European small caps have experienced a notable decline of 13% since the close of 2021, in stark contrast to the 11% rise observed in large caps. This divergence, primarily attributed to a derating spurred by central banks initiating rate-hiking cycles, has positioned small caps at a 4% discount relative to their larger counterparts. This relative valuation marks one of the lowest points since the Global Financial Crisis, as outlined by strategists at Goldman Sachs in a recent note.
Against the backdrop of an impending rate cut by the European Central Bank (ECB) in June, alongside robust Q1 GDP growth and an uptick in merger and acquisition (M&A) activity, investors are deliberating whether it’s opportune to delve into small-cap investments. However, Goldman Sachs strategists remain cautious, expressing doubts that the modest sequential growth acceleration will suffice to bolster small caps’ outperformance, especially in light of delayed rate cut forecasts by the Bank of England and the Federal Reserve, now projected for August and September, respectively.
Despite this cautionary stance, Goldman’s strategists have pinpointed four areas where investors may unearth opportunities within the realm of small-cap stocks.
Firstly, attention is drawn to leveraged buyout (LBO) targets, with two specific screens delineated within this category. The initial screen focuses on small and mid-cap companies (with a market cap under €10 billion) boasting lower net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA), a reduced valuation premium relative to the norm, and a higher return on equity (ROE) compared to sector medians. The second screen hones in on companies exhibiting lower net debt to EBITDA, a discounted valuation, and a lower ROE compared to sector medians.
Furthermore, Goldman’s strategists perceive promise in real estate and technology laggards, particularly if bond yields undergo further descent. These sectors, which exhibit sensitivity to interest rates, could witness significant upside in such a scenario. Notably, real estate small caps demonstrated robust performance earlier this year amid declines in bond yields.
Additionally, UK small caps emerge as a compelling catch-up trade opportunity. The UK small-cap index has languished since the close of 2021, primarily attributed to its exposure to consumer discretionary sectors and the postponement of anticipated rate cuts by the Bank of England. With the prospect of improved economic activity in the UK and potential declines in bond yields, UK small caps, especially within real estate and consumer discretionary sectors, could showcase outperformance.
Lastly, Goldman’s strategists spotlight small caps presenting the highest price upside, as indicated by 12-month target prices from equity analysts. These companies hold potential for notable gains based on analysts’ assessments.