reflection paper
asdfg
SmallCap.pdf
Investing in Today’s Economic Climate
Presented by: Eric Green, CFA , Director of Research, Senior Portfolio Manager, Senior Managing Partner
February 4, 2019
For educational use only. Not for distribution to, or for use with, individual investors.
Agenda
1. Penn Capital Introduction
2. Outlook for Equity, High Yield, and Commodities
3. Interest Rates and Inflation
4. The Case for Small Cap Equities
1
Section 1
Penn Capital Introduction
2
Mr. Green began his career at Penn Capital in July 1997.
As Director of Research, Mr. Green is responsible for guiding the firm’s day-to-day investment research process. He also serves as the Portfolio Manager for Penn Capital’s Small Cap, Smaller Companies Growth, and Mid Cap equity strategies as well as chairing the Penn Capital Equity Strategy Committee. Throughout his career, Mr. Green has focused on the energy, media, gaming, and leisure industries. He is a member of the firm’s Executive Committee which drives overall strategy and management of the firm.
Prior to joining Penn Capital, Mr. Green gained experience with the Federal National Mortgage Association, the Royal Bank of Scotland, and the United States Securities and Exchange Commission where he served as a financial analyst in the Division of Investment Management. Mr. Green is also Vice Chairman of the Board of Directors for the Anti-Defamation League (ADL), Mid-Atlantic Region and Co-Chairman of the ADL's 2018 Walk Against Hate.
He received a BSBA, Cum Laude, from American University and received an MBA from the Yale School of Management.
Bio
3
Client Allocation (%)
Public 31%
Commingled 17%
Taft-Hartley 13%
WRAP/Model Delivery 13%
Retirement/Other 8%
Sub-Advisory 8%
Corporate 7%
Non-Profit 2%
Insurance 1%
Firm Overview
High Yield Credit $1.7b†
Defensive Floating Rate Income $120**
Defensive Short Duration High Yield $266
Defensive High Yield $969
Opportunistic High Yield $277
Customized Solutions $46
Equity $1.2b
Micro Cap $198
Smaller Companies Growth $70
Small Cap $658
Small to Mid Cap (SMID) $167
Mid Cap $61
Total Assets Under Management $2.9b* (as of 12/31/2018)
AUM Allocation (%)
Credit Strategies 59%
Multi-Credit 41%
Dedicated Bond 14%
Dedicated Loans 4%
Equity Strategies 41%
*AUM includes non-discretionary assets associated with model delivery accounts **$160m total loans held. † Includes over $335m invested in Socially Responsible Investing (SRI)
Penn Capital Facts Independently Owned, Investment-Driven Culture • Founded in 1987; Headquartered in Philadelphia • 58 total employees; 27 partners • Investment Driven – 23 member investment team • Institutionally focused
Specialists in Capital Structure Investing • Fully integrated credit and equity investment team • Fundamental, bottom-up proprietary research process • Over 1,000 company management meetings per year
Investment Philosophy and Characteristics • High Conviction – High active share • Capacity Constraints – Liquidity advantage and style integrity • Client Focused – Partnership in developing custom solutions
Investment Vehicle Availability • Institutional Mutual Funds • Institutional Limited Partnership • Institutional Separate Accounts
4
Targeting Optimal Capital Structure Catalysts
We believe greater investment returns can be achieved by identifying companies moving toward their Optimal Capital Structure
For illustrative purposes only
Under-levered Over-levered
Leverage Multiple
Optimal Capital Structure
S to
c k
P ri
c e
Inflection Point
Leveraging Improvements Earnings potential Growth initiatives
Financing flexibility
De-leveraging Improvements Market sentiment
Credit rating upgrade Access to capital markets
Optimal Characteristics Balance sheet fundamentals
Weighted average cost of capital Efficient market pricing
Investment Process and Philosophy
5
Case for a Private Equity Approach to Public Market
For illustrative purposes only
Debt Catalyst Targeting
• Debt catalysts can provide leading indicators to equity value in periods of low market clarity
• Debt analysis requires a differentiated skillset, enhances research complexity, and is rarely performed by equity managers
• Private equity approach to public market utilizes size, free cash flow, and debt catalyst factors to enhance and optimize growth
Warning Signs
Approaching Maturity Wall
Lack of Liquidity
Covenant Breaches
Deteriorating Cashflow
Credit Downgrade
Unintentional Leveraging
Positive Catalysts
Deleveraging
Leveraged Recap
Refinancing
Improving Free Cashflow
Credit Rating Upgrade
Discounted Bond Purchases
Higher Stock Prices and Higher Multiples
Lower Stock Prices and Lower Multiples
Case for a Private Equity Approach to the Public Market
6
De-leveraging Opportunities Enhance Enterprise Value
Enterprise value is defined as the market value of the equity plus the par value of the debt minus cash. Our enterprise value focus allows us to view every opportunity like a private equity investor
Leveraged Capital
Structure 60% Debt
40% Equity
40% Debt 60% Equity
Low Leverage Capital
Structure 20% Debt
80% Equity
Deleveraging: As companies pay down debt and enterprise value remains constant, equity value increases
Lower Leverage: With less perceived risk, equity value and enterprise value increase
Enterprise Value: (Market Value of Equity + Par Value of Debt) – Cash
At this stage a company becomes a very attractive private equity investment as it is under-levered and has demonstrated its ability to reduce debt.
