost for a bank that is separate and distinct from a provision. A bank could decide to provide an access of charge-offs in any particular quarter or any particular year and in doing so would be building reserves for future losses. 'Non-Interest expense' is pretty self explanatory, the expense base for the banks and that really culminates in a return on assets, which is the far right column.

Another way that you could differentiate the small banks from the large banks if you take that second column, that interest income 'spread revenue' as it's referred to, that would be a larger percentage of revenue and earnings for a small-cap bank than it would be for a large-cap bank. So on average that would be roughly 70% of revenue for a small-cap bank so therefore 30% of the revenues would be fee oriented.

Why is all of this important? I think it is important because it is one determinant and really what is going to drive earnings growth for the group. I think it's instructive that if you look at where we are now, relative to the cycle lows of 2009 and relative to the long term median and it can give you a framework to really think where the group might be going from here.

So I will direct you to the far right column 'Return on Assets' and you can see that for the group ROA dropped in 2009 at a little more than 50 basis points. We've had a pretty nice recovery off of those cycle lows to almost 1.45%. This is as of the end of 2014 which is the most recent data from the FDIC. So we recovered to 1.45%, so a nice recovery but still below the longer term trend, that 24 year trend. If you look at what has driven that recovery off of the 2009 lows it's really been a non- revenue side of the equation. It's been a recovery in net charge-offs off of the death of the crisis and it's been pretty good expense control on the part of smaller-cap banks and what has really been missing has been the revenue side of the equation. That ties into interest rates, what the FED hopefully, from the banks perspective, is on the cusp of doing - which is raising rate.

As we look on a go-forward basis what really is the opportunity to close that ROA gap versus a long term median is on the debt interest income side. A debt interest margin. That is a function of when rates start to go up and the small-cap banks in particular can earn a higher spread on the asset that they're generating. You can also note that their credit cost as reflected by net charge-offs are also below a longer term median. From the standpoint of that dynamic it's a race between higher rates and when we enter the next credit cycle for the banking industry as a whole. The question is are the tail winds from higher rates going to get here quicker than the potential head winds from higher credit costs?

So if you look at loan growth, I'm going to start on the bottom portion of this chart. Banking is a cyclical industry so I think that we need to understand where we are in that cycle. There is a very strong relationship between commercial bank loan growth and gross domestic product, GDP, which is what is reflected in that bottom chart. And it's hard to see from the chart but if you were to look at that relationship and you were to consider where GDP stands today, we are about 2 to 3% below, from a loan perspective, where that relationship suggests we should be. There's 2 to 3% growth opportunity just to get back to that trend line.

When you think about tighter mortgage under -writing guidelines and when you think about the fact that industrial spending and XXX (28:01) in general has been a little bit slower to recover you can understand why we're under that trend line, but that's where we fit today. If you were to extrapolate that relationship out and you were to consume kind of 2 to 3% GDP growth, that would suggest based on this relationship kind of mid-single digit loan growth for the group.

The top chart shows small-cap, small bank loan growth relative to large. What you will note there is that small-cap banks, small banks have been able to grow their loan portfolios at a healthier rate than their larger-cap brethren. I think that's worked for a few reasons, I think from a borrowers perspective the experience with a small-cap bank is a little bit better. It's a little bit more of a pleasant experience. It's a quicker loan approval process, you get to speak with the CEO of these small-cap banks and that's an experience that you don't really capture when you're working with the larger-cap banks. So I think that's driven some markets share to small-cap banks. And I think the other factor is that from a lender perspective and an employment perspective working at a small-cap bank has become a lot better proposition than working at a large-cap bank.

What we're seeing is that a lot of these smaller banks have aggressively hired lenders from larger-cap banks and typically when those individuals come over it takes 12 to 18 months for them to move their book of business over to the smaller banks. So that's certainly been a factor as well.

One of the interesting things about looking at small-cap banks versus large is that if you look at an MSA, so I'll pick on my home state, if you look at the state of Indiana it's a slower growth state but there are pockets within that state that represent good growth. So if you look at the northern side of Indianapolis, the fishers area, that's an attractive growth area. If you're a small-cap bank that's either acquiring in those MSA's or you're opening the XXX (30:22) branches within those MSA's, that's real meaningful growth to you. That is really going to move the needle and drive revenue and drive earnings. If you are a larger cap bank quite frankly it's really not big enough to really move the needle. So I think that's one of the things that makes investing in the small-cap banks interesting is the loan growth opportunities that these individual banks possess.

