Small-cap stocks in Europe seem to be making a comeback. After two years of declining relative valuations, the usual premium these stocks hold over large caps has vanished, even turning into a discount at the end of last year. However, recent weeks have seen this discount narrow significantly.
Small caps have long been favored by many investors for their potential for faster earnings growth. Over the past twenty years, the premium on these stocks over larger ones has sometimes exceeded twenty percent. However, there have also been times when this premium dipped below five percent, and on rare occasions, it vanished entirely, resulting in these stocks trading at a discount.
This phenomenon hadn’t occurred in two decades until last autumn. Then, the average premium on shares in the MSCI Europe SMID compared to Large caps dropped below zero. This situation was reversed following the positive interest rate news that has energized financial markets since October.
Revival of small caps?
Is the small-cap premium about to make a strong comeback? Lodewijk van der Kroft, responsible for Benelux and Nordics at asset manager Comgest, has reviewed the data and believes that small caps are on track for attractive growth. “There is room for recovery in the current Price/Earnings (P/E) ratios,” he said, “especially when we consider the current valuation against consensus earnings growth expectations.”
Van der Kroft attributes the rapid depreciation of European small caps between early 2022 and mid-2023 largely to the conflict between Russia and Ukraine. “Investors began to view European small caps negatively, especially those with less international business,” he said. “Then, as interest rates rose swiftly, small caps, which are particularly sensitive to interest rate movements, were impacted.”
Van der Kroft doesn’t believe there are structural reasons for the low valuations.
“Some point to the limited influx of small caps into stock exchanges, suggesting that private equity is keeping the most interesting companies out of reach of investors. However, I’ve observed that IPOs of large companies have also been limited, yet that hasn’t deterred large caps. Besides, with 917 companies in the European small-cap index, there’s ample choice for active investors seeking quality.”
Valuation trends
The valuation of smaller companies wasn’t the issue, Van der Kroft said. “The P/E ratio is currently around thirteen, which could be seen as average. It’s the rising valuation of large caps that has caused the premium to disappear.”
As for the return of the premium, early signs are positive, at least for optimists. Van der Kroft said. “Long-term investors should inherently be optimistic.”