Debt Value Equity Value Additional Enterprise Value Potential
Equity ValueDebt Value
Debt Value Equity Value
Additional Enterprise Value Potential
Case for a Private Equity Approach to the Public Market
7
Section 2
Outlook for Equity, High Yield, and Commodities
8
Corporate and high yield sectors tend to be more sensitive to improving credit and economic conditions which typically coincide with rate increases.
Periods of Rising 10 Yr. Treasury Rates
*Periods over one year are annualized
-5.01
1.14
-13.72
-4.51
-1.20
2.03
-3.15
1.15
10.85
6.66
2.92
6.28 7.23 7.05
3.42
5.58
2.89
9.21
2.49
7.80
-15
-10
-5
0
5
10
15
October 1993 to January 1995 5.34% to 7.60% (+2.26%)
June 2003 to June 2006 3.43% to 5.11% (+1.68%)
May 2013 to December 2013 1.66% to 3.04% (+1.38%)
July 2016 to Sept 2018 1.49% - 3.05% (+1.56%)
P e
rf o
rm a
n c
e (
% )*
US 10 Yr Treasuries
Investment Grade Bonds
Bank Loans
Short Duration BB-B HY 1-3 Yr Bonds
High Yield Bonds
Interest Rate Sensitivity
As of 9/30/2018. FOR ILLUSTRATIVE PURPOSES ONLY. Source: Morningstar Direct, Credit Suisse. Indices used: ICE BofA Merrill Lynch US Treasury 10 Yr+, ICE BofA Merrill Lynch US Corporate Master, Credit Suisse Leveraged Loan, ICE BofA Merrill Lynch US HY BB-B 1-3Yr. *Periods over one year are annualized. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment. Indices are unmanaged and not available for direct investment. Past performance is no guarantee of future results.
9
-250
100
450
800
1,150
1,500
1,850
2,200
12 /
1 /
19 9
6
6 /
3 0
/ 19
9 7
12 /
3 1/
19 9
7
6 /
3 0
/ 19
9 8
12 /
3 1/
19 9
8
6 /
3 0
/ 19
9 9
12 /
3 1/
19 9
9
6 /
3 0
/ 2
0 0
0
12 /
3 1/
2 0
0 0
6 /
3 0
/ 2
0 0
1
12 /
3 1/
2 0
0 1
6 /
3 0
/ 2
0 0
2
12 /
3 1/
2 0
0 2
6 /
3 0
/ 2
0 0
3
12 /
3 1/
2 0
0 3
6 /
3 0
/ 2
0 0
4
12 /
3 1/
2 0
0 4
6 /
3 0
/ 2
0 0
5
12 /
3 1/
2 0
0 5
6 /
3 0
/ 2
0 0
6
12 /
3 1/
2 0
0 6
6 /
3 0
/ 2
0 0
7
12 /
3 1/
2 0
0 7
6 /
3 0
/ 2
0 0
8
12 /
3 1/
2 0
0 8
6 /
3 0
/ 2
0 0
9
12 /
3 1/
2 0
0 9
6 /
3 0
/ 2
0 10
12 /
3 1/
2 0
10
6 /
3 0
/ 2
0 11
12 /
3 1/
2 0
11
6 /
3 0
/ 2
0 12
12 /
3 1/
2 0
12
6 /
3 0
/ 2
0 13
12 /
3 1/
2 0
13
6 /
3 0
/ 2
0 14
12 /
3 1/
2 0
14
6 /
3 0
/ 2
0 15
12 /
3 1/
2 0
15
6 /
3 0
/ 2
0 16
12 /
3 1/
2 0
16
6 /
3 0
/ 2
0 17
12 /
3 1/
2 0
17
6 /
3 0
/ 2
0 18
12 /
3 1/
2 0
18
3 Year Forward Annualized Returns
Nov-00 Jun-02 Mar-08 July-08 Sept-11 Feb-16
Russell 2000 Index 8.50% 12.81% 8.57% 5.18% 21.26% N/A
5 Year Forward Annualized Returns
Nov-00 Jun-02 Mar-08 July-08 Sept-11 Feb-16
Russell 2000 Index 10.12% 13.88% 8.24% 9.45% 15.82% N/A
Mar 2008 Nov 2000
June 2002
Sep 2011 Feb 2016
July 2008
IC E
B o
fA /
M L
U S
H ig
h Y
ie ld
C o
n st
ra in
e d
In d
e x
S p
re a
d s
Spreads Over 800: Forward Equity Returns
As of 12/31/18. Source: Morningstar Direct. Past performance is no guarantee of future results. Indices are unmanaged and not available for direct investment. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment.
