Why big isn’t always the most beautiful
Small caps are often less well known, but are no less interesting for investors. Investing in smaller companies can be a way to diversify your portfolio and tap into higher return potential. It’s especially true today, given that the pendulum has been swinging towards large caps and big tech for years; and every pendulum swing reverses sooner or later.
Successful investments are often based on style factors such as growth, value, quality, momentum, low volatility and market capitalisation. Within the latter factor, large caps and megacaps like Apple, Microsoft and Nvidia invariably dominate the news, while small and medium-sized players remain underexposed to many investors. However, those who look further often discover surprising opportunities in small caps (market capitalisation < 2 billion EUR) and mid-caps (market capitalisation < 10 billion EUR).
At a time when many investors are investing very actively in the ‘Magnificent Seven’ big tech stocks, it is too easily forgotten that things can change. 'Investors are fishing en masse in the same pond today’, says Anthony Cruysmans, European Small & Mid Caps Expert at KBC Asset Management. 'Investors who fully embrace 'size' as a style factor, and therefore choose smaller companies alongside large caps and megacaps, increase their chances of diversification, and of potentially higher returns over the long term.'
Why small caps and mid-caps should not be ignored
Small caps and mid-caps have historically offered added value compared with large caps. With a time horizon of 24 years, this translates into an annualised return of around +6.9%, which beats large caps by +3.3%. This better return is due to factors peculiar to small and mid-cap stocks, including risk compensation, liquidity premium, margin expansion and management. They also deliver growth from a lower base. Smaller companies tend to be younger and more flexible and are able to develop and expand quickly. They still have a considerable curve ahead of them. And remember: large caps were themselves once small caps or mid-caps.
Small caps and mid-caps are often more agile, whereas large caps are often tied to more complex decision-making.
Anthony Cruysmans, European Small & Mid Caps Expert at KBC Asset Management
'Like a sailing boat that can change course quickly, small caps and mid-caps are often more agile,’ Cruysmans continues. 'Larger companies have more difficulty changing course quickly and are often tied to more complex decision-making. Smaller companies often remain under the radar of institutional investors because they are less liquid. This lack of attention regularly leads to undervaluation. Moreover, these companies tend to be easier to understand, with less complex structures and product lines.'
Small caps and mid-caps also often have a more local character, which makes them an interesting option in a geopolitically charged world. Last but not least, the takeover potential is more credible: a big fish is more likely to eat a small one, which raises the prospect of a takeover premium for investors. Moreover, there has been a recent trend to delist small champions and turn them into private companies, which also creates an opportunity.
The pendulum may be swinging again
The pendulum has swung too far towards large caps.
Siegfried Top, Investment Strategist at KBC Asset Management
'In recent years, small caps have lost out to bigger players and Big Tech,' argues Siegfried Top, Investment Strategist at KBC Asset Management. 'The latter are often seen as the future, which is fair enough, but diversification remains essential for a well-balanced portfolio. The pendulum has swung too far in one direction. Valuations are rising, while pessimism towards small caps and mid-caps is strikingly high. But exaggerated movements - both positive and negative - are often followed by normalisation.'
Has that moment arrived?
So when is the best time to invest in small caps and mid-caps? ‘A buy and hold strategy' is the quick answer. 'Historically, European small caps and mid-caps have traded at a premium. Prior to 2021, they were trading at a premium of 10-15% to the broader European market; Today, that premium has turned into a discount of around 15% on average,' Cruysmans says.
Global economic growth appears to be in a ‘soft landing’ phase, indicating a period of lower growth and gradually falling interest rates, especially in Europe. 'That downward trend is important because smaller companies are more dependent on bank credit, while large companies almost never need to borrow or are sitting on mountains of cash. Added to this is the political situation,' Top continues. 'Trump's election is seen as positive for US small caps as the newly elected president favours protectionist policies, lower taxes and less regulation. This could affect the situation in Europe, where large caps with high international exposure may be more vulnerable than domestically focused small caps. But, of course, they are not completely immune, either.'
Separating the wheat from the chaff
Investing in small caps and mid-caps involves risks. They are more sensitive to the vagaries of the local economy, and are also more likely to operate in niche markets. 'So it’s best to make sure you have a slightly longer investment horizon and greater diversification,' Cruysmans concludes. 'An active investment approach, underpinned by a professional strategy and solid fundamental analysis, remains essential to separate the wheat from the chaff. And sometimes you have to dare to go against the grain. Because the pendulum may swing, and you want to be in the right place at the right time.'
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The information contained in this publication is for information purposes only and should not be considered as investment advice.
