Little followed by analysts and little known by investors, European small caps are undervalued, despite their superior growth prospects. And while the last two years have hardly been kind to them, now seems a particularly good time to enter this market.
Stronger growth translates into outperformance
Smaller and more dynamic, secondary stocks can post much higher growth rates than mature companies. It’s mathematically very simple: for a small company with sales of CHF 600 million, a new contract worth CHF 100 million will translate into a 15% increase in revenues. Conversely, this will be almost imperceptible for a listed heavyweight. Over the long term, therefore, small caps tend to outperform large caps. Over 20 years, the MSCI Europe Small Cap Net Return index has returned 427%, almost twice as much as the MSCI Europe Large Cap Net Return index (232%).
Inefficiency offers opportunities
In practice, investing in European small caps means tackling the least efficient segment of the market, because it is less closely followed, less liquid and suffers from more difficult access to information. Despite these disadvantages, inefficiency is an asset for the experienced and patient investor, because it enables those who know how to find them to unearth gems at sacrificial prices and thus achieve superior performance over the long term. The situation is radically different for larger companies, which are widely followed by cohorts of analysts who track every announcement and product launch. As a result, their share prices immediately take account of any new information. With these large stocks, it is much rarer to come across major price aberrations.
Going one step further than the others
Unearthing these forgotten nuggets is not so simple, however, and investors in small caps must be prepared to go to a little more trouble than those who stick to blue chips. Since these companies receive little or no coverage from analysts, they have to carry out in-depth primary research themselves, seeking information at source and meeting management. This often means playing an active role, for example by providing strategic advice or helping them to improve their communications.
An asset class that has been neglected for two years
While small caps outperform in the long term, this is not always the case in the shorter term. In fact, European small caps have been lagging for two years, for a number of reasons.
- These companies are often perceived as operating locally. They suffer from this domestic bias and from the relative economic weakness of the eurozone. This is not a generalisation, as some companies are active throughout the world.
- There is an assumption that they would be penalised by the tightening of financing conditions, particularly bank loans, as banks are their main source of finance. Once again, this impression needs to be tempered by the fact that many small European stocks have very strong balance sheets and little debt.
- Finally, the expansion of passive management has led to a concentration of investments in the largest caps, to the detriment of smaller stocks.
Very attractive valuations
The market’s current lack of interest has one significant advantage: while small caps usually trade at a premium of around 20% to large caps – due to their superior growth prospects – they are currently trading at a significant discount, which is unprecedented since 2008. The forward-looking 1-year P/E for the MSCI Europe Small Cap index is 10x, compared with 13x for the MSCI Europe Large Cap, valuation levels close to 20-year lows. Valuations are so low that many family shareholders, who are particularly well placed to know the true value of their company, are opting to buy back outstanding shares in order to delist at a substantial premium to the market price, as was the case with Bobst at the end of 2022 and other stocks that have returned to private hands.
An attractive entry point
At this level, European small caps appear grossly undervalued. Macroeconomic forecasts point to growth of 0.5% in 2024 for the eurozone, and interest rates should stabilise or even fall. Potential bad news therefore seems to have already been priced in, and current levels offer a unique opportunity to take a position in this asset class.