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For Professional Investors Only – Marketing Material Small-caps: a large investment opportunity | September 15 1

Passive Insights September 2015 MARKETING MATERIAL – FOR PROFESSIONAL INVESTORS ONLY (as defined in MiFID Directive 2004/39/EC Annex II)

Small-caps: a large investment opportunity

Deutsche Bank AG Deutsche Asset & Wealth Management db X-trackers ETF Team Winchester House 1 Great Winchester Street London EC2N 2DB United Kingdom Hotline: +44 (20) 7547 1747 [email protected] etf.deutscheawm.com Authors

Vincent Denoiseux Passive Asset Management [email protected] Pierre Debru Passive Asset Management [email protected] Content

1. Small-caps, a not-so-well defined equity category 2

2. The long term investment case for small-caps investing 5

3. A fundamental case for small-caps investing 12

4. Small-caps: a diversifier within a global equity portfolio 15

5. Towards a quantitative framework for small-caps investing 18

“From a small seed a mighty trunk may grow.”

Aeschylus This marketing document has been produced for information purposes only by a Structuring function of Deutsche AWM and contains opinions developed by the Passive Asset Management team. This does not constitute investment advice or independent research. This paper is intended for professional investors only who understand the strategies and views introduced in this paper and can form an independent view of them. Please refer to the risk factors and disclaimers at the end of this document.

Executive Summary Investing in low capitalization stocks (usually referred to as “small-caps”) has been regarded for a long time as a niche investment area. Often considered as higher risk / higher potential opportunities, and showing a much lower analyst coverage than their larger peers (the “large caps”), small-caps have traditionally been a reserved playing field for active equity managers. The availability of passive small-caps vehicles now brings a cost efficient alternative to investors. While wrapping a basket of equities in an ETF is common, we will see below that the significant diversification observed between small-caps makes index products particularly interesting in this field. In this issue of Passive Insights, we show that in the medium to long term, small-caps are supported by a compelling investment case: ― Small-caps have delivered significant long term outperformance

compared to large caps. In the academic literature, such outperformance is often referred to as the “small-caps risk factor”, or “size factor”. The most prominent research has been published by Fama & French

1 who concluded that the size factor was one of the

three most rewarded equity risk factors.

1 “Common risk factors in the returns on stocks and bonds”, Eugene F. Fama and Kenneth R. French, Journal of Financial Economics, 1993

http://etf.deutscheawm.com/

mailto:[email protected]

mailto:[email protected]



― Investing in small-caps represents a high conviction approach to expressing a positive view on economic recovery. Small-caps have historically outperformed large caps in high GDP growth periods, and therefore an equity investor could implement a positive macro view using small-caps ETFs.

― Small-caps are more exposed to local / regional economies than large caps. With fewer multinational firms and more local based businesses, small-caps represent a more narrow way to invest in local economies.

― Small-caps equities demonstrate strong diversification benefits compared to large caps equities.

― Small-caps represent a more diverse investment universe than large caps. As an example, the average correlation of stocks in the STOXX small-caps index with the main index itself is 50%, compared to an average correlation of 75% for the components of the EuroSTOXX 50. An investment in a portfolio of small-caps, like indices, is therefore likely to benefit from a significant diversification benefit.

― While often considered as a high risk investment, small-caps indices exhibit in reality a similar risk profile compared to large caps, with their historical volatilities being in the same value range.

Nonetheless, small-caps are not a risk-free asset class. In light of their higher historical drawdowns, lower liquidity and relatively high current valuation ratios

2, an investor in small-caps would need to:

― Consider a medium to long term investment horizon (rather than a short term one),

― Be ready to sustain higher losses than the ones related to larger caps, ― Monitor the valuations ratios and main economic forecasts, ― Ensure the investment in small-caps is both diversified and ultimately

combined with lower risk asset classes within the overall portfolio. In the last section we present the building blocks of what will form our small-caps monthly report. The small-caps scorecard will cover earning forecasts, valuations, macro-economics and sentiment, and will aim to provide investors with insights on the opportunity of investing in small-caps.

