SMIDs continue to offer good investment opportunities

Over the last few years (with the exception of 2016), European SMIDs have repeatedly put in better performances than large-cap stocks. Despite the strong comeback of volatility at the start of the year, this market segment continues to do well.

Over the first four months of the year, a number of different trends have been witnessed. In January and February, volatility leapt on equity markets as a whole, but it particularly affected large-cap names, which were penalised by ETF sales and by the poor performance of bond proxies in a period of rising interest rate expectations. The lower proportion of bond proxies within the small-cap segment meant that they were not as badly affected. From March, a second phase of uncertainty appeared, with fears sparked by Donald Trump’s protectionist measures and the problems blighting Facebook. During this period, it was defensive names that held up best. Lastly, in April, markets normalised, with a sectoral rotation into values stocks.

In this more turbulent environment, SMIDs continued to outperform their large-cap counterparts. From January to April, the MSCI Europe Large Caps returned +0.04% (to 27 April), whereas the MSCI Europe Small Caps chalked up +1.20%.

Steady momentum set to continue

This solid performance should continue this year given the positive economic fundamentals of this asset class.

For 2018, European SMIDs’ earnings growth is expected to be around 19–20%. These expectations are higher than those of large caps, which are set to see their earnings growth settle around 12–13% this year. Small companies inherently have greater growth potential than large companies that have often already matured on their markets.

But small caps also have the advantage of being more exposed to domestic European markets than large caps and stand to benefit from the regional economic recovery that is currently under way.

This solid dynamic is also favourable for mergers & acquisitions, for which SMIDs are often prime targets. M&A activity has picked up at the beginning of the year and this should continue given the current low-rate environment in Europe, before rates progressively rise as the ECB winds up its intervention programme.

Still good value

European SMIDs still have the advantage of having strong balance sheets, with average leverage ratios of around 1x net debt / EBITDA, around half the level of their US counterparts.

After several years of strong performance, SMID cap valuations are now above their long-term average in absolute terms. However, valuation levels remain broadly similar to those of large caps but SMID cap earnings growth is outpacing that of their large cap counterparts.

To make the most of the opportunities being offered by the SMID segment, it is always important to be able to remain selective. Irish, French and Spanish SMEs currently offer attractive opportunities   and we have an overweight exposure to these geographies within our asset allocation.