Euro SMIDs - Are they unusually cheap versus the rest of the market?

With many of the market’s biggest names powering the rally in European equities, there has been much talk over recent weeks about whether European small and mid-caps look cheap compared to their large peers. Niall Gallagher analyses the long-term structural factors at play, suggesting that, while SMIDs are attractively valued, they really are no cheaper than their larger counterparts.

04 July 2024

One question several clients have asked me recently is whether European Small and Mid-caps (SMID) offer exceptional value in the context of the broader European market. Perhaps this is because they have SMID managers knocking on their door offering “very cheap” European SMID funds and a half-decent story as to why now is a great time to invest in Euro SMID.

At GAM we are fairly sceptical that there is a severe market capitalisation dislocation within European markets. And that is reflected in our positioning; if we thought Euro SMID stocks were especially interesting or exceptionally cheaply valued, we would be overweight the 4th and 5th quintile of market capitalisation versus the MSCI Europe Index – but we are not. So, our short answer is no, we do not think Euro SMID is particularly cheap or interesting versus the rest of the market. But we think it is worth explaining the answer we have been giving to clients, as well as showing some data that proves the point. This article is divided into two parts – a short and straightforward performance / valuation part that shows some simple data to back up our point, and then a longer, more structural section that explains why we would be cautious around European SMID, and why many aspects of markets often have structural dimensions.

The short data bit

Let us first consider the ‘cyclical’ position – even with / without structural headwinds, are European SMID stocks especially cheap or dislocated versus the rest of the European equity market? Figure 1 shows a range of valuation metrics over the longest period we could find, while Figure 2 shows a range of performance and profitability metrics. These two figures in combination demonstrate several points:

1. Taken over a very long period – since 1990 – Euro SMID does not appear to be cheap compared to European large-cap equities on price/earnings and dividend metrics but rather about in line with the long-term average values. Indeed, if anything, large-cap stocks were cheap versus Euro SMID until about 2022 when the valuation of large caps caught up with the normal / average valuation metric to Euro SMID. Historically, large caps traded at a discount to Euro SMID and now trade at a small premium but the difference between them from the long-term median relationship is small and certainty nowhere near as large as the premium large caps traded to versus Euro SMID in the late 1990s.
2. There has been a large positive inflection in the Return on Equity (ROE) of large caps (bottom right chart in Figure 2) and this accounts for large caps seeing an expansion in their Price-to-Book multiples versus Euro SMID (bottom left chart of Figure 1). This inflection in large cap ROE is due to significant profitability expansion in the European banking sector (a large cap sector) but there are other factors at play here too, such as the extraordinary growth in the profitability of a handful of mega cap stocks such as Novo Nordisk, ASML etc – a parallel to what is going on in the US equity market.


3. Perhaps of most interest is the performance data in Figure 2 which shows that there are prolonged periods when large caps outperform Euro SMID, and vice versa. One can think of the 1990s when large-cap stocks outperformed Euro SMID during the dot.com bubble and then the reversal from 2002 to 2022 when Euro SMID outperformed large cap stocks for a very long time. Indeed, the underperformance of Euro SMID to large caps is recently challenging the assertions of those who claim that SMID is trading at distressed levels and is a global outlier within asset markets. If we are in another long cycle where, for a variety of global reasons, profitability is accruing to a narrow part of the market then large caps outperforming Euro SMID may only just be starting and, as the data shows, these trends can last for a decade or more.

Figure 1: Valuation of European large cap versus SMID

Figure 2: European large cap versus SMID

The structural bit

This section is rather longer, but there are some very important structural phenomena for asset allocators / owners to think through before any allocation favouring Euro SMID; these factors certainly influence our decision-making when it comes to allocating capital within our European portfolios. There are several structural reasons why we believe Euro SMID has begun to underperform in recent years and why this may continue:

1. Over the last two decades – but accelerating in the last decade – Europe (inc. UK) has seen a significant de-equitisation within asset-allocating institutions, such as pension funds and insurance companies, in aggregate, reallocating a large portion of their assets away from equities towards bonds. This has happened across insurance and pension industries but has been most pronounced in the UK where the gigantic private sector Defined Benefit (DB) sector with circa USD 1.8 trillion in AUM has (almost) entirely closed to new members, due to a combination of truly terrible government policies, excessively conservative actuaries and bad accounting standards, the result of which has been to force a large-scale switch out of equities into fixed income securities. Putting this into numbers, over the past 25 years the share of private sector UK DB pension AUM invested in equities has fallen from about 75% to 15% - a 60% swing in assets representing over USD 1 trillion in today’s money and equivalent to about a third of current UK GDP. The bulk of this 60% shift from equities to bonds has come from UK equities – and this has received much political and media attention in recent months in the UK – but it should be noted that UK private sector DB schemes were also historically large investors in Europe ex-UK equity markets, with a circa 10-15% allocation of AUM to that asset class, so there has also been a ‘draining’ of liquidity from other European markets caused by this UK private sector DB scheme de-equitisation. On top of this the insurance sector – across much of Europe – has significantly de-equitised in response to changing regulations such as Solvency 2 and others, and the centrality of large European insurance companies such as Allianz and Generali to national stock markets has gone. The net effect of this large scale de-equitisations from large institutions, combined with a low household propensity to own equities / invest in equity funds, has been to significantly reduce the demand for European equities.


