Capital Markets: Observations & Insights

Capital Markets: Observations and Insights Productivity Pick-Up Winter 2018

Productivity Pick-Up

Productivity. We all want more of it — to be able to do more in less time because we can’t find more hours in the day. The economy also craves productivity. While it does produce slightly more labor hours each year, the more important determinant of economic growth is output per labor hour or productivity. Last quarter we wrote about our belief that business spending would improve and lead the economy forward. Indeed it has and we think this is only the beginning. The recently completed U.S. tax reform bill only strengthens our conviction in this thesis. But it is the impact of stronger business spending on which we focus in this presentation. Investment is a key driver of productivity, which in turn dictates long-run economic growth. Therefore, we are hopeful that the surge in business spending that we anticipate will boost the long-run potential growth of the U.S. economy.

Then we can all stop hoping for more hours in the day.

Daniel C. Chung, CFA Chief Executive Officer Chief Investment Officer

Brad Neuman, CFA Senior Vice President Client Investment Strategist

Page 1

Key Observations

• Business spending is set to accelerate and outpace the broader economy, given strong earnings growth, tax reform, solid business confidence, and accommodative financial and lending conditions • Increasing corporate investment should help drive a resurgence in productivity growth, which is the key to stronger, sustainable long-term economic growth • Leading indicators suggest the economy will continue to expand and corporate profits will continue to rise

Table of Contents

Productivity Pick-Up

Pages 3-6

Performance

Pages 7-14

Fundamentals

Pages 15-22

Valuation

Pages 23-27

Page 2

Productivity Drives Potential GDP ​ Productivity Pick-Up

• Economic output = labor hours x output per hour (i.e., productivity)

• Therefore, to increase long-run economic growth, we have to increase productivity growth

…And Recently Both Have Trended Lower

Productivity Drives Potential GDP…

Potential GDP

Productivity

Potential GDP

Productivity

18,000

120

4%

16,000

Productivity Index (2009=100)

100

14,000

3%

12,000

80

10,000

60

2%

8,000

6,000 $ Billions

40

1%

4,000

20

2,000

0

0

0%

Year-Over-Year Change (5-Year Average)

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

2017

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Source: FactSet using CBO potential GDP data and U.S. Bureau of Labor Statistics productivity data as well as Alger estimates for 4Q17.

Page 3

​ Productivity Pick-Up

Productivity Growth Dependent on Business Spending

• Stronger business spending should drive innovation as businesses have more cash to deploy to research and development and capital expenditures

• Historically, increases in business spending lead to higher productivity

Business Spending vs. Labor Productivity (1988-2016)

R 2 = 0.64

10.0

= Year

8.0

6.0

Higher business spending leads to higher productivity

4.0

2.0

0.0

% Increase in Business Spending

-2.0

0.0

1.0

2.0

3.0

4.0

5.0

% Increase in Productivity

Source: Bureau of Labor Statistics. Business spending is capital intensity (capital services per hour worked and advanced one year), and labor productivity is output per labor hour.

Page 4

Recipe for an Increase in Business Spending ​ Productivity Pick-Up

• Profit growth

• Tax reform—lower statutory rates, foreign profit repatriation, accelerated depreciation

• Higher business confidence—driven in part by lower regulation and certainty on taxes

• Banks’ increased willingness to make commercial loans

• Accommodative financial conditions—interest rates and spreads

S&P 500 EPS

Business Spending

20%

15%

An acceleration in earnings growth should help drive a double-digit increase in business spending

Forecasted

10%

5%

0%

Year-Over-Year Change

-5%

2011

2012

2013

2014

2015

2016

2017E

2018E

Source: FactSet. Business spending is U.S. private fixed nonresidential investment with an estimate for 4Q17 as well as 2018, the latter based on a regression with S&P 500 EPS. S&P 500 EPS 2017 estimate based on consensus and 2018 is Alger estimate.

Page 5

Higher Investment to Lead to Higher Productivity ​ Productivity Pick-Up

• A surge in business spending on assets (e.g., plants, property, equipment, IT, etc.) should drive higher productivity

Business Assets

Productivity

5%

4%

3%

2%

Forecasted

1%

(3 Year Average)

Year-over-Year Change

0%

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

2015

2017

2019

Source: FactSet, Bureau of Economic Analysis and Alger estimates. Business assets is U.S. real private nonresidential capital stock, which is advanced two years. Productivity is U.S. output per labor hour. Estimates are based on regression with real private capital stock.

