Amid monetary normalization and hopes for a recovery in Europe, can small-cap stocks once again serve as a catalyst for performance?
Although long overlooked, small-cap stocks have historically benefited from periods of economic recovery. The Erasmus Gestion team shares with Hubfinance its analysis of the conditions necessary for their return to favor in 2025.
Against a backdrop of monetary normalization and an expected economic recovery in Europe, can small caps once again become a driver of performance in 2025?
Against a backdrop of monetary normalization and economic recovery in Europe, small caps could once again become a performance driver for investor portfolios in 2025, provided that several key factors materialize.
1 - Stabilization or decline in interest rates in Europe: An accommodative monetary policy, marked by a reduction in key interest rates, is often correlated with the outperformance of small caps. Historically, this effect becomes fully apparent about a year after the first rate cut, by stimulating growth and valuations for these companies.
Furthermore, monetary normalization should improve financing conditions for small caps, which are now significantly less indebted than in 2018.
In our fund, the average net debt-to-EBITDA ratio stands at approximately –0.1x, indicating a net cash position, reflecting a sound financial structure and enhanced growth potential.
2 - A long-awaited economic recovery in Europe
In 2023 and 2024, Germany’s growth will significantly underperform that of the Eurozone, as shown in the chart below.
However, Germany’s stimulus plan is expected to boost GDP growth and support the momentum of European defense spending, which is projected to reach up to €800 billion by 2030.
During periods of economic growth, small-cap stocks tend to outperform because they are:
- More domestically focused than large caps (and therefore better positioned to capture a local recovery)
- More agile in capitalizing on new growth opportunities
The sectors represented in small caps (industry, consumer discretionary, niche technologies, etc.) are pro-cyclical, and therefore highly sensitive to economic activity.
Sector breakdown of our Erasmus Small Cap Europe fund
3 - Attractive Valuation
After several years of underperformance, European small caps are now significantly undervalued relative to large caps:
- Historical discount on the price-to-earnings ratio: historically—and statistically speaking—a valuation of European small caps at these levels implies a 15% annualized return over the next five years.
- Potential for a valuation rebound if investors return to this asset class
U.S. large caps are currently trading at historically high levels, while European small caps, on the other hand, are trading at historically low valuations. This contrast strengthens the upside potential for this asset class, offering attractive opportunities for investors.
European small caps are trading at a historic discount relative to large caps. Is this situation primarily technical, or does it reflect a more structural trend in asset allocation?
The historic discount of European small caps relative to large caps is the result of a combination of technical and structural factors:
1 - Cyclical technical factors:
- Rising interest rates (2022–2023), which have penalized small companies, which are often more sensitive to the cost of capital
- Massive outflows from the asset class since 2028, with nearly 40% of those outflows not having returned
- Reduced analyst coverage of this asset class: Less analyst attention on small caps leads to a lack of visibility among investors, fueling their undervaluation.
Valuation of Small Caps vs. Large Caps in Europe
2 - More Structural Factors
- Changes in institutional investors’ asset allocations, driven by the rise of rapidly growing passive management, automatically favor large-cap stocks through ETFs and index strategies.
- Small caps, which are more domestically focused, suffer from a perception of higher risk.
In your view, what are the most relevant fundamental criteria today for identifying the most promising small caps in an uncertain environment?
In an uncertain environment (low macro visibility, still-high interest rates, unstable geopolitics), identifying the most promising small caps requires a fundamentally rigorous approach.
In our team, we focus on: Return on Capital Employed (ROCE), Alignment of Interests with Management, Debt/EBITDA, and Free Cash Flow growth.
We have an extensive in-house team of analysts and portfolio managers dedicated to covering a broad universe of securities. This expertise ensures we have in-depth knowledge of every ratio, KPI, or fundamental data point related to them.
You are about to launch a closed-end fund dedicated to European small and micro caps. Why is this format particularly relevant in the current environment, and how does it address the behavioral biases of long-term investors?
The imminent launch of our EDL 2030 fund, a closed-end fund focused on European micro- and small-caps, is a particularly strategic decision in the current environment. This format is designed to address two major challenges: the inherent illiquidity of this investment universe and investors’ behavioral biases.
Unlike an open-end fund, its five-year closed-end structure eliminates the risk of facing a wave of redemptions precisely when reinvestment is needed. Freed from this liquidity pressure, the manager is no longer forced to sell assets at a loss to cope with waves of redemptions.
As a result, portfolio stability is automatically enhanced. The management team can thus implement a conviction-driven strategy—more concentrated and patient—by focusing solely on the intrinsic value of companies without having to make trade-offs under the pressure of cash flows.
This framework offers protection against several behavioral biases that undermine performance:
- Volatility-driven flight bias: With no possibility of redemptions, investors are protected from the temptation to panic and sell their positions at the worst possible moment.
- Overreaction to events: The fund’s long-term time horizon acts as a buffer, neutralizing impulsive decisions driven by short-term emotions.
- Trend-following (herd behavior): The stability of the structure prevents the manager from being influenced by market flows, allowing them to avoid participating in irrational herd movements.
- Short-term myopia: The closed-end structure aligns the investor with the company’s value creation horizon, well beyond quarterly fluctuations.
