Small-caps underperformed…

Several factors have driven the medium-term underperformance of small caps but higher interest rates have been a key factor. The worsening European economic picture has also weighed on the asset class.

As our chart shows, the performance of small caps versus their larger peers has been closely linked to changes in economic activity.  

…but could rate cuts spur a comeback?

However, falling inflation and slowing growth allowed the European Central Bank to cut interest rates in June from 3.75% to 3.5%. Will this be a catalyst for small-cap outperformance? It’s too early to tell – but, at the time of writing, the asset class had outperformed its larger peers since the first cut (to 12 August).

Historical data is supportive. Our table shows the performance of US small, mid and large caps (SMIDs) after three, six and 12 months following a rate cut. The outperformance is clear. True, this data only refers to US equities, but we believe there are enough similarities with their European counterparts to draw similar conclusions.  

European smaller companies attractively valued

Smaller companies are cheap relative to history and large-cap equivalents, but there are significant regional differences.  

Looking at European equities, smaller companies are trading at attractive valuations. The chart below shows the 12-month forward price/earnings (P/E) ratio of the MSCI Europe Small Cap Index versus the MSCI Europe Index. There are a few factors to observe.

Due to their superior growth and return potential, euro small caps have typically traded at a premium to their larger peers, averaging around 26% (straight blue line).

But today, they are significantly below this premium and cheaper in relative terms, trading at an 8% discount versus large caps.

In relative terms, the asset class is cheaper than at any time in the past 18 years. This includes the Global Financial Crisis, when it traded at a 6% discount to its larger peers. The subsequent outperformance is clear to see. Will history repeat itself? We see no reason why not. 

Growth as a style is not expensive

Of course, not all smaller companies are equal. Through our unchanging process, we favour quality growth companies. During periods of stress, investors usually favour businesses with robust profitability, good cash flow, strong management, and sound ESG (environmental, social and governance) standards. High barriers to entry, unique growth drivers and pricing power are also attractive characteristics.

By contrast, businesses with elevated debt levels or that rely on external factors to succeed could fall by the wayside.

Importantly, quality-growth stock valuations are no longer stretched, offering potential upside. Small-cap growth is at around one standard deviation below the five-year average in both Europe ex-UK and UK markets.

This compares favourably with US bond yields and value stocks – both of which are close to levels seen during previous market highs.

Final thoughts…

Many risk-averse investors are avoiding smaller companies. However, we believe there are compelling reasons to reconsider. History shows that small caps outperform large caps when central banks start to cut rates. Valuations are also historically attractive, while growth as an investment style looks inexpensive.

You can find out more about our European Small Companies capabilities by visiting your local fund page. 

The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide for future results.