Page 6

Sector Disparities ​ Performance

• In 2017, the technology sector vastly outperformed other sectors of the market both in the U.S. and globally, driven by strong fundamentals • U.S. tax reform and rising interest rates influenced 4Q17 performance with relatively high tax rate sectors outperforming those with lower tax rates or bond-like characteristics

4Q17 Returns (%)

2017 Returns (%)

50

U.S.

World

U.S.

World

10

40

8

30

6

4

20

2

10

0

0

-2

-10

Energy

Utilities

Energy

Utilities

Telecom

Materials

Telecom

Materials

Financials

Industrials

Financials

Industrials

Technology

Real Estate

Health Care

Technology

Real Estate

Health Care

Consumer Staples

Consumer Staples

Consumer Discretionary

Consumer Discretionary

Source: FactSet as of 12/31/17. U.S. represented by S&P 500 and World is represented by MSCI All Country World Index in local currency.

Page 7

Scale Rewarded ​ Performance

• Large cap stocks with low volatility did best in 2017, while dividend yield, which had benefitted in recent years from lower rates, underperformed • Tax reform drove 4Q17 performance; many domestic stocks that have low revenue multiples and high tax rates outperformed

2017 Excess Return (%)

4Q17 Excess Return (%)

2.6

1.7

1.5 1.4

0.7

1.1 1.0

-0.3 -0.4 -0.4

-0.3

-0.9 -1.0

-0.7

-1.4

-1.2

-1.6 -1.8

-1.9

-2.2

-3.5

-4.0

Market Cap

Book / Price

EPS Growth

Market Cap

Debt / Equity

Book / Price

EPS Growth

Debt / Equity

Price Volatility

Dividend Yield

Price Volatility

Trading Activity

Dividend Yield

Earnings / Price

Revenue / Price

Trading Activity

Earnings / Price

Revenue / Price

Relative Strength

Relative Strength

Earnings Variability

Earnings Variability

Source: FactSet as of 12/31/17 using Northfield defined quantitative factors for the Northfield broad U.S. market database.

Page 8

​ Performance

Prices and Fundamentals Converge

• Stock prices and fundamentals converged in 2017 after having previously diverged

• Growth stock fundamentals continue to imply outperformance

Growth Relative to Value

Stock Prices

Fundamentals

Convergence

110

105

Disconnect

100

95

90

Jul-16

Jul-17

Oct-16

Apr-17

Oct-17

Jun-16

Jan-17

Jun-17

Feb-17

Mar-17

Nov-16

Dec-16

Nov-17

Dec-17

Aug-16

Sep-16

Aug-17

Sep-17

May-17

Source: FactSet as of 12/31/2017. S&P 500 Growth and Value Indices used to represent Growth and Value stocks. Fundamentals are LTM EPS.

Page 9

The Earnings Growth Resurgence Is Boosting Performance ​ Performance

Total Return = Dividend Yield + EPS Growth +/- P/E Change

MSCI All Country World Index ex-USA

S&P 500

Dividend

EPS Growth*

P/E Change

Dividend

EPS Growth*

P/E Change

35%

25%

30%

20%

25%

15%

20%

10%

15%

5%

10%

0%

5%

EPS Growth Acceleration

-5%

0%

EPS Growth Acceleration

-10%

-5%

-15%

-10%

-15%

-20%

Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17

Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17

12- Month Total Return:

12- Month Total Return:

2%

16%

32%

14%

1%

12%

22%

-12%

17%

21%

7%

2%

7%

19%

Source: FactSet as of 12/31/17. *Based on consensus estimates of next 12-month EPS. Actual earnings per share might be materially different than shown. MSCI ACWI ex-US performance based on local currency.

Page 10

​ Performance

Bull Market Is Aging Well

• Bull markets have been getting longer over time

‒ Factors prolonging economic expansions include: increased fiscal and monetary intervention, structural changes in the economy, and technological advances, such as improved inventory management

‒ The current bull market is 3.5 years younger than the 1990s bull market

14

2010-Current Average: ?? Years

12

1980-2010 Average: 7.2 Years

10

1950-1980 Average: 4.3 Years

Current Bull Market (ongoing)

8

1930-1950 Average: 1.7 Years

6

4

Duration of Bull Market (Years)

2

0

1932

1943

1954

1965

1976

1987

1998

2009

2020

Year that Bull Market Ended

Source: FactSet and Goldman Sachs as of 12/31/17. Bull markets over six months in duration since 1930.

Page 11

​ Performance

Has Active Relative Performance Troughed?