1. Small-caps, a not-so-well defined equity category A tentative definition for small-caps While a public reference such as Investopedia

3 defines small-caps as “[…]

stocks with a relatively small market capitalization”, such a definition is unhelpfully complemented by: “the definition of small-caps can vary among brokerages”. Small-caps are generally loosely defined either by market capitalization bands, a percentage breakdown of the overall capitalisation or, sometimes, even more simply as being the listed equities which are not constituents of the relevant large caps indices.

2 As of end of June 2015

3 Source Investopedia, at the following link : http://www.investopedia.com/terms/s/small-cap.asp

http://www.investopedia.com/terms/s/small-cap.asp



Index Nomenclature

Europe Large Caps Index

STOXX Europe 50 Net Return Index™

Europe Small Caps Index

STOXX Europe Small 200 net Return Index™

US Large Caps Index or Russell 1000

Russell 1000 TR Index™

US Small Caps Index

Russell 2000 TR Index™

UK Large Caps Index

FTSE 100 TR Index™

UK Small Caps Index

FTSE Small Cap TR Index™

Germany Large Caps Index or DAX

DAX Index™

Germany Small Caps Index or MDAX

German DAX Mid-Cap Index™

Japan Large Caps Index

Topix 100 TR Index™

Japan Small Caps Index

TOPIX Small TR Index™

Figure 1: Usual market capitalisation bands related to small, mid and large caps4

Market Cap

Large Caps 10bn$ or greater

Mid Caps 2bn$ or greater

Small-caps 300m$ or greater

Micro/Nano Caps Less than 300m$

There is diversity in small-caps indices In the absence of a clear definition, the actual composition and characteristics of small-caps indices may differ significantly from one index to another. This may be, among others factors, related to : ― The index provider: each index provider typically adopts a particular

view/definition on where to position the threshold between large caps and small-caps.

― The investment universe: some indices focus on small-caps while others combine mid and small-caps. This is usually a direct consequence of how the corresponding large caps index is defined (e.g. if the large caps index is heavily concentrated or not).

― The exact investment goal: while the index name generally aims to capture at least partially its investment objective, with small-caps the available indices adopt different selection and capitalization bands for their construction regardless of their name.

Figure 2: Average market capitalization of several small-cap indices

Source: Deutsche AWM, DataStream, as of end of June 2015

Figure 2 illustrates this definition pitfall. Despite their respective names, the average market capitalization of the constituents of the Europe STOXX Small 200 Index is actually higher than the one for the MDAX which itself is not exactly a ‘small-caps only’ index, but rather a small and mid caps one, and one that would therefore be expected to have larger capitalizations. In contrast, the average market capitalisation of the FTSE Small-caps is much smaller.

4 Source Investopedia, http://www.investopedia.com/articles/analyst/010502.asp

http://www.investopedia.com/articles/analyst/010502.asp



Overall, small-caps indices differ quite significantly from each other, and we therefore invite the reader to take a close look at the indices and products being contemplated for an investment, ensuring they match his constraints and investment objectives.

Small-caps are overlooked by investors despite representing most of the listed equities Large caps tend to capture most investor attention as they represent most, if not all, of their portfolios and benchmarks. This is probably related to their de facto larger representation in market cap weighted indices. While such market cap weighting schemes provide investors with high capacity and liquidity, they have the inherent side effect of simultaneously disregarding small-caps. Furthermore, small-caps are usually not household names and therefore are generally not recognized by non sophisticated investors. This again keeps small-caps out of the limelight and off investor radars. Last but not least, holding ratios often mechanically prevent large asset managers and/or mutual funds having significant holdings in small-caps. But while their market capitalization mechanically increases their representation weight-wise, large caps actually represent a minority of the number of publicly traded stocks. Small-caps represent most of the equities in a given region. Figure 3: Distribution of equities in the MSCI Europe Investable Market Index by capitalisation bands

Source: MSCI, as of June 2015

As part of a market cap weighted index, small-caps stocks exhibit by construction a small weight compared to the market, but collectively they still represent 10-20% of the overall market, depending on geographies. Therefore, one may consider that omitting small-caps is not a small oversight, and may in fact be considered in itself a somewhat active decision. Until now, we have analysed small-caps investing through quite a technical prism: representativeness, number of stocks and weights within market cap weighted indices. Let’s now look at the real performance drivers of small-caps versus their larger peers.

