Small caps outperform over time, now trading at discount to large caps - providing long term opportunities

European Micro Cap, European Small Cap, Nordic Micro Cap, Nordic Small Cap

2020-04-16

Due to the dreadful COVID-19 virus the stock markets have dived, but also to some extent recovered from bottom levels in March. The consequences of the virus are serious for all of us. Several countries are in lock down and the hit on the economy is horrendous. However, the corona cases seem to plateau in both Europe and the US, which gives us a glimmer of hope of seeing the end of the pandemic and return to an open society. 

The sell-off in the markets hit the stock markets severely in a short period of time, especially the smaller companies. Main indices in the world were almost 40% down at worst, but by mid-April, indices pare some of the losses towards -15% for the year in the US, and between -15% and -25% in the Nordics and Europe. Small caps in the US have dived 30% this year, in Europe and the Nordics somewhat less, approximately -25%. When risk aversion is high and liquidity dries up, small caps are abandoned and overlooked as investors flee to safe havens, favouring large caps. 

However, over a longer time period, looking at a hundred years of history in the US small caps outperform large caps by a wide margin (source: Ibbotsons Classic Yearbook). The same phenomenon is visible in Europe and the Nordics during the last 20 years. 

Small Caps

Small Caps: Nearly 100 years of excess returns (Source: Ibbotson Classic Yearbook)

 

Every major underperformance period for small caps has historically proven to be a buying opportunity for the long term. Small Caps trade at a discount to large caps. After the sell-off in March, but also after the bounce in April, smaller companies’ valuation, especially in the Nordics, but also in Europe, are now touching multiyear lows relative to large caps. The valuation gap does not incorporate the absolute valuation levels, but the relative valuation difference between 12 month forward looking PE (price earnings) between small and large caps (the blue line in the chart). In the Nordics the relative valuation gap was at worst wider than in the financial crisis. To some extent the valuation difference is affected by estimate changes and the timing of them. 


Nordic P/E, Small/Mid cap vs. Large caps (trailing and forward)

Nordic

Source: Factset, Handelsbanken Capital Markets

Europe P/E, Small/Mid cap vs. Large caps (trailing and forward)

Europe

Source: Factset, Handelsbanken Capital Markets

 

Timing is always difficult, but looking at history, an investment in turbulent times should favour the long-term investor. 

Why invest in smaller companies:

-Better returns over time

-Smaller companies often driven by entrepreneurial, active and long-term owners 

-Smaller companies have larger opportunities to grow vs larger companies

-Despite higher growth over time smaller companies are now priced at a clear discount to large caps, i.e. investors do not expect to get paid for the risk taken by investing in smaller companies

-Smaller companies are often poorly covered by the investment community leading to opportunities for investors doing their homework

 

Fondita’s small cap funds:

Fondita Nordic Small Cap

Fondita Nordic Micro Cap

Fondita European Small Cap

Fondita European Micro Cap

 

Our Funds