Don’t invest in European small and mid caps...

Is it just me, or has the positive start to the year on the stock markets all but banished memories of last year’s heavy losses? Admittedly, the gains made over the past few weeks are balm for the tormented soul of any investor - and I am no exception. Nevertheless, let us remind ourselves of the following:

The DAX lost more than 12 percent last year, with the index dropping by as much as 25 percent along the way. German small and mid caps were even harder hit, losing around 28 percent of their value as of 31 December 2022. Small and mid caps were also trampled underfoot more severely than their bigger brothers during previous downturns such as the outbreak of the COVID-19 pandemic and the 2008 financial crisis.

However, heavy losses like these do not alter the fact that investors in small and mid caps fare better in the long run than those investing in DAX and other large-cap stocks. While the DAX has generated annual growth of 8.2 percent over the past 20 years (as of 31 December 2022), investors in SDAX stocks generated returns of 10.2 percent over the same period, with the MDAX even rising by an average of 11.2 percent per year. Aggregating the outperformance of small caps over this long period also reveals significant differences in performance in absolute terms: DAX +381 percent, SDAX +598 percent, MDAX +730 percent.

And that’s not all that emerges from looking back into the past.

 

As soon as the mood on the stock markets calms down again, small and mid caps typically recover more quickly than average.

The first few weeks of the new year reinforce this point, but will the trend continue this time around, and what makes me so confident that small and mid caps will outperform large caps in 2023?

One factor is their valuations, which have bounced back markedly overall. Our European universe is currently trading at a P/E ratio of 15x for 2023, having been at 22x as recently as the end of 2021. However, we have also seen that valuations can drop much lower in times of systemic crisis, as they did during the Euro crisis in 2011 when the P/E ratio was just 8x.

Everything thus depends on how corporate profits unfold in 2023, as economic developments could put them under pressure. Right now, it is still unclear how bad the recession in Europe and the USA will actually turn out to be. What is clear, however, is that the equity market is looking to the future and has generally already priced in what will happen after the anticipated recession. As a result, most heavy losses are seen before or at the start of a downturn in the real economy, which means share prices reach their lowest levels well before the beginning of a recession.

 

For me, that means that the disproportionately high losses suffered by small and mid caps in 2022 currently represent attractive entry prices.

While we certainly shouldn’t be fooled by the positive start to the year on the stock markets, as there are sure to be some ups and downs in the year ahead, the time has come for strategic investors. Small caps have so much more to recommend them right now than just their catch-up potential.

• The European small and mid-cap universe consists of more than 1,200 investable companies encompassing both growth and value stocks - and not just, as is often assumed, stocks with a predominantly cyclical focus (a preconception that refuses to go away).
• Amid the incredible variety of sectors, there are many high-quality companies offering access to the entire economic value chain (I’m sure there isn’t a single household in Germany that doesn’t own at least ten products from across the European small and mid-cap universe).
• It includes companies with focused business models that are often global leaders in their particular niche and therefore have good negotiation and pricing power (such as Krones or the GEA Group in Germany, or Dutch specialty chemicals distributor IMCD);
• It also includes companies whose strong competitive positioning is reflected in attractive margins and who can emerge stronger from a recession (including Belron, a subsidiary of Belgian firm D’leteren, whose services in Germany are known under the CARGLASS brand, or Austrian catering company Do & Co);
• Finally, it encompasses companies whose lean structures and short decision-making paths enable them to react ultraflexibly to changing market conditions and exploit the creative destruction that crises bring.

 

These are precisely the skills we need in periods of social and economic upheaval such as those we are currently experiencing.

Take the energy crisis, for example. The tense situation in the energy sector has prompted an economic transformation, as the price mechanism and actual physical scarcity of resources has forced the market to adapt much more rapidly than it would otherwise have done. Government regulation (EU Green Deal) would never have created the kind of momentum that was generated out of necessity in 2022. While the EU Taxonomy targets specific sectors and products, the price mechanism has prompted companies to carefully scrutinise ALL of their products and processes against the backdrop of energy shortages.

I am convinced that the challenges ahead of us can only be addressed with product and process innovations. These innovations happen in dynamic, high-growth companies – and in Europe (unlike in the USA) that usually means small and mid caps. Many of these companies create products that ensure the economy can undergo a sustainable transformation in the first place.

If you believe in the problem-solving expertise of these companies, you must give them sufficient weighting in your asset allocation and portfolio. Active stockpicking is the best way to avoid unsuitable stocks and invest in businesses that will emerge from the current situation as winners.

 

31.01.2023