News

Laurent Denize – Global Co-CIO ODDO BHF

Europe faces significant structural challenges that impact its productivity compared to the US. Market fragmentation and regulation, a high proportion of small businesses, elevated taxes and lower R&D spending are some of the key contributors to this disparity. However, since the global financial crisis, these downsides have not worsened; in fact, many have become less detrimental.

European small firms make up a significant part of the corporate sector, especially in comparison to the US. American companies with 250 employees or more account for 59% of business employment, compared to 43% in Germany and 48% in France. Small businesses often allocate resources less efficiently than larger firms and are slower to adopt new technologies.


Investors are right to ask: can small companies capture the forward value created by the artificial intelligence revolution? We aim to demonstrate that, by definition, small companies will participate in any Schumpeterian evolution, as progress eventually spreads out to the entire economy.

The next question is: when? We believe the time has come to reposition for broader value creation, and we see early signs of this in the new positive earnings per share (EPS) trend. But first, let's delve into some theory.

Fama and French, among other researchers, have shown that small-cap stocks tend to outperform large-caps in the long run. Historically, investors have been willing to pay a premium for small and mid-cap stocks, recognising their higher growth potential compared to large caps.

However, in times of heightened macroeconomic uncertainty like today, investors tend to prefer the relative safety of blue-chip stocks. Smaller stocks often face risks related to their balance sheets, have high sector or geographic concentration, and may lack the scale to absorb significant business shocks.

This largely explains why European small and mid-caps - equities with a market capitalisation between EUR 200 million and EUR 10 billion - have underperformed their larger counterparts in recent years. As of the end of May 2024, small caps have continued to lag behind large caps in all major investment regions, with a 300-basis points underperformance in Europe and a 750-basis points in both Japan and the US.

Nevertheless, we believe that small and mid-caps offer higher long-term earnings growth at a discount and should perform better in the second half of 2024, particularly in Europe.


Small and Mid-Caps is a long-term call

History tells us that in the long run, Small and Mid-caps have tended to outperform Large caps. Over the past 20 years, the former have outperformed the latter by 130% across Europe. Long-term outperformance can be attributed to several factors. First, small and mid-caps tend to deliver higher growth, driven by a smaller base and disruptive business models that support rapid expansion. Second, they offer lower exposure to defensive and lower-growth sectors such as consumer staples, energy and utilities. Third, the lower coverage by financial analysts gives rise to greater pricing anomalies, which represents interesting opportunities for investors. Fourth, these companies have historically represented a pool of targets for acquisitions, paid at high premia by buyers.


Rate cuts support Small and Mid-caps, particularly in Europe

The rise in interest rates initiated by the ECB in early 2022 was the fastest and most significant in European history. It has been a key factor in the underperformance of small and mid-caps, considered to be more sensitive to monetary tightening as they tend to finance their growth with a higher percentage of debt than large caps. The start of ECB monetary easing, by reversing the impacts of the past two years, should benefit small and medium-sized companies. In the US, the impact of FED rate cuts should be even more positive, given that over 40% of debt is short-term or floating rate.


Small and mid-caps benefit from pick-up in activity data

With better soft macroeconomic data surprises and better domestic activity momentum in Europe compared to the US, European small and mid-caps stand to gain. Purchasing Managers' Indices (PMI), which are based on a monthly survey of manufacturing companies, are an important forward indicator. They show a strong correlation with the performance of small and mid-caps, which has become even more pronounced in recent years. The fresh improvement in these indices is another signal of rising prices for small and mid-caps. The fact that European Small Caps are discounting no pick-up in PMIs yet should amplify the rebound.


Small and mid-Caps have de-rated significantly and now trade near a 20-year low relative valuation

The valuation discount for small and mid-caps relative to large caps has now reached a point where a reversion to the mean seems inevitable, particularly in Europe. European small and mid-cap stocks are trading at a 12-month forward P/E of 12.5x, an approximately 5% discount to large caps. However, over the last 17 years, the Stoxx Mid 200 has traded at a 12% premium to the Stoxx Large 200, compared to a 4% discount today. For the Stoxx Small 200, the historical average is a 17% premium, versus a 6% discount today. A correction to this considerable undervaluation is overdue. We therefore expect small and mid-caps to return to trading at a premium over their larger counterparts, which implies double-digit outperformance potential.


Small and mid-caps performance undershooting strong EPS momentum

Earnings growth revisions are a key signal for re-entering the small and mid-cap segment. Here, too, there is reason for optimism for both Europe and the US, with earnings estimates being revised upwards at much higher levels than for large caps. In Europe, 2024 estimated EPS growth is expected to increase by +8% for small caps and +13% for mid-caps, compared to less than +3% for large caps. All of this suggests that the long dry spell for small and mid-caps is over.


Conclusion:

• Strategic preference for “Mid” over “Small”.
• Tactical preference for Europe over the US.
• Selection is key.

It is time to re-invest in the Small and Mid-Caps segment with a preference for Mid over Small. EPS growth momentum is better for pretty similar valuation discounts. Balance sheets are healthier with ND/EBITDA levels 10-15% lower than Small-Caps. Last, if ECB gave a clear signal that this is the start of an easing cycle, liquidity remains better for Mid-Caps.

As regards geographies, we tactically favour Europe over the US due to: 1/ greater confidence in further ECB rate cuts than the FED, which is unlikely to cut its rates before September, 2/ anticipation of more positive economic surprises to come in Europe, 3/ more attractive valuations in both absolute and relative terms, and 4/ better momentum in EPS revisions.

As regards sectors, when re-entering the small and mid-cap asset class, it is advisable to be selective. We favour sectors that stand to benefit from economic recovery and falling interest rates. These include industrials, healthcare, technology, consumer discretionary and materials. On the other hand, we underweight the highly indebted real estate sector, banks (which have benefited from high interest rates) and more defensive sectors.

Then comes the final question: Are we serious about the timing after the French Assembly dissolution?

It's fair to say that the uncertainty surrounding the French elections does not bode well for French assets, although it doesn't affect the entire European market. Firstly, we don't know the election outcome, but it's likely that the future Prime Minister's maneuvering room will be limited. Investors have made it clear recently that they won't tolerate any soaring deficits. Even the ECB has stated that there is no reason to panic or intervene currently. 

We are not traders but long-term investors. We have been waiting for the "perfect" entry point. By definition, it doesn't exist, but the sum of identified signals has been significant. We believe in active management driven by conviction. We stick to our view but with a significant change: European small and mid-caps make sense, but without French ones. When we talk about France, it's not just about being part of French indexes but also about their proportion of revenues in France. If opportunities arise after the elections, there will always be plenty of time to seize them.

Disclaimer

This document has been prepared by ODDO BHF for information purposes only. It does not create any obligations on the part of ODDO BHF. The opinions expressed in this document correspond to the market expectations of ODDO BHF at the time of publication. They may change according to market conditions and ODDO BHF cannot be held contractually responsible for them. Any references to single stocks have been included for illustrative purposes only. Before investing in any asset class, it is strongly recommended that potential investors make detailed enquiries about the risks to which these asset classes are exposed, in particular the risk of capital loss. 

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