The High Productivity, Low Barrier Era

The High Productivity, Low Barrier Era
Lehman Brothers Small-Cap Strategy James H. Furey, CFA, Managing Director 02/02/05 Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at or can call LEHMAN to request a copy of this research. Investors should consider this report as only a single factor in making their investment decisions. PLEASE SEE ANALYST(S) CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 37

Today’s “Small” Talking Points
The “High Productivity, Low Barrier Era” and Its Effects on Small-Caps. Is the Small-Cap Cycle Over? Our Approach to Small-Cap Decision-Making 02/02/05

High Productivity, Low Barrier Era

The High Productivity, Low Barrier Era
What is the “High Productivity, Low Barrier Era”? The Digital Revolution still defines our time. Era of Unintended Consequences Portfolio Manager “DNA” must change: Sector Performance in Up & Down Markets Seasonality 02/02/05

High Productivity, Low Barrier Era
“Digital Revolution” still defines our time but unintended consequences exist and are the key to investing success Connecting the disparate dots… 02/02/05

Small-Cap Portfolio Manager DNA
Analysis of Sector Statistics in a Rising Small-Cap Market (1Q85 to 4Q04) Source: Lehman Brothers and FactSet Analysis of Sector Statistics in a Declining Small-Cap Market (1Q85 to 4Q04) Source: Lehman Brothers and FactSet 02/02/05

Small-Cap Portfolio Manager DNA (cont’d)
Analysis of Sector Statistics in a Rising Small-Cap Market (1Q85 to 4Q04) Source: Lehman Brothers and FactSet Analysis of Sector Statistics in a Rising Small-Cap Market (2Q00 to 4Q04) Source: Lehman Brothers and FactSet 02/02/05

Small-Cap Portfolio Manager DNA (cont’d)
Analysis of Sector Statistics in a Declining Small-Cap Market (1Q85 to 4Q04) Source: Lehman Brothers and FactSet Analysis of Sector Statistics in a Declining Small-Cap Market (2Q00 to 4Q04) Source: Lehman Brothers and FactSet 02/02/05

Seasonal Small-Cap Performance
R2000 monthly average nominal returns – best in Dec to Feb; negative July through Oct Source: Lehman Brothers and FactSet 02/02/05

Small-Cap Sector Weights – Changing World
The three horizontal bands represent average weight bounded by plus and minus one standard deviation. Shading demarcates underperformance for the sector’s 12 month forward performance relative to the R2000. Energy Technology Source: Lehman Brothers and FactSet Source: Lehman Brothers and FactSet 02/02/05

Is the Small-Cap Cycle Over?

Is the Small-Cap Cycle Over? Bears Argue…
Is it “Simply Irresistible” to Short Small-Caps & Go Long Large? What the Small-Cap Bears are saying Monetary policy, 10-2 year US Government spreads, Real Fed Funds, Small-cap nominal valuation (P/S, P/B, P/E) & relative (P/E) 02/02/05

10-2 year US Gov’t spreads are falling and have been for a year Source: Lehman Brothers; Ibbotson and the Federal Reserve 02/02/05

Small-cap P/S and P/B are expensive nominally R2000 P/S w/12mo Fwd Nom Rtn R2000 P/B w/12mo Fwd Nom Rtn Source: Lehman Brothers and FactSet. 02/02/05

Small-cap P/E’s are expensive, nominal & relative But they do not correlate with RELATIVE performance R2000 P/E (Russell Method*) R2000/S&P500 Rel P/E (Russell Method*) Source: Lehman Brothers and FactSet. *Russell Method excludes Top and Bottom 10%. 02/02/05

1994 Redux: Small-caps underperformed after 1994 Fed tightening Real Fed Funds and Russell 2000 Forward 52-week Relative Performance vs. S&P 500 Source: Lehman Brothers and FactSet. 02/02/05

Relative price to sales expands when Real Fed Funds are negative but can contract when Real Fed Funds rise as they did in 1994 Real Fed Funds and Russell 2000 Relative Price to Sales Valuation vs. S&P 500 Source: Lehman Brothers and FactSet. 02/02/05

Real Fed Funds rising above zero can potentially slow small-cap valuation expansion Real Fed Funds vs. Russell 2000 Nominal Price to Sales Source: Lehman Brothers and FactSet. 02/02/05

Their “Short Small-cap / Long Large-cap” trade is not a “Go Short ALONE” strategy Small-caps since 1986 are most often profitable as long as Real Fed Funds are less than 3.25%. Real Fed Funds and Forward 52-Week Russell 2000 Nominal Returns Source: Lehman Brothers and FactSet. 02/02/05

Small-Caps Can Still Outperform. Bulls Argue…
“High Productivity, Low Barrier Era” forces likely Keep REAL and NOMINAL rates low, Favor “more local” less intellectual property (IP) based small-caps, Support high valuation. Investors bearish on small-caps’ RELATIVE performance may be underestimating the “High Productivity, Low Barrier Era” ability to keep rates low, policy stimulative, and investors focused on small- caps where there is less IP . 02/02/05

2005’s January losses are inconsequential in the context of this small-cap cycle do not even erase the prior three months’ RELATIVE or NOMINAL gains Russell 2000 Trailing 3-Month Relative Return vs. S&P 500 Source: Lehman Brothers and FactSet, data as of January 25, 2005. 02/02/05

