First of all, over 30 years, investing in small caps remains one of the best strategic bets in the global equity market (see chart below).
Returning to European small caps, we can see that they have slightly outperformed large caps over the last 2 months.
This is hardly surprising, given that the performance of small caps is closely linked to the local economic situation. Small caps are in effect a “call” on European growth: they perform well in absolute and relative terms (compared with large caps) when the cycle in Europe is favourable. In fact, European mid & small caps are much more cyclical than large caps, with an overweight in Industrials and Materials versus an underweight in Healthcare and Consumer Goods / Beverages.
Furthermore, European small caps are less international and less export-oriented than large caps. They generate more than 70% of their sales in the Eurozone, compared with around 60% for the large caps.
It is therefore logical that EPS growth for European small caps should be highly sensitive to economic growth in the eurozone (a ratio close to 4:1 to nominal GDP growth).
However, after 5 quarters at a standstill, the eurozone posted real GDP growth of 1.2% on a quarterly annualised basis in Q1 2024, the strongest growth since Q3 2022).
This upturn in the economy reflects :
- Household sentiment improving as inflation eases;
- The recovery in tourism (the gradual return of Chinese tourists seems to be confirmed);
- The improvement in financial conditions linked to the ECB rate cut expected in June;
- As well as the resilience of the US economy and the reacceleration of activity in China.
A similar rate of growth can be envisaged for the coming quarters, despite the many obstacles (more restrictive fiscal policy, trade tensions, weak productivity).
In particular, household consumption is expected to grow by around 1% this year, compared with 0.5% in 2023.
Housing investment should also pick up again in H2, as banks begin to relax their lending conditions.
Even today, the performance of small caps continues to lag behind the composite PMI for the eurozone.
However, the pace of activity in the Eurozone is moving at 2 speeds. On the one hand, there is the dichotomy between a languishing North (Germany, Austria, Ireland) and a dynamic South (Spain, Greece, Italy). Secondly, there is the opposition between industry and services. In manufacturing, the situation remains complicated. The Q2 results and, above all, Siemens’ disappointing guidance for the 2024 financial year validate this message.
The underperformance of small caps is also clearly excessive when compared with the tightening of credit conditions in the Eurozone.
Small caps are more sensitive than large caps to bank lending conditions in the Eurozone. They are more intermediated and have more debt. What’s more, credit conditions are inversely correlated with the economic cycle.
The graph below shows that, when adjusted for the long-term trend, the relative performance of small caps deteriorates as credit conditions tighten, and vice versa.
The slightest deterioration in credit conditions in recent quarters should have benefited small caps in relative terms, but so far this has not been the case.
But beyond the macroeconomic arguments, we note that more than 2 years of derating of European small caps still results in a very high relative underperformance of small caps in a historical perspective, despite the slight recovery observed over the last 2 months.
And the valuation of small caps remains very attractive compared with large caps, both in absolute and relative terms.
The MSCI EMU Small 12m fwd PE is currently 12.8x, just 1 PE point above the lows recorded during the market stresses of October 2022 and October 2023. Conversely, the PE 12m fwd of large caps has regained almost 4 PE points since the low point in autumn 2022.
Historically, small/mid caps have traded at a premium to large caps (an average premium of just over 20% over the last 15 years).
Small and mid caps are currently trading at a discount (-5%) to large caps, which is extremely rare (the last time was in 2008 for small caps and 2016 for mid caps).
Relative to the large caps, the small caps are trading 25 percentage points below their historical average and the mid caps are trading almost 20 points below their historical average: they are therefore taking on board a large amount of bad news about the economic cycle.
At the same time, the stabilisation of the Euro, even if fragile, is rather good news for small caps in relative terms, unlike in 2022 when the fall in the Euro favoured large caps.
There is one final argument in favour of this asset class. The Mid Cap Europe index is much more geographically diversified than the MSCI Europe index. The weighting of the 4 largest countries (UK, France, Switzerland, Germany) is just over 1/3 compared with over 2/3 for the MSCI Europe. This makes the asset class all the more attractive for European equity management.