What drives small cap outperformance?

First, it’s easier to grow earnings from a smaller base. Second, many smaller companies are often nimble and agile, allowing them to respond to changing market dynamics and capitalise on emerging trends. Finally, smaller companies receive less attention from analysts and investors. This can lead to undervaluation and the potential for meaningful price appreciation when the companies deliver.

Why smaller companies don’t outperform all the time

Let’s be frank. Small caps don’t always outperform. For example, the three years to December 2024 were challenging.

This was due to several factors: the rapid rise in inflation and subsequent dramatic climb in interest rates, the war in Ukraine, supply-chain disruptions, and several additional macroeconomic concerns. But there’s another factor at play: index composition.

Over the last three years, a few heavyweight names have driven the large-cap index, with Novo Nordisk, Shell, Novartis, SAP, and HSBC all up over 50%.

By contrast, the sheer weight and diversity of smaller companies mean it’s impossible for a handful of names – no matter how well they perform – to drive the entire index.

This brings us to the importance of an active approach.

An asset class where active investing can thrive

Looking at stock-level returns, on a discrete annual basis, the highest returns primarily come from lower down the market cap spectrum. The chart below shows the percentage of the top-performing 100 European stocks (combining MSCI Europe and MSCI Europe Small Cap) by market cap. As we can see, small-cap outperformers heavily outweigh large-caps. This trend has even been evident over the last three, difficult years.

Skilled active managers can therefore potentially deliver compelling returns. They can pick the winners from the vast, dynamic investment universe. Over the past five years, only 40% of stocks in the European small-cap index have outperformed, highlighting the need to be selective.

The return argument is compelling, but what about risk?

Smaller companies are inherently riskier than their larger, more established peers. Over the long term, however, we believe small caps’ higher levels of return and attractive diversification benefits more than compensate for the additional risk.

Plus, much of this risk is tied to early-stage companies that have yet to deliver a profit or that operate in highly cyclical parts of the market. When you filter out these businesses – as we do – the risk level of the remaining subset isn’t as high as many imagine. Importantly, these companies also have the potential to deliver substantial returns over time.

Diversification benefits

A meaningful allocation to small caps offers significant diversification benefits. Due to their revenue sources and sector allocations, small caps give investors access to different risk characteristics compared to large-cap stocks. Additionally, small caps tend to be more domestically focused than larger peers and often operate in the most dynamic areas of the European market, notably industrials and consumer discretionary.

How much might investors allocate to European small caps?

We believe investors should consider a meaningful allocation to the asset class. Here’s why.

According to Morningstar, only 7% of the total European equity fund assets under management (AUM) are invested in smaller companies, while eVestment data shows only10% of total strategy AUM is invested in small caps. These percentages are below the 14% weight that small caps represent within the broader European equity market cap, as defined by MSCI.

For many investors, small-cap investments are considered an off-benchmark allocation. Therefore, investors must have confidence that an allocation will deliver superior risk-adjusted returns.

Is now the time to invest?

We believe an allocation to the asset class should be long-term and strategic. However, two factors currently heighten the attractiveness of small caps.

Valuations have never looked better

European small caps are the cheapest of all regions, trading at 13.7x 12-month forward price-earnings ratio. This is cheaper in absolute terms than European large caps (currently at a 4% discount) and far below the long-term average premium of 26%. The last time we saw a comparable relative valuation was during the Global Financial Crisis. The outlook isn’t perfect (it never is), but we do think it’s better than in 2008, making now a potentially attractive time to invest.

One common reason clients won’t invest is the belief that ‘Europe is cheap, but lacks growth’. This might be true when considering gross domestic product or large-cap growth. However, smaller companies are different. On a forward-looking basis, European small caps are expected to grow more quickly than global equities while trading at a lower valuation. 

Rate cuts – slowing but falling

Historical data indicates that small-cap stocks tend to outperform large-cap stocks when interest rates fall. This trend is often attributed to the increased growth potential and agility of smaller companies in a lower interest rate environment.

In recent months, however, markets have tempered their expectations on US rate cuts. Many believe that US President Donald Trump’s policies, from tariffs to taxes, could be inflationary and slow the pace of cuts. On the flip side, his policies are also expected to boost economic growth, an environment in which small caps  usually thrive. We shall see. Meanwhile, the European and UK central banks have signalled they will continue to cut rates in 2025.

Final thoughts…

European smaller companies remain underrepresented in investor portfolios. We believe they are missing out. Small caps have outperformed large caps over the long term, with Europe leading the pack. Many small caps are nimble and agile, able to capitalise on changing market dynamics and by responding to the ever-evolving investment landscape. They also offer diversification benefits thanks to their varied revenue sources, with many operating in niche markets not found in the large-cap space.

Risk will always be a concern for investors. However, this can be mitigated through an active investment approach and blended portfolios. A focus on high-quality, profitable companies has also been a profitable strategy.

With current attractive valuations and the potential for outperformance in a rate-cutting environment, we believe now could be an excellent time for investors to consider increasing their holdings in European small caps.