So that is the profitability and the growth side. I want to talk a little bit about consolidation. It's an industry that has experienced a lot of consolidation over the last 30 years. Some of that consolidation has been forced i.e. the credit cycle of the early 90's, early 2000's and the great depression of 2008/2009. Some of that has been driven by regulations. Interstate banking regulations in the mid 90's that made it easier to operate branches across state lines with the driver of consolidation. And there has been secular drivers as well. Dom talked about XXX (31:34) technology impacting the consumer space. Well the same is true with the banks. It used to be the internet and still is. And now it's mobile and the branches are becoming less and less meaningful so banks are rationalizing their branch infrastructure either through closing branches through acquisition or just closing them independently from an organic perspective.

So one of the factors that is driving consolidation currently and will continue to do so is the regulatory environment. As a result of the great recession and the implementation of the Dodd Frank Act life for banks has gotten noticeably more difficult. Particularly when you cross that 10 billion dollar in asset threshold. Once you cross that 10 billion dollar in asset threshold you are subjected to something called a DFAST test which is the Dodd Frank Act stress test. You have to stretch your capital levels based on input from the government in terms of a base line and an adverse scenario. So GDP stock market scenarios that are provided to you, you have to stress test your capital under those scenarios to make sure you have enough capital to survive. So as you might imagine the implementation of that test requires investment in human capital, it requires investment in technology.

Based on banks that have crossed that threshold that investment is probably several million dollars.

Another way that life becomes more difficult once you cross 10 billion is the Durbin Amendment which limits the amount of interchange that you can collect on debit card transactions. So depending on the size of that business for your bank that is a meaningful headwind. So what I have done on the bottom table I have tried to express those headwinds on the Y Axis the incremental expense side. So if you look at roughly 2 million of incremental expense to put in human capital and IT and you assume up to 10 or 12 million dollars of incremental headwind from Durbin, that is the incremental expense that you have to overcome once you pass through the 10 billion dollar threshold. If you assume various after tax return on assets, which is depicted on the X Axis, you can arrive at how much do you have to grow as a bank, how much do you have to grow your assets as a bank just to off-set that incremental expense. So if you are operating at 9.99 billion of assets a day and you have an 8 million dollar of incremental headwind and you generate and after-tax ROA of 1% you have to grow a little more than 5% just to off-set that incremental expense for crossing 10 billion dollars in assets. Remember back to an earlier slide 2 to 3% GDP growth is consistent with XXX (34:55) low growth. You need roughly a year's worth of growth just to get back to where you started once you cross the 10 billion dollar assets. So I think this has been a meaningful driver of consolidation in the banking industry and I think that that will continue to be the case.

The final two slides will look at valuation. I look at valuation for the banks a couple of different ways. One is on price-to-tangible books. Pre-financial crises the industry was looked at more on a price to book basis and we moved price to tangible after the financial crises. Tangible would take out good will and other intangibles, like core deposit intangibles, to arrive at a tangible book value number. It's basically more assets that are theoretically easier to monetize. There is a very strong relationship between price-to-tangible book value and the returns that you generate on that tangible capital. So one of the things that I will look at is that I will regress price-to-tangible book multiples versus expected returns on tangible capital numbers; to try to identify attractive opportunities in the group. I will try to identify banks that are trading below price-to-tangible book multiples that should be justified based on the returns that they are generating. So I think that price-to-tangible book is one very effective way to value the group and it is a metric that I use extensively.

The other one is P/E multiples, you can see here on slide 27 that the group is trading roughly in line with the longer term average from a P/E perspective. If you were to look at P/E multiples of small versus large banks; small banks traded a premium to large. That has been the case post the great recession. That has been the case pre the great recession. That has been the case back to the 1990's. Small-cap banks have always traded a premium to large. Today they trade at a couple multiple points premium to the group and I think that is true because they are less cyclical business relative to the large-cap group.

So to summarize I think that from a profitability standpoint, we talked about tailwinds versus headwinds, the growth has been good for the group and the outlook is still reasonably constructive. From a consolidation standpoint I think that provides a floor for valuations for the industry.

So with that I will turn it over to Chris for the outlook for healthcare.

Chris Adams - 37:58

Okay Mike, thank you very much. Before I get into the details on healthcare I would just like to begin by saying what gets me most excited as an investor is when the long term fundamentals of an area are really strong. And there is the ability for a secular growth XXX (38:25) to play out over the long term. I would argue that healthcare is just such a sector. And the way I would like to discuss this with you today is by analyzing the demand conditions in the healthcare sector and the supply conditions in the healthcare sector. And I think you will find that as the discussion evolves that both are exceptionally strong. That is not to say there isn't risk; clearly there is, but the fundamentals in the sector are strong.

