European small caps shouldn t be overlooked

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Document for professional clients JUNE 2017 EQUITY PERSPECTIVE European small caps shouldn t be overlooked Yves Maillot - Head of European equities Investing in small caps in Europe in today s

1 Document for professional clients JUNE 2017 EQUITY PERSPECTIVE European small caps shouldn t be overlooked Yves Maillot - Head of European equities Investing in small caps in Europe in today s context puts investors in an ideal position to take advantage of the current growth trend, providing a long-term source of outperformance for equity portfolios. This may look blindingly obvious. All large companies started out as small companies and the ones that managed to stay the course were the most agile enterprises, which manufactured products that best matched market expectations, were led by management who dared to invest in their vision, and were appropriately managed from a commercial and financial standpoint: some of them even went on to become world heavyweights. The success of new technologies and the expansion of the digital universe speeded up this process, and the largest market capitalizations now include companies that were unknown or even non-existent only a few years ago (GAFA). 1

SMALL COMPANIES ARE THE MAIN SOURCES OF INNOVATION AND GROWTH Small and mid caps account for 99.8% of companies in Europe (in number of companies). They employed 90 million people (2014 figures), i.e. 67% of total jobs, and created more than 70% of new jobs in recent years.

2 SMALL COMPANIES ARE THE MAIN SOURCES OF INNOVATION AND GROWTH Small and mid caps account for 99.8% of companies in Europe (in number of companies). They employed 90 million people (2014 figures), i.e. 67% of total jobs, and created more than 70% of new jobs in recent years. Virtually all SMEs are microenterprises that employ fewer than ten staff. In the European Union, the most active young companies are those in the knowledge-intensive business services sector and where operations are based in countries with favorable macroeconomic conditions. Over recent years, these have been the main job-creating companies in Europe, and growth in new technologies, services and digital further reinforces this trend. Investing in SMEs innovation potential looks like a given and is vital for the European Union in order to reinvigorate growth and breathe life into the job market. In this respect, countries that did not invest much in R&D during the crisis saw a larger drop in employment and were not able to generate a sufficient recovery in their economy. Average R&D spending in Europe (2%) is well below countries such as South Korea and Japan (4% and 3.4% respectively) or even the US (close to 3%). SMALL CAPS DISPLAY STRUCTURAL STOCKMARKET OUTPERFORMANCE Listed small and mid caps outperform large caps in the mid to long term. In the US, where small and mid cap indices were set up several years ago, figures are striking. According to research by Ibbotson, the annualized premium as analyzed over a long timeframe (series started in 1950) for small caps compared to large companies stands at around 3% (+2.90%). In Europe, figures have a shorter historical track record, but figures over recent years all confirm this conclusion. Over the past 16 years since end April 2001 (when the dot.com bubble started to burst), the chart opposite shows an annual outperformance of 5% for the MSCI Europe small caps total return (orange line) over its MSCI Europe counterpart (white line). that outside the periods around times of severe crisis (2001, 2008, 2011), small and mid caps outperform their rivals virtually systematically, particularly when we look at a longer period of analysis (over a period of ten years, they outperform nine times out of ten) with the performance gap structurally increasing. This Comparative performances for MSCI Europe and MSCI Europe small caps ( ) It may seem logical that large multinationals, with hefty financial firepower, franchises worldwide and strong profitability, would display better stockmarket performances. Yet a report by Citigroup comparing performances of the stocks making up the world MSCI shows a very severe underperformance for the 50 largest stocks, to the benefit of the smaller caps. Looking beyond this result, we should particularly mention Source : Bloomberg swiftly points to the conclusion that this segment fully deserves to be included in long-term asset allocation strategies, or feature permanently in a well diversified equities portfolio. 2

3 TWO DIFFERENTIATING FACTORS ARE GOOD NEWS FOR SMALL CAPS Two major features can explain small caps outperformance to large companies: z Strong profit growth: if we look at small caps fundamental features, we do not see higher profitability, wider margins or more robust balance sheets than for large caps. When all is said and done, the real difference between small and large caps is their earnings growth, which is higher on average for small companies than for their heftier counterparts (average growth 5-6% higher for listed European small caps over the past ten years see charts 2a and 2b). Small caps are indeed often positioned on the first stage in their growth and in their products or services life cycles, so they therefore harbor much greater potential. Higher growth for these companies is the real differentiating factor that sets them apart from their larger counterparts. They are also often more focused on one or several niche markets, they enjoy greater flexibility and their more entrepreneurial nature enables them to tap into new trends more easily. The combination of these various features helps small caps enjoy stronger revenue growth. Despite the impact of economies of scale that larger groups enjoy, smaller companies display faster profit growth rates. Over the medium to long term, this additional growth generates better stockmarket performances for small caps. z Merger-acquisition premium: however, earnings growth is not the only factor that explains the outperformance for small caps. M&A is also a key aspect in explaining their stockmarket outperformance as small and mid caps are often targets for large companies as they aim to seek out new technologies, market niches or share. Conversely, mega caps are rarely the targets of takeovers, they therefore do not harbor an acquisition premium and hence display weaker stockmarket performances. 12-month long-term earnings growth differentials between MSCI Europe Small Cap and MSCI Europe (top) and MSCI EMU Small Cap and MSCI EMU (bottom) - (source Factset) EPS L TGrowth - MSCI Europe Small less MSCI Europe EPS LT Growth MSCI EUROPE Small Cap = 14.03%; EPS LT Growth MSCI EUROPE = 12.69% EPS L TGrowth - MSCI EMU Small less MSCI EMU EPS LT Growth MSCI EMU Small Cap = 15.93%; EPS LT Growth MSCI EMU = 10.10% Source Natixis AM: data from 12/30/2006 to 05/31/

