Small Caps: an unloved and misunderstood asset class
Outside of Italy we continue to find great opportunities in what’s still a relatively unloved, unknown and misunderstood asset class – small caps more broadly. Investors tend to shun small caps for many reasons, the three most common being: 1) a lack of liquidity; 2) mostly unfamiliar names, which makes investors wary; and 3) perceived higher risk (‘small caps will always underperform large caps in market drawdowns’ is what we often hear).
Let’s take these points in turn. Whilst individual smaller companies can be less liquid than their larger peers, the breadth and depth of the asset class can more than compensate for this. Secondly, it is true that small caps are less well-researched by the sell side, but this increases the odds of them being mispriced, making the asset class well suited for fundamental investors who rely on their own research capabilities to find the best opportunities.
Finally, when it comes to a perception of higher risk, as we demonstrated in a July 2021 blog called “Global Small Caps – Volatility overestimated, diversification potential underestimated”, we showed that over the last four bear markets, small caps didn’t underperform large caps on average, meaning that small caps can outperform in both upturns and downturns, thereby potentially delivering not just higher through-the-cycle returns than large caps but importantly higher risk-adjusted returns too.
Crucially, the results are similar whether you look at global, European, US, Japanese or EM small caps vs large caps. For long-term investors the returns have been exceptional for European small caps, both against European large caps but also against MSCI World.
Great companies aren’t born, they’re grown
All the stock market giants of today started life as a small company – sometimes, even founded inside a garage. In our view, it makes sense for investors to cast their eyes on the often-ignored small cap sector to find the hidden gems.
We believe that the European small cap space provides a fertile hunting ground for active managers like us. But as it naturally consists of more unfamiliar names that are less researched by sell-side analysts, having a consistent investment process with a rigorous due diligence process is vital.
Our aim is to truly understand the businesses behind the names and how they add value to their surroundings. We firmly believe that our focus on value creation for all stakeholders will continue to be a key driver of long-term shareholder returns.
