International Small Company Memorandum (A0059006.DOC;1)



TO: South Carolina State Firefighters’ Association

FROM: S. Bart Valley, Cheryl R. Holland, Charles B. Flowers

DATE: June 22, 2007

SUBJECT: International Small-Capitalization Asset Class

One of our duties in managing your investment assets is to consider a broad spectrum of potential asset classes for inclusion in your portfolio. In keeping with the Prudent Investor rule, our investment and management decisions with respect to individual assets or asset classes are evaluated not in isolation, but rather in the context of your portfolio as a whole and as a part of your overall investment strategy. We seek out asset classes whose inclusion should increase overall portfolio return, reduce overall portfolio risk, or a combination thereof.

Towards this end, we are recommending the addition of international small capitalization stocks to your portfolio. International small capitalization stocks are the equities of companies with lower market capitalization rates within international developed countries, primarily the UK, Continental Europe, Japan and the Pacific Rim. Although international small cap stocks are relatively risky when held in isolation, research shows that over time these stocks offer both higher rates of return and significant diversification benefits to US-based investors. Although we make no attempts at market timing, there are also several factors related to the current global market environment that make now an unusually good time to consider international small cap exposure. Because of these factors, we are recommending going forward with a four percent allocation to this asset class per your targets as stated in your Investment Policy Guidelines.

The first rationale for the inclusion of international small cap stocks is their potential for high rates of return over the long-run. Small cap companies tend to be more volatile than large cap companies and have a higher failure rate over time. Research into asset class returns confirms that risk and return are positively correlated, so as a compensation for this greater risk, small cap stocks provide higher rates of returns than large cap stocks over time (this is known as the small cap effect). The small cap effect is even more pronounced in international markets. For the past thirty years ending December 30, 2002 US small cap stocks posted average annual returns of 12.33% versus an average return of 10.66% for US large caps. Internationally, small caps offered an even higher premium, averaging 12.57% per year versus 9.34% for large caps.[i] These higher rates of return will serve as an important component of the long-term growth of your portfolio.

The compounding effects of this performance is shown in the following chart, which shows how one dollar invested in each of these asset classes would have grown in the 30 years from 1972-2002.

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Along with higher expected returns, international small cap stocks also offer significant diversification benefits to the portfolio. Small cap stocks tend to be more tied to their domestic markets than are large cap stocks. While international large cap companies such as Toyota and Sony gain a large portion of their earnings outside their home borders, smaller companies generate most of their earnings domestically and are thus more tied to their home economy. What this lack of globalization means for US investors is that the returns correlation between US markets and international small cap stocks is much lower than what we see with international large company stocks, meaning international small-cap stocks actually provide the portfolio greater diversification benefits.

The correlation between international small cap stocks and US large cap stocks from 1980-2002 has averaged a very low 0.41 (as compared to a 0.55 correlation between international large caps and US large caps). Furthermore, diversification with international small cap stocks has worked best when we have needed it most. The benefit of international diversification comes from international stocks having higher returns than US stocks when US stocks perform poorly, and small cap international stocks provide even more of this type of benefit than do large cap stocks. For example, international small caps actually gained 2% in 2002 while domestic large and small caps and international large caps all posted double digit losses.

While our focus here is certainly on the long-term benefits of including international small cap stocks in your portfolio, a number of factors in the current global economic and market environment indicate that these stocks may be particularly well positioned. Throughout most of the 1990’s, international large cap stocks outperformed international small cap stocks. While that trend has reversed in the past two years, the valuations of international small cap stocks in almost all developed countries and across most industries remain at or near historical lows. International small-cap stocks currently offer significantly lower price-to-book[ii], price-to-earnings[iii], and price-to-cash flow[iv] ratios than both domestic stocks and international large cap stocks. A summary of this data as of year-end 2002 is shown in the following chart:

| |Intl Small Cap |Intl Large Cap |US Small Cap |US Large Cap |

|3 Yr Avg Price/Book[v] |2.4 |4.0 |4.2 |5.8 |

|3 Yr Avg Price/Earnings |21.2 |25.1 |22.0 |29.1 |

|3 Yr Avg Price/Cash Flow |10.7 |13.5 |15.7 |18.4 |

What this data shows is that in relative terms and considering underlying business fundamentals, international small cap stocks are significantly cheaper than domestic equities and international large cap equities. In addition to the current “value” presented by international small caps, continued globalization should also present significant opportunity for growth. The introduction of the Euro, cross-border mergers and acquisitions, linking of global capital markets, and continued deregulation should all prove beneficial to smaller international companies in coming years.

We will use the DFA International Small Company fund as the vehicle to gain exposure to international small cap stocks. This is a broadly diversified mutual fund that invests in thousands of small companies across Japan, the United Kingdom, Europe and the Pacific Rim. Since its inception in 1996, this fund has posted top quartile performance relative to its peer group while posting some of the lowest risk scores in the international small cap category.

It is important to remember that international small company stocks do involve a significant level of risk, and there will be times when these stocks underperform other assets in your portfolio over extended periods. The positive correlation between risk and return only becomes certain over longer time periods, and investors desiring the higher rates of return of riskier assets must be prepared to live through some uncomfortable periods in which these assets offer significantly lower returns than less risky assets. However, such periods of underperformance are simply manifestations of the very diversification that over the longer run enhances the risk/return profile of your overall portfolio. The long-term benefits of international small-cap exposure are clear: higher expected returns and improved diversification. The recommended addition of this asset class will further enhance your portfolio’s ability to withstand ever-changing global economic conditions and inevitable market fluctuations.

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[i] US large cap measured by the S&P 500 Index. US small cap measured by the DFA US 6-10 Index. International large cap measured by the MSCI EAFE Index. International small cap measured by the DFA International Small Cap Index.

[ii]Price-to-Book ratio compares a stock’s market value to the value of the company’s total assets minus total liabilities (book value). It is determined by dividing current stock price by common stockholder equity per share.

[iii] Price-to-Earnings ratio shows the multiple of earnings at which a stock sells. It is determined by dividing current stock price by the company’s earnings per share.

[iv] Price-to-Cash Flow is calculated by dividing a company’s current stock price by its annual free cash flow per share.

[v] The figures in the chart are arithmetic averages bases on values for the years 2000-2002.

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