L'Agefi (04.12.2020) - Small- and mid-cap companies (SMID caps) have traditionally delivered superior long-term growth and returns than large caps. They also allow investors to gain exposure to key secular trends. However, finding the most promising companies requires a highly disciplined selection process.

The SMID-cap universe is so broad and diversified that some investors still regard them with apprehension. However, SMID caps have proven benefits for investors, amply justifying their inclusion in portfolios provided that rigorous stock selection is used. Not all of them offer innovation and growth potential. Finding the hidden gems in this universe requires a selective, long-term approach. This is even more important given that the asset class remains immature and, in general, under-covered by financial analysts. This means that a disciplined approach can enable investors to detect market inefficiencies offering attractive entry points.

SMID caps have a proven long-term track record. In Europe, they have regularly outperformed large caps, even in a year as unusual as 2020. Like all listed stocks, SMID caps have been highly volatile because of overriding concerns about the pandemic’s impact on public health, the global economy and individual companies’ business levels. The market segment was particularly hard hit in the first quarter of 2020 as the first wave of Covid-19 spread across Europe. The MSCI Europe Small Cap index, which includes almost 1,000 listed companies across 15 European markets, has now rebounded strongly from its March lows and its year-to-date performance is better than that of the MSCI Europe index.

This outperformance is partly down to the polarisation of returns within European equity markets and the sector composition of the small-cap universe. More growth-oriented stocks, i.e. those most likely to benefit from long-term trends that have been accelerated by the pandemic, have performed particularly well. However, sectors where business levels have been badly affected by lockdown measures have continued to lag behind. 

It so happens that innovative and disruptive companies are very well represented in the European SMID-cap universe compared with the large-cap universe.

They operate in sectors such as technology, healthcare equipment, engineering, cleantech, communication services and online retailing, and so they tend to address niche markets, protecting them against economic turbulence. The SMID-cap universe has limited exposure to more traditional “old-economy” sectors like banking, insurance, oil and gas, telecoms, utilities and automobiles, which are suffering from the current disruption.

In Switzerland in particular, SMID caps include companies that are driving innovation in various industries.

The healthcare sector, for example, which benefits from a particularly favourable ecosystem and includes several heavyweights of the Zurich stock exchange, has also produced a number of small- and mid-cap companies.

Some of them are well positioned to take part in the efforts to fight the pandemic, and this has helped boost their share prices this year.

Swiss SMID caps have another advantage: they are supported by Switzerland’s political stability, the Swiss franc’s safe-haven status and low debt levels in the Swiss economy, along with the Swiss National Bank’s proven expertise in dealing with external shocks. Over the long term, the Swiss small-cap market – like its large-cap counterpart – has outperformed most regional and global indices due to its ability to take part in rallies while being more resistant to market turbulence and corrections. In 2020, the SPI and SPI Extra (the Swiss SMID-cap index) have once again stood out through their resilience.

When selecting stocks, as well as looking at the sector in which they operate – which will partly determine their long-term growth prospects – investors should focus on certain fundamentals. Most of them would appear on any standard investment checklist: solid financials, strong management and clear competitive advantages. However, to identify the most promising SMID-cap stocks, investors need to look a little deeper and factor in aspects such as ESG (environmental, social and governance) performance, CFROI (cash flow return on investment) and R&D expenditure.

By doing so, investors will be able to capture the greatest long-term value-creation potential, while making their investments more meaningful in terms of helping fund the companies that are most committed to building the world of tomorrow.