Over the last two years sentiment among investors regarding Europe has been transformed and the euro crisis is now a distant memory. Today, while economies in much of the region still trudge along recovery lane, many entrepreneurially-managed smaller firms are showing they can grow and adapt faster; indeed, small-cap stocks have shown excellent long-term risk-adjusted returns.
Investors in small-cap stocks currently stand to gain from larger, cash-rich companies’ M&A ambitions. Financing is readily available to large caps (either from banks or via capital markets where the strength of demand for corporate debt is reflected in very low yields). The prospect of acquisitions of small- and mid-size European companies by larger entities is therefore another compelling aspect in favour of European small caps at this time.
What are small-cap stocks and what advantages can they offer investors?
Small-capitalisation stocks (small caps) are typically listed companies whose market capitalisation falls in the low tier of the market cap range, the two other tiers being mid- and largecap stocks. The most important point, though, is that small cap are often those of companies in their pioneering or early growth phase. This is perhaps the best angle to approach this group as an investor, since such stocks are a way to ‘play’ superior growth investment vehicles. In Europe, a common rule of thumb says that small caps have market capitalisations of up to around EUR 3 billion and account for about 15% of the free-float adjusted equity market capitalisation of the region.
Financial theory asserts that small-cap stocks in developed markets should outperform large caps over the long term, although their volatility can be somewhat higher. Eugene Fama, a Nobel economics laureate in 2013, and Ken French produced what is regarded as the definitive study showing that over time, small-cap stocks unmistakably tended to outperform largercapitalisation companies. Other research supports the same conclusion, even when approaching the subject from different angles. This seems to be a global pattern, since only very rare exceptions invalidate this view, as shown by a study by Elroy Dimson and Paul Marsh, two London Business School academics.
And when it does, it seems to be due to the widespread dominance of local oligopolies that leave no room for small caps even to exist, such as in Mexico or Malaysia.
In effect, past performances commonly show that small-cap companies have generated significantly higher annualised returns than both their large-cap counterparts and the World Index, with only moderately higher volatility. In other words, not only has the absolute return been stronger for small-cap stocks, but the risk-adjusted performance (as measured by a Sharpe ratio for instance) has been superior as well (see Exhibit 1).
Exhibit 1: Better risk-adjusted returns for small caps
Source: BNP Paribas as of 28/02/14. Indices used: Small-cap – Russell 2000, Large-cap – S&P 500, World – MSCI World. Past performance is no guarantee of future returns.
What lies behind the outperformance of small-cap stocks in the long run?
Sales and earnings growth are key drivers of long-term performance for equities, and they happen to be often stronger for small-cap stocks than for larger listed companies. Part of the explanation for this is the fact that small caps often invest significantly more, relative to their size, than their larger counterparts. For instance, small caps often spend more on research and development (relative to sales) than large caps. Investing in small-cap stocks also coincides with capturing the returns from the early stages of new industries as they develop and benefit from the more entrepreneurial management and flexible business models inherent to their smaller size. Many such companies can indeed capture new market opportunities and adapt more quickly to changing trends, which is subsequently reflected in more robust sales and earnings growth (see Exhibit 2).
Exhibit 2: Sales and earnings per share (EPS) compound annual growth rate (CAGR) from 2003 to 2013
Source: UBS estimates, Bloomberg. Note: large caps = STOXX large-cap index, midcaps = STOXX mid-cap index; and small caps = STOXX small-cap index. Financials have been excluded from the indices for the analysis. Historical sales and EPS numbers are for the current members of the respective indices. Past performance is no guarantee for future returns.
Does the current environment favour European small caps?
Concerns about the eurozone crisis have almost vanished: European institutions have emerged stronger, sometimes strengthened by the addition of new powers (e.g. banking supervision for the ECB). Such developments added further weight to the view that the crisis is over. Besides, peripheral eurozone markets have even seen their bond yields falling dramatically, sometimes to record low levels, which is a good omen for their respective economies. So in an environment where PMIs are recovering, albeit at different speeds across the region, and where the ECB stands ready to counter deflationary risk in part via a very accommodative monetary policy, European small-cap companies should benefit the most from further growth ‘normalisation’.
Moreover, European small-cap earnings and dividend growth rates are currently expected to be stronger than those forecast for most of the other developed equity markets. At the same time, their valuation (as illustrated by their price-to-book ratio in Exhibit 3) is generally aligned with the other developed equity markets, and indeed is cheaper than the US market. On these metrics, European small-cap stocks appear therefore more attractive than most developed equity markets.
Exhibit 3: Comparison of valuation characteristics of European small caps with other equity asset classes
Source: BNP Paribas Asset Management, as of end of June 2014.
*Med NTM: median next twelve months
**FY0,1,2: over the next 2 years (fiscal year 0,1,2)
As I have already pointed out, given that growth is recovering in Europe, though timidly, large companies could find it attractive to reposition themselves within the European region through acquisitions of European small caps. Conditions currently look favourable for a significant M&A uplift at the current stage of the economic cycle.
Why is stock selection so important?
Using analyst coverage data for small and large-cap stocks, i.e. the number of analysts providing at least one annual earnings forecast for a company, we found that small-cap companies on average attract nearly three times less research coverage than large caps. This lack of coverage can lead to significant inefficiencies and mispricing of small-cap equities, which can be exploited through a combination of solid proprietary company research and active portfolio management.
Ultimately, our view is that in the small-cap universe, alpha is best generated through a bottom-up approach. However, with around 900 constituents in the MSCI Europe Small Cap index, how does a bottom-up fund manager narrow such a broad universe?
To make such a broad investment universe ‘workable’, our fivestrong European small and mid-cap team – where each member combines analyst and portfolio manager responsibilities and has an average experience of 13 years – has developed, with the help of our Financial Engineering team, a powerful proprietary quantitative screening tool that reduces this vast investment universe to a more accessible one. Filters, such as superior balance sheet quality, growth potential and cash flow returns, are involved in this process.
The tool helps portfolio managers spot companies that score highly, and these are then subjected to further in-depth, inhouse research. The success of blending quantitative screening with subsequent qualitative research is reflected in the longterm performance of our European small-cap strategy.
Because of the importance of the stock selection process in delivering consistent alpha from this very dense investment universe, we believe that an assessment of the stock selection skills of the portfolio managers is a prerequisite to any investor’s decision to allocate to this rich but broad European small-cap universe.
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