10
Chart1
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| 2/28/2013 |
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| 2/28/2014 |
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| 1/31/2015 |
| 2/28/2015 |
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| 4/30/2015 |
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| 2/28/2017 |
| 3/31/2017 |
| 4/30/2017 |
| 5/31/2017 |
| 6/30/2017 |
| 7/31/2017 |
| 8/31/2017 |
| 9/30/2017 |
| 10/31/2017 |
| 11/30/2017 |
| 12/31/2017 |
| 1/31/2018 |
| 2/28/2018 |
| 3/31/2018 |
| 4/30/2018 |
| 5/31/2018 |
| 6/30/2018 |
| 7/31/2018 |
| 8/31/2018 |
| 9/30/2018 |
| 10/31/2018 |
| 11/30/2018 |
| 12/31/2018 |
Sheet1
| Month End | Spreads |
| 12/1/1996 | 313 |
| 1/31/1997 | 304 |
| 2/28/1997 | 273 |
| 3/31/1997 | 284 |
| 4/30/1997 | 294 |
| 5/31/1997 | 268 |
| 6/30/1997 | 267 |
| 7/31/1997 | 271 |
| 8/31/1997 | 259 |
| 9/30/1997 | 259 |
| 10/31/1997 | 299 |
| 11/30/1997 | 290 |
| 12/31/1997 | 296 |
| 1/31/1998 | 300 |
| 2/28/1998 | 287 |
| 3/31/1998 | 283 |
| 4/30/1998 | 298 |
| 5/31/1998 | 318 |
| 6/30/1998 | 337 |
| 7/31/1998 | 338 |
| 8/31/1998 | 520 |
| 9/30/1998 | 595 |
| 10/31/1998 | 652 |
| 11/30/1998 | 544 |
| 12/31/1998 | 566 |
| 1/31/1999 | 560 |
| 2/28/1999 | 521 |
| 3/31/1999 | 519 |
| 4/30/1999 | 476 |
| 5/31/1999 | 475 |
| 6/30/1999 | 487 |
| 7/31/1999 | 466 |
| 8/31/1999 | 490 |
| 9/30/1999 | 507 |
| 10/31/1999 | 513 |
| 11/30/1999 | 491 |
| 12/31/1999 | 476 |
| 1/31/2000 | 487 |
| 2/29/2000 | 508 |
| 3/31/2000 | 575 |
| 4/30/2000 | 588 |
| 5/31/2000 | 616 |
| 6/30/2000 | 617 |
| 7/31/2000 | 626 |
| 8/31/2000 | 643 |
| 9/30/2000 | 677 |
| 10/31/2000 | 779 |
| 11/30/2000 | 906 |
| 12/31/2000 | 916 |
| 1/31/2001 | 787 |
| 2/28/2001 | 770 |
| 3/31/2001 | 818 |
| 4/30/2001 | 806 |
| 5/31/2001 | 768 |
| 6/30/2001 | 816 |
| 7/31/2001 | 827 |
| 8/31/2001 | 805 |
| 9/30/2001 | 1018 |
| 10/31/2001 | 961 |
| 11/30/2001 | 839 |
| 12/31/2001 | 824 |
| 1/31/2002 | 789 |
| 2/28/2002 | 819 |
| 3/31/2002 | 708 |
| 4/30/2002 | 688 |
| 5/31/2002 | 728 |
| 6/30/2002 | 875 |
| 7/31/2002 | 971 |
| 8/31/2002 | 961 |
| 9/30/2002 | 1033 |
| 10/31/2002 | 1059 |
| 11/30/2002 | 883 |
| 12/31/2002 | 890 |
| 1/31/2003 | 829 |
| 2/28/2003 | 838 |
| 3/31/2003 | 772 |
| 4/30/2003 | 644 |
| 5/31/2003 | 679 |
| 6/30/2003 | 613 |
| 7/31/2003 | 567 |
| 8/31/2003 | 546 |
| 9/30/2003 | 551 |
| 10/31/2003 | 473 |
| 11/30/2003 | 448 |
| 12/31/2003 | 418 |
| 1/31/2004 | 405 |
| 2/29/2004 | 434 |
| 3/31/2004 | 441 |
| 4/30/2004 | 391 |
| 5/31/2004 | 428 |
| 6/30/2004 | 410 |
| 7/31/2004 | 402 |
| 8/31/2004 | 406 |
| 9/30/2004 | 383 |
| 10/31/2004 | 363 |