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“I can resist anything except temptation.” (Oscar Wilde)

2. The long term investment case for small-caps investing

From an investment analysis perspective, it is difficult not to be seduced by the long term outperformance of small-caps versus large caps. As shown below, this outperformance is significant and consistent across regions and countries, over a long investment horizon. While this long term historical excess return is a result of strong fundamental and macroeconomic characteristics, which we will recap later, it’s worth first taking a closer look at the risks and rewards of investing in small-caps across cycles.

Strong outperformance versus large caps As shown in Figures 4, 5 and 6, from a pure performance standpoint, following a period of underperformance in the 80s and 90s, small-caps have exhibited stellar returns (in both absolute and relative terms) compared to large caps over the last 15 years. Figure 4: Historical performance of European and US small-cap indices vs. large caps indices

Source: Deutsche Bank, Bloomberg – From December 2000 to June 2015. Past performance, actual or simulated is not a reliable indicator of future results.

Figure 5: Historical performance of UK and Japan small-cap indices vs. large caps indices


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Figure 6: Historical performance of small-caps indices vs. large caps indices across regions

Large Caps Small-caps Outperformance

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US 5.49% 8.21% 2.72%

Japan -0.03% 5.60% 5.63%

UK 3.90% 5.35% 1.44%

Germany 3.73% 10.39% 6.66%


The consistent outperformance of small-caps versus large caps across regions – as represented in Figure 6 – is remarkable and has been one of the reasons behind the prolific academic research on what is commonly referred to as an ‘equity risk premium’.

The ‘small-caps equity risk factor’: a birds-eye view of the main academic findings Academics and practitioners have widly studied the so-called “small-caps premium” (or again “small-caps risk factor”) first discoverd in the early 1980s. Such a premium has been identified across regions and in both developed and emerging markets. It was initially identified in the US when Banz (1981) demonstrated an over performance of US small-caps from 1936 to the late 1970s in both absolute and risk-adjusted terms. A series of studies then tried to explain the origin of that premium. In particular, a higher systematic risk (Fama and French, 1993), a higher cash flow risk (Campbell and Vuolteenaho 2004) as well as behavioural biases (Lakonishok et al. 1994.) have been proposed as drivers. Another strand of literature postulates that the small-caps premium essentially reflects unobservable factors of smaller firms, such as liquidity (Amihud, 2002), information uncertainty (Zhang, 2006), financial distress (Chan and Chen, 1991) and default risk (Vassalou and Xing, 2004). Independently from its origin and its long term success, it is now widely accepted that the size premium varies significantly over time.

A cyclical out-performance Despite being one of the first identified rewarded risk factors, the outperformance of small-caps has not been stable over time. Historically, small-caps have successively gone through periods of fairly sharp out and under performance. Most notably, in the two decades after it was documented by Banz, small firms underperformed large firms in both the US and the UK. More recent evidence from the 2000s points to a reversal of this trend, as illustrated above.



Figure 7 compares the long term performances of the Russell 1000 and Russell 2000. The chart shows a cyclical pattern that has been reproduced during both the Asian, IT crises respectively in 1997 and through 2000 to 2003 and more recently during the subprime crisis in 2008.

Figure 7: Long term performance of a US small-caps index vs. alarge caps index

Source: Deutsche Bank, Bloomberg – From Dec 1978 to June 2015. Past performance, actual or simulated is not a reliable indicator of future results.

