Beating market giants with small stocks

Over the past two decades, European small-cap equities have consistently demonstrated their potential to enhance portfolio performance. Historical data shows that small caps have outperformed large caps by an average of 2% per annum throughout this period.

However, the recent three-year period has presented challenges for small-cap investors. Rather uncharacteristically, small caps have underperformed their larger counterparts—leading some to start looking elsewhere. Despite this short-term underperformance, history suggests that such dips often present attractive entry points. Previous downturns in small-cap performance have generally been followed by robust recoveries, rewarding investors who maintain a medium to long-term perspective. Let’s not forget that small caps are currently trading at a larger discount to large caps than they were 20 years ago—9% on a forward P/E basis compared to 7% two decades ago. On more stable metrics like Price-to-Book ratio and Enterprise Value to Sales they trade at discounts of 26% and 39% respectively—between 4-6% lower than 20 years ago, which, from a historical perspective ,was already a low point. This underscores the strong opportunity in the current market environment.

And it’s not just a matter of timing. Small caps have plenty of unique features that explain their potential for long-term outperformance. We break down why we believe these undervalued stocks are still a must-have in diversified European equity portfolios:

Higher return potential: At the core of small caps' appeal is their higher return potential, which largely stems from a risk premium. Investors are compensated for the additional risks associated with small caps, such as greater price volatility, higher beta, increased transaction and information costs, and lower liquidity—leading to a premium which can benefit those willing to stay invested for the long term. Over the last 20 years, European small caps have exhibited significantly higher earnings growth than large caps—7.7% per annum compared to 3.7% for large caps. This robust growth has been the primary driver of their total performance, with minimal contribution from rerating. While higher historic earnings growth is no guarantee for the future, there are a few reasons to remain constructive on medium-term superior earnings growth for European small caps

Growth from a smaller base: Small companies can achieve substantial growth percentages more easily because they're expanding from a smaller revenue and earnings base. M&A can be a more significant contributor to value creation with small rather than large caps: such a deal can really move the needle for a small company—whereas for large companies, such deals often only have a marginal effect. Such deals can have a substantial impact a small company's value—whereas for large companies, such deals often only have a marginal effect.

Entrepreneurial spirit: Small caps often embody a more entrepreneurial culture, enabling quicker decision-making and less bureaucratic inertia. Without the layers of bureaucracy that can slow down larger organisations, these companies can quickly adapt to market changes and capitalise on new opportunities. This agility can offset challenges like lack of scale and drive future earnings growth. With inherently more flexible structures, small companies can swiftly capitalise on emerging trends or market opportunities, giving them an edge over larger, less nimble competitors.

Deglobalisation benefits: In the current shift towards deglobalisation, regionalisation, and a drive for self-sufficiency—particularly in essential industries—small-cap companies are particularly well positioned. These smaller firms are typically more focused on domestic or European markets, making them better aligned with the increasing preference for local sourcing and production. As global supply chains become less reliable or more expensive, the agility of small caps allows them to fill gaps in the market, meeting local demand more efficiently than larger, globally diversified corporations. Small caps can also adapt swiftly to changing regulations and market conditions brought about by deglobalisation. Their closer proximity to customers and suppliers helps them to understand regional needs and preferences more intimately. This local expertise not only creates stronger customer relationships but also reduces exposure to international risks such as trade tensions and currency fluctuations. In this environment, the domestic orientation of small-cap companies becomes an important strategic advantage.

Family-owned and founder-led companies: A significant proportion of European small-cap companies are family-owned or founder-led. This ownership structure often brings a unique set of advantages that contribute to long-term value creation. Family owners and founders usually have substantial personal stakes in their businesses, aligning their interests closely with those of other shareholders. This alignment encourages management to make decisions that prioritize sustainable growth over short-term profits. Their commitment to the business often translates into prudent financial management, such as maintaining healthy balance sheets and reinvesting earnings to fuel innovation and expansion.

More than only growth potential: Apart from earnings growth, there are many other reasons to be exposed to European small caps: Small caps are often the big caps of the future. Investing in them early can provide significant returns as these companies grow and mature. In fact, mergers and acquisitions are a notable driver for small-cap performance. Most M&A transactions also involve smalls caps (often as a target). Factors such as unique franchises, growth-oriented business models, and distinctive market positioning make them attractive acquisition candidates. The small-cap universe is vast—approximately 85% of listed shares in Europe can be considered small caps—providing a large pool to identify compelling business models. However, this space is less efficient, with fewer analysts covering small-cap stocks, and those who do often have less experience. This inefficiency opens up the potential for additional returns through careful stock selection

Because—despite the opportunities—selectivity is crucial when investing in small caps. While there are plenty of promising rising stars in this universe, it also includes fallen angels, perpetually loss-making companies, and firms with overly narrow focuses. Focusing on quality companies is essential to distinguish the wheat from the chaff. Academic studies have shown an overexposure to low-quality companies within small caps. By correcting for this, small-cap quality stocks outperform both large-cap quality stocks and small-cap lower-quality stocks. That’s why we believe investing passively in European small caps may not be the optimal approach.

In conclusion, European small caps offer a compelling proposition for diversified portfolios. Their higher return potential, superior earnings growth, and unique advantages make them an essential consideration for investors. While the small cap universe comes with its shares of challenges, particularly in selecting the right companies, the potential rewards can definitely justify the effort. With careful bottom-up stock selection and the right medium to long-term perspective, European small caps can significantly contribute to any diversified portfolio’s performance.

Disclaimer

Marketing Communication. Investing incurs risks.

The views and opinions contained herein are those of the individuals to whom they are attributed and may not necessarily represent views expressed or reflected in other DPAM communications, strategies or funds.

The provided information herein must be considered as having a general nature and does not, under any circumstances, intend to be tailored to your personal situation. Its content does not represent investment advice, nor does it constitute an offer, solicitation, recommendation or invitation to buy, sell, subscribe to or execute any other transaction with financial instruments. Neither does this document constitute independent or objective investment research or financial analysis or other form of general recommendation on transaction in financial instruments as referred to under Article 2, 2°, 5 of the law of 25 October 2016 relating to the access to the provision of investment services and the status and supervision of portfolio management companies and investment advisors. The information herein should thus not be considered as independent or objective investment research.

Investing incurs risks. Past performances do not guarantee future results. All opinions and financial estimates are a reflection of the situation at issuance and are subject to amendments without notice. Changed market circumstance may render the opinions and statements incorrect.