| 11/30/2004 | 317 |
| 12/31/2004 | 310 |
| 1/31/2005 | 329 |
| 2/28/2005 | 283 |
| 3/31/2005 | 352 |
| 4/30/2005 | 419 |
| 5/31/2005 | 413 |
| 6/30/2005 | 385 |
| 7/31/2005 | 330 |
| 8/31/2005 | 366 |
| 9/30/2005 | 354 |
| 10/31/2005 | 361 |
| 11/30/2005 | 367 |
| 12/31/2005 | 371 |
| 1/31/2006 | 342 |
| 2/28/2006 | 337 |
| 3/31/2006 | 313 |
| 4/30/2006 | 304 |
| 5/31/2006 | 312 |
| 6/30/2006 | 335 |
| 7/31/2006 | 345 |
| 8/31/2006 | 349 |
| 9/30/2006 | 344 |
| 10/31/2006 | 329 |
| 11/30/2006 | 320 |
| 12/31/2006 | 289 |
| 1/31/2007 | 272 |
| 2/28/2007 | 282 |
| 3/31/2007 | 285 |
| 4/30/2007 | 274 |
| 5/31/2007 | 246 |
| 6/30/2007 | 298 |
| 7/31/2007 | 419 |
| 8/31/2007 | 455 |
| 9/30/2007 | 420 |
| 10/31/2007 | 436 |
| 11/30/2007 | 575 |
| 12/31/2007 | 592 |
| 1/31/2008 | 695 |
| 2/29/2008 | 767 |
| 3/31/2008 | 821 |
| 4/30/2008 | 686 |
| 5/31/2008 | 653 |
| 6/30/2008 | 735 |
| 7/31/2008 | 800 |
| 8/31/2008 | 836 |
| 9/30/2008 | 1096 |
| 10/31/2008 | 1617 |
| 11/30/2008 | 1988 |
| 12/31/2008 | 1812 |
| 1/31/2009 | 1626 |
| 2/28/2009 | 1738 |
| 3/31/2009 | 1703 |
| 4/30/2009 | 1345 |
| 5/31/2009 | 1170 |
| 6/30/2009 | 1055 |
| 7/31/2009 | 922 |
| 8/31/2009 | 912 |
| 9/30/2009 | 793 |
| 10/31/2009 | 760 |
| 11/30/2009 | 765 |
| 12/31/2009 | 639 |
| 1/31/2010 | 654 |
| 2/28/2010 | 671 |
| 3/31/2010 | 584 |
| 4/30/2010 | 561 |
| 5/31/2010 | 698 |
| 6/30/2010 | 713 |
| 7/31/2010 | 659 |
| 8/31/2010 | 692 |
| 9/30/2010 | 626 |
| 10/31/2010 | 593 |
| 11/30/2010 | 622 |
| 12/31/2010 | 541 |
| 1/31/2011 | 508 |
| 2/28/2011 | 478 |
| 3/31/2011 | 477 |
| 4/30/2011 | 476 |
| 5/31/2011 | 509 |
| 6/30/2011 | 542 |
| 7/31/2011 | 558 |
| 8/31/2011 | 730 |
| 9/30/2011 | 841 |
| 10/31/2011 | 707 |
| 11/30/2011 | 779 |
| 12/31/2011 | 723 |
| 1/31/2012 | 661 |
| 2/29/2012 | 598 |
| 3/31/2012 | 599 |
| 4/30/2012 | 604 |
| 5/31/2012 | 696 |
| 6/30/2012 | 644 |
| 7/31/2012 | 616 |
| 8/31/2012 | 598 |
| 9/30/2012 | 574 |
| 10/31/2012 | 563 |
| 11/30/2012 | 565 |
| 12/31/2012 | 534 |
| 1/31/2013 | 495 |
| 2/28/2013 | 498 |
| 3/31/2013 | 486 |
| 4/30/2013 | 455 |
| 5/31/2013 | 462 |
| 6/30/2013 | 521 |
| 7/31/2013 | 471 |
| 8/31/2013 | 478 |
| 9/30/2013 | 483 |
| 10/31/2013 | 436 |
| 11/30/2013 | 427 |
| 12/31/2013 | 400 |
| 1/31/2014 | 421 |
| 2/28/2014 | 381 |
| 3/31/2014 | 377 |
| 4/30/2014 | 371 |
| 5/31/2014 | 367 |
| 6/30/2014 | 353 |
| 7/31/2014 | 404 |
| 8/31/2014 | 384 |
| 9/30/2014 | 440 |
| 10/31/2014 | 430 |
| 11/30/2014 | 467 |
| 12/31/2014 | 504 |
| 1/31/2015 | 526 |
| 2/28/2015 | 446 |
| 3/31/2015 | 482 |
| 4/30/2015 | 459 |
| 5/31/2015 | 458 |
| 6/30/2015 | 500 |
| 7/31/2015 | 536 |
| 8/31/2015 | 570 |
