Small-cap equities can spice up your investments

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Focusing on the prospects of European and US small-cap equities compared to European and US large caps, we see a compelling opportunity for small caps in Europe, but less so for US small caps given our medium-term outlook and expectations of lower risk-adjusted returns. Nevertheless, we believe a good active manager can add value for investors in the US small-cap segment in the coming years.

European recovery can add spice to your investments

With Europe now showing real signs of emerging from the recent crises, the euro down against the US dollar, monetary policy generally loose and oil prices well below USD 65 a barrel, many companies stand to benefit. Small caps should profit the most as they have higher operating leverage to a domestic recovery than large caps, higher domestic revenue exposure and a higher exposure to cyclical sectors such consumer discretionary.

When it comes to further structural reforms in Europe, small caps should be best placed to take advantage of such initiatives. Liberalising and deregulating markets, particularly in ‘peripheral’ countries where the barriers to entry in some markets have been the highest, should end the protection of national champions and boost competition.

On balance, the companies that stand to lose out from market liberalisation tend to be long-established large caps, for example, European energy and telecoms companies.

As smaller and more dynamic businesses, small caps have been able to take advantage of new opportunities created by increased access to markets previously inaccessible. They tend to react faster to changing trends and to market opportunities.

This is a unique feature of Europe compared to the US where competition is already tough and there is no reform agenda.

Small caps in the crosshairs

As the recovery becomes more apparent, the lengthy period of underinvestment by the world’s largest companies will likely put them at a comparative disadvantage. To compensate for this, we expect further merger and acquisition activity in the years ahead as cash-rich large caps with easy access to cheap finance pursue growth opportunities (many of which can be found among the small caps).

The one headwind for small-cap equities is valuations: they are more expensive than large caps on several metrics (see chart below). However, this is less of an issue given the tailwinds such as cyclical improvements and structural reforms.

It is worth nothing that the lack of depth and breadth of analyst coverage of European equities compared to US equities and of small caps in particular means that there are ample opportunities for active managers to outperform their benchmark.

So despite their higher valuations, we believe European small caps can still offer growth and diversification benefits both for equity-only and multi-asset investors.

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Sources: MSCI, Eurostat, ONS, Statistics Norway, Statistics Sweden, Denmark Statistics, Bloomberg, Datastream, BNP Paribas Asset Management, as of 31/03/2015

US small caps: active managers can add value

US small caps now look less compelling in valuation terms (see chart below) and are likely to see greater volatility in the coming years as the Federal Reserve normalises its monetary policy and US interest rates rise.

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Sources: Russell, Standard & Poor’s, IBES, Bureau of Labour Statistics, Bloomberg, Datastream, BNP Paribas Asset Management, as of 31/03/2015

But we believe active managers can add value to US, but also European small-cap investments, given the limited analyst coverage and the greater breadth of small-cap indices.

In our view, managers who can identify compelling investment opportunities, for example, in growth themes such as biotech, mobile payments and the Internet of Things and manage the higher volatility should be able to generate higher risk-adjusted returns over a multi-year horizon compared to a buy-and-hold passive strategy.

As for Europe, we believe the greater breadth of compelling small-cap opportunities makes it less urgent to choose between active and passive management.

Jason Tannen

Portfolio Manager

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