The comeback of small and mid-caps
By Olgerd Eichler, fund manager in Mainfirst’s Blend / European Equities team
European markets grew by a remarkable figure of almost 30% between the start of 2020 and the end of 2023. But closer analysis of this period reveals that small and mid-cap equities lagged well behind the blue chips. This trend raises interesting questions about the underlying dynamics and strategic decisions.
Large caps form the backbone of popular index funds and their names are familiar to people who have nothing to do with professional investment analysis. In uncertain times, large caps ostensibly offer stability. However, anyone who invests only in blue chips is missing out on a major opportunity as, historically, small and mid-caps have always outperformed large and established companies over the long term. Anyone who invested in European small caps 20 years ago has locked in a total return of 495%, compared with only 226% for European large caps.
An analysis of the MSCI from November 1975 to June 2023 shows that this is not a one-off and that second-tier stocks outperform blue chips over longer horizons outside of Europe as well. It turns out that nine times out of ten in the past, small caps have outperformed large caps over a 15-year investment horizon.
One reason for this is that small and mid-sized companies not only have more scope for growth but can also be more flexible and innovative. These companies often have less red tape, which enables them not only to act more quickly but to react to changes with agility. This inherent agility is a key advantage.
In an ideal scenario, it is worth investing in second-tier stocks if the company starts out as a small or medium-sized company and grows into a market leader. During this process, the investor’s shares continually go up in value, undoubtedly a gratifying development. Of course, not all small and mid-sized companies make it to the top. The road is littered with obstacles and many companies fall by the wayside. That said, investment in second-tier stocks remains attractive, since they offer a unique opportunity to participate in dynamic developments and potentially achieve outstanding returns.
European second-tier stocks seemingly more undervalued than before
The past three years have been challenging for second-tier stocks, since investors often tend to fall back on the supposed safe havens in uncertain times. The higher key rates have also made bonds and money market funds more attractive, prompting many investors to take their money out of the equity markets.
In absolute and relative terms, European second-tier stocks seem to be more undervalued than they have been in a long time. While the major leading indices such as the MSCI Europe, the STOXX 50 and the DAX had already or very nearly reached new heights at the end of 2023, the small cap indices are still well below their record-highs of recent years. This presents investors with attractive return opportunities.
We are amazed that the discounts at which second-tier stocks are trading to blue chips have hardly come down at all over the past year. Incidentally, this is a global phenomenon, with the trend in valuations in recent years going from a P/E ratio premium for secondary stocks to a discount.
On 14 December, Federal Reserve Chair Jerome Powell, signaled the possibility of the end of the rate hike cycle and the start of rate cuts in 2024 but did not go into detail. Immediately afterwards the SDAX rose by an impressive 3.5%, while the DAX actually fell by a marginal 0.1%. The MSCI Europe Small Cap Index also rose by a substantial 3.2%, far more than the MSCI Europe Large Cap Index, which only gained 0.5%. We saw the market react in a similar fashion one month prior, on 14 November, when a marked slowdown in US inflation was reported and markets interpreted this as the first sign that interest rate cuts were on the way. This emphatically highlights the long-term potential that second-tier stocks harbour.
In addition, European stocks are trading at a substantial discount to US stocks. This difference in valuations not only illustrates the differing market conditions but also presents a promising opportunity for observant investors. While American markets sometimes trade at higher valuations, European second-tier stocks seem to be undervalued, which creates upside potential and scope for attractive returns. This dynamic illustrates that the reactions to monetary announcements and economic signals not only cause short-term shifts in markets but can also open up long-term opportunities for smart investors.
Overvalued large caps
The discerning investor sees the relative attractiveness of second-tier stocks versus large caps. Either large-cap stocks are currently overvalued or else small-cap stocks are undervalued. This subtle balance provides scope for strategic thinking and tactical decisions in the portfolio.
The same deductive approach also applies to European versus US equity markets. An investor who buys the right securities at this time theoretically stands to benefit if the valuations of small and mid-caps versus large caps and the valuation of European equity markets relative to the American equity markets return to their historical average. This creates an opportunity for potential performance that is not just limited to short-term fluctuations but holds out the long-term prospect of optimising returns.
Small and mid-cap companies not only have the potential to grow and innovate but also reflect the diversity and resilience of the broader market. The art of investment is not only about finding short-term opportunities but also about being foresighted, in order to benefit long-term from the macro- and micro-economy.