| 9/30/2015 | 662 |
| 10/31/2015 | 590 |
| 11/30/2015 | 640 |
| 12/31/2015 | 695 |
| 1/31/2016 | 777 |
| 2/29/2016 | 775 |
| 3/31/2016 | 705 |
| 4/30/2016 | 621 |
| 5/31/2016 | 597 |
| 6/30/2016 | 621 |
| 7/31/2016 | 569 |
| 8/31/2016 | 510 |
| 9/30/2016 | 497 |
| 10/31/2016 | 491 |
| 11/30/2016 | 467 |
| 12/31/2016 | 422 |
| 1/31/2017 | 400 |
| 2/28/2017 | 374 |
| 3/31/2017 | 392 |
| 4/30/2017 | 381 |
| 5/31/2017 | 374 |
| 6/30/2017 | 377 |
| 7/31/2017 | 361 |
| 8/31/2017 | 385 |
| 9/30/2017 | 356 |
| 10/31/2017 | 351 |
| 11/30/2017 | 361 |
| 12/31/2017 | 363 |
| 1/31/2018 | 329 |
| 2/28/2018 | 347 |
| 3/31/2018 | 372 |
| 4/30/2018 | 346 |
| 5/31/2018 | 363 |
| 6/30/2018 | 371 |
| 7/31/2018 | 346 |
| 8/31/2018 | 349 |
| 9/30/2018 | 328 |
| 10/31/2018 | 381 |
| 11/30/2018 | 429 |
| 12/31/2018 | 472 |
B: Bonds U: Utilities R: REITs S: Staples T: Telecom
What was once safe, may now be risky
11
-12x
-10x
-8x
-6x
-4x
-2x
0x
5x
10x
15x
20x
25x
30x
20 06
20 07
20 08
20 09
20 10
20 11
20 12
20 13
20 14
20 15
20 16
20 17
20 18
P/E Russell 2000 Cyclical Sectors (Left) P/E Russell 2000 Defensive Sectors (Left) P/E Difference (Right)
Cyclical vs Defensive Sector
-2x
-1x
0x
1x
2x
3x
4x
5x
5x
10x
15x
20x
25x
30x
20 06
20 07
20 08
20 09
20 10
20 11
20 12
20 13
20 14
20 15
20 16
20 17
20 18
P/E Russell 2000 Small Cap (Left) P/E Russell Top 200 Large Cap (Left) P/E Difference (Right)
Small Cap vs Large Cap
-16x
-14x
-12x
-10x
-8x
-6x
-4x
-2x
0x
5x
10x
15x
20x
25x
30x
20 06
20 07
20 08
20 09
20 10
20 11
20 12
20 13
20 14
20 15
20 16
20 17
20 18
P/E Russell 2000 Top Leverage Quintile (Left) P/E Russell 2000 Bottom Leverage Quintile (Left) P/E Difference (Right)
High Leverage vs Low Leverage
P/ E
vs H
is to
ri c
A vg
-13.2%
-4.5%
-20%
-15%
-10%
-5%
0%
Cyclical Defensive
P/ E
vs H
is to
ri c
A vg
-10.8%
+10.7%
-20% -10%
0% 10% 20%
Small Cap Large Cap P /E
v s
H is
to ri
c A
vg
-27.6%
+14.9%
-40%
-20%
0%
20%
High Leverage Low Leverage
D iff
er en
ce : C
yc lic
al P
/E –
D ef
en si
ve P
/E
D iff
er en
ce : S
m al
l C ap
P /E
– La
rg e
Ca p
P/ E
D iff
er en
ce : H
ig h
Le ve
ra ge
P /E
– Lo
w L
ev er
ag e
P/ E
Pr ic
e to
E ar
ni ng
s (N
TM ) R
at io
Pr ic
e to
E ar
ni ng
s (N
TM ) R
at io
Pr ic
e to
E ar
ni ng
s (N
TM ) R
at io
Cyclical, Small Cap, and Leverage Factors at Historically Low Relative Valuations