So let's begin with the demand for healthcare. What creates demand for healthcare? Well that's people, it's you and me, it’s all of us. The more people there are the more we will use healthcare but even more importantly the older we are the more likely we are to use healthcare. And sadly that is just a reflection that the one thing we can be certain of as we age is that we will become sicker. There is a higher incident of chronic diseases and also fatal diseases the older you become. So the first chart here, on chart page number 29 really is going to that issue of what are the population dynamics in the United States. As you all know the body designated by the government to track the population is the US Census Bureau and under the Constitution every 10 years it is mandated that the Census Bureau must take a census. The next one is coming up in 2020 and you will recall that the last one in 2010 you get that long form from the government and you have to fill it out. So what that allows the US Census Bureau to do based on the returns from that and also what they know about net immigration into the United States, if they can model with a high degree of accuracy what is going to be happening to the population in the country. And this chart takes a very long term view from today through 2060. But I draw your attention to two things; one is the total number of people in the country is growing strongly but then I break it down for your, recall I said older people are sicker, I break it down for you between the under 55's and under 55's.

So let's just focus on the left end of the chart. Look at between now and 2030, the next 15 years, not only does the population grow but critically there will be 25 million extra people over 55. That is a 28% increase. We all know this, the baby boomers are retiring and that is a critical dynamic. But to really make this point powerfully for you I would like you to turn to the next chart, chart no. 30 and here I break down those age groups into smaller segments, typically 5 year segments. And what this chart dramatically shows if you go to the right hand side of the chart, just look at the explosion by 2060 in the oldest age group. So if you look at age groups from 65 upwards, look at that growth. So what that means is that the population is growing and it's getting substantially older and that means that the demand for healthcare in the United States is going to be growing exponentially.

So that is the demand side of the equation, what about the supply side? If you think about what is the supply, well the supply of healthcare comes from healthcare companies. Drug companies, bio-technology companies will develop drugs to help us treat our diseases. Medical device and technology companies will build and design new medical devices. Hospitals will build new outlets where you can go and be treated. So what I am showing you here is just honing in on the drug and the bio-tech area which is a key component of the supply of healthcare services in the United States. So let's begin actually dropping to the bottom of the chart and this shows you over the last 5 years the regulatory body in the United States which is responsible for approving any new drug, as you know, is the FDA the Food and Drug Administration. No drug can be legally sold in the US without their approval. And they quiet simply look for two things. Is the drug safe? In other words you take it will it not kill you; very important. Secondly, does it work? There is no point a drug being safe if it actually doesn't treat your disease. So based upon their criteria the data at the bottom of the chart shows you the number of new drugs approved by the FDA every year since 2005. Obviously it varies from year to year the precise number, but the trend is unmistakable. It has basically doubled over the last 10 years or so. So the supply, just as the demand for new drugs is going up, the supply of new drugs is also going up. Pretty sweet.

Why might that be happening? Well part of the answer is that drug and bio-technology companies have become more efficient in their R&E process, they have gotten more inventive. I am sure you have read the papers and seen a number of new therapies treating horrible diseases such as cancer and hepatitis C. Part of that is coming from more efficient research but the top half of the chart goes to this issue of the regulator, the food and drug administration. And clearly the speed at which they approve drugs will have a meaningful impact on the availability to help those patients. And the good news here is the FDA has in the past rightly come in for a lot of criticism as being this big bureaucratic body holding up the approval of new drugs but the truth is they hear that criticism, they hear it from voters and they hear it from politicians and government and they have been taking a number of steps over the last 20 years or so to develop programs to speed up the approval of new drugs. And that is the top half of the chart here, you will see four pies and each of these represents a program undertaken by the FDA to do that.

So let's start on the left with the pie marked Accelerated Approval. This was introduced by the FDA in 1992 and what it seeks to do is allow the faster approval of drugs for serious illnesses that fill an unmet medical need. In other words the drug is serious, it can kill you and right now there are not many therapies to help you. One would be cancer for example. What accelerated approval does... in the old days the FDA used to say we need to run a trial for 20 years to make sure that we see that more people survive after 20 years. Now that is a long trial, right! But there is a shorter way of looking at that and that is your tumor. Is your tumor shrinking? Because common sense would tell you that if your tumor is shrinking your cancer is in abatement. So what the FDA said for accelerated approval we will look at shrinking tumors as good enough to approve the drug.

Go to the other end of the chart, another 1992 innovation was Priority Review. What priority review said was the designation given to a drug that, again, offered a major advancement in treatment where an inadequate therapy existed. And what that did was if the FDA gave you priority review it shortened the period of time in which you would have to be reviewed and it would speed up the process and therefore help expedite approvals.

