After the Annus Horribilis, How are Prospects for European Smid Caps?
By Don Fitzgerald, CFA, portfolio manager at DNCA Finance
Small caps1 were hit hard by the difficulties in Europe in 2022. Although we still lack visibility, the scenario of a recession seems less and less likely. A recovery in the economy in 2023 would be favourable to smid caps, an asset class that tends to outperform large caps in phases of economic recovery.
The negative catalysts (the strong dollar and the underperformance of sectors overrepresented in the smid cap universe) are fading and this should facilitate a return to favour for the asset class.
Written in January 2023.
1 Smid cap : Small & Mid-caps. Micro-cap : 0 – 1 Md€. Small-cap : 1 – 5 Mds€. Mid-Cap : 5 – 10 Md€. Large Cap : +10 Mds€
2 Fed : Federal Reserve. Central Bank of the USA.
3 IPO: A takeover bid for shares in a listed company in which the acquirer publicly announces its intention to buy.
4 The P/B compares the book value of the company's assets with its stock market price over a 12-month period. Source: DNCA Finance and Bloomberg as of 31/12/2022. Data subject to change over time.
5 Strategy to reduce the circulation of the coronavirus to zero, through strict measures taken as soon as cases appear, combined with drastic control of outbreaks
6 MSCI Europe Small Cap compared to MSCI Europe Large Cap from 30/09/2022 to 31/12/2022. Source: Bloomberg.
7 Growth: a management style that consists of targeting stocks that are qualified as growth stocks, i.e., with a high visibility on their activity. Value: consists of selecting stocks that are discounted, i.e., stocks whose price is lower than it should be in relation to the intrinsic value of the company. Blend: a mixed strategy consisting of having no bias and mixing the portfolio of growth and value stocks.
This article has been provided for information purposes only to professional clients. It must not be used for retail investors. The provision of this material or reference to specific sectors or markets in his article does not constitute investment advice or a recommendation or an offer to buy or sell any security. Investors should consider the investment objectives, risks, and expenses of any investment carefully before investing. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.
DNCA FINANCE – Affiliate of Natixis Investment Managers. DNCA has been approved as a portfolio management company by the French Financial Market Authority (Autorité des Marchés Financiers) under number GP00-030 since 18 August 2000. 19, place Vendôme – 75001 Paris. www.dnca-investments.com
The negative catalysts (the strong dollar and the underperformance of sectors overrepresented in the smid cap universe) are fading and this should facilitate a return to favour for the asset class.
The perceived risk of a European energy crisis had a particularly strong impact on the stockmarket performance of Europe’s Small and Mid cap segment.
Generally speaking, being companies with a smaller international revenue share than their larger counterparts, they suffered from their domestic bias. The crisis of investor confidence in Europe and the Fed's monetary policy2 also caused a sharp rise in the dollar favouring dollearners and large caps to the detriment of smid caps.
Smidcaps were also affected by their sectoral bias. The worst performing sectors of the year, such as Consumer Discretionary and Real Estate, are over-represented in the smid cap pool, whereas the better performing sectors, such as Oil and Gas, are much less present in the segment.
Generally speaking, being companies with a smaller international revenue share than their larger counterparts, they suffered from their domestic bias. The crisis of investor confidence in Europe and the Fed's monetary policy2 also caused a sharp rise in the dollar favouring dollearners and large caps to the detriment of smid caps.
Smidcaps were also affected by their sectoral bias. The worst performing sectors of the year, such as Consumer Discretionary and Real Estate, are over-represented in the smid cap pool, whereas the better performing sectors, such as Oil and Gas, are much less present in the segment.
In our view the long-term performance drivers of small and mid-caps remains intact. These companies are more agile and have a more entrepreneurial corporate culture. Hence, they tend to have a better growth profile.
Their managers are often also major shareholders, and this helps to secure a better alignment of interests between shareholders and management.
Shareholders of small and mid caps also often benefit from a takeover premium when a stock is withdrawn from the market in the event of a bid4, a more frequent occurrence for smaller sized companies. Small caps also tend to have a smaller following by financial analysts and therefore tend to have greater market inefficiencies, a source of performance for active management. We are of the view that none of these factors is called into questioned.
Finally, experience tells us that after periods of strong underperformance, such as in 2008, 2010 and 2018, smid caps have not only caught up but subsequently outperformed the broader market.3
Their managers are often also major shareholders, and this helps to secure a better alignment of interests between shareholders and management.
Shareholders of small and mid caps also often benefit from a takeover premium when a stock is withdrawn from the market in the event of a bid4, a more frequent occurrence for smaller sized companies. Small caps also tend to have a smaller following by financial analysts and therefore tend to have greater market inefficiencies, a source of performance for active management. We are of the view that none of these factors is called into questioned.
Finally, experience tells us that after periods of strong underperformance, such as in 2008, 2010 and 2018, smid caps have not only caught up but subsequently outperformed the broader market.3
The segment is somewhat out of the spotlight at the moment, so in our view is offering an interesting entry point right now. The underperformance of smid caps has deepened the valuation gap with large caps.