Over the most recent past, this cyclicality has been quite evident in the US but also across regions as exhibited in Figure 8: ― Small-caps indices have outperformed the most in periods of strong

economic rebound (2003, 2009-2010) ― Small-caps have under-performed in late cycle or during recession

(2007-2008). ― Following the 2008 crisis, after a strong rebound in 2009, the last five

years have essentially been mixed across regions. Figure 8: 12m rolling excess return of small-caps indices vs. large caps indices across regions

Source: Deutsche Bank, Bloomberg – From Dec 2000 to June 2015. The average outperformance is calculated in local currency. Past performance, actual or simulated is not a reliable indicator of future results.

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Facing cyclicality of returns, the investor in small-caps needs to think long term It is important to acknowledge that there have been and will likely be – despite the absence of a crystal ball – periods when small-caps deliver negative absolute and/or relative returns. Therefore, it seems important for an investor to adopt a long term horizon when contemplating an investment in small or mid caps. As an example of the importance of a long-term investment horizon, Figure 9 illustrates how an increasingly longer term horizon is rewarded. As the holding period increases, small-caps outperform more systematically large caps. Over a 1Y holding period small-caps have outperformed large caps 75% of the time in Europe since 2000, while if the holding period is extended to five years this percentage increase to 98%.

Figure 9: Percentage of rolling investment periods (1Y, 3Y and 5Y respectively) where small-caps indices have outperformed large cap indices over different holding horizons

Source Bloomberg, Deutsche AWM, June 2005-June 2015. Past performance, actual or simulated is not a reliable indicator of future results.

The Figure above shows the percentage of daily rolling investment periods where small caps indices have outperformed large caps indices (over 1, 3 and 5 years respectively). Past performance, actual or simulated is not a reliable indicator of future results. This is an important result that confirms the need for contemplating a long term horizon when investing in small-caps.

Surprinsingly limited market risk compared to larger caps

From fundamental business risk to market risk In the light of their past periods of significant underperformance – in particular during market downturns – there is a strong common belief that small-caps carry a higher risk than large caps, but it’s probably worth marking the distinction between small-caps and micro caps (or even ’penny stocks’). Institutional investors are more interested in what we would define as the ‘investible’ part of the small-caps universe – i.e. usually represented by small-caps indices sponsored by the top tier index providers – which essentially comprises equities with a market cap above USD 300M, hence covering established companies with broad clienteles and product lines. Therefore, the risk of such stocks should be more in line with their large part counterparts than what may initially be expected.

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In the following we aim to validate this through actual market risk measures. The market risk of a portfolio of securities can essentially be broken down into: a) The stock specific risk, b) The diversification benefits at the portfolio level, obtained by

combining the securities.

A single small-cap equity is more risky than a large cap ... From a fundamental perspective, small-caps traditionally carry higher business and financial risk than large caps. We would therefore expect this to be reflected in terms of market volatility. Figure 10 represents the average 3Y historical volatility of the individual components of small and big cap indices across countries.

Figure 10: Average 3Y volatility of index components

Source: Datastream, Deutsche AWM, as of end of June 2015. Past performance, actual or simulated is not a reliable indicator of future results.

Results are overall in line with expectations, i.e. that small-caps demonstrate significantly higher volatility than large caps, with US small-caps showing a 10% higher volatility than large-caps. The question however is how does this translate into index volatility, having factored for the eventual diversification benefits.

... but this higher specific risk is compensated by larger diversification benefits Small-caps are more diversified than their large caps counterparts. This is reasonably well understood with regards to their business models, which are likely to be more local and more specific than large and often international firms. From a market risk perspective, one way to identify this higher diversification is to calculate the average correlation between all the equities. A good proxy, which we will call ‘intra-correlation’, can be represented by the average correlation between the index and each of its components. The higher the intra-correlation, the lower the diversification benefit expected from these components.



Figure 11 illustrates the intra-correlation, and shows clearly that each small-caps index – including the small-caps Europe index – demonstrates a significantly lower intra-correlation than large caps indices, and hence a much higher diversification benefit, when investing in each of its components.

