Are European small caps due for a revival?

While CAPM is still prominent in the financial world today, many studies showed that the model was flawed. Applied to the above, the model explained ‘only’ 2/3 of the realised return. The unexplained part was attributed to either luck, talent or some other as yet unknown factor. Thus, economists later ‘discovered’ other factors to explain the unknown and the first two factors that emerged were:

Value: stocks with a low price-earnings ratio (P/E) or price-to-book ratio achieve higher returns than companies with a high valuation.

Size: stocks with a small market capitalisation achieve higher average returns than those with a large market capitalisation.

Combined, this resulted in the three-factor model of US economists Eugene Fama and Kenneth French. The explanatory value of their model rose to as much as 90%. Again, the unexplained part was attributable to ‘skill’, ‘luck’, or some other factor (momentum, low vol, quality etc.).

Each time, economists did extensive mathematical research based on historical data. Whoever wants to put theory into practice quickly encounters some difficulties: many individual companies in the portfolio, each with a low weighting, high transaction costs that cancel out the extra return. Moreover, portfolios took both ‘long’ and ‘short’ positions to outperform; however, this is impossible for many investors.

Practice: the size factor as part of an investment strategy

Despite the mentioned constraints, these factors can be integrated into an investment strategy focused on a concentrated portfolio.

• Size: Capricorn Partners' preference is for European small & mid cap companies. They believe small and mid caps have higher long-term growth potential compared to large caps.
• Value: Capricorn Partners follows a thematic investment strategy with a focus on three themes: Digital, Cleantech and Health. Clients will quickly come across stocks with relatively high valuation multiples within each theme. Nevertheless, Capricorn Partners takes valuation into account by being critical of overly high valuations within their growth themes.
• Quality: If, among the cheap or smaller stocks, clients also exclude companies with low profitability, this had a positive effect on long-term returns. In Capricorn Partners' stock picking process, they exclude companies with too much debt or too low Return on Equity.

The size factor today

The Stoxx Europe Small 200 realised an average annual return of about 10.5% over the past 15 years, better than the 9% that large caps realised annually. However, during the difficult stock market year 2022, small caps corrected more strongly than large caps. In itself not so surprising, investors trade the riskier small caps in difficult times for the more stable financial performance and higher liquidity of large caps. However, also during the subsequent recovery in 2023 until today, small caps did not deliver the same returns as large caps.

In the US, small caps are lagging their large cap peers for over 10 years now. The Russell 2000 Index, the US small cap index par excellence, returned just under 7%. Large caps performed significantly better with an average 12% total return per year. Despite these markedly lower returns, US small caps remain more expensive than US large caps (chart 2). With a P/E ratio of almost 24x expected earnings, small caps are more expensive than large caps (20.7x expected earnings). In contrast, earnings per share expectations for small caps clearly lagged behind earnings expectations for the Russell 1000 Index (chart 1).

The situation in Europe is different and more favourable. European small caps trade today at around 13x expected earnings, cheaper than large caps (13.8x expected earnings (chart 4) which is an unusual situation. Especially since expected earnings for European small caps grew more strongly than those of European large caps over the past 10 years (chart 3). From a historical perspective, European small caps today are up to 20% cheaper. They offer the prospect of higher growth at a lower valuation, a combination that makes us positive about small caps. Especially when you add a focus on growth, a strong balance sheet and higher profitability.