2. Over the last 17 years – since the Global Financial Crisis (GFC) – there has been a very pronounced shift away from active to passive equities within equity allocations in Europe, with the passive share growing from circa 15% at around the time of the GFC to over 40% now. Shifting from active to passive equities in the context of market cap-weighted benchmarks concentrates ownership in the largest part of the equity market and drains liquidity from Euro SMID. Active managers typically have an overweight position in SMID versus market cap-weighted benchmarks while passive funds clearly do not.


3. In more recent years there has been a shift away from regional equity fund allocations by asset allocators towards global equity funds. Again, this action concentrates capital in many of the largest companies, in this case US-listed technology businesses, and drains liquidity from SMID parts of the market, especially Euro SMID if the shift is out of Europe / UK active equity funds into global equity funds. This has been most pronounced in the UK market in both institutional (ie pension), wealth and retail channels but it is evident elsewhere too, to a lesser extent.

The net effect of these phenomena has been to extract a large amount of natural demand from European equities (inc. UK) and to concentrate the remaining equity capital into many of the largest European and global companies. Stocks such as ASML, Novo Nordisk, LVMH, L’Oréal etc continue to attract buyer demand from a combination of global equity funds (passive and active) and European equity funds (passive and active) but Euro SMID has far lower natural buyer demand with typically only dedicated European active equity funds and a small amount of household buying demand available. These are completely insufficient to replace the loss of large-scale institutional buyers and the lost European active equity funds. Of course, this is a broad generalisation across the entire European continent, and some countries – the Nordics and Switzerland – have a more dynamic local investment culture in their domestic stock markets, but low equity allocation across many large countries (UK, France, Germany, Italy, Spain), combined with large institutional extraction from equities by the huge UK private sector DB schemes and European insurance companies has severely reduced buyer demand for Euro SMID.

The following two charts are from a very interesting report from the New Financial think tank and are for the UK market only (the data and the analysis within their report has attracted a lot of attention in the UK). The first chart illustrates some of these points very well, with a dramatic reduction in equity allocation and a wholesale scaling-back of UK stock market ownership within the UK. While the UK is one market only, it has historically been a very outsized source of capital for European capital markets and a large equity market in its own right. So there is both a very strong UK equity market impact of this shift and a somewhat significant impact on other European markets.

Figure 3: UK market shifts in asset allocation

The second chart illustrates the point that for the remaining ‘open’ pension schemes – public sector DB schemes and private sector Defined Contribution (DC) schemes - only a very small amount of the equity total is now in local equities. This is obviously bad for UK equities, but it is likely that the non-UK equity allocations are now largely to global funds whereas previously the allocation would have been regional.

Figure 4: Breakdown of UK fund capital allocation

The final chart illustrates two points: first, the very low allocation of equities by European households versus US households; and second, a staggering fact that almost half of European equities are owned by non-Europeans nowadays. Indeed, if we strip out ‘non-financial corporations’ (ie move to free-float adjusted by taking out foundation / family ownership of listed companies) it appears that US investors (individuals and institutions) own more of European equities than Europeans (individuals and institutions) do! Given that overseas investors are far more likely to buy the largest, most global companies, this illustrates the growing bias away from, and lack of buyer demand for, European SMID.

Figure 5: Household ownership of equities in Europe and Euro area equity ownership

Is it possible that we have overplayed these structural phenomena and that more active capital could come back into Euro SMID if the cyclical conditions are right? Might we also see a lot more active engagement by private equity firms buying cheap Euro SMID stocks, as is happening in the UK? This is possible but we think a more significant policy response is required at an ‘official’ level to spur a longer duration pick-up in demand in Euro SMID and we do not see any evidence for this.

Pulling it all together we find it hard to support the assertion – that some are making – that European SMID stocks trade a significant discount to European large cap as it is simply not supported by the data. We think it is correct to state that European SMID is attractively valued – but no more so than European equities in general – and there are structural reasons to be cautious on European SMID given the composition of European and global savings.