Figure 11: Average correlation of index constituents with each index

Source DataStream, Deutsche AWM, as of end of June 2015. Past performance, actual or simulated is not a reliable indicator of future results.

A rather counter-intuitive consequence: small-caps indices have been less volatile than large caps indices Figure 12 illustrates the difference in volatility between small and large caps. Out of the six regions considered, only two small-caps indices exhibit higher volatility than the large caps index covering the same region.

Figure 12: Historical volatility of small and large cap indices

Source: Deutsche AWM, Datastream, data as of end of June 2015. Past performance, actual or simulated is not a reliable indicator of future results.

Overall, and somewhat counter intuitively, small-cap indices exhibit on average lower volatility than large caps indices across the cycle mainly thanks to high diversification between stocks. In other words, the diversification between small cap stocks largely outweights the extra volatility that each of those stocks exhibits individually.



In figure 13, we look at the performance of a US small caps index in conjunction with the performance of a US large caps index. This figure illustrate quite clearly that when large caps are up, small caps tend to be up more and that when large caps are down small caps tends to go down more and even more so during crisis. Therefore, despite similar or lower volatility, investors should not forget that small-caps tend to exhibit higher beta (Figure 13, very much in line with their cyclicality) and can therefore exhibit higher drawdown (figure 14) and higher risk during market downturn (Figure 13).

Figure 13: Regime Analysis of US Small and Large caps indices monthly returns

Source: Deutsche Bank, Bloomberg – From Dec 1978 to June 2015. Using Monthly returns

Figure 14: Historical Max drawdown of Small and Large caps Indices across Regions

Source: Deutsche Bank, Bloomberg – From Dec 2000 to June 2015.

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3. A fundamental case for small-caps investing Following a birds-eye view of the long term risk-return profile of small-caps, we now analyse the most relevant fundamental grounds supporting an investment into small-caps.

Small-caps usually convey higher expected growth potential Leaving aside their strong long term past performance, small-caps demonstrate appealing growth potential. Small-caps are often at the forefront of creative development and hence of strong growth potential. New companies and new technologies are the reservoir of the long term growth of countries. Some of those stocks with promising technological developments represent the chance to get in on the ground floor of the large caps of the future. Figure 15 represents the various expected long term growth forecasts (analyst consensus) for each particular large or small-caps index, cross region and country. From this figure, we can derive two main comments: ― Small-caps demonstrate a significantly higher expected earnings

growth than large caps and, ― this pattern is remarkably consistent across countries and regions

Figure 15: Long term earning growth estimates (consensus)

Source: DataStream, IBES, Deutsche AWM, as of end of June 2015

Among others, Europe small-caps in particular demonstrate an expected 12% pa growth of their earnings, while large caps only demonstrate an expected 8% earnings growth.



Small-caps are less covered by equity analysts Small-caps are often under covered by analysts. This lack of coverage can be explained in terms of either or both sell-side or buy-size interest: small-caps, due to their lower trading volume and capacity, are more complex to integrate in an institutional portfolio, which is itself likely to make them not so attractive from a brokerage business perspective. Figure 16 represents the percentage of stocks in small and large caps indices which are covered by at least one analyst, while Figure 17 shows the average number of analysts per stock for each small / large caps index, with a cross-country perspective. Both Figures tend to demonstrate that small caps equities are less well covered by analyst and therefore more effort are needed for investor to follow those stocks.

Figure 16: Percentage of stocks in a given index being covered by at least one analyst

Source: DataStream, Deutsche AWM, as of end of June 2015

Figure 17: Average Number of analysts covering the stocks

Source: DataStream, Deutsche AWM, as of end of June 2015

This under-coverage is often used as an argument in favour of active management compared to passive vehicles.



However, it turns out that generating alpha within the small-caps investment universe seems to be less easy than expected. According to the year-end 2014 numbers from the SPIVA report

5, with regards to US

equities 88.14% of the US Small-caps Core Equity managers have been outperformed by their benchmark over the last 10Y through to the end of 2014. The picture is similar for US Mid Cap Core managers, 88.4% of which have been outperformed by their respective benchmarks.

