Small Caps: Direct Exposure to Europe’s Structural Transformation
24 OCT, 2025
By Caroline Gauthier, Co-Head of Equity at Edmond de Rothschild AM
Eurozone small caps have delivered very strong performance so far this year, rising nearly 20% and significantly outperforming large caps, despite ongoing uncertainties such as tariffs and geopolitical risks. This rally, largely concentrated in the first half of the year, reflects a clear shift in investor perception, who now see Europe as determined to rebuild its sovereignty and competitiveness. More recently, this extraordinary performance has stabilized, mainly due to the rebound of large caps rather than a loss of momentum among small caps.
We are moving from the “announcement phase” to the “implementation phase.” Each step in executing Germany’s fiscal plan, and every European initiative aimed at simplifying regulation or deepening integration, should gradually reduce the region’s risk premium and sustain renewed investor interest over time. We expect clearer signs of economic improvement and a more visible acceleration in small-cap earnings growth relative to large caps as we approach 2026. In our view, this marks the beginning of a long-term structural phase rather than a short-term tactical opportunity.
Small caps tend to outperform when monetary conditions start to ease and growth visibility improves, usually in the early and mid-stages of an economic recovery. In recent years, their underperformance largely reflected the sharp and rapid rise in interest rates, which temporarily affected valuations and raised unfounded concerns about financial strength.
As inflation moderates and ECB rate cuts begin to take effect, this dynamic is shifting. Lower rates support both capital expenditure (capex) and valuation multiples, while improved credit conditions ease financial burdens. This regime change should translate into a gradual revaluation of this asset class over time.
Interest rates and inflation have been key factors in relative performance in recent years. The rapid and intense monetary tightening cycle of 2022–2023 hit small caps particularly hard, as higher discount rates pressured valuations and raised doubts about balance sheet strength. However, these concerns were largely unfounded: eurozone small caps are not more indebted than large caps, and most maintain solid financial profiles.
As inflation normalizes and monetary policy turns accommodative, this headwind becomes a tailwind. Lower rates improve credit conditions, bolster confidence, and allow investors to refocus on fundamentals. Given their domestic exposure and operational leverage, eurozone small caps are particularly sensitive to this transition, creating a favorable risk–reward asymmetry: limited downside potential after years of correction, and significant upside as valuations realign with fundamentals.
Despite their strong rally this year, eurozone small caps remain attractively valued. They currently trade at a 14% discount to large caps on a P/E basis, whereas historically they traded at a premium of around 20%. This gap reflects years of underperformance and low investor exposure, rather than a deterioration of fundamentals. A simple reversion to the mean could imply outperformance potential of approximately 35–40%.
In our view, this represents one of the most interesting asymmetries in the equity market today. After years of compression, small caps offer both valuation appeal and operational leverage in an improving macroeconomic environment. The gradual return of capital flows and normalization of the risk premium could drive significant revaluation over time.
We expect a gradual recovery, with varying speeds across sectors and countries rather than a linear rebound. In the short term, growth indicators remain modest, but medium-term prospects are improving. Monetary easing should translate into better credit conditions and stronger PMIs, while fiscal support—particularly Germany’s historic plan—will progressively permeate the real economy.
Together, these factors point to a J-curve dynamic. The upcoming phase is less about announcements and more about implementation. Each concrete step should help reduce the eurozone risk premium and build a more favorable environment for small caps. Still underrepresented and attractively valued, these companies offer abundant opportunities for active managers and remain one of the richest areas for stock picking in Europe.
The eurozone offers a particularly rich and diverse universe for active managers focused on stock selection. The depth of the small-cap segment allows access to high-quality companies across a wide range of sectors, many of which hold strong competitive positions in their niches. This also explains why they are often prime targets for acquisitions by large corporations or private equity investors seeking growth.
We currently see attractive opportunities in themes combining structural and sovereign dimensions, such as defense, infrastructure, industrial goods, energy transition, and digitalization. These areas are central to Europe’s reindustrialization and competitiveness agenda. Small caps are often pure players in these fields, offering investors direct exposure to the transformation taking place in the European economy.
We apply a disciplined stock-picking approach guided by our “4C” framework: Growth (compound annual revenue growth), Competitive advantage, Value creation, and Chief (management team). We look for companies with sustainable growth backed by real competitive advantages and led by visionary management teams capable of effective execution in the short term without losing sight of the long-term horizon.
Financial discipline is a key part of our selection process. We pay particular attention to balance sheet strength and cash generation. Approximately half of the companies in our portfolio have strong liquidity positions and robust free cash flow profiles, providing flexibility to invest, innovate, and adapt to different market environments.
This focus on quality and financial resilience allows us to build a diversified, high-conviction small-cap portfolio that combines qualitative business models with long-term growth potential.