• While there are secular pressures affecting U.S. active management, cyclical factors tend to be much more powerful in the short term. Examples include: ‒ small cap performance

‒ overall market performance ‒ non-U.S. stock performance ‒ interest rates/bond-like equities

Active Relative Performance Is Cyclical

2017 saw the best large cap active management performance in eight years

100%

80%

60%

40%

20% % of Fund Assets Outperforming

0%

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

Source: Nomura/Instinet, Joseph Mezrich and FactSet through 12/31/17. Fund performance is trailing five-year data. Sidebar data based on active performance from Bank of America Merrill Lynch U.S. Equity and U.S. Quant Strategy using Lipper data

Page 12

Small Caps Due for a Comeback ​ Performance

• Small caps dramatically underperformed large caps in 2017 in stark contrast to their historic outperformance

• Taken together, these data points may imply small caps are poised for a comeback

Small Cap Performance Relative to Large Cap Performance

400

253

Small caps underperformed large caps last year in contrast to their long term outperformance

193

200

20

0

-200

-400

-600

-800 Basis Points (Annualized)

(860)

-1,000

1 yr

5 yr

10 yr

20 yr

Source: FactSet as of 12/31/17 using S&P Small Cap and Large Cap indices.

Page 13

​ Performance

Structural Issues Driving Growth vs. Value

• Growth stocks have dramatically outperformed (+31%) Value stocks over the past decade

• The culprit for value investors has been the very weak performance of buying low P/B stocks, while P/E strategies have fared much better • Book value may no longer be as relevant given changing business models, e.g., R&D is not capitalized in book value

110

P/E

100

P/B, not P/E, has driven Value underperformance

90

80

P/B Russell 1000 Value / Growth

70

60

Total Return Index

50

40

2007

2009

2011

2013

2015

2017

Source: FactSet as of 12/31/17. Price-to-earnings and price-to-book returns are based on the E/P and B/P Northfield factors for the Northfield broad U.S. market database.

Page 14

Leading Cycle Indicators Are Benign ​ Fundamentals

• Every major recession in the past 75 years has been preceded by substantial Fed Funds rate tightening or inflation acceleration, or both • We believe the Fed can be patient given forces weighing on inflation, including innovation (price transparency), labor dynamics (retirees), and globalization

Recession

Fed Funds Effective Rate

Inflation

20

Today, short-term interest rates and inflation are both less than 2%

18

16

14

12

10

8 Percentage

6

4

2

0

-2

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

2014

2017

Source: FactSet as of December 2017. Inflation represented by PCE Price Index ex-food and energy (year over year).

Page 15

Fed Tightening Unlikely to Derail Equities Yet ​ Fundamentals

• The stock market has actually historically risen with the Federal Funds rate • Only after rates have stopped rising are equities likely to have peaked

• With the Fed still trying to normalize rates, equities may have room to run

Fed Not Done, So Stocks Not Done? (Current Hiking Period)

Stock Market Declines After Peak in Fed Funds (Average of ’99/’00 & ’04/’05 Periods)

Cumulative Hike

S&P 500

Cumulative Hike

S&P 500

2.5

114

2.5

150

112

2.0

Forecasted

140

2.0

110

S&P 500 (Indexed to 100)

S&P 500 (Indexed to 100)

108

130

1.5

1.5

106

120

1.0

104

1.0

110

102

Cumulative Rate Hike (Percentage Points)

0.5

Cumulative Rate Hike (Percentage Points)

0.5

100

100

0.0

98

0.0

90

0

2

4

6

8

10

12

14

16

18

0

5

10

15

20

25

30

35

Months Since First Hike

Months Since First Hike

Source: FactSet. Estimated future Fed rate hikes based on “Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents,” December 2017.

Page 16

​ Fundamentals

Leading Indicators Suggest Earnings Will Continue to Rise

• The Conference Board Leading Economic Index (LEI) typically leads earnings by 6-18 months and usually peaks one to two years prior to a recession • Given that the LEI is increasing solidly year over year and hit a record high in 4Q17, we believe the economy and earnings have room to run

130

Leading Economic Index indicates further EPS growth

$150

120

$130

18 Month Lead

S&P 500 EPS

110

$110

100

$90

90 Leading Economic Index

$70

80

$50

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Source: FactSet, Conference Board as of December 2017. Based on NTM EPS estimates.

