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Is the small size effect on European mid-caps a myth?

The notion that small stocks grow stronger and outperform large stocks over time may have become an investing truism, but is that statement fair in a European mid-caps context? asks Eva Fornadi, analyst and portfolio manager at Comgest.

The earnings growth of mid caps has not been stronger than large caps in Europe since the turn of the century.

In our opinion, just relying on the ‘small size effect’ has not been good enough for managing mid-cap portfolios.

Volatile earnings, severe drawdowns and high dispersion of stock returns are good reasons to be selective.

Lay of the land

It can’t be argued that the economic environment has been particularly friendly or hostile for either mid-cap companies or European large-cap business models.

The past 16 years featured all kinds of cycle conditions: a period of exuberant growth known as the ‘super cycle’ (2003 to 2007), the recession triggered by the global financial crisis (2008-2010), the low growth environment and emerging markets slowdown (2011-2015) and a muted recovery (2016-2018) followed by a slowdown during last year.

Indeed, contrary to what the ‘small size effect’ suggests, over the past 16 years, realised earnings per share increased with a compound annual growth (CAGR) of 7.8% for the MSCI Europe Mid Cap versus 7.6% for the MSCI Europe Large Cap index during that period.

Figure 1. Realised EPS of MSCI Europe mid vs.large caps indices:

FIGURE 1. REALISED EPS OF MSCI EUROPE MID VS. LARGE CAPS INDICES

Source: Comgest/FactSet financial data and analytics; data as of 29-Nov-2019, expressed in EUR.

More prone to failure or pressure

The volatility of earnings in mid caps was much higher in the same timeframe (past 16 years), in general amplified by their earlier phase of strategic development compared to large-cap companies.

Mid-cap companies usually benefit disproportionately in an economic upswing because of their comparatively high exposure to the economic cycle.

However, in times of economic stress, such as the 2008-10 global financial crisis, mid-cap companies are more prone to failure or pressure.

In addition, the volatility of earnings translates into more volatile performance which is amplified by the much lower liquidity of mid-cap, and this in turn works in the favor of mid caps when money flows into the asset class.

Nevertheless, market sell-offs can be painful.

Reasons to believe in alpha

As such, volatile earnings and performance, as well as lack of ‘the small size effect’, are good reasons to be very selective when managing European mid-cap portfolios.

Despite the volatile asset class, it does not mean that there is a lack of consistent and dynamic growth companies which should deliver returns for the alpha investors.

And there are reasons to believe in alpha.

First of all, mid-cap stocks are not extensively covered and investor communication does not reach the same large investor base which large cap investor relation teams target.

Secondly, the dispersion of stocks returns for mid caps is much higher than for large caps.

This is why applying a quality growth approach – such as the one we adopt in our Comgest Growth Europe Smaller Companies fund – can make all the difference in the mid-caps space.

By investing in a small number of handpicked quality growth companies, we expect to benefit from their superior earnings growth compared to the benchmark index.

Proof in the pudding

From our experience investing in mid caps over the past 20 years, there are a number of companies which have proven to be winners and alpha generators, notwithstanding the ‘small size effect’.

Sartorius Stedim, a supplier to the biopharmaceutical industry, can be seen as the poster child of a dynamically growing and highly profitable consumables business and of long-duration growth in European mid caps.

The company produces a technology that is used throughout the biopharma process chain (ie fermentation, filtration, purification, fluid management of protein liquids).

A reduction of contamination, lower life cycle cost and higher flexibility of its single use products are reasons to believe that the penetration of single-use technology across the whole market for products used to produce enzymes and proteins (the raw materials of the biopharma industry) has room to rise further from its current 35% share.

What’s more, via its global distribution footprint, we believe that Sartorius Stedim is not only well positioned in its historic core market Europe, but also in the important US as well as the dynamically growing Chinese market.

Another example is Simcorp, a Danish-based company that provides back and front- end software solutions for asset managers, pension funds, insurers and wealth managers.

In a market still dominated by many contributing factors – such as by in-house services, the increasing complexity of the regulatory environment, the search for better risk management and cost efficiencies as well as faster and leaner reporting and processes – there has been a constant shift towards outsourcing IT services to dedicated vendors like Simcorp, which has a well-trained maintenance and services workforce and a flexible software suite.

Simcorp’s target clients manage assets above €15bn.

Eva Fornadi

The company is strongly positioned in the European market, has made inroads into the rapidly growing Asian financial markets, but is still in the early days of its North American expansion.

Looking forward it is targeting double-digit organic revenue growth with improved margins – making it a great hold for our portfolio.

Based on our experience, the lack of the ‘small size’ effect in the mid-cap space is real but investors should not be discouraged by this, rather they should focus on finding and investing very selectively in quality growth companies for the long-term as these should generate returns in their portfolio, no matter what size.

This article was written for Exprt Investor by Eva Fornadi, analyst and portfolio manager at Comgest. 

Kirsten Hastings

Kirsten is international editor of Expert Investor and International Adviser. She joined Last Word Media in October 2015. Kirsten has a Masters in Financial Journalism from the...

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