Small companies… unique opportunities
The past few years were challenging for Small-Caps. As investors tend to flee to ‘safe havens’ in times of financial stress or uncertainty in the market, small- and medium- ized companies operated in the shadow of their larger competitors. Living up to the motto ‘big is beautiful’, Magnificent Seven stocks went through the roof. Despite all this, anyone who invests in big names only is missing out on an opportunity. Small companies are relatively more attractive than large companies and present a unique opportunity for observant investors.
We could compare the stock market to Spotify: while Spotify gives us access to a wide range of music, just a handful of artists get all the attention. The stock market is likewise dominated by a limited number of big names, although countless hidden gems can be found among the small companies.
Anthony Cruysmans, expert in European Small- and Mid-Caps at KBC Asset Management
“Small companies are underestimated all too often”, says Anthony Cruysmans, expert in European Small- and Mid-Caps at KBC Asset Management, “but they have proven capable of generating substantial profits. Although past performance does not guarantee future results, historical figures show that European Small- and Mid- aps outperform Large-Caps on the stock exchange in the long term.”
Companies with plenty of ambition and room for growth
Small- and Mid-Caps are shares of companies with a market capitalisation of less than 10 billion euros. Mid-Caps generally have a market capitalisation between 2 and 10 billion euros, whereas Small-Caps have a market capitalisation of less than 2 billion euros. One of the main advantages of Small- and Mid-Caps is their potential for rapid growth.
Small- and Mid-Caps are the backbone of our economy. Often finding themselves at one of the early stages of their growth process, they have more room to grow than larger, more established companies.
Anthony Cruysmans, expert in European Small- and Mid-Caps at KBC Asset Management
Small- and medium-sized companies generally foster a company culture with a clear long-term focus. “Their simpler business model allows Small- and Mid- aps to respond to market changes more quickly, and their small scale facilitates business process adaptation and new strategy implementation”, says Cruysmans. “This inherent flexibility can be a key advantage in fast-changing markets.”
Finally, larger players often seek to acquire Small- and Mid-Caps. An acquisition may cause a sudden rise in share prices, especially if the relevant company operates in a promising niche market or has developed enabling technologies. “We have recently seen a revival in the acquisition market”, Cruysmans notes, “which could definitely give the returns of Small- and Mid-Caps an extra boost.”
Smaller shares, larger fluctuations
Small- and Mid-Cap investors should be prepared for larger interim fluctuations in the value of their investments. Small- and medium-sized companies are more geared to the local economy, but also operate in niche markets more often. These two factors reduce their ability to reverse any slowdown in turnover growth – irrespective of the reason for the slowdown – by generating additional turnover in another market.
Lower liquidity is a drawback in less favourable times but may become a catalyst for outperformance in good times.
Anthony Cruysmans, expert in European Small- and Mid-Caps at KBC Asset Management
“The main reason for the larger volatility of Small- and Mid-Caps is their limited liquidity as well as the lower numbers of buyers and sellers, which may increase the gap between bid prices and asking prices.” This lower liquidity makes it harder for institutional investors to invest in Small-Caps. “Large players risk disrupting the market with their financial clout”, says Cruysmans. “Retail investors generally do not consider the lower liquidity of Small-Caps a problem.”
Record-low valuations are attracting long-term investors
European Small-Caps currently trade at particularly low valuations compared to their large counterparts. “Before 2021, on a price-to-earnings basis both Small- and Mid-Caps traded at a premium of around 10 to 15% versus the broad market”, Cruysmans notes.
Although, historically, Small- and Mid-Caps always traded at a premium that was in line with the broader market, this premium has now turned into a substantial discount.
Anthony Cruysmans, expert in European Small- and Mid-Caps at KBC Asset Management
- A cycle that benefits Small- and Mid-Caps
“A logical reason for the present undervaluation are the recent cyclical headwinds”, Cruysmans explains. There has always been a clear connection between small companies’ performance on the stock exchange and the economic situation. If the economy performs well, Small-Caps are often the first to benefit. The opposite holds true when economic developments are less favourable. “When fears of a recession subside, small companies are in a good position to outperform the market.”
- Private Equity has also discovered cheap, fast-growing companies
“The substantial revival of Private Equity in the past few decades provided small- and medium-sized companies with new financing options, which led more medium-sized companies to stay private or postpone public listings. This could reduce the investment pool for investors in this market segment”, says Cruysmans. “Moreover, small, listed outperformers are delisted and taken private more frequently. This creates an opportunity for existing investors, as it increases the potential for return. Investors benefit not only from market recovery, but also from attractive takeover premiums when Private Equity firms take their profits.”
- The Magnificent Seven: must-have or only-have?
Although it has captured everyone’s imagination for almost two years now, Artificial Intelligence (AI) is a trend that has so far mainly benefited large companies. Take the Magnificent Seven, for example, who are delivering staggering returns, thereby boosting overall stock market performance. “These tech giants take up more and more space both on the stock exchange and in many client portfolios, but portfolio diversification is and remains a wise choice”, Cruysmans argues.
The Magnificent Seven are overshadowing their smaller industry peers. And it’s precisely in that shadow where potential opportunities can be found. A few smaller yet innovative niche players often act as a driving force within the large technology sector.
Anthony Cruysmans, expert in European Small- and Mid-Caps at KBC Asset Management
The integration of digital technologies is fundamentally changing our daily lives, mainly driven by semiconductors with applications such as data calculation and storage. With the rapid emergence of Generative AI, the demand for powerful semiconductor chips has steadily increased.
The Small-Cap universe provides access to companies that are global leaders in important niches of the semiconductor chain. Although the future direction of new technologies remains uncertain and does not guarantee success, investors may benefit from potentially revolutionary developments by investing in these companies. “In the world of chips and AI, technology and innovation go hand in hand. Think of the semiconductor industry as a chain”, says Cruysmans. “Each and every link in the chain is important and necessary to guarantee a smooth process and enable the production of chips. Small niche players contribute to this complex chain at the packaging or assembly stage, for instance.”
An active approach makes all the difference
As not all small- and medium-sized companies reach the top, future success depends on the ability of investors to separate the wheat from the chaff. “Small- and Mid-Caps provide investors with opportunities, but doing your homework is paramount”, Cruysmans concludes.
An active investment approach, underpinned by a well-thought-out strategy and a solid fundamental analysis, is essential to making well-informed decisions that increase the chances of success.
Anthony Cruysmans, expert in European Small- and Mid-Caps at KBC Asset Management
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This article is informational only and should not be considered investment advice.