As of December 31, 2018. P/E calculated using current price and NTM earnings. Source: FactSet. Cyclical Sectors: Consumer Discretionary, Energy, Financials, Industrials, Technology, Defensive Sectors: Consumer Staples, Health Care, Real Estate, Telecommunications, Utilities. Russell 2000 Leverage Quintile calculated by Debt / Capitalization Ratio. Leveraged index returns are ex Financial sector due to greater usage and unique balance sheet treatment/utilization of debt from other sectors. Indices are unmanaged and not available for direct investment. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment. Past performance is no guarantee of future results.
12
• Federal Reserve Policy
• US-China Trade Deal
• US Government Shutdown/Reopen
• Worldwide Economic Growth or Lack of Growth
• US Slowdown in earnings growth
• Oil Prices
6 Major Issues Impacting Markets
13
• Supply and demand is balancing for crude oil in the US and around the world
• Worldwide demand increasing about 1 – 1.5 million barrels per day
• Depletion is about 3 million barrels per day
• Capital expenditures for exploration and production companies are down more than 50%
• Over $300 billion in projects have been cancelled or postponed through 2020
• OPEC has prevented the market from balancing earlier
• Original goal was to recapture market share
• Huge financial pain experienced by OPEC members during this low price environment
• Saudi Arabia reverses stance and needs to stabilize market for Aramco IPO
• Cut production in late November; this will speed up balancing of the market
• Marginal barrel of oil costs at least $65-70 per barrel
Oil and the Energy Sector
14
Section 3
Interest Rates and Inflation: What is the outlook for each and how will they affect other investments?
15
Equity Performance During Rising Rate Environments
Past performance is no guarantee of future results. Sources: Morningstar Direct. Indices are unmanaged and not available for direct investment. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment.
Rising Rate Periods 10Y Treasury Rate (%) Annualized Returns (%)
Start Date
End Date
Duration (Months)
Starting Rate Ending Rate Change
(bps) BbgBarc Agg Bond Index
S&P 500 Index
Russell 2000 Index
Oct-98 to Jan-00 16 4.42 6.67 +225 -0.61 28.32 27.85
Jun-03 to May-06 36 3.35 5.11 +176 1.91 11.64 19.16
Dec-08 to Apr-10 17 2.96 3.66 +70 9.01 24.77 36.10
Jul-12 to Dec-13 18 1.66 3.01 +135 -0.17 25.30 30.35
Sept-17 to Sep-18 13 2.12 3.05 +93 -1.56 18.64 20.54
Historical Periods of Rising Rates
-0.61
1.91
9.01
-0.17 -1.56
28.32
11.64
24.77 25.30
18.64
27.85
19.16
36.10
30.35
20.54
-10
0
10
20
30
40
Oct 1998 to Jan 2000 Jun 2003 to May 2006 Dec 2008 to Apr 2010 Jul 2012 to Dec 2013 Sept 2017 to Sep 2018
BbgBarc Agg Bond Index S&P 500 Index Russell 2000 Index
P e
rf o
rm a
n c
e (
% )
16
No bubble compared to past periods of excess…
• Low quality non-refinance issuance has remained relatively low.