Small-caps, a more local exposure As illustrated in Figure 18, small-caps indices exhibit an average exposure to local markets which 10 to 20% higher than large caps indices. From a business perspective, this is relatively intuitive as small-caps tend to be less diversified geographically and more entrenched in their local market. They therefore tend to give a more localized exposure than large caps, which are often multinationals that happen to have their headquarters in a given country. This local exposure is one of the explanation for the strong cyclicality of small-caps and it also strengthens somewhat the case for using small caps as a good tool to implement a positive macro view in specific regions.

Figure 18 : Exposure to domestic markets

Source Factset, Deutsche AWM

6, as of end of June 2015

5 Year end 2014 SPIVA

® U.S. Scorecard, published by S&P Dow Jones Indices,

6 With regards to each contemplated equity index, its aggregated exposure to domestic market is

calculated as average of the exposure to domestic market calculated for each of its constituents. With regards to each index constituent, this exposure is calculated as the average of the percentage of domestic sales, domestic income and domestic assets. Such an average is non asset-weighted to avoid biases when comparing small, mid and large cap indices.

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4. Small-caps: a diversifier within a global equity portfolio

From a portfolio construction standpoint, there are 3 main parameters to take into consideration when contemplating the investment in an additional asset class: a) risks b) returns and c) diversification. Having covered the investment case and risk and return characteristics in the previous sections, we now aim to show how small-caps can improve equity and bond portfolios.

Small-caps carry a real diversification benefit to global equities As discussed above, small-caps are pretty much excluded from most of the traditional equity benchmarks. While this supports an investment case related to the limited flows into this market segment (which is dampened by the quite high valuation ratios of small-caps compared to large caps), this systematic exclusion brings a very useful complementary benefit: “real” diversification. A common criticism against international diversification using traditional benchmarks is the fact that the actual diversification brought by a portfolio of indices like the S&P 500, EuroSTOXX 50 and Nikkei 225 is ultimately limited due to the high degree of connection between these markets. As shown in Figure 19, the constituents of the S&P 500 demonstrates a 95% average correlation with the MSCI World. Being excluded from most of the main benchmarks, small-caps indices naturally increase the diversification of a global equity portfolio compared to their larger caps peers. This is shown clearly in Figure 19, where we can see that the average correlation of the constituents of the small-caps indices is well below the equivalent for the S&P 500, or UK small-caps, demonstrating an average correlation to MSCI World as low as 35%.

Figure 19 : Average correlation of index constituents against MSCI World

Source DataStream, Deutsche AWM, as of end of June 2015



A closer look at active sectors weights Structurally, small-caps indices do not have the same sector exposure as large caps indices. As illustrated below, across regions, small-caps indexes are underweight defensive sectors, such as healthcare, consumer staples and utilities, and overweight cyclical sectors such as consumer discretionary and industrials. One of the main reasons for this structural difference is that some sectors are more prone to economies of scale and therefore tend to create larger caps companies when other sectors tend to produce more small-caps companies. Such disparity in the sector make up of both family of indices also gives a clear indication that small-caps indices would provide strong diversification to an equity portfolio.

Figure 20: Europe Small-caps index Sector Active weight (vs. large caps index)

Source: Deutsche Bank, Bloomberg – As of June 2015

Figure 21: US Small-caps index Sector Active weight (vs. large caps index)

Source: Deutsche Bank, Bloomberg – As of June 2015

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Including small-caps indices increases the risk-adjusted returns of an equity portfolio Following these observations, we construct two families of equity portfolios: ― diversified across regions but invest only in large-caps stocks ― diversified across regions as well as market cap bands through small

caps indices The weightings in these two families of portfolios are calculated using the classic mean-variance optimisation approach developed by Markowitz

7.

