“If you wait for a catalyst you will probably miss the opportunity!” This was the line immediately batted back to me when I recently spoke to a fund manager about the challenges facing small-caps across the globe in recent years.
Soaring interest rates, geopolitical uncertainty and the amazing growth of the ‘Magnificent 7’ tech stocks has left companies further down the market-cap scale firmly on the sidelines.
The last decade or so has been all about these US large-caps and while we are not saying it is the end of the road for them (far from it), we do believe returns will be much broader in the next decade. So you start looking for value – and that is where small-caps come back into the equation.
Much has been made of both the plight and valuation opportunity of UK small-caps, but the same is true of their counterparts in Europe. Indeed, Europe is where small-caps are the most undervalued globally, currently priced at a 12-month price-to-earnings (P/E) ratio of 13.7 – a number not seen since the GFE in 2008*.
Since July 2021, the MSCI Europe small-cap sector has underperformed the MSCI Europe (30% vs. 9%) but that is an anomaly over the longer term. Over 25 years, European small-caps have returned over 920% (vs. 330% for the MSCI Europe).
There are a host of reasons for this – these include small-caps being more likely to be part of a merger & acquisition; small-caps tending to have more cash vs. debt than larger companies; and the fact that despite being a larger universe (small and mid-caps represents 2000 companies vs. 160 large-caps in Europe) they are under-researched.
What is probably a bigger surprise is European small-caps have outperformed both global equities (578%) and the S&P 500 (759%) over the same period.
I’d argue the opportunity is immense for an area of the market which is under-researched when compared to its larger counterparts. Small-cap companies can also give investors better exposure to an individual country as well as a unique blend of industries and companies which are less prominent in other regions. The sector also has material differences to its larger peers in Europe.
Positive optimism as headwinds become tailwinds
So why now? Well, we’ve already seen a jump in excess of 20% in the first couple of months since ‘Liberation Day’, as small-caps are more domestically focused than their peers. History also shows that small-caps comfortably outperform large-caps in the first 12 months of a new rate cutting cycle, as the lending environment for small-caps in Europe becomes more attractive.
Marlborough European Special Situations manager David Walton says positive data has already started to filter through on the back of the downward path on interest rates, citing German residential building permits rising 6% in March and French construction sector sentiment improving by four points to 101 in May.
He also points to the OECD issuing a forecast for eurozone GDP growth of 0.8% in 2025 and 1% in 2026. He says: “This is indicative of the outlook we hear from most companies we are meeting; there is an underlying resilience to the demand for their products and services while their growth outlook is steady rather than spectacular. Smaller companies, which form the vast majority of the fund’s portfolio, continue to be attractively valued at a discount to large companies.”
Germany’s plans to overhaul its conservative fiscal spending policies – which includes a new €500bn infrastructure investment fund – may also be a major boost to small-caps across the continent.
But there are other factors also worth considering – not least that the underperformance versus large-caps in the past four years is starker than it was in the GFC, meaning Euro small-caps are now on a record 12% discount to the wider market. Small-caps are also on a greater P/B discount than during the GFC (34% vs. 32% in 2008).
Ultimately, one of our main investment beliefs is that small and mid-caps outperform large-caps over the longer term. When you consider the average return for the MSCI Europe ex-UK small-cap index over the past 25 years is 9.2% per annum (4.8% for large-caps), it is an opportunity that is difficult to ignore at this valuation point.
Those wanting exposure might consider the Janus Henderson European Smaller Companies fund, where the managers take a style-agnostic approach to building a portfolio of around 100 names. The fund also targets companies at various points in the investment cycle – allowing the managers to diversify their revenue streams accordingly. The WS Montanaro European Income fund is higher conviction, with a portfolio of around 40-50 quality names, and yields around 3.5%.
Darius McDermott is managing director of FundCalibre and Chelsea Financial Services. The views expressed above should not be taken as investment advice.