Currently at a 15-year low, the 12m4 P/B of European smid caps sits at a 20% discount to large caps at the end of December 2022. An undervaluation which we believe could represent a buy signal in 2023.:
Also, if we take into account the historical correlations with leading economic indicators, it would suggest that the smid caps have overcorrected relative to the fundamentals. Another element that seems to corroborate our analysis.
Currently at a 15-year low, the 12m4 P/B of European smid caps sits at a 20% discount to large caps at the end of December 2022. An undervaluation which we believe could represent a buy signal in 2023.:
Also, if we take into account the historical correlations with leading economic indicators, it would suggest that the smid caps have overcorrected relative to the fundamentals. Another element that seems to corroborate our analysis.
Europe seems to have weathered the energy crisis better than many feared.
The industrial slowdown continues but is less severe than expected, and on the consumer side, government support has proven effective. Political risk is moderating after the turbulence of 2022, the UK seems to be gaining in stability and Italy retains a constructive approach towards the EU. China is reopening with the end of its "zero covid" strategy5, which could compensate for the US slowdown in global growth. With inflation falling, things should normalise and some of the losers of 2022, such as European smid caps, could recover significantly.
The weakness of the euro, which enabled large caps to outperform small caps last year, has recovered around 10% since its low point last September6, and this trend reversal should also encourage a reallocation of flows to small caps.
The industrial slowdown continues but is less severe than expected, and on the consumer side, government support has proven effective. Political risk is moderating after the turbulence of 2022, the UK seems to be gaining in stability and Italy retains a constructive approach towards the EU. China is reopening with the end of its "zero covid" strategy5, which could compensate for the US slowdown in global growth. With inflation falling, things should normalise and some of the losers of 2022, such as European smid caps, could recover significantly.
The weakness of the euro, which enabled large caps to outperform small caps last year, has recovered around 10% since its low point last September6, and this trend reversal should also encourage a reallocation of flows to small caps.
Past performance is not indicative of future performance.
After 15 months of capital outflows, we are seeing the end of this movement.
Investment style could be important. Over the long term, the performance of a stock reflects its earnings growth, an argument in favour of the growth style.7 Over the past decade, growth style has highperformed that of value by a wide margin. Valuation spreads have reached levels that we felt were unsustainable in the long term, as the premium paid for growth had become too high. Accordingly, we saw a reversal of the trend in 2022, in favour of value.
For 2023, we believe that many small & mid cap growth stocks are still trading at generous valuation levels. We therefore tend to favour a more balanced or "blend" approach for 2023.7
After 15 months of capital outflows, we are seeing the end of this movement.
Investment style could be important. Over the long term, the performance of a stock reflects its earnings growth, an argument in favour of the growth style.7 Over the past decade, growth style has highperformed that of value by a wide margin. Valuation spreads have reached levels that we felt were unsustainable in the long term, as the premium paid for growth had become too high. Accordingly, we saw a reversal of the trend in 2022, in favour of value.
For 2023, we believe that many small & mid cap growth stocks are still trading at generous valuation levels. We therefore tend to favour a more balanced or "blend" approach for 2023.7
1 Smid cap : Small & Mid-caps. Micro-cap : 0 – 1 Md€. Small-cap : 1 – 5 Mds€. Mid-Cap : 5 – 10 Md€. Large Cap : +10 Mds€
2 Fed : Federal Reserve. Central Bank of the USA.
3 IPO: A takeover bid for shares in a listed company in which the acquirer publicly announces its intention to buy.
4 The P/B compares the book value of the company's assets with its stock market price over a 12-month period. Source: DNCA Finance and Bloomberg as of 31/12/2022. Data subject to change over time.
5 Strategy to reduce the circulation of the coronavirus to zero, through strict measures taken as soon as cases appear, combined with drastic control of outbreaks
6 MSCI Europe Small Cap compared to MSCI Europe Large Cap from 30/09/2022 to 31/12/2022. Source: Bloomberg.
7 Growth: a management style that consists of targeting stocks that are qualified as growth stocks, i.e., with a high visibility on their activity. Value: consists of selecting stocks that are discounted, i.e., stocks whose price is lower than it should be in relation to the intrinsic value of the company. Blend: a mixed strategy consisting of having no bias and mixing the portfolio of growth and value stocks.
This article has been provided for information purposes only to professional clients. It must not be used for retail investors. The provision of this material or reference to specific sectors or markets in his article does not constitute investment advice or a recommendation or an offer to buy or sell any security. Investors should consider the investment objectives, risks, and expenses of any investment carefully before investing. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.
DNCA FINANCE – Affiliate of Natixis Investment Managers. DNCA has been approved as a portfolio management company by the French Financial Market Authority (Autorité des Marchés Financiers) under number GP00-030 since 18 August 2000. 19, place Vendôme – 75001 Paris. www.dnca-investments.com
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