The case for European small-cap stocks

Key takeaways:

• Having long traded at a premium to large caps given their superior growth profile, European small- and mid-cap stocks are now in the unusual position of trading at a discount across a range of financial metrics.
• In our view, the valuation profile of European small-cap stocks is currently rather attractive, sitting at the low end of the historical range, as well as in relation to larger peers. We believe this provides a potentially strong backdrop for future outperformance.
• There is much greater dispersion in performance in the small-cap universe, presenting more opportunities to exercise stock-picking skill. We think small cap is an area of the market where active management is especially important.

In Europe, small- and medium-size enterprises make up more than two-thirds of the workforce and more than half of the economic value added. In many respects, they can be considered the lifeblood of the European economy, yet over the last 2.5 years, the share prices of small- and mid-cap (SMID) companies have lagged the broader market. So far in 2024, trading in the European market has been heavily concentrated in a small subset of large-cap stocks. SMID funds, meanwhile, have haemorrhaged assets under management across all regions, with 2024 representing the third consecutive year of outflows. Over the last two years, Europe and UK SMID funds have experienced the worst outflows since the global financial crisis in 2008. Consequently, SMID-caps are currently a significantly under-owned asset class.

Having long traded at a premium to large caps given its superior growth profile, the SMID Index now finds itself in the unusual position of trading at a discount across a range of financial metrics including price-to-FY2¹ earnings (P/E), price-to-book, price-to-sales and price-to-cashflow. After derating sharply over the last couple years, we believe that European small-cap stocks are now poised to provide superior returns over the long term. All of the reasons which may have justified the small-cap premium in years past—such as higher growth potential—still exist today. We believe that the derating at the small-cap end of the market is an overreaction to short-term factors and is an instance of near-term pessimism obscuring promising long-term opportunities.

Why now?

Performance has lagged in recent years, meaning that valuations now appear quite compelling. In the United States, aside from a short spell of outperformance during the early phases of the COVID-19 pandemic, small-cap stocks (included in the Russell 2000 Index) have lagged behind their larger peers (in the S&P 500 Index) since 2016.² A similar story has emerged in Europe, albeit over slightly different timeframes. The real gap between SMID and the broader market in Europe developed in late 2022 and has widened further during the first quarter of 2024.

In historical terms, an unusually large spread between the two ends of the market has formed. High levels of inflation and an increase in the cost of capital have hit small-cap stocks hard as many possess less robust balance sheets, higher proportion debt is shorter duration, and pricing power is weaker than for larger businesses.

As seen in the chart above, since its peak in late 2021, the smaller end of the market has derated much more sharply than the large cap such that for SMID, the valuation looks more attractive than the market as a whole, with the P/E now 15% below its 10-year average.

In our view, the valuation profile of European small-cap stocks is currently rather attractive, sitting at the low end of the historical range, as well as in relation to larger peers. We believe this provides a potentially strong backdrop for future outperformance.

Fertile ground for stock picking

Many of the factors which historically made the SMID universe such fertile ground for stock selection remain present today. We see potential opportunities due to patchy coverage, as the analysis of European SMID companies tends to be far less comprehensive than that of their large-cap counterparts. For instance, there are nearly twice as many companies in Europe as in the United States that are covered by two or less sell-side analysts. Less sell-side analyst coverage means that there are greater inefficiencies in the market to take advantage of.

It is important to note that the European small-cap universe is a huge investable market with impressive breadth and liquidity. Each major European market has hundreds of companies with market caps under US$8 billion and average daily trading volume exceeding US$1 million. Such an opportunity set represents a strong hunting ground for investors and offers greater scope for exercising stock selection skill.

There is also much greater dispersion in performance in the small-cap universe, presenting more opportunities to exercise stock-picking skill. In such a market, the difference between investment success and failure can be the ability of the stock selector to identify the drivers of value creation and discriminate between genuinely good and bad businesses.

For this reason, we believe the small-cap part of the market is an area where active management is especially important. Many small- and mid-cap businesses are loss-making in the long term, making active management vital in distinguishing the likely winners from the likely losers.

That said, there are also a large number of good businesses in the small-cap world. There are a greater number of family-owned businesses within the small- and mid-cap universe, and many companies evince a long-term mentality, with quality attributes and good capital allocation decisions. The task for a small-cap portfolio manager is to identify these businesses at attractive prices. And significantly, when small caps are judged correctly, there can be an outsized return potential, as earnings and revenue estimates can greatly exceed consensus expectations, leading to a potentially larger share price gain.

Higher growth potential at earlier stage of corporate lifecycle

The SMID universe includes companies that are often at an earlier stage in their lifecycle than their larger-capitalization peers, meaning the companies have a longer growth runway and greater potential for strong performance. We think this remains the case today. 

In addition, because they are still small, any successful new opportunities will have a much bigger positive impact because of the smaller baseline effect (vs. their larger peers).

Optionality to become an acquisition target

Further investor appeal comes from the opportunities for SMID companies to become the acquisition targets of larger buyers who are seeking cost opportunities, to gain critical mass, and to expand into new product/geographical areas. Private equities are another group of interested buyers. At the end of 2023, private equity investors were sitting on US$2.59 trillion of uninvested capital.³ While the short-term focus will likely be to release capital from stale funds, capital allocation should become more important as uncertainty about interest-rate policy comes down. Once this happens, financing costs can be more accurately modelled, and businesses valued with more conviction. We would expect to see more activity in this respect going forward.