By Don Fitzgerald, CFA, portfolio manager at DNCA Finance
Small caps 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.
Why was 2022 a particularly difficult year for European Small & Mid-caps?
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 policy(2) 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.
Does this environment challenge the long-term outperformance of smid caps?
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Shareholders of small and mid caps also often benefit from a takeover premium when a stock is withdrawn from the market in the event of a bid(4), a more frequent occurrence for smaller sized companies.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).
Is there an interesting investment opportunity?
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 12m(4) 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.
What is the outlook for 2023?
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(5)” strategy, 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 September(6), and this trend reversal should also encourage a reallocation of flows to small caps.
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” (7) approach for 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) Blend: a mixed strategy consisting of having no bias and mixing the portfolio of growth and value stocks.