4 HIGHER RISK PREMIUM? Traditional economic theory tells us that achieving higher profitability is dependent on taking more risks. So does the outperformance for small caps in the mid to long term point to excessive additional risk-taking? Contrary to common opinion, if we measure risk on the basis of volatility, historical volatility measurements on small cap indices as compared to their larger counterparts do not reveal considerable differences between these two groups of indices, with small cap indices often displaying slightly lower volatility (chart 3). Historical volatility differences on the respective indices depend on the periods in question and the length of the period analyzed. In this respect, it is worth noting that investing in small caps only really makes sense over a reasonably long period of time (five years or more), and that in the long term, the notion of risk as measured by volatility gradually loses its meaning. In fact, we should use liquidity to assess risk for small caps. It is true that they always tend to display lower liquidity, due to their small size and small free float (portion of capital that trades on the market). However, as is the case for volatility, the more the investor looks to the long term, the more the potentially negative short-term effects of weak liquidity disappear. However, it is important to bear in mind that the risk/ return ratio for small caps is very attractive in that their additional performance well and truly offsets the risk generated by weaker liquidity, and the segment s volatility is no higher than for large caps. This is borne out by long-term data and it is increasingly true as the investment timeframe increases. Historical volatility (200 days) from 12/31/2011 to 05/31/2017 (MSCI Europe/MSCI Europe Small Cap/MSCI EMU/MSCI EMU Small Cap) Source Natixis AM: data from 12/31/2006 to 02/28/2017 4

5 MORE VALUATION INEFFICIENCIES MEAN MORE OPPORTUNITIES For liquidity purposes, investors very clearly tend to focus on the large cap market, so these large listed companies enjoy broad fundamental analyst coverage (each European large cap is covered by on average 22 sell-side analysts), and future earnings projections are therefore fairly well monitored, thereby reducing periods of price inefficiency. However, coverage on smaller capitalizations (mid, small and micro stocks) is less extensive, with small caps in the MSCI Europe covered by on average 3-5 analysts, and this leads to many more inefficiencies. Meanwhile, on the microcapitalization market (less than 150m), a large proportion of stocks are not even covered by financial analysts. The market therefore lets inefficiencies build up over long periods, which promotes the emergence of attractive opportunities for investors in the long term. The difficulty for sell-side financial analysts in making the work involved in analyzing and monitoring small caps financially feasible forces the investor (buy-side) to carry out the groundwork i.e. meeting company management, site visits, looking into business models, financial analysis and drafting earnings projections and valuations. When this work is carried out, analysis of this high-growth segment leads to investment opportunities that emerge rarely, if ever, among large caps. Changes in market regulation (paying for research in MiFID II) raise concerns that already insufficient coverage of small caps will further deteriorate, as the business model for this type of financial analysis is unlikely to be profitable. At Natixis Asset Management, our small caps team s work combines fundamental expertise and many years of experience to provide investors with the wherewithal to take full advantage of this highly attractive investment universe. FAVORABLE CONTEXT FOR EUROPEAN SMALL CAPS Current economic fundamentals are positive for European mid caps. The cyclical nature of small cap indices mean that they are structurally more able to benefit from a context of growth than mid and large cap indices. By way of illustration, energy, industrial, consumer and technology stocks account for around 60% of the small cap index, while they account for less than half of the large cap index. Conversely, the large cap universe carries less than 20% defensive stocks from sectors such as healthcare, food and telecommunications. This profile is beneficial in periods of crisis, but it is not the best approach in the current context. At this stage, world trade is back on the path to growth, and this benefits economies in the euro area, which are beginning to enjoy slightly faster growth (+2% average annualized GDP growth expected in 2017) with more jobs and stronger investment. To conclude, this recovery context brings a number of factors into play, particularly the political and economic situation that is specific to the market structure with the long-term conclusion of a clear trend towards outperformance for this segment on the stockmarket. We therefore think that it is a particularly good time to invest in European small caps. Text completed on June 5,

NATIXIS ASSET MANAGEMENT S SMALL CAP FUND MANAGEMENT REWARDED Natixis Asset Management s small cap equity fund management expertise was singled out by AGEFI Actifs at the Actifs du Patrimoine

6 NATIXIS ASSET MANAGEMENT S SMALL CAP FUND MANAGEMENT REWARDED Natixis Asset Management s small cap equity fund management expertise was singled out by AGEFI Actifs at the Actifs du Patrimoine ceremony on May 30, Natixis Asset Management received the Actif d Or de la Performance 2017 award, which recognized its European small and mid cap equity fund management. For further information, visit Past performances are not a reliable indicator of future performances. References to a ranking, award or rating for a fund are not an indication of future results. Methodology and award rules are available 6

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