The capitulation point in small caps may have passed… and the tide seems to be turning.
It might still be too early to say and we will need a few months to confirm, but it is beginning to look like October 2023 might have been the capitulation point for small caps after several years in the doldrums. Small cap shares saw an accelerated fall over the Autumn as redemptions in small cap funds led them to liquidate positions at ever lower prices. As often seen at points of capitulation, the market became particularly unforgiving with some shares sold down as much as 40 to 50% on any profit disappointment.
Even if it’s not really yet noticeable in the small cap indices which are still lagging large cap, we have noticed several incremental changes in the smaller end of the market : i) Redemption flows out of small cap funds have subsided and ii) Broker bid-offer lists for blocks to trade in small caps had been lop-sided for two years with many more blocks on offer than bid for. This has progressively turned since mid-December with now more blocks of shares on the bid side. One swallow does not make Spring, but these are telling signs nonetheless.
Small caps starting to outperform
If May was another Nvidia month, there was something else starting to take shape in Europe. Having been out of favour for several years, smaller companies are starting to outperform. After having hit their capitulation low-point in October last year, smaller companies had been trailing large caps for several months, until they substantially outperformed in April and May. Valuations had reached ‘historic’ discounts to both large caps and their Private Equity-owned peers. As can be seen in the chart below of the relative performance of small caps to the MSCI Europe index, the outperformance seems only in its early stages.
Microcaps emerging from a long period of abandonment
Over the last three years investors have been shunning smaller company funds, who in turn have been seeking refuge in more liquid midcaps (1 to 10 bn€ market capitalisation) and selling most of their smallcap investments below EUR 500/1000m, putting additional pressure on microcap shares. This is the core area in which the Argonaut fund has always operated and where we have a competitive advantage in terms of focus, experience and primary research process. Whilst other funds exited, we kept our focus on this less efficient ‘grey’ area of the market where mispricings go less noticed. Despite staying focussed in the out of favour microcap area of the market, the Argonaut Fund managed to outperform through stockpicking and constructive engagement (see our recent report on the subject).
It may not yet be a confirmed trend, but the graph below shows that microcaps in Europe have started outperforming smallcaps by 4% over the last two months. We have been fighting headwinds over the last three years, but the period of abandonment and extreme undervaluation may be coming to an end.
Is the outlook for Europe brightening ?
European economies have been bumping along the bottom for the last two years or so with parts of Northern Europe (Germany and the UK) popping in and out of mild recession. Even if the recent political instability that has erupted in France creates renewed uncertainty, we have commented over the last 4 months that the messages on the outlook we have been getting from smaller company managements has been getting progressively less negative. Last year companies were saying that trading was tough and that they feared a recession ahead. This year the general message we have been getting is that trading continues to be tough and that they can’t yet quite see the light at the end of the tunnel. This may only seem like a small incremental improvement, but we are beginning to see it confirmed in the form of slightly better Euro area growth figures for the first quarter, slightly improving leading indicators and slightly better company figures for Q1 with guidance for, maybe, an improvement in business trends in the second half of the year. These may only be ‘slight’ improvements, but they contrast with last year’s generally negative anticipations for European growth. There may still be no ‘light at the end of the tunnel’, but it does seem that it has stopped getting darker.
Catalysts now
A trend only really becomes a trend after it has been confirmed over a greater number of months and it might seem over-courageous today to establish that we are at the beginning. However, we do see several catalysts that are beginning to take shape.
- Valuations of small and microcaps are close to their lowest in 20 years…….
- ……after having reached the capitulation point in October 2023.
- Business owners are buying back their shares and delisting their companies at large premiums……whilst IPOs are still rare due to the discount of Listed to Private Equity
- The steady flow of redemptions out of small cap funds seems to have slowed.
- Company results in the first quarter are starting to look more encouraging….vs low expectations.
- Company management are getting progressively less negative / more positive on the outlook.
- First signs of green shoots for European economies.
- Our portfolio companies’ profits to grow 20% this year.
- Smaller companies outperform when central banks start cutting rates.
For our portfolio companies, we see earnings growth of circa 20% this year. On top of ‘self help’ measures (restructuring, streamlining, cost reduction measures…) and positioning on growth segments, companies are likely to suffer less than last year from the inventory cycle and should be able to expand margins with higher selling prices in a lower cost inflation environment.