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Equities , Topics

Opportunities in high quality small & mid caps

Small & midcaps have outperformed large caps since the market lows recorded during the financial crisis in 2009. Candriam expects small caps to continue outperforming, but focusing on high quality companies which will prove more resilient to the withdrawal of cheap liquidity provided by central banks.

Chart 1: Small & midcap companies have outperformed the large cap indices.
Performance Small Caps vs Market

There has been much academic discussion on the validity and sustainability of the outperformance staged by smaller & midsize companies over the past years, as small caps trade on a valuation premium compared to large caps. However, recent studies (“Size Matters, If You Control Your Junk”*) show that if you select high quality small cap securities, i.e. profitable businesses that display profit growth, safety and have a high pay-out, they by far outperform their larger counterparts.

Innovative companies in growing niche markets

This academic discovery vindicates our investment approach in this segment. We select companies that are active in growing niche markets, based on their dynamic management and their innovation capabilities. In many cases these smaller companies are managed by their founders who tend to be more prudent when using leverage, as their own wealth is at stake. These founders also recognise the importance of cashflow, profitability and growing revenues when developing the company. Over time, shareholder-friendly company management teams know that performance mainly comes down to cashflow generation and the allocation of capital towards its best uses.

In addition, the management structure of small companies is usually lighter than their larger peers, allowing them to take decisions more rapidly and be more reactive. As pointed out by the Boston Consulting Group, agility now rivals scale as a key to success.

Expensive or not?

When looking at current valuations, European small & midcaps appear to be trading at a premium over large companies. However, this premium is still in-line with the historical average (Chart 2). This fact justifies our conviction to be exposed to this market segment.

Chart 2: Small cap valuation premium, in-line with its historical average.
Premium Small Caps vs Market

Leverage on economic momentum

Furthermore, small cap stocks generally have a higher proportion of domestic revenue, allowing them to benefit fully from a strong local economy. This is particularly the case in Europe, where the economy is gradually recovering, which should be beneficial to small caps. Moreover, small cap companies typically pay a higher tax rate than large caps which generate more international revenues. Any cut in the corporate tax rate would therefore be of greater benefit to smaller companies.

Additionally, the more domestic orientation of small caps leaves them less exposed to potential protectionism, which Candriam sees as a possible source of risk. Small & midcap companies are also less exposed to emerging markets and commodities, two asset classes that have shown more fragility while the Fed is raising rates.

Finally, small cap stocks also typically have higher betas and therefore frequently perform well during sharp market rallies. In the medium term, we believe we shall remain in a low growth environment. In this context, European small and midcap companies should continue to be sought after by investors as they offer stronger growth prospects.

An opportunity

Investing in small cap companies is not without risks, as there is usually a lack of quality research coverage. This sort of information vacuum may deter many investors and can create significant price volatility when the markets turn negative. However, for investors who are prepared to do their homework, they offer a great opportunity.
We expect 2018 to be bullish for the markets and for small caps, but the forthcoming European tapering and the end of cheap liquidity could create significant volatility with potential macro risks, especially for small companies, as low liquidity may exacerbate share price moves. In addition, it could also mark the end of cheap credit spreads. This is why we advocate remaining focussed on investing in high quality small companies with sound balance sheets.

*Asness, Clifford S. and Frazzini, Andrea and Israel, Ronen and Moskowitz, Tobias J. and Pedersen, Lasse Heje, Size Matters, If You Control Your Junk (January 22, 2015).