Page 17

​ Fundamentals

Economic Outlook

Tailwinds

• Robust corporate profits

• Fiscal stimulus/tax reform

• Strong business and consumer confidence

• Solid U.S. consumer balance sheet

Headwinds

• Tightening monetary policy

• Rising U.S. labor costs

• China growth slowdown

• Geopolitical risk

Page 18

Smaller Capitalization Stocks Poised to Outperform ​ Fundamentals

• Stronger fundamentals : Estimated small cap EPS growth for 2018 more than double large cap

• More levered to fiscal stimulus : Small caps are more U.S.-oriented and have higher operating leverage • Rising interest rates : Small caps have historically outperformed large caps in rising rate environments and vice versa in falling rate environments

• Attractive valuation : Small cap sales multiple discount implies opportunity

Earnings Per Share

Enterprise Value/Sales Russell 2000 / Russell 1000

0%

R2000

R1000

-5%

170

Historically Large Discount

-10%

160

Small Caps Growing Faster

-15%

150

-20%

140

-25%

130

-30%

120

-35%

110 EPS Indexed to 100

-40%

100

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2017

2018

2019

Source: FactSet as of December 2017. EPS for 2017-2019 are consensus estimates and actual earnings per share might be materially different than shown.

Page 19

​ Fundamentals

Innovative Companies Grow Earnings and Stock Prices Faster

• Innovation propels economic growth over time

‒ Studies have shown, and our research demonstrates, that the most innovative companies grow their sales, earnings, and stock prices faster*

Innovation Drives:

EPS Growth…

and

…Stock Prices

11%

500

Most Innovative

400

300

5%

200

Least Innovative

100

Est. EPS Growth 2007-2017

-

Most Innovative

Least Innovative

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Source: FactSet. Most/least innovative based on R&D percent of sales. Est EPS growth December 2007 - December 2017 measured after classification of S&P 1500 companies into innovation quintiles in December 2007. Most/least innovative stock performance based on S&P 1500 quintiles one month returns for same time period, normalized for market value. * Baruch Lev and Suresh Radhakrishnan, “The Stock Market Valuation of R&D Leaders.”

Page 20

Speed of Innovation Is Accelerating Fundamentals

• Innovations are penetrating U.S. markets at an even faster pace

‒ “Growth” stocks should benefit from innovation while “value” stocks that appear cheap may simply be victims of change

Years from Market Entry to 50% Penetration in the U.S.

The faster speed of innovation may be exacerbating the disparity between growth and value fundamentals

200

160

120

80

40

0

TV - 1936

PC - 1974

VCR - 1965

ATM - 1969

Stove - 1750

Radio - 1897

Roads - 1880

Internet - 1989

Dishwasher - 1924 Air Con. - 1933

Steam Ship - 1810 Railroad - 1830

Hospitals - 1776

Cable TV - 1950

Wash. Mach. - 1904 Air Travel - 1914

Telephone - 1880

Microwave - 1967

Newspaper - 1704

Credit Card - 1950

MP3 Player - 1998

Smartphone - 1996

Social Media - 2004

Electric Power - 1882

Secondary Schools - 1810

Source: Asymco.

Page 21

​ Fundamentals

The Growth Advantage

• Three variables drive P/E multiples: growth, returns, and risk

• As compared to the Russell 1000 Value, the Russell 1000 Growth has higher expected EPS growth, higher returns on equity, and lower risk in the form of better balance sheets

Stronger Growth

Higher Returns

Lower Risk

R1000G R1000V

R1000G R1000V

R1000G R1000V

14.4%

2.5x

24.6%

9.9%

1.3x

10.1%

Long-Term EPS Growth

Return on Equity

Net Debt / EBITDA

Source: FactSet as of December 2017. Growth represents consensus long-term analyst estimates, and actual future EPS growth rates might be materially different than the forecasts shown.

Page 22

The Great Rotation ​ Valuation

• Moving from monetary stimulus and quantitative easing to fiscal stimulus and increased deficits should drive a Great Rotation from bonds to stocks • The magnitude of the rotation will be fueled by the valuation disparity between equities and bonds, which are expensive by comparison ‒ The earnings yield of equities is more than 300 bps greater than the yield of 10-year Treasury notes vs. 55 bps median over the past half-century prior to the Global Financial Crisis

Equity vs. Bond “Yields”

S&P 500 EPS Yield

Treasury Bond Yield

16

14

Stocks are attractively valued relative to bonds

12

10

8

6

>300 bps

4

2

0

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

Source: FactSet, Federal Reserve, and S&P, as of 12/31/17.

Page 23

Not All Sectors Are Expensive ​ Valuation

• Growth-oriented sectors are reasonably valued compared to history, particularly given low levels of interest rates, in contrast to many other sectors

37%

Reasonably Valued

23%

21%

20%

20%

18%

9%

2%

1%

P/E Relative to 20-Year Median

Utilities

Materials

Financials

Industrials

Real Estate

Technology

Health Care

Cons. Staples

Cons. Discretionary

Source: FactSet, based on S&P 500 Index, 12/31/17. Note: energy and telecom are excluded; the former because of an extremely high P/E due to depressed earnings and the latter owing to a small number of constituents. Real estate is a new sector classification, so for the historical data shown above, an industry group category that has approximately 16 years of data was utilized.

