European equity investors hunt for big returns in small places
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[June 15, 2023] By
Lucy Raitano
LONDON (Reuters) - Investors are turning their attention back to
European small and mid-cap stocks as low valuations spark long-term
interest even as the immediate economic outlook remains gloomy.
Europe’s smaller companies have seen relative valuations sink as
concerns about an economic slowdown have favoured defensives over
cyclicals, while banking turmoil stoked credit crunch fears and an AI
boom boosted mega-caps.
The MSCI Europe SMID index of European small to mid-cap firms is trading
near 2008 lows versus the wider market in terms of valuations, including
both price/earnings and price-to-book ratios.
While economic slowdown concerns persist, investors say much of the risk
is factored into the price of so-called SMIDs, meaning they will have
less downside than big stocks if Europe finds itself in a prolonged
recession.
"Small and mid-caps are more advanced in pricing in a recession than
large caps. You can get them at fairly low multiples and a cheap
valuation," said Emmanuel Cau, head of European equity strategy at
Barclays, whose team upgraded small caps to overweight on June 8.
The bank's small cap basket is invested across sectors, or 'sector
neutral', to make it "less prone to the ups and downs of cyclical
acceleration and deceleration."
Among Barclays’ higher conviction overweight-rated SMID stocks listed in
a note on May 24 are German online food delivery platform Delivery Hero
and UK oil and gas producer Harbour Energy. Their shares are down 18.5%
and 17% respectively since the start of this year.
TURNING POSITIVE
Europe's largest asset manager Amundi recently noted that its clients,
after sidelining smaller caps following years of high volatility and
weak performance, have turned more positive.
"Clients are more interested than usual in small and mid-caps, recently
we got a couple of requests specific to this asset class," said Cristina
Matti, a portfolio manager at Amundi.
Still, investors will be highly selective.
As well as being more cyclical, SMIDs tend to be less liquid than bigger
caps, counting against them when investors want assets that are easier
to sell in a pinch.
Jitters around the availability of credit after March's banking turmoil
has also been a concern, with small and mid caps seen as more sensitive
to credit crunches. But M&A remains a supportive theme, said Amundi's
Matti, as big players seeking external growth can look to the small cap
sector for niche expertise to add to their portfolios.
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The German share price index DAX graph
is pictured at the stock exchange in Frankfurt, Germany, June 14,
2023. REUTERS/Staff/File Photo
"When people are trying to find alpha to add to their portfolio,
small caps tend to be the place to look at," said Matti.
AI RALLY FAVOURS MEGA CAPS Breakthroughs in generative AI have kept
investor attention on mega-cap stocks recently. "We are seeing a
winner takes all, large cap quality angle coming through," said
Graham Secker, chief European equity strategist at Morgan Stanley.
Yet that is also prompting scrutiny of SMIDs from an AI perspective.
Some mid-cap software companies could start to benefit while many
small and mid-caps that don't have the resources to invest in AI
will be at a disadvantage long term.
“We see the opportunity now from here in terms of finding the
smaller and mid cap companies which are going to be both positively
and negatively influenced by these trends,” said Bernie Ahkong,
co-CIO at O’Connor Global Multi-Strategy Alpha, part of UBS Asset
Management.
TIMING IS EVERYTHING
The clincher for a revival of small caps will be economic data
bottoming out, as that could signal the start of a rotation back
into cyclical stocks.
"If we’re right and the European economic data gets worse over the
next three months, now is not the time for investors to buy, rather
they will want to get close to the turn, which hasn’t happened yet,"
said Morgan Stanley's Secker.
Data last week showed the euro zone fell into a technical recession
over the winter.
"You have to be absolutely certain that the prospect of the economic
outlook 5-6 months from now is already well reflected in that
[valuation]," said Thomas McGarrity, head of equities for RBC Wealth
Management.
"Ultimately, they (small caps) are a rich hunting ground for
long-term investors."
(Reporting by Lucy Raitano; Editing by Susan Fenton)
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