Europe’s investment landscape has changed. Investors’ perceptions of risk and reward, which had been shaped by more than 10 years of outperformance by small and mid-cap stocks, may need to be jettisoned. Large-cap stocks, which had been overlooked as rather dull in comparison to their allegedly racier smaller company counterparts, present a powerful combination of quality and value that should offer superior relative performance in both today’s highly challenging market conditions and quite possibly for many years to come.
Recent years have proved to be fruitful for European small and mid-cap stocks. The performance of stocks from the small and mid-cap areas of the market before 2008 has been so strong that for some investors they have become synonymous with the notion of alpha; large-cap stocks, in contrast, have come to be regarded as offering a less dynamic pattern of returns.
Anecdotal evidence of investors’ contrasting attitudes to small/mid and large caps bears out this observation. A survey conducted at a recent conference found that while the majority of respondents say European small/mid caps will underperform the broad market over the next 12 months, almost all surveyed felt that European small/mid caps will outperform over the next 10 years. This is despite the fact that a broader 20-year horizon shows that European large-cap stocks have outperformed their smaller counterparts over time (see chart).
The outperformance of European small and mid-cap stocks over large caps in recent years owes much to an investment environment that has since altered radically. In a world of low volatility, investors’ perceptions of risk were diminished. A favourable macroeconomic backdrop of low and stable interest rates and low inflation, combined with a world awash with liquidity, led to fertile conditions for small and mid-cap stocks. In many ways, however, it was a case of a rising tide lifting all boats; investors did not necessarily have to distinguish between companies on grounds of quality, which was to the advantage of many small and medium-sized companies.
Those benign conditions have gone, replaced by heightened volatility, much higher levels of risk aversion and a far tougher earnings environment. In this new world, identifying the winners and avoiding the losers becomes a greater challenge. Investors need to be far more discerning than they were during the bull market of 2003-07, when share prices benefited from a powerful wind at their backs. Now investors need to focus on quality. And it is large-cap stocks that tend to exhibit higher quality across a range of factors.
Larger companies typically generate higher levels of free cash flow, enjoy higher profit margins and produce superior returns on capital employed than mid and small-cap stocks, which can destroy value at the bottom of market cycles and are generally more cyclical in their overall returns. Large companies also tend to benefit more from high barriers to entry, have superior asset quality, sounder strategic positioning, more sustainable returns and stronger company management than their smaller company counterparts.
The improving relative fortunes of large-cap stocks versus small and mid-cap stocks will probably not be a short-term phenomenon either. Any assumption that the valuation premium exhibited by European small-cap stocks versus large-cap stocks will unwind quickly could prove misplaced. The valuation premium of small-cap stocks over large caps may have started to narrow in the past 12 months, but there is still a long way to go before small caps look inexpensive relative to large caps.
Experience of investing in Europe confirms the relative appeal of large caps over their smaller brethren. Small and mid-cap stocks are generally more expensive than large caps, yet the companies concerned have weaker balance sheets, less impressive management teams and more cyclical and less sustainable business models. Instead, we are continuing to find many interesting investment opportunities in the European larger-cap arena.
OPAP, a Greek gambling company, which has a monopoly within the Greek gambling industry, is one such example. The stock offers an attractive mix of growth and value, benefiting from the company’s dominant market position, its robust growth rate, the stock’s high dividend yield and the introduction of new and experienced management.
The eurozone economy is in a downturn. However, on a relative basis, core Europe looks better placed than many other developed economies for the far tougher global economic environment that we face. Households in Germany, France and the Netherlands benefit from far superior savings ratios and entered this slowdown with much lower levels of debt than their British counterparts.
These core European economies have lower rates of inflation than America and Britain and, in the case of Germany and the Netherlands, current account surpluses rather than deficits. Furthermore, Europe’s corporate tax environment has become less punitive. An improving dividend culture has taken root as European companies become more shareholder-friendly and dividend policies become more explicit.
European large-cap stocks are better positioned than smaller European companies for relative outperformance in this tougher economic and market environment. Despite selling off heavily over the past year as risk aversion levels have risen, European small and mid-cap stocks still look overpriced relative to large-cap stocks on an historical basis.
Large companies have a proven capacity to generate more sustainable returns through a full market cycle, while the levels of debt on the balance sheets of Europe’s larger companies are low for this point in the cycle.
Other advantages, such as ability to profit from barriers to entry and generally more able and experienced management teams, suggest European large-cap stocks are likely to benefit from an environment where the strong will become stronger.