Since early 2022 when central bank interest rate increases became a reality, European small-caps have underperformed their large-cap peers.
Yet, European small-caps have outperformed large-caps since the inception of the MSCI small-cap indices in 2001. Between that period and the end of March 2024, European smaller companies have generated returns of 5x an initial investment compared to around 2.5x for European large-caps.
Clearly, this positive historical result for small-caps also includes periods of underperformance, such as the one we are going through right now.
However, it is precisely when the market has lost interest in an asset class that opportunities can be found. Small-caps are an inefficient, under-researched market, which means uncovering the best investment opportunities can be more meaningful as there is less analyst coverage and readily available information.
The recent underperformance of European small-caps has resulted in a substantial valuation discount. European small-caps are one of the cheapest size/region combinations we observe today.
This is partly because European small-caps have been buffeted by a plethora of macroeconomic uncertainties. Rising interest rates and geopolitical tensions, combined with ongoing supply chain volatility in the aftermath of the pandemic, have hit this sector hard. Inflation is proving stickier than expected (although is starting to cool) and the labour market remains hot.
If you look at the latest earnings reports from this group of companies, very few made bold, positive predictions for their performance in 2024.
Equally, the market has been distracted by the outperformance of US big tech which is facing an artificial intelligence-infused boom and has seen valuations climb to staggering heights, leaving other asset classes in the dust.
However, in our view, this valuation discount of European small-caps compared to large-caps presents opportunities for long-term investors. Historically, smaller companies have traded at a premium valuation to their larger peers most of the time. A number of factors suggest an inflection point is close by.
We believe European small-caps will continue to post stronger long-term growth than their larger peers especially as the economic environment improves. Latest guidance from the European Central Bank suggests rate cuts could be on the horizon and composite Purchasing Managers Index data are looking more promising, suggesting this period of economic contraction is largely behind us.
The European banks sub-sector is performing particularly strongly as the market’s implied cost of equity is falling. This is in line with our expectations as we think the market has been too conservative in its returns assumptions and that its long-term reflection of risk should normalise with lower rates.
An additional boon to the sector could come in the form of increased merger and acquisition activity. If valuations remain low, it is likely we will see a rise in acquisitions as larger companies buy up their smaller counterparts. We have already seen a number of transactions over the past few years and, if valuations remain at current levels, this is likely to increase, thereby benefitting investors and generating share price premiums.
Small businesses are often more niche and entrepreneurial, as well as displaying greater agility. And they occupy a large investment universe: in Europe there are about twice as many small-cap companies compared to their larger peers. Additionally, smaller companies tend to have fewer divisions, fewer products and fewer end markets to worry about – which also enables them to be nimbler.
As always, there are winners and losers and some areas where there are share price declines driven by short-term developments. Nonetheless, opportunities may present themselves for investors who are willing to look through the near-term macro-economic uncertainties.
Those companies with strong fundamentals and robust balance sheets should see earnings growth outstrip large-caps. We are starting to see the green shoots of a market re-rating.
Ingmar Schaefer is a senior portfolio manager for small-cap strategies at Van Lanschot Kempen. The views expressed above should not be taken as investment advice.