(Bloomberg) -- Falling interest rates and a pick-up in mergers and acquisitions are proving to be a winning combination for Europe’s struggling small- and mid-cap market.
M&A activity for deals below $5 billion has rebounded after three years of underperformance versus blue chips, according to data compiled by Bloomberg. With 240 deals proposed, pending or completed this year, the total is already the highest since 2009.
The surge in M&A is backed by valuations. After years of underperformance, small and mid-caps in Europe trade at price-to-forward earnings levels relative to big caps unseen since the global financial crisis. Historically, the cohort has traded at a premium due to its potential for stronger growth, but for most of the past year it’s been at a discount.
“These companies are trading so low that they are attracting interest from both private equity and trade buyers,” said Hywel Franklin, head of European equities and who manages a European small cap fund at Mirabaud Asset Management. He points to Bridgepoint Group Plc’s €1.62 billion offer for French software group Esker SA and reports of takeover approaches for Spain’s drug manufacturing group Laboratorios Farmaceuticos Rovi SA as recent examples of dealmaking picking up.
Small- and mid-cap stocks typically carry more leverage than their blue-chip counterparts, making them more vulnerable to higher financing costs. Inflation has also hit small businesses harder, pushing investors into safer and more resilient large caps.
Many calls in the past 12 months to reinvest in small caps have resulted in losses for investors who are still reluctant to buy. Sluggish economic growth in Europe has continued to weigh on the group since it is typically more domestically-focused than large international peers.
Alexandre Hezez, chief investment officer at Group Richelieu, says small caps are still a “tough sell” given their recent performance, even though it’s the right macro environment. Gilles Guibout, head of European equities at Axa IM, says the ongoing downward profit revisions ahead of the upcoming earnings season may also weigh on small caps.
But others say the picture for the asset class is starting to improve as inflation comes down and investors ramp up bets that the European Central Bank will accelerate monetary easing. A 25 basis-point cut is widely expected in October, followed by 100 to 125 basis points by July next year, taking the main interest rate close to 2%.
Combined outflows from European small- and mid-cap funds have narrowed since 2022, according to data from EPFR Global. About $161 million has been redeemed so far this year, compared with $9.9 billion and $23.5 billion in 2023 and 2022, respectively.
Small caps are also expected to benefit from the increasing breadth of the stock market, with investors shifting attention to a wider range of stocks and sectors, rather than the handful of megacaps that have been driving returns in the past year.
Alain Bokobza, head of global asset allocation at Societe Generale SA, started advising his clients to prepare for the broadening of the market in June and says the shift is starting to pay off. Barry Glavin, head of equities at Amundi SA, says he’s seen growing client interest in small caps and more dedicated capital allocation.
Deutsche Bank AG strategists Maximilian Uleer and Carolin Raab are confident small caps should significantly outperform larger peers over the next 12 months due to lower financing costs, better earnings revisions and exposure rotation.
“Small caps remain our favorite factor,” the strategists said.
--With assistance from Kit Rees.
©2024 Bloomberg L.P.
