Small and medium-size enterprises have been the lifeblood of the European economy, accounting for more than two-thirds of the workforce and more than half of the economic value added
Simply put, small and-mid cap companies provide opportunities outside of large-caps
The MSCI Europe Small-Cap Index is made up of around 1,056 constituents, with an average market-cap of US$1.5bn. The largest constituent is around US$9.3bn – so the index includes companies that have a relatively high market-cap. In contrast, mid-caps, which are represented by the MSCI Europe Mid Cap index, comprise 232 companies with an average market cap of US8.3bn – the largest company being US$30.2bn. This creates an opportunity to access around 1,250 names with the ability to provide far more diversification across both risk and growth compared with large caps, which number around 197 companies as represented by the MSC Europe Large Cap Index - which have an average market-cap of $38bn.
The sheer volume of small and mid-cap opportunities also creates a different blend of companies that are not prominent in large cap indices. This unique blend also means small and-mid cap companies represent different sectors when compared with large caps, which are traditionally weighted towards the large pharmaceutical and financial companies. This is best illustrated in the table below.
A tail of different sectors
Source: MSCI, as at 31 March 2022
Many large-cap names are global companies, which a significant proportion of earnings derived from markets outside of Europe. Consequently, they are often not a pure reflection of economic activity happening domestically, and funds investing in this asset class can better respond to the cyclical differences across Europe. This is particularly beneficial as economies recover from the pandemic and navigate the increased geopolitical risks. Alongside this, smaller and mid-sized companies tend to be at an earlier stage in their development, which can create strong growth opportunities versus large caps, which in the more mature developed market economies, can see their growth path slow.
 Source: MSCI as at 31 March 2022
Small businesses and mid-caps are a key part of the global economy. They create jobs and drive economic development and innovation
Furthermore, small and mid-cap equities in Europe are not a beta play. They deserve a strategic allocation in balanced portfolios and have clearly demonstrated stronger alpha versus large caps over the last five years.
MSCI Small Cap
MSCI Mid Cap
MSCI Large Cap
5-year sharpe ratio
Source: FE Trustnet, in Euros over ten years to 30 April 2022
Risk and liquidity still rules
Two factors that spring to mind with many investors when looking at small and mid-caps is risk and liquidity. From a risk standpoint, if we look at the table below, for a marginal increase in risk, small caps have delivered strong returns over the last ten years.
5-year risk & return
MSCI Small Cap
MSCI Mid Cap
MSCI Large Cap
Source: FE Trustnet, in Euros over ten years to 30 April 2022
There is also the perception that small-caps can be really impacted by market events. However, this is not often the case. When we look at the return of the above asset classes at a time when the COVID pandemic first took hold and began to have a significant impact on global markets, European small-caps lost 6.02% against large-caps, which declined 3.67%. Their down capture was similar to large-caps.
Turning to liquidity, European companies faced unprecedented trading conditions during the height of COVID and this naturally raised liquidity concerns. This can be mitigated through diversification and by building a portfolio with an average capitalisation of €1bn, with the goal of limiting liquidity risk. Companies with strong balance sheets, lower levels of debt and good cash generation, also position them in a more flexible position if there is an economic shock.
Finally, another factor is that small and mid-cap companies are less exposed to passive flows, which can usually drive volatility and liquidity. Because of their size and weighting in the index, larger companies generally account for a large percentage of passive AUM. In turn, this means fundamentals play a larger part in small and mid-cap returns.
The route to stronger ESG
The EU introduced the ‘Sustainable Finance Action Plan in 2018 in order to meet its energy targets for 2030. This led to the EU Taxonomy, a classification system that establishes a list of environmentally sustainable economic activities to develop consistent reporting standards on ESG and climate alongside helping companies become more ESG and climate friendly. Although this only applies to large companies from January this year, along with the new Corporate Sustainability Reporting Directive (required from 2026 for small companies), we believe larger companies will set down similar reporting standards for their supply chains, which tend to be smaller to mid-sized companies – to ensure there is complete taxonomy alignment.
That said, smaller companies are also generally less-well researched, which means their innovation and focus around ESG may be overlooked by the broader market. They also have less resources compared with large-cap companies and often struggle with completing ESG and climate-data disclosures. This provides active managers with an advantage because uncovering the true extend of a smaller company’s focus on sustainability often requires a visit to that company, alongside strong engagement with senior management.
 Small caps represented by the MSCI Europe Small Cap Index and large caps the MSCI European Large Cap Index from 2 March 2020 to 30 June 2020 – on Euros.
Small-caps are far less researched than large-caps. SMid-caps globally are covered by three brokers on average, versus the 15 that cover the average large-cap
However, through our bottom-up research, and travelling to all corners of Europe, we’ve seen first-hand that there are many examples of small and medium sized companies that are leading in the important area of ESG, reflecting their ability to innovate and be more flexible. For example, Strix is the global leader in the design, manufacture and supply of reliable kettle safety controls providing more energy efficiency and developing technologies for improving the quality of water. The company plays a strong lead in the contribution towards managing water stress – a key global issue. The small and mid-cap universe is full of these ESG leaders, and we believe this is an area of potential future value.
Furthermore, so much emphasis is placed on the ‘E’ of the ‘ESG’ – there is usually more information available on environment and governance factors and information on social factors can be relatively scarce. However, from our perspective, small and mid-sized companies play an important societal role. For example, this area of the market plays a vital part in the provision of employment, supplying 2 out of 3 jobs in the EU and Switzerland. They support highly localised economies in Europe through the creation of local jobs, leading to value creation for local households.
Increased resource efficiency, circular economy solutions and participation in green markets represent important opportunities for European SMEs to improve their productivity, boost their competitiveness, register growth and create employment
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