Small-Caps have outperformed in the past dating to 1958 when Real US Government 10-year rates were less than 2.5%, as is also the case today Real 10-Year US Gov’t Interest Rates plotted vs. Small-Cap Forward 52-Week Relative Returns Source: Lehman Brothers; Ibbotson and the Federal Reserve 02/02/05

History supports the view that small-caps outperform when NOMINAL 10-year US Government rates are below 5.0% Nominal US Government 10-Year Rates and Forward 52-Week RELATIVE Performance Source: Lehman Brothers; Ibbotson and the Federal Reserve 02/02/05

1994 yield curve shifted up; yield curve did not A flattening and lower intermediate term yield curve after five Fed hikes in six months may induce the Fed to stop raising rates sooner than expected Yield Curve Feb 3 - Dec Shift upwards. Late flattening & compressing small-cap RELATIVE valuation Source: LehmanLive.com 02/02/05

The Fed may have to drop their tightening regimen if 10-year rates keep declining and that will be bullish for small-caps The Yield Curve from Jun 30, 2004 to Today. Flattening with Risk of Inverting. Sm-Cap Valuation Expands? Source: LehmanLive.com 02/02/05

Small-caps’ price to sales and price to book RELATIVE valuations are not expensive R2000 P/S Rel to S&P500 w/12mo Fwd Rel Rtn R2000 P/S Rel to S&P500 w/12mo Fwd Rel Rtn Source: Lehman Brothers and FactSet. 02/02/05

Other factors support further small-cap outperformance Large-cap Healthcare’s larger weight in the S&P 500 and its struggle with new drug discovery sufficient to replace patent expiration, Large-cap Technology’s high S&P 500 weight and its vulnerability to “High Productivity, Low Barrier Era” pressures, Currently bullish tax policy with low favorable capital gains, Hedge & Quant funds’ affinity for small-caps Positive 2005 relative earnings strength Small-caps being “more local and less global” Real Fed Funds may not turn positive until Fed Funds reach 3.0%, indicating monetary policy remains stimulative 02/02/05

Small-Caps at Risk but Not Rolling Over
To Summarize, the Bearish & Bullish Arguments: 02/02/05

Our Approach to Small-Cap Decision Making

Our Approach to Small-Cap Decision Making
Quantify: Sentiment Risk & Reward Earnings Performance & Momentum Technicals You may agree or disagree with our conclusions BUT our data will likely be the basis for YOUR decisions implicitly or explicitly 02/02/05

Sector Performance/Momentum
Russell 2000 Sector Performance and Momentum Source: Lehman Brothers and Baseline 02/02/05

Sector Performance vs. Momentum Grid
Source: Lehman Brothers 02/02/05

Industry Performance vs. Momentum Grid

Assigning Values to Perf. vs. Mom. Grid

“Voice of the Small-Cap Market”
Source: Lehman Brothers and FactSet 02/02/05

Thank You. Jim Furey, CFA, Managing Director
Lehman Brothers Small-Cap Strategy ;

Analyst Certification
I, James Furey, hereby certify (1) that the views expressed in this research accurately reflect my personal views about any or all of the subject securities or issuers referred to in this and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this . Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this communication. Investors should consider this communication as only a single factor in making their investment decision. Important Disclosures: The analysts responsible for preparing this report have received compensation based upon various factors including the Firm’s total revenues, a portion of which is generated by investment banking activities. Stock price and ratings history charts along with other important disclosures are available on our disclosure website at And may also be obtained by sending a written request to: LEHMAN BROTHERS CONTROL ROOM , 745 SEVENTH AVENUE, 19TH FLOOR NEW YORK, NY 10019 This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates ("Lehman Brothers") and has been approved by Lehman Brothers International (Europe), authorized and regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. This material is distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers. With the exception of disclosures relating to Lehman Brothers, this research report is based on current public information that Lehman Brothers considers reliable, but we make no representation that it is accurate or complete, and it should not be relied on as such. In the case of any disclosure to the effect that Lehman Brothers Inc. or its affiliates beneficially own 1% or more of any class of common equity securities of the subject company, the computation of beneficial ownership of securities is based upon the methodology used to compute ownership under Section 13(d) of the United States' Securities Exchange Act of In the case of any disclosure to the effect that Lehman Brothers Inc. and/or its affiliates hold a short position of at least 1% of the outstanding share capital of a particular company, such disclosure relates solely to the ordinary share capital of the company. Accordingly, while such calculation represents Lehman Brothers' holdings net of any long position in the ordinary share capital of the company, such calculation excludes any rights or obligations that Lehman Brothers may otherwise have, or which may accrue in the future, with respect to such ordinary share capital. Similarly such calculation does not include any shares held or owned by Lehman Brothers where such shares are held under a wider agreement or arrangement (be it with a client or a counterparty) concerning the shares of such company (e.g. prime broking and/or stock lending activity). Any such disclosure represents the position of Lehman Brothers as of the last business day of the calendar month preceding the date of this report. This material is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may be used to pay that income. © 2005 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in your home jurisdiction. Lehman Brothers policy for managing conflicts of interest in connection with investment research is available at Ratings, earnings per share forecasts and price targets contained in the Firm's equity research reports covering U.S. companies are available at 02/02/05

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