Europe Small Caps: they say history never repeats itself. But doesn’t it often rhyme?

In the past, small caps have tended to rebound strongly after inflation peaks. Small caps’ intrinsic qualities – agility, strong pricing power –, supplemented by careful selection by an experienced team, may allow them to stand out from the crowd once again in the near future, like a bright and powerful clarinet sound can take us almost by surprise.

Sometimes we hear a slightly different symphony again, but recognize its theme - or as one says “History never repeats itself, but it does often rhyme”.

The last time developed countries faced strong inflationary forces was about 50 years ago, in the seventies. Interesting comments may be drawn from this period.

Back then, not only did small cap companies outperform the main traditional asset classes in real terms, but they were among the rare ones to deliver positive returns (see graph). Note that we see here how small caps performance can be decorrelated from large caps, thus providing a diversification effect into portfolios.

When inflation started to soar in 1973, following the end of the Bretton Woods system, small caps underperformed while the world was gradually entering into a recession. Smaller companies’ revenues are generally the first to be affected by an economic slowdown, and investors prefer safer boats in the storm. Small companies also have less access to debt and equity capital markets than larger companies.

But right after the peak of inflation, small caps entered a phase of strong outperformance which was barely impacted by the second inflationary shock, thanks to their stronger dynamism and entrepreneurial leadership. Small companies also tend to react faster than larger ones to changing environments. Note that we are showing US data in the absence of equivalent historical series for Europe, due to the market structure at the time.

At Candriam, we believe that small caps, which have underperformed large caps since the second semester of 2021, may start to outperform soon. This may coincide with the Fed pivot or the moment investors have more visibility on the taming of inflationary forces. We shall monitor closely Central banks policies and the bottoming out of PMI¹ figures to call the bottom on small caps.

Furthermore, we also believe that our selective approach to investing in small caps names, which has proven successful over a period of 10 years, is more crucial now than ever (annualized gross excess return of 3.6% over ten years, and a Sharpe ratio of 0.82²).

The cornerstone of our approach is our team’s expertise, backed by 15 years of experience in small cap research and investment. Our internal resources in both financial and extra-financial research are key to spot the opportunities in a highly dispersed asset class with low sell-side coverage. We are a team of 34 specialists sharing the same floor and the same philosophy.

Our approach is long term. We implement a proprietary disciplined analysis framework along 5 investment criteria which we believe are key in the current environment:

  • Quality of management: good management and staff should be retained and incentivized, particularly so in smaller companies. This is one of the reasons why we have started, together with our ESG analysts, a dialogue with the companies in which we invest to better understand their organization and retention and development programs. We look for a long-term dialogue with these companies, and we prefer supportive engagement rather than systematic exclusion. When engaging with smaller corporates, we are not dogmatic and we consider their specific challenges. For example, given their smaller size or due to a family ownership, it is more common to have no separation between Chairman and CEO roles. Part of this long-term relationship is also to share best practices in social and governance areas. Obviously, we remain strict on controversies which we monitor on an on-going basis. In the absence of improvement, we simply cut down our exposure, partially or totally.
     
  • Underlying market growth: in a changing economic environment, it is essential to understand which niches have real growth potential beyond short term fads. For example, we see the new climate related regulations as growth opportunities for the private sector, which is keen to contribute to climate protection and resource savings. More specifically in this segment, we believe the European Green Deal will favor companies that are active in insulation.
     
  • Competitive advantages: we target companies with pricing power or potential market share growth, as margin protection is key in an inflationary environment (see table below). Companies can build these competitive advantages through innovation or with a favorable market structure.

 

  • Profitability: while other strategies would only look at growth, we focus on profitability too. We look for stocks that are already profitable, not potentially profitable. As shown in the table below, companies with lower profitability tend to suffer more severely from higher input costs.

  • Leverage: debt should be managed cautiously in a rising interest rates environment. Focusing on leverage is key both from a financial and a responsible point of view. It is thus essential in our investment framework.

We strongly believe high returns and responsible investment are compatible. Markets could soon offer a unique opportunity to invest in small caps at very attractive levels. We also believe that engagement, combined with responsible investing, is key to improve our risk reward. So, are you ready to hear the clear and bright sound of the clarinet?

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All investment strategies involve risks, including the risk of loss of capital. The main risks associated with our European Small & Mid cap strategy are: Risk of capital loss, Equity risk, Currency risk, Liquidity risk, Concentration risk, Derivative risk, ESG Investment risk.

Past performance of a given financial instrument or index or an investment service or strategy, or simulations of past performance, or forecasts of future performance does not predict future returns.

ESG Investment Risk: The non-financial objectives presented in this document are based upon the realization of assumptions made by Candriam. These assumptions are made according to Candriam’s ESG rating models, the implementation of which necessitates access to various quantitative as well as qualitative data, depending on the sector and the exact activities of a given company. The availability, the quality and the reliability of these data can vary, and therefore can affect Candriam’s ESG ratings. For more information on ESG investment risk, please refer to the Transparency Codes, or the prospectus if a fund.

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¹ PMI: Purchasing Managers’ Index: an index of the prevailing direction of economic trends in the manufacturing and service sectors.

² Candriam European Small & Mid Caps GIPS composite, gross performance in EUR, to end October 2022. Benchmark is MSCI Europe Small Caps NR. Past performance of a given financial instrument or index or an investment service or strategy does not predict future returns.

  • About this author
    Christian Solé
    Deputy Head of Fundamental European Equity / Senior Fund Manager / Analyst

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