We can summarise this approach as follows: ― The variance-covariance matrix needed for the mean-variance

optimisation is calculated with the historical volatility and correlation of the indices;

― The expected return is defined as the historical returns of such indices ― For each contemplated volatility target, the optimiser looks for the

‘optimal portfolio’, defined as the portfolio demonstrating the highest return and observing a set of constraints

Figure 22 represents the 2 efficient frontiers obtained through this optimisation exercise, i.e., the 2 universes made of all optimal portfolios. Navigating across these efficient frontiers enables an investor to select a particular target volatility and then to look for the optimal portfolio demonstrating this desired level of volatility. Across all volatility levels, the portfolios being able to invest in small-caps stocks exhibit higher expected returns. This is a clear consequence of the strong diversification between small-caps and large-caps indices

Figure 22: Efficient frontier of portfolios with or without small caps exposure.

Source: Deutsche Bank, Bloomberg – June 2005- June 2015. Past performance, actual or simulated is not a reliable indicator of future results.

7 See Markowitz, H.M. (March 1952). "Portfolio Selection". The Journal of Finance 7 (1): 77–91 and

Markowitz, H.M. (1959). Portfolio Selection: Efficient Diversification of Investments. New York: John

Wiley & Sons.

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5. Towards a quantitative framework for small-caps investing

As shown above, small-caps did demonstrate a pretty consistent pattern of outperformance over the long term but such excess returns have been delivered with a fair amount of cyclicality. If an investor was able to tactically time his investment in small-caps, that would therefore generate an enviable additional source of performance and/or risk reduction compared to a straight long term exposure in small-caps. Whilst timing of asset classes is indeed a difficult objective to pursue, in what follows we try to identify several indicators to help investors in assessing the opportunity for small-caps investing. This encompasses the following criteria: ― Macro-economic outlook, a higher GDP growth usually leading to an

outperformance of small-caps, ― Forward earnings, either on an absolute or cross-sectional (small vs.

big caps) as well as historical basis, ― Valuation ratios, either on an absolute (cheap/rich), cross-sectional as

well as historical basis, ― Sentiment, looking at short term earning revisions by analysts, ― Flows, looking at historical flows into small-caps vehicles.

A macro-economic perspective: small-caps outperformance is closely linked to GDP growth A way to illustrate the cyclicality of the outperformance of small-caps versus large caps is to superimpose their rolling excess returns with macroeconomic indicators. In the two figures 23 and 24 we used leading indicators published by OECD as well as the realised GDP growth in Europe. Both indicators exhibit a clear correlation with the over-performance of small-caps confirming that they perform better in high growth or early recovery periods.

Figure 23: Rolling 6M excess returns of Europe and US small-caps vs. large-caps indices and rolling 6M OECD leading Indicators variations

Source: Deutsche Bank, Bloomberg – Dec 2000-May 2015. Past performance, actual or simulated is not a reliable indicator of future results.

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Figure 24: Rolling 6M excess returns of Europe small-caps vs. large caps and Rolling 6M GDP growth variations

Source: Deutsche Bank, Bloomberg – June 2000-March 2015

As discussed previously, such pro-cyclicality is often associated with the stronger exposure of small caps to local economies and innovative sectors.

Historical earnings and future growth: monitoring the expected fundamentals One of the primary goals of small-caps investors relates to their alleged ability to deliver a higher earnings growth rate than the ones of large-caps. As illustrated in Figure 25, the respective 12M forward Earnings Per Share (“EPS”) of small-caps indices have developed at a strong pace across geographies. However, depending on regions this index EPS is at record level or still a way off such record.

Figure 25: Historical 12M forward EPS: small-caps indices

Source Deutsche Bank, Thomson Reuters. From Jun 2005 to Jun 2015

As for other equity investments, the forward EPS represents a core fundamental driver of expected price evolutions for small-caps indices. Nonetheless, when considered alone, it may lead to significant under/over valuations. Its evolution therefore needs to be looked at in conjunction with complementary factors as we will see below.

