Last year was one of the most torrid on record for European small caps. The MSCI Europe Small Cap index plummeted by almost 35% in the first 10 months of 2022, their worst performance in 25 years.
It is important to realise that the market sell-off was not especially broad; growth stocks and small-caps were hit hardest. In fact, last year was the biggest relative drawdown of small-caps vs large-caps of all time. This is because small-caps are seen as riskier, but over the long-term this is not necessarily true.
This year looks to be a better one for Europe and it may prove to be an especially good time to get back into small-caps. Europe is in recovery, with inflation past its peak and the possibility of interest rate cuts in the second half of 2023 (in the US).
The energy crisis did not hit most of the continent anywhere near as badly as was thought back in early 2022, although growth is still set to be weak in Germany and weaker still in the UK.
This should lead to inflation and interest rates fading out as the main driver of equity markets. Instead the focus is returning to the fundamentals of individual companies.
We do not expect a broad-based recovery. Investors will still need to seek out the companies with pricing power who can demonstrate structural growth and also companies that exhibit attractive valuations after the sharp sell-off.
However, the mood and expectations of investors and banks is still very subdued, more so than we have seen for a long time, which creates some attractive entry opportunities. Indeed, European stocks are interesting again because there is already much more negativity priced in for the old world than for the US. The European markets have been showing relative strength compared to the US for some months now.
The small-cap segment should experience a particular boost. Traditionally, small and medium-sized enterprises post stronger growth than large companies do over the long term. This is the so-called ‘small-cap’ premium. For example, over the past 21 years, the risk-adjusted returns from the MSCI Europe Small Cap have been significantly above those of the MSCI Europe Large Cap and MSCI Europe Mid Cap.
The issue here is that the outperformance is not linear. In times of crisis small-caps have historically performed worse and this certainly proved to be the case in 2022. Yet small-caps are historically a good indicator of coming economic cycles. This means they often start falling before the first signs of economic problems and regularly turn around before the economic data has bottomed out.
The groundwork is definitely there for a strong turn around. Many casualties of the general sell off, especially in the quality-growth space, have the potential to bounce back strongly over the medium term. This is so because companies with often very good fundamentals found their strengths overshadowed by the general sell-off.
Even firms with strong moats that could prove their pricing power through several rounds of price increases were faced with a valuation compression. This was true even if they were only affected to a very limited extent by the energy crisis (due to the low energy intensity of the business) and hardly had to accept any additional burden from interest rate increases due to low debt.
The world of small-caps is filled with high-quality growth companies, many of which are global market leaders in their respective segment. Particularly promising are sectors that are benefiting from megatrends such as digitisation in healthcare or the technology sector, progress in medical technology, or the increasing demands regarding energy efficiency.
An example of a small-cap whose valuation took a pummelling is Danish brewer and lemonade producer Royal Unibrew. The firm has been increasing profits over the past few years but struggled in the first three quarters of 2022.
The significant increase in commodity prices as well as higher costs for electricity and gas led to a considerable reduction in profitability. However, the downturn did highlight its strong pricing power and the sold off shares presented an attractive entry point.
Overall, small-caps have notched up historically bad performance in 2022 but there are compelling reasons to think the long-term outperformance of small caps will hold and that now is a good time to be exploring a move back into the space.
Matthias Born is chief investment officer and head of equities at Berenberg. The views expressed above should not be taken as investment advice.