• Majority of issuance continues to be used for debt refinancing which enables companies to lock in low rates for extended periods of time.
• Refinance amounts are expected to remain above our 40% alert level as companies anticipate higher rates in the future.
• Speculative issuance for acquisitions is on the rise but mostly for strategic acquisitions which are often accompanied by equity issuance.
• 2018 is on track to use the fourth most amount of equity for M&A since 2000. 2014-2015 represented a post-2000 high in the amount of equity used for acquisitions.
• M&A expected to continue to pick up, but we expect high yield companies to be net beneficiaries of acquisition activity.
• LBO issuance has been moderate in the bond market but rising in the loan market, which bears watching.
Source: JP Morgan, Bloomberg. Graphs as of December 31, 2018. The red lines illustrated in the charts above represent Penn Capital’s internal alert level for these data points. The gold bars indicate those that breach, or are close to, the alert level. The blue bars represent those that do not. Lower rated new issuance includes bonds rated Split-B or lower.
39% 37%
41%
46%
0% 3% 4% 3%
16%
26% 29%
22% 22%
28% 27%
13% 15% 16%
30%
38%
44%
52%
46%
5%
16%
22%
17% 17%
26%
38%
16% 17% 22%
0%
10%
20%
30%
40%
50%
60%
19 8
6
19 8
7
19 8
8
19 8
9
19 9
0
19 9
1
19 9
2
19 9
3
19 9
4
19 9
5
19 9
6
19 9
7
19 9
8
19 9
9
2 0
0 0
2 0
0 1
2 0
0 2
2 0
0 3
2 0
0 4
2 0
0 5
2 0
0 6
2 0
0 7
2 0
0 8
2 0
0 9
2 0
10
2 0
11
2 0
12
2 0
13
2 0
14
2 0
15
2 0
16
2 0
17
2 0
18
Acquisition Financing/LBO as a Percent of Total Issuance
1.8% 1.9%
2.7%
3.6%
0.9% 1.0%
0.1% 0.1% 0.5%
1.7% 1.3%
2.7%
5.1%
1.3%
0.5%
1.4% 1.4%
2.0%
2.2% 2.3%
1.1% 0.9%
1.9%
1.0%
0%
1%
2%
3%
4%
5%
6%
19 9
5
19 9
6
19 9
7
19 9
8
19 9
9
2 0
0 0
2 0
0 1
2 0
0 2
2 0
0 3
2 0
0 4
2 0
0 5
2 0
0 6
2 0
0 7
2 0
0 8
2 0
0 9
2 0
10
2 0
11
2 0
12
2 0
13
2 0
14
2 0
15
2 0
16
2 0
17
2 0
18
Lower Rated New-Issue Volume, Excluding Refinancings
Aggressive issuance from 1996 to 1999 accounted for 7.9% of 1998's year-end market size
Aggressive issuance from 2004 to 2007 accounts for 10.3% of 2007's year-end market size
46%
54% 50%
41%
91%
70% 73% 72%
50% 45% 44%
53% 50%
48%
34%
78% 77% 75%
57% 50%
38% 35%
41%
76%
65%
54% 60%
56% 54%
43%
58% 63%
61%
0%
20%
40%
60%
80%
100%
19 8
6
19 8
7
19 8
8
19 8
9
19 9
0
19 9
1
19 9
2
19 9
3
19 9
4
19 9
5
19 9
6
19 9
7
19 9
8
19 9
9
2 0
0 0
2 0
0 1
2 0
0 2
2 0
0 3
2 0
0 4
2 0
0 5
2 0
0 6
2 0
0 7
2 0
0 8
2 0
0 9
2 0
10
2 0
11
2 0
12
2 0
13
2 0
14
2 0
15
2 0
16
2 0
17
2 0
18
Refinancing as a Percent of Total Issuance
Issuance Trends – No bubble compared to period of excess
17
0
250
500
750
1,000
1,250
1,500
1,750
2,000
2,250
0%
2%
4%
6%
8%
10%
12%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
JP Morgan 12 Month US Default Rate (Left) High Yield Spread (Right)
As of December 31, 2018. Source: BoA Merrill Lynch, JP Morgan
High Yield Spreads vs. Default Rate
18
Section 4
The Case for Small Cap Equities
19
• Active portfolio management can add value. • A greater percentage of return comes from stock selection factors
instead of style or industry.
