European espresso: Is it time for a catch-up trade in European mid-caps?

Today’s video is about European mid-caps, where I think there is a really compelling investment opportunity shaping up. European mid-caps have been a fantastic asset class over the long term, but this has not been the case over the last two to three years. Mid-caps have actually underperformed large-caps by more than 30 per cent over that [three-year] period[1].

That all culminated at the beginning of this year in a very narrow market, where a handful of large-cap stocks accounted for the entirety of the market’s performance. Now since mid-March we have seen signs of stabilisation and actually mid-caps have started to claw back a tiny bit of the underperformance they have accumulated.

A key element in this tentative fightback relates to valuation levels. They had become stressed to the extremes. After poor performance, mid-caps have de-rated, which has resulted in valuation discounts which we have not seen for decades.

Clearly the macro also has a role to play here. More confidence around sustained economic growth and an end to monetary tightening would be beneficial to mid-caps. Everyone has a view on the macro, but we also know that most people get it wrong most of the time, so that’s not a call we want to make here. Getting the timing exactly right is a very tricky game and I think it misses the bigger picture. The bigger picture for me is that the setup for mid-caps is currently more attractive than ever.

What has never changed is that mid-caps offer access to secular growth in less overhyped, less crowded conduits. So we talk about stocks that often fly under the radar of many investors. Companies that operate as an enabler for other companies which are more often associated with mega trends, such as electrification, data centres, or weight loss drugs.

There are other supportive factors. M&A (mergers and acquisitions) has been relatively subdued in recent years, but we see signs of pickup. And M&A has traditionally been a performance driver of the small and mid-cap space. And last but not least – investor flows. Challenging performance made many investors run for the hills. When the tide turns, these investors are likely to re-engage, which could offer some technical support, and which should help to address some of the anomalies we are currently seeing.

[1] Source: Refinitiv DataStream, Janus Henderson Investors, in euros, three years to 31 March 2024, Euro Stoxx Mid Index with Euro Stoxx 50 Index. Past performance does not predict future returns.

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De-rating/de-rated: The downward adjustment of a company’s financial ratios, such as the price-to-earnings (P/E) ratio, in response to business or market uncertainty. Or, in the case of a bond, lowering the credit rating.

Discount: Refers to a situation when an asset (eg. stock) is trading for lower than its fundamental or intrinsic value, on an absolute or relative basis.

Large-caps: Well-established companies with a valuation (market capitalisation) above a certain size, eg. US$10 billion in the US. It can also be used as a relative term. Large-cap indices, such as the UK’s FTSE 100 or the S&P 500 in the US, track the performance of the largest publicly traded companies, rather than all stocks above a certain size.

Mid-caps: Companies with a valuation (market capitalisation) within a certain scale, eg. US$2-10 billion in the US, although these measures are generally an estimate. Mid-cap indices, such as the S&P MidCap 400 in the US, track the performance of these mid-sized publicly traded companies. Mid-cap stocks are generally perceived to offer better growth potential than their larger peers, but with some additional risk.

Monetary policy: Central bank policies, aimed at influencing the level of inflation and growth in an economy. Monetary policy tools include setting interest rates and controlling the supply of money. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.

Secular growth: A significant or enduring change within an industry or sector that drives a period of sustained or persistent growth.

Small-caps: Companies with a valuation (market capitalisation) within a certain scale, eg. US$300 million to US$2 billion in the US, although these measures are generally an estimate. Small-cap stocks tend to offer the potential for faster growth than their larger peers, but with greater volatility.