Trend reversal ahead for small and mid caps?

War in Ukraine, a surge in inflation and the steepest rise in interest rates in decades are all factors that led to a widespread risk-off mindset in equity markets. Small and mid-cap stocks were hit the hardest by these developments and they dropped to deeply oversold levels. These market segments always give up the most ground in times of turbulence due to their lower market liquidity and certain challenges in accessing external financing. Valuation multiples are therefore at the historically low levels last seen at the height of the financial crisis in late 2008. Small and mid caps are actually trading at a discount to large caps. This indicates that considerable pessimism has already been priced in.

Comeback potential
Indeed, it does look like small and mid caps could deliver much better returns going forward. The strong performance of European small caps since the end of October is an initial indication of this. Their 13% gain during this time eclipsed the performance of the STOXX 50 index, which advanced only 6%. There is a good chance that small and mid caps will continue to gain ground over large caps. This scenario is supported by the significant decline in inflationary pressure, which suggests that neither the Fed nor the ECB are likely to tighten their monetary policy any further. Meanwhile the general economic environment appears to be relatively stable. In our baseline scenario we anticipate a soft landing in the US and a gradual improvement in economic growth in Europe during the second half of 2024. Macro stability in China and the expected winding down of inventory destocking could also add some tailwind to the anticipated trend reversal in small and mid caps. But there are also risks. A possible recession, new geopolitical challenges or a resurgence of inflation could put the small-cap comeback on pause.

Focus on companies with potential
Our investment approach for our Entrepreneur family of funds is focused on top-quality companies. High margins, distinctive innovation, strong pricing power and attractive cash flows are key criteria in our stock selection process. Particularly interesting are companies with little debt, which lowers their exposure to higher levels of interest and inflation rates. The average net debt to operating profit ratio of the companies in our portfolio is 0.6x, well below the market average of 1.2x to 1.5x. A low level of debt is an important factor when interest rates are trending higher. Lower capital costs, higher cash flows and less need for outside financing become tangible competitive advantages in such an environment. Last but not least, it helps when a company is active in a structural growth market, which adds growth triggers and upside potential to the portfolio. Examples of structural growth themes are nearshoring and reshoring, digitalization, electrification and the transition to clean energy. There are many small and mid-cap companies – tech, manufacturing and logistics companies for instance – that stand to benefit from foreseeably higher levels of infrastructure investment worldwide going forward.

Conclusions
A new capex boom driven by both business strategy and government policy is sweeping the western world. This global infrastructure investment cycle is a mega trend that will stay with us for at least the next decade. Companies that sell the best shovels for this new “gold rush”, be it in the form of innovative technology, must-have services or smart solutions – for example from logistics providers, energy infrastructure companies, or Internet-of-Things specialists – will clearly benefit the most.