• Consolidation and regulatory pressures have reduced analyst coverage in the Small Cap space leading to less efficient markets.
• A reduction in active market makers has made the market less liquid and capacity more important.
• Publicly traded Small Cap equities are attractive Mergers & Acquisitions (M&A) targets.
• Small Cap equities offer the opportunity for higher active share ratios. • Better diversification and lower correlation relative to other key asset
classes.
The Small Cap Advantage
20
What is the current “Small Cap” definition:
• The definition of Small Cap can vary by index provider, but it is generally a company with a market capitalization of between $300 million and $3 billion
• The largest stock in the CRSP index is $9 billion in market cap
• Micro Cap stocks are typically between $300 to $500 million
How does the industry define Small Cap?
21CRSP: Center for Research in Security Prices
1992 2018
IPO – June 26, 1992 Market Capitalization
$273 Million
SBUX: $85 Billion 12/31/2018
SMALL CAP INVESTING IS FOCUSED ON THE FIRST 2X-15X IN APPRECIATION
$
Why invest in Small Cap equity stocks?
22
Event/Trend Consequence Large Caps
Small Caps
Sarbanes Oxley Changed compensation incentives and
reporting risks…jail time!!
Bush Tax Cuts Lower tax rates on dividends
Central Bank Policies - QE
The Federal Reserve and other Central Banks lowered rates
Demographics Baby boomers started retiring and
increasing the need for income
Global Market Volatility
Flight to Safety – Greece, China and Oil
Growth of Passive Investments
Capitalization based indexes expanded market share
Factors driving Large Cap’s performance advantage over Small Cap’s since 2006 may be ending…
23
Year Russell 1000 (%) Russell 2000 (%) Calendar year performance
difference LC-SC
1995 37.77 28.45 9.32
1996 22.45 16.49 5.96
1997 32.85 22.36 10.49
1998 27.02 -2.55 29.57
1999 20.91 21.26 -0.35
2000 -7.79 -3.02 -4.77
2001 -12.45 2.49 -14.94
2002 -21.65 -20.48 -1.17
2003 29.89 47.25 -17.36
2004 11.40 18.33 -6.93
2005 6.27 4.55 1.72
2006 15.46 18.37 -2.91
2007 5.77 -1.57 7.34
2008 -37.60 -33.79 -3.81
2009 28.43 27.17 1.26
2010 16.10 26.85 -10.75
2011 1.50 -4.18 5.68
2012 16.42 16.35 0.07
2013 33.11 38.82 -5.71
2014 13.24 4.89 8.35
2015 0.92 -4.41 5.33
2016 12.05 21.31 -9.26
2017 21.69 14.65 7.04
2018 -4.78 -11.01 6.23
R1000
R2000
The Russell 1000 (large cap) and 2000 (small cap) indices have roughly split leadership with Large Caps outperforming Small Caps in 13 of the past 24 calendar years.
Each asset class experienced periods of consecutive calendar year out-performance.
The next cycle could favor Small Cap investing
Past performance is no guarantee of future results. Sources: Morningstar Direct. Indices are unmanaged and not available for direct investment. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment. 24
• The “Size Effect” is real and obtainable, but it requires a long-term perspective.
• Small Cap stocks offer structural advantages that are only increasing with the impact of various trends like increased regulation, lowest interest rates and overvalued large cap stock prices.
• The next cycle could substantially favor Small Cap stocks, but it is important to access investment strategies focused on real value or opportunities in the market.
Conclusion
25
26
• Questions
• Case Studies
• New ideas/Favorite Ideas
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The contents may not be reproduced in whole or in part or otherwise made available without the prior written consent of Penn Capital.
Disclosure
27
Furey Research Partners, LLC does not guarantee the accuracy or completeness of this report, nor does Furey Research Partners, LLC assume any liability for any loss that may result from reliance by any person upon such information. The information and opinions contained herein are subject to change without notice and are for general information only. This research is for our clients only. Any unauthorized use or disclosure is prohibited. Receipt and viewing of this research report constitutes your agreement not to redistribute, retransmit or disclose to others the contents, opinions, conclusion or information contained in this report.
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Disclosure – Furey Research Partners
28