The third pie came along in 1997 and this is Fast Track. And again common theme here, fast track is a designation to speed up the review of the drug for a serious or life threatening condition and that reduced the typical approval time from 10 months to 6 months for the regulatory review.

And lastly the second pie is the most recent one of all, approved in 2012, and it was designed to develop drugs in underserved disease areas. Initially this was, believe it or not, for tropical diseases but more recently president Obama has extended this to rare childhood diseases. And again the common theme - speed up the review for life changing, life saving therapies such as Cystic Fibrosis.

So what I have discussed so far is sweet conditions for demand and supply in the industry so that has set us up really well for a strong performance from the healthcare sector. Turning to my last chart, page 32, what you will see here and Mike touched on it at the beginning of the presentation is, not surprisingly, with all this growth in healthcare look at the way that healthcare has grown as a sector weight in the Russell 2000 index. It is now approximately 15% of the index so it has a dramatic impact in the overall performance of a small-cap core portfolio. So make sure that your managers have an adequate exposure to healthcare.

But maybe the one question-mark over healthcare, and you are all aware of this, is look at the fact that healthcare PCE, which stands for personal consumption expenditure, so what I am showing you with the blue line is how much of your spending gets devoted towards healthcare. No shocker here, we are all spending more on healthcare. Higher copay, higher deductibles, higher drug prices and that's a little question mark on the sector because how much more spending can the consumer have to devote towards healthcare before it becomes a concern. So that is something to watch. But nevertheless really sweet conditions for the sector as a whole.

So just to conclude I would like to simply sum up what you have heard today from the three presenters. When you are considering small-cap investing. Firstly please remember small-cap companies are unique and there's an opportunity for good active managers to add value through good stock selection. Secondly, it is very important to understand the industry dynamics, the sector dynamics in small-caps. Because small-cap revenue sources can be dramatically different from their large-cap brethren. And lastly, one of the advantages, do you remember early on Mike showed you how over 15 years small-caps have really outperformed. No surprise, it's because small-cap companies are quicker to innovate and produce long term solutions for traditional business models.

That's the end of my prepared remarks and I will now pass back to Ericka.

Erica Kay - 51:04

We do have time for a couple of questions here and I think that instead of doing a couple we will get back to you off-line if you have sent in a question, or if you would like to do so now. But one common question that we are seeing come in which I think it would be valuable to spend our last few minutes on is about bio-tech. I will just read one of the many here.

So many domestic small-cap active managers state an aversion to investing any meaningful capital to bio-technology companies due to the complexity of applying traditional valuation models to it. So what is your approach to bio-tech and pharma? I think Chris can speak best on that.

Chris Adams - 51:46

That is an excellent question, thank you for it. Yes bio-tech is definitely, when you look at the small-cap portfolio, one of the higher risk areas of any small-cap portfolio. However it's also a large part of the Russell 2000 index. The risk adverse person would say 'I don't like the risk, I want to avoid it'. Unfortunately if you don't invest in bio-tech the risk you run is bio-tech performs strongly and you woefully under-perform. So unfortunately saying no to bio-tech completely we believe is a non starter. However, we are very careful about the type of bio-tech exposure that we believe in and therefore our approach is to look for the relatively lower risk names in the space. And what do I mean by a relatively low risk name, that would be a name with either an approved drug with the FDA, so a real business generating, real revenue. Or a drug or a company that may not yet finally have an approved drug but if very close to having an approved drug. It's completed its trial data and is waiting for the FDA to review the trial data and approve the drug. We think those where we can review the data and get comfortable with the drug, remember I said, it works and it's safe and we will by names that we think are about to be approved. You need some exposure to bio-tech but you need to carefully evaluate the risk you are taking on and know what you have in the portfolio.

Erica Kay- 53:38

I think that is great, thank you Chris. I hope all of you have really gained an insight into what our team are doing every day and what they are spending their hours on and the specialty sectors that they have.

To just conclude today I would like to point you briefly to the coming Outlooks for Delaware Investments. To hear more from the small-cap core equity team they will have an 'Outlook' out later this December and it will be posted on our website through January. You are able to subscribe to receive this 2016 Outlook via the survey widget at the bottom of our window, so as soon as that is available we will be sure to send that to you. As well as, I would like to point you to the Insights section of our website where members of the team actively participate in posting timely commentary. A little bit more reactive to some market events or proactive into things that they thing are going on on a weekly basis.

I would like to thank you for your attention today and as always your participation and the teams participation. So thank you very much.


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