18. Jun 2019 Equities New

Small stocks, big opportunities

Small caps are often relegated to the margins. Unjustly. For they can often more than hold their own with larger caps.

  • European small caps have performed considerably better than the shares in large companies over the last 20 years.
  • Small caps present no higher risk than large blue chips.
  • The second-tier market has niche providers with an excellent competitive position in areas with high market entry barriers.
4 minutes to read

To select the right shares, many investors still use the motto: big is beautiful. Many private investors’ portfolios are stuffed full of the big blue chips: companies in the Dax 30, Euro Stoxx 50 and US Dow Jones Index dominate the picture. No wonder - after all, these are the companies that are regularly covered in the media.

But sometimes it’s worth thinking outside the box. There are many companies outside the mainstream that could be of interest to investors. In Germany, these companies are contained in the MDax and Sdax small-cap indices. For Europe, second and third-tier shares are found in the STOXX Europe Small 200 and STOXX Europe Mid 200. These indices map the 200 smallest and medium-sized companies from the comprehensive STOXX Europe 600. 

Small caps have outperformed blue chips over the past 20 years

A long-term returns comparison reveals how significant small caps’ potential is. The STOXX Europe Mid 200’s performance exceeded that of large companies by 146 percentage points over a 20-year period, for example. Small European equities in the STOXX Europe Small 200 index did better still, outperforming the big names by 167 percentage points.

The STOXX Europe 600 tracks the performance of 600 stocks from 18 European countries.

Performance of the last 12 months

STOXX EUROPE SMALL 200
Net Return Index

STOXX EUROPE MID 200
Net Return Index
STOXX EUROPE LARGE 200
Net Return Index
05.14 - 05.15 19.5% 22.3% 19.5%
05.15 - 05.16 -6% -4.4% -11.4%
05.16 - 05.17 17.2% 17.3% 15.7%
05.17 - 05.18 6.7% 7.9% -0.1%
05.18 - 05.19 -4.5% -5.6% 1.3%

Past performance is not a reliable indicator of future performance; As of: May 31, 2019; source: DWS Investment GmbH, Thomson Reuters Datastream, monthly data

European small caps have a similar risk profile to large blue chips.

Small-cap risks are overestimated

Interesting to note that this result can often be achieved with slightly lower risk. Since 2000, the average 30-day fluctuation range – the volatility -- was 16.1 for the STOXX Europe Small Caps index and 17.5 for the large companies in the STOXX Europe Large 200, respectively[1].

"The widespread fear that investors in smaller stocks are introducing more risk to their portfolios is therefore unfounded," says Philipp Schweneke, head of European small/mid caps at DWS. "However, for that to apply, investors should not put all their eggs in one basket, but instead spread their risks, for example by investing in funds."

How small businesses score

There are good reasons why returns from small companies can be better than those from larger corporations. There are many highly specialised niche providers among small caps, which the public has barely heard of but which are extremely successful in their own market. Often referred to as 'hidden champions', such companies have established a dominant market position in their segment over many years and continue to build on that. Many have superior technology, which is well protected by patents, a well-known brand or a service that is hard to copy. "It is extremely difficult for competitors to gain a foothold in a market like that and put pressure on the incumbent," explains Schweneke. This creates perfect conditions for profitable growth and positive stock-market performance.

Another reason why small and medium-sized companies tended to have better long-term performance in the past is that they are easier to control. "Greater management influence and better corporate governance structures should have positive long-term effects on companies’ development," says Schweneke.

In search of undervalued stocks

But how do you find the right stocks among a multitude of companies? Schweneke, who manages DWS European Opportunities, relies on exhaustive corporate analysis and close market monitoring. "Small caps are monitored by many fewer analysts than large companies[2]. That means specialists have a better chance of encountering undervalued stocks."

The eight-member small caps team at DWS usually does not rely simply on studying company data when conducting its analysis. It normally evaluates companies personally. "We often receive important background information during our discussions with management and we can also get an idea of the quality of the management team," says Schweneke.

Fund managers also study the market for companies that could be takeover candidates. That normally also drives a company’s stock-market performance. And there can even be extraordinary return opportunities for investment professionals when new companies are floated on the stock market.

What are the advantages of small cap funds?

According to Schweneke, the potential of Europe's small caps has not yet been fully exploited. "Many investors are not currently aware of Europe's small and mid caps, even though they make up around 80 percent of the European stock market,” he says. “We also believe in the recovery potential of the European economy, which has recently lost some ground to the US."

However, it is not very easy to keep on top of the market because of the large selection of companies in Europe. But private investors still have the chance to benefit from the opportunities that Europe's small caps have to offer through funds.

Almost three-quarters of European small caps are monitored by a maximum of five analysts, more than 20 percent are not monitored at all.

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1. Source: DWS Investment GmbH, Thomson Reuters Datastream, as of: May 2019

2. Source: Morgan Global Small & Mid Cap View December 2018

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