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A valuation perspective: what is a ‘right entry price’ for small-caps? As for any investment, valuation is a critical point when assessing an entry/exit point on a particular asset. It’s possible to look at valuation from a very long term perspective, and hence as a strategic allocation tool, or on a more short term level, to develop a more tactical methodology. We consider the following multi-stage analysis: ― The absolute level of forward P/E may provide indications regarding a

general over/under valuation of small-caps and/or equities in general. ― The cross-sectional comparison between the respective P/E of small

and large caps enables a relative analysis between them regardless of their absolute level. This may be a relevant tool to analyse markets at current levels (end of June 2015).

Figure 26 and 27 respectively represent the 12M Forward P/E of European equities and US equities, and more specifically the Forward P/E of small small and large caps indices. While we can see that pretty much all P/E are near their historical highs, European small caps indices are relatively cheap, or more precisely, the premium traditionnaly observed between small and large caps indices is currently at an historically low point. US small caps indices, based on this Forward P/E comparison, seem relatively expensive.

Figure 26: Historical 12M Forward P/E – European Equities


Figure 27: Historical 12M Forward P/E – US Equities


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Figure 28 represents a both cross-sectional, historical and cross-regional visualisation of the main valuation metrics of small-caps. This is likely to be a useful component of the decision tree for a small-caps investor.

Figure 28: Valuation Ratio overview (vs 10Y High and Lows)

Source Deutsche Bank, Thomson Reuters, Datastream. From Jun 2005 to Jun 2015

A sentiment perspective: utilizing earning revisions While earnings and valuations analysis gives fundamental tools to valuate and estimate the opportunity of an investment in small-caps, a sentiment analysis may bring a more tactical point of view. Sentiment of analysts is often recapitulated through the earning revision ratio (ERR) calculated as

Where PositiveRevisions, NegativeRevisions and NumberOfEstimates respectively count the number of positive/negative earning revisions over a 12 months period, as well as the number of estimates which have been provided by the analysts on the components of a particular index. The earning revision ratio can be associated with the ‘momentum of analyst estimates’, as it aims to provide insights on how the financial analysts community is revising its views with regards to a particular market segment.



From Figure 29, whilst the earning revision ratio went through a large dip in 2008-2009, followed by the strong recovery of 2009-2010, more recent sentiment – as observed over the last year – seems to be neutral to negative on both US and Europe small-caps.

Figure 29: Sentiment: 12 months Earnings Revision Ratio

Source Deutsche Bank, Thomson Reuters, Datastream. From Jun 2005 to Jun 2015

An investor flow perspective Flows may be seen as a double-edged sword when analysing a particular asset class. On one hand, high flows into a particular asset class shows momentum and investor appetite, which may be further confirmed by later flows. On the other hand, such high flows show that a particular asset class has become a focus point of the market participants and in some case some kind of self fulfilling success story. A trend following investor is likely to follow this type of flow signal, while a contrarian one would see exceptionally high flows into a particular asset class as a over-heating sign.

Figure 30: Global monthly flows in small-caps funds and ETFs

Source Deutsche Bank, Morningstar, May 2005-April 2015

From Figure 30, we can conclude on a very significant investor’s interest in favour of small caps over the last year (as of end of April 2015), with record-level inflows into open-ended funds and ETFs.

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Conclusion Small-caps are often disregarded by investors, with capacity and liquidity often flagged as a reason for doing so. But while these points do need to be looked at with particular attention, they should not overshadow the strong investment case underlying the historical outperformance of such small caps indices. Over the long term, small-caps indices have demonstrated compelling characteristics for any equity investorie strong performance, contained risk and strong diversification compared to traditional equity investment (large caps stocks).



Following the publication of this paper, we aim to make available on a regular basis a small-caps scorecard (see Figure 31) which will cover earning forecasts, valuations, macro-economics and sentiment, and will aim to provide investors with insights on the opportunity of investing in small-caps.

Figure 31: An example of Small-Caps Valuation Report

Source Deutsche AWM

For investors interested in investing in small caps, the ETF range of Deutsche Asset and Wealth management provides a diversified range of tools to implement their views across regions.



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passive insights - dws€¦ · figure 3: distribution of equities in the msci europe investable...

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