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Why invest in small caps?

  • Damien Kohler Manager of the Asset Management team
  • Paris
  • 20.12.2018

Small caps are companies with a relatively low market capitalization. For investors, these assets are riskier than large cap companies, but they are also more affordable and may offer better performance. Damien Kohler, Manager of the Asset Management team at BNP Paribas Asset Management, explains more.

What is your position at BNP Paribas? 

Since 2006, I have managed the European Small and Mid Cap Asset Management team at BNP Paribas Asset Management. Over the years, my team and I have become one of the leading managers of this asset class. Indeed, we currently manage nearly €6bn in assets. This result is the fruit of our constant commitment, as well as our rigorous and robust investment process, while we are also honored with the continued trust of our ever-expanding customer portfolio.

What can you tell us about European small and mid caps, specifically the small cap market? How do you define them? 

These are assets of “small” size, meaning the size of their market capitalization. We can include market capitalizations ranging from €500m to several billion euros. But these assets are not defined solely by a fixed range of market capitalization. In fact, their value depends on market fluctuations and evolves in response to new IPOs, stock purchases on the market and rising stock prices. They may change in status and become mid or large cap values. There are also benchmark indices that attempt to collect these stocks into coherent groups.

These assets are also numerous (the MSCI Europe Small Cap index notably includes nearly 1,000 of them). These stocks have less liquidity and receive less coverage from market analysts. All these attributes point to the difficulties we have to overcome to get a handle on these types of investments and their potential. So much so that it is important for us to be extremely well organized and vigilant, notably in terms of liquidity risk. Nevertheless, a growing pool of investors have taken an interest in this field because it represents a goldmine of attractive stocks for their growth profiles.

Small and mid cap assets continue to outpace the benchmark indices in Europe. How do you explain this phenomenon?

That’s true! If we look at how the MSCI Europe Small Cap (dividends reinvested) has performed in comparison with the MSCI Europe (dividends also reinvested) from late December 2000 through September 2018 (meaning over a long period), the Small Cap index has gone up 324% compared with 64% for the Large Cap index. In other words, the MSCI Europe Small Cap generated an annualized rate of return of nearly +8.5% per year over that period, compared with +2.8% for the Large Cap index.

Clearly, it is not the region’s economic performance that is driving this spectacular performance, since the region has faced a number of crises. It is largely due to the growth profiles of European small caps, meaning the specific features of their economic models.

In short, the main reasons we find more growth profiles among European small caps relate to the following elements:

  1. Niche companies operating frequently in unsaturated markets that deliver high organic growth potential (the best growth!).
  2. Companies that tend to invest more than large caps (relative to their size), which explains their superior long-term growth prospects.
  3. Managers whose assets often focus primarily on the capital they hold in these “small” companies, which spurs them to increase the value of their investment by advancing/growing their company’s fundamentals and profits.

Despite the fact that, during large stock market corrections, their lack of liquidity can cause the performance of small caps to lag, we believe this asset class remains a fundamental part of any portfolio, while presenting solid reasons to deliver strong performance over the long term.

What advantages do small caps offer to investors?

As I just mentioned, their benefits lie essentially in their attractive growth profiles. In fact, growth is a rare quality in developed economies, especially in Europe. For this reason, at the cost of higher volatility than large caps, small caps can offer investors substantially higher performance than large caps, in the long term. That’s what makes them so interesting for investors, if not essential, and even for large caps themselves. The latter do not hesitate to acquire small caps (through tender offers) to revitalize their own growth. 

France has enacted tax incentives to encourage investors to support innovative small companies. Have other countries taken similar measures?

Small companies are major employers within the national economies where they are located. Moreover, they pay all their business taxes, with no real means to avoid paying domestic taxes (unlike large caps such as the GAFAs). So it makes sense for governments to help them secure financing on the market. In fact, they have less access to financing than large companies.

Photo : ©pattilabelle

Small caps are frequently the object of mergers and acquisitions. What role do these operations play in the growth of the small caps market?

Mergers and acquisitions serve more to correct undervalued assets. They do not actually function as growth drivers for the small caps market. They help to put small caps in the spotlight. They also help to educate investors about the interest and characteristics of these assets. On one hand, we are thrilled to see some of the stocks in our portfolio receive a tender offer. In an instant their share price achieves the market performance they should have reached two or three years later. On the other hand, these same tender offers deprive the market (and our portfolios) of stocks that will need to be replaced. That takes time and extra research. 

What small cap investment vehicles does BNP Paribas offer? 

We have two main small cap funds: one invests in small caps across Europe (Parvest Equity Europe Small Cap, which received a five-star rating from Morningstar in late November 2018*) and the other invests in small caps from the eurozone (BNP Paribas Smallcap Euroland). These are two large funds (compared with most competitor offers). They benefit from a performance history that I would describe as long and strong. Their large size also provides investors with a relatively high level of liquidity when they subscribe and buy their shares. This also provides an additional source of confidence. These funds have received such a high level of investment because so many investors have confidence in us. 

How do you see the future of small caps? 

We look at the future of small caps in a favorable light. This is an asset class that investors have become more familiar with over the past decade. And this asset class should also continue to rise above the rest due to its numerous growth profiles and wide variety of sources. 

Investments placed in these funds are subject to market fluctuations and risks inherent to investing in securities. Investment values and returns can rise and fall. Investors may not recover the entirety of their investment. The funds described above present a risk of capital loss. For a complete definition and description of risks, please see the brochure and KIID (Key Investor Information Document) for each fund. Past performance does not guarantee future results. 

Photos : header ©hstiver

*Data Source - © 2018 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Morningstar stars rank from 1 to 5, with the top ranking being 5 stars. All Morningstar ratings shown in this document are for Classic capitalizing shares, as of end of November 2018

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