European midcaps gain in attractiveness

Rising inflation and rising rates are traditionally followed by stronger nominal economic growth, which generally becomes supportive for small caps. But there are even more fundamental reasons that make small and mid-cap equities an attractive asset class for investors seeking to optimise the risk profile and maximise returns from their European equity allocations. 

The MSCI Europe Small-Cap Index consists of around 1,056 constituents, with an average market capitalisation of $1.5 billion. The largest component is about $9.3 billion, so the index includes companies with a relatively large market capitalisation.  In contrast, mid-cap companies, represented by the MSCI Europe Mid Cap index, comprise 232 companies with an average market capitalisation of $8.3 billion, the largest of which is $30.2 billion. This creates an opportunity to access some 1,250 names with the ability to provide much more diversification in both risk and growth compared to the large caps - some 197 companies represented by the MSC Europe Large Cap index - which have an average market capitalisation of $38 billion.

The sheer volume of European small and mid-cap opportunities also creates a different mix of companies that do not stand out in the large-cap indices. This unique mix also means that small- and mid-caps represent different sectors compared to large-caps, which traditionally favour large pharmaceutical, financial and industrial companies.

Many large-cap companies are global companies, earning a significant proportion of their profits in markets outside Europe. As a result, they are often not a pure reflection of economic activity taking place domestically, and funds investing in this asset class can be more responsive to cyclical differences across Europe. This is particularly beneficial as economies recover from the pandemic and weather rising geopolitical risks.  In addition, small and mid-sized companies tend to be at an earlier stage of their development, which can create strong growth opportunities vis-à-vis large-cap companies, which in more mature developed market economies may see their growth trajectory slow down. 

Beyond the above, small and mid-cap equities in Europe are not a beta game. They deserve a strategic allocation in balanced portfolios and have clearly demonstrated higher alpha compared to large stocks over the last five years.

Two factors that many investors particularly monitor when looking at small and medium sized companies are risk and liquidity. From a risk perspective, small caps have delivered strong returns over the last ten years. 

If we focus on the performance of this asset class we see that it first made its presence felt during the pandemic and started to have a significant impact on global markets. On the liquidity side, European companies faced unprecedented trading conditions during the height of COVID, which naturally raised liquidity concerns. This can be mitigated by diversification and building a portfolio with an average capitalisation of EUR 1 billion, with the objective of limiting liquidity risk.  Companies with strong balance sheets, lower debt levels and good cash generation are also in a more flexible position should an economic downturn occur. 

The road to a stronger ESG 

The EU introduced the "Sustainable Finance Action Plan" in 2018 to meet its energy targets for 2030. This gave rise to the EU Taxonomy, a classification system that sets out a list of environmentally sustainable economic activities to develop consistent ESG and climate reporting standards along with helping companies become more ESG and climate friendly. 

Although this only applies to large companies from January this year, along with the new Directive on corporate sustainability reporting (required from 2026 for small companies), we believe that, to ensure full alignment of the taxonomy, large companies will establish similar reporting standards for their supply chains, which are often made up of small to medium-sized companies. 

But it is no secret that smaller companies are also often less researched, meaning that their innovation and approach to ESG may be overlooked by the wider market. They also have fewer resources compared to large-cap companies and often struggle to complete ESG and climate data reporting. 

However, through our bottom-up research model, and by travelling to all corners of Europe, we have found that there are many examples of small and medium-sized companies that are leading in the important area of ESG, reflecting their ability to innovate and be more flexible. 

The small and mid-cap universe is, in fact, full of such ESG leaders, and we believe this is an area of potential future value. From our perspective, European small and mid-caps play an important social role, playing a key role in job creation, and supporting local European economies.