Page 24

Growth Valuations Are Reasonable ​ Valuation

• Despite their recent outperformance, Growth stocks remain attractively valued compared to Value stocks, relative to history and their respective growth rates

Russell 1000 Growth vs. Russell 1000 Value PEG Ratio (P/E Divided by Long-Term Growth Rate)

Russell 1000 Growth vs. Russell 1000 Value P/E

30% premium is low relative to history

1.7x

1.5x

Russell 1000 Value

Russell 1000 Growth

Source: FactSet, Bank of America as of 12/31/17.

Page 25

​ Valuation The Single Greatest Predictor of Future Stock Market Returns

• Current valuations suggest equities, particularly growth stocks, should materially outperform bonds over the coming decade • The full impact of tax reform implies lower P/Es and higher annualized returns than current estimates shown below

S&P 500 P/E vs. 10-Year Returns

Russell 1000 Growth P/E vs. 10-Year Returns

= month

= current

Tech bubble

25%

25%

R² = 0.79 (0.85 ex-tech bubble)

R² = 0.85

20%

20%

15%

15%

10%

10%

5%

5%

0%

0%

-5%

-5%

-10%

-10%

5

10

15

20

25

30

5

10

15

20

25

S&P 500 10-Year Annualized Return

Russell 1000G 10-Year Annualized Return

Russell 1000 Growth Price/Earnings

S&P 500 Price/Earnings

Source: FactSet. Monthly data through December 2017 and beginning in January 1986 (S&P 500) and December 1978 (Russell 1000 Growth). The tech bubble, represented by the 10- year returns beginning in April 1987-March 1990 and ending in April 1997- March 2000, skewed the regression by resulting in higher returns for given valuations than the historical relationship would imply.

Page 26

Addressing Interest Rate Risks—It’s Too Soon to Worry ​ Valuation

• Potential Risk : higher bond yields  lower equity valuations?

• Potential Solution : favor equities over bonds given that increasing interest rates have supported higher P/E multiples at low absolute levels

S&P 500 NTM P/E vs. 10-Yr Treasury Note Yield 1964-2017

25

Higher Rates Rising P/E

Higher Rates Falling P/E

= Month

20

15

P/E

10

5

-

5

10

15

10-Year Yield

Source: RBC Capital Markets and FactSet. Data through December 2017.

Page 27

Disclosure

​The views expressed are the views of Fred Alger Management, Inc. as of December 2017. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Fred Alger Management, Inc. These views should not be considered a recommendation to purchase or sell securities. Individual securities or industries/sectors mentioned, if any, should be considered in the context of an overall portfolio and therefore reference to them should not be construed as a recommendation or offer to purchase or sell securities. References to or implications regarding the performance of an individual security or group of securities are not intended as an indication of the characteristics or performance of any specific sector, industry, security, group of securities, or a portfolio and are for illustrative purposes only.

​ Risk Disclosures : Investing in the stock market involves gains and losses and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as the prices of growth stocks tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political and economic developments.

​The S&P 500 Index is an unmanaged index generally representative of the U.S. stock market without regard to company size. The Russell 1000® Growth Index is an unmanaged index designed to measure the performance of the largest 1000 companies in the Russell 3000 Index with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth Index is an unmanaged index generally representative of common stocks designed to track performance of small-capitalization companies with greater than average growth orientation. The Russell 2000 Value Index is an unmanaged index generally representative of the small-cap value segment of the U.S. equity universe and measures the performance of Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 3000® Growth Index is an unmanaged index designed to measure the performance of those Russell 3000® Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index is an unmanaged index generally representative of stocks from the Russell 3000 Index with lower price-to-book ratios and lower expected growth rates. The MSCI ACWI Index (gross) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices. The indices presented are provided for illustrative purposes, reflect the reinvestment of dividends and do not assess fees and expenses that would have the effect of reducing returns. Investors cannot invest directly in any index. The index performance does not represent the returns of any portfolio advised by Fred Alger Management, Inc. and actual client results might differ materially than the indices shown. Note that past performance is no guarantee of future results. Comparison to a different index might have materially different results than those shown. ​Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell ® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication.

​ALCAPPRESSPR-0118

Fred Alger Management, Inc. • 360 Park Avenue South, New York, NY 10010 • 800.992.3863 • www.alger.com

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