(News Bulletin 247) – After more than two years of underperformance, small and mid-caps are suffering from an excessive discount. The start of a more accommodating monetary cycle and a gradual improvement in macroeconomic indicators argue in favor of a recovery in European small and mid-caps.

Well underway since the start of the year, the awakening of small and mid-caps has been somewhat disrupted by the latest political developments in France. These values, which are more exposed to the French economy, suffered a serious blow after the surprise announcement of the dissolution of the National Assembly by Emmanuel Macron on Sunday June 9.

Over the week of June 10, the CAC Mid&Small index, the flagship barometer of this universe of values ​​on the Paris Stock Exchange, lost 9.2%, while its little brother, the CAC Small, lost more than 11%.

This mini stock market earthquake comes at a time when the ground is more favorable for a stock market recovery of small and mid-caps, a universe of values ​​which is still lagging behind large ones.

The European Central Bank (ECB) has just initiated a first rate cut at the beginning of June, which should benefit small and mid-caps, underlines Oddo BHF.

The management company recalls that the ECB had carried out “a cycle of increasing interest rates the fastest and most extensive in the history of Europe”, which was then detrimental to these companies because they generally finance more of their growth through borrowing than large caps. In a previous article, we described other reasons for the underperformance of small and mid-caps.

Double-digit outperformance potential

Still from a macroeconomic point of view, the latest statistics published in Europe also speak in favor of small and mid-caps. Laurent Denize Co-Director of Investments at Oddo BHF cites the recent improvement in purchasing managers’ indices, which provides a new signal of rising prices for small and mid-caps.

“The fact that European small caps have not yet integrated this recovery in PMIs should amplify the rebound further,” continues the specialist.

Especially since small and mid-caps are currently operating at relative valuations close to the lowest in 20 years, notes Oddo BHF.

The manager reports that European small and mid-cap stocks trade at a 12-month forward price-to-earnings ratio of 12.5, a discount of around 5% to large caps. “However, over the past 17 years, the Stoxx Mid 200 has traded at a 12% premium to the Stoxx Large 200, compared to a 4% discount today. For the Stoxx Small 200, the historical average is a premium of 17%, compared to a discount of 6% today”, adds Laurent Denize.

In this context, “the discount of small and mid-caps compared to large capitalizations has reached such a point that a return to the mean seems inevitable, particularly in Europe”, also points out the specialist, who therefore expects this that small and mid caps are once again trading at a premium to large caps. According to him, this catch-up movement on the stock market would imply a potential for double-digit outperformance.

The return to favor of small and mid-caps

According to Oddo BHF, earnings growth revisions are a key signal for investors wishing to return to the small and mid-cap segment.

In Europe but also in the United States, operators have every interest in being optimistic since profit estimates are revised upwards, to levels much higher than for large caps. In Europe, Laurent Denize indicates that estimated earnings per share growth for 2024 is expected to increase by +8% for small caps and +13% for mid caps, compared to less than +3% for large caps.

“All these elements suggest that the long journey through the desert of small and mid-caps is behind us,” hopes the specialist.

Caution in France

Laurent Denize considers the moment opportune to return to the small and mid-cap segment, although with a preference for mid-caps over small ones. He justifies this choice by a stronger earnings per share growth dynamic among the averages, with similar valuation discounts. Mid-caps also have healthier balance sheets, with net debt/Ebitda levels 10-15% lower than those of small caps.

Regarding geographic areas, Oddo BHF tactically favors Europe over the United States, citing in particular “greater confidence” in further rate cuts from the ECB than from the American Federal Reserve, which is not expected to lower rates before September.

From a sectoral point of view, the management company recommends “being selective” and favoring sectors which should benefit from the economic recovery and the fall in interest rates. She cites in particular the industrial, health, technology, non-essential consumer goods and basic materials sectors. On the other hand, Oddo BHF is underweight the highly indebted real estate sector, banks (which have benefited from high interest rates) and more defensive sectors.

What about French values ​​which suffer from uncertainty on the political front? The management company opts for caution. “European small and mid-caps make sense, but not the French ones. When we talk about France, it is not only a question of being part of French indices, but also of their proportion of income in France,” believes Oddo BHF. “If opportunities arise after the elections, there will always be time to seize them,” concludes the management company.