The case for small-cap investing

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Why investors should consider small caps for their strategic asset allocation?

  • Small-cap stocks have shown excellent long-term returns compared with large caps
  • Entrepreneurially managed small companies can grow faster than large companies
  • Investors in small-cap stocks stand to gain from larger, cash-rich companies’ growth ambitions

Small-cap stocks and the advantages they can offer investors

Small-capitalisation stocks are typically those of listed companies whose market capitalisation ranges from EUR 500 million to EUR 3 billion. In Europe, such stocks account for some 14% of the free float-adjusted market capitalisation, offering ample variety and diversification opportunities. Another advantage is their potential to grow strongly as they evolve from inception to maturity.

Small caps in developed markets have outperformed their large-cap and global counterparts over the last 15 years, with only moderately higher volatility. Shifting your investment mix from a global all-cap to a (European) small & mid-cap perspective can earn you higher returns over the longer run.

Small caps and outperformance

Sales and earnings growth are the key drivers of this longer-term performance. Obviously, sales revenues would be easier to grow substantially from EUR 500 million than from EUR 50 billion. Many small caps can capture new market opportunities and adapt quickly to changing trends, which translates into more robust sales and earnings growth.

Investment returns can be expected to follow a similar path as new industries develop and benefit from their more entrepreneurial management and flexible business models.

Current conditions: favourable for small caps
Large companies are now sitting on large cash piles, but many are finding it hard to grow revenues by themselves. Low interest rates are also making the financing of mergers and acquisitions attractive and we believe takeovers are likely to target small caps given their growth potential.

Investors in small caps stand to benefit. In such an environment, adding European small caps to your portfolio could produce substantial results.

Small caps: picking the right ones

Selecting the winners among the small caps is less a case of picking a growth sector and more one of promising stocks. Since fewer analysts follow small caps than they do large caps, this means solid company research is essential when putting together a portfolio. By the way, managing the portfolio actively can also add value.

But with 893 companies in the MSCI Europe Small Cap index, how do you narrow the segment down to the worthwhile ones?

Our European Small and Mid-Cap team uses a powerful in-house tool to limit the number of investment opportunities to those quality companies with high growth potential and solid pay-outs to shareholders. In a follow-up step, companies that score highly are subjected to in-depth research.
We believe such a disciplined approach is the cornerstone to successful investment performance. So when you consider an allocation to small caps, start by assessing the stock selection skills of your portfolio manager.

Discover more about Parvest Equity Europe Small Cap.

Damien Kohler

CFA Charterholder, Head of the European Small & Mid Caps team at BNP Paribas Asset Management

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