Jun 03, 2019 Equities

German small and mid-cap – opportunities beyond the mainstream

If investors ignore smaller companies, they are overlooking opportunities for above-average gains. As second-tier equities are often volatile, it makes sense to build a solid foundation with standard shares.

  • Standard shares provide a sound basis for any portfolio. But anyone seeking higher returns cannot afford to ignore second and third-tier companies.
  • This sector has specialist companies in attractive niches with greater growth potential.
  • Fund managers, who research equities intensively, can discover interesting investment opportunities that the broader market has not yet spotted.
4 minutes to read

If you want to invest in German shares, you are spoilt for choice. Over 400 companies on the Frankfurt Stock Exchange vy for investors. Of these, not quite half have made it into one of the well-known indices: the Dax (30 standard companies), MDax (60 medium-sized companies), SDax (70 smaller companies) and TecDax (30 major technology companies). Companies’ market capitalisation, trading volume and, for TecDax, sector determine whether they are included in an index.

Is small beautiful?

The Dax, which comprises world famous German conglomerates, typically gets the most attention. But the small and mid-cap indices have no need to hide behind their big brother. Quite the reverse. Over three, five and particularly ten years, the MDax, SDax and TecDax have left the Dax standing in terms of performance.

  TecDax MDax Dax 30 SDax
04.2014 - 04.2015 30.79% 26.33% 19.28% 17.67%
04.2015 - 04.2016 1.18% -1.06% -12.36% 4.36%
04.2016 - 04.2017 28.82% -18.34% -19.29% -17.65%
04.2017 - 04.2018 25.43% 5.49% 1.40% 14.96%
04.2018 - 04.2019 10.89% 0.30% -2.13% -4.23%

Past performance is not a reliable indicator of future returns; Source: Bloomberg L.P., DWS International GmbH, as of April 30, 2019.

Exchange-listed family-run companies where the founding family holds sway often have stronger growth than large companies with a broad investor base.

The smaller-cap segments of the stock market include many companies with above-average growth potential. Due to their smaller size, they can adjust more quickly to new market trends and they are often pioneers of major disruptions. Many of these companies are privately owned medium-sized enterprises that may have come to the stock market to cover capital needs but where the founding families still often call the shots. This can be a big advantage. According to a study[1] by the Leibniz Centre for European Economic Research (ZEW) and the Research Institute of Small and Medium-Sized Companies and Entrepreneurship (IfM) at the University of Mannheim, family-owned businesses grow more dynamically than large companies with fragmented capital holdings.

Major potential for growth

Another attraction of smaller-cap equities is that some have become global market leaders in their niche. There are several examples of this in mechanical engineering, one of the sectors where Germany excels. The public has often barely heard of these companies, but they have achieved an almost unassailable position in their own market segment, and there is strong demand for their products abroad. And a business that is a minor but innovative small cap today, may become a major player on the world market in future. After all, everyone starts small.

On the other hand, niche players make for riskier investments. In contrast to big companies, smaller firms’ low level of diversification means they are vulnerable when business segments or markets disappear, or when competitors gain market share.

Opportunities may arise because small and mid-cap businesses are largely ignored on the capital markets. Many banks have cut back on analysing them or completely stopped due to regulatory controls. You are more likely to find investment opportunities that promise above-average returns if fewer investors are interested in certain companies.

Treasure hunting beyond the mainstream comes at a high cost. It takes substantial resources to understand and evaluate fully a company, its sector, the market and the competitive environment. There is also a dearth of available information on many companies. Funds, which have specialist securities analysts and follow a disciplined selection process, can provide a good solution. Close contact with businesses over the long term is also an advantage when it comes to picking the right shares. Fund managers who meet with companies’ senior management can evaluate aspects of the business that are not reflected in the numbers. Is the company's management up to the task before them? Does the company’s strategy still reflect the demands of the market? How sustainable are the company’s operations?

Uncovering trends, avoiding fashions

Another way to early identify promising shares is by recognising structural trends and themes that enable growth regardless of the economic cycle. There could, for example, be big opportunities in artificial intelligence and in the biotech and medical technology sectors, or in the Internet of Things and in applications that digitise industrial production (Industry 4.0).

Small and medium-sized companies are often overshadowed on the stock exchange by standard large-cap equities. As a result, experienced equity analysts can uncover promising opportunities.

The search is not for fashionable shares, based on short-term hype, but for solid companies that can maintain a successful market position in the long term.

So, it is not just a case of simply following the latest fashion. Fashionable shares, such as Internet stocks in the early noughties and wind power and photovoltaics later, may promise high gains in the short term, but there is always a risk that the success story will end in tears when fashion moves on and business models are exposed to critical analysis.

Always keep looking ahead

Good fund managers don’t just differentiate long-term investment opportunities from short-term hype, they also take an active approach and don’t just follow a market index. Otherwise, there is a risk of betting too heavily on past winners and overlooking new opportunities. The same rule applies to smaller-cap securities as to all other shares: they offer opportunities, but not without risk. If the entire market begins to slide, even exemplary companies can see their valuations impacted. Long experience is a decisive advantage in such difficult market phases.  The DWS equity team, which has investment analysts who bring an average of over 16 years' professional experience to the table, has proven expertise in both standard and second-tier equities. The DWS Germany Fund has, for example, regularly been ranked among the top ten in performance tables over various time periods.

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1 . https://www.zew.de/de/presse/pressearchiv/familienunternehmen-sorgen-fuer-mehr-beschaeftigung/

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