It has not been a good year for equities across the board, with small-cap names struggling to keep pace with their large-cap peers on a year-to-date basis.
To the end of October, the performance of the MSCI Europe Small Cap Index was -25.2% in EUR. This compares to comparatively lesser losses of -12.8% for the STOXX 600 and -11.8% for the MSCI Europe.
But 12 months in financial markets does not tell the full story.
Small caps look good on a 10-year view
Looking across what might be considered a more normal investment timescale, small caps have been impressive. Despite this year's losses, on a 10-year view European smaller companies have registered an increase of 81%, compared to the Stoxx 600 at 44% and the MSCI Europe at 41%.
One problem we often see is investors trying to time their entry point into smaller companies on the fear the segment will underperform large-caps during a market sell-off.
Given how notoriously difficult it is to make correct timing calls, this creates its own problem as small caps typically outperform large caps over the longer term, and the periods where that outperformance is greatest are during recoveries from market lows.
“It’s very easy to miss this turning point as it occurs when sentiment towards risk assets is at its lowest because of near-term outlook concerns.”
2022 has been a year featuring multiple market phases. It started with hopes of further economic recovery from Covid constraints. That optimism was replaced with rising interest rate and inflation concerns, then war, and most recently, a foreign exchange crisis.
The rapidly changing nature of market drivers has made the investment landscape very difficult to navigate.
The fundamental backdrop has deteriorated for equities across the board as a result of commodity price rises and slowing economic momentum.
Destiny sets the path to success
We have found that the key to harnessing return potential has been to find companies that can control their destinies in this environment – in many cases, through being able to control prices and thus protect margins.
Having entrepreneurial and dynamic management can also prove a great help for many smaller companies; we have seen that less complex organisational structures and shorter reporting lines have led many smaller companies to be able to better anticipate the market environment and adjust business practices accordingly.
Still more companies have been able to use corporate activity to opportunistically add to earnings power and emerge from the crisis stronger.
A recovery in economic momentum should help the performance of smaller companies – after all, history shows that the revenue growth of smaller companies is correlated to nominal GDP growth over time. Let us not forget that equities can act as an inflation hedge to a degree, by passing on inflationary increases in costs into their prices, thus growing revenues in nominal terms.
Finding European gems
Many investors believe that the US is head and shoulders above the rest of the world in terms of innovation, but we disagree.
“We are finding innovative companies across Europe, many with excellent growth prospects.”
A good example is the nutraceutical provider PharmaNutra, which through its innovative lipid binding technology can speed up the absorption of medical substances into the body. PharmaNutra's most important area is iron deficiency – a problem that affects more than one billion people a year, and therefore provides a global platform for growth. We see a bright future ahead for the company.
With an inflationary shock of a magnitude not seen in many years underway, there is a lot of uncertainty around the economic outlook.
It is worth remembering, however, that market prices anticipate the future, and it is usually well before earnings estimates stop falling that prices start to recover.
We remain vigilant for small-cap opportunities because where there is fear it pays to be greedy.
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