Setting the scene

As a long-term investment, small caps are hard to beat. Since reliable data began in January 2001, they have consistently outperformed large caps across every major region. Europe stands out: over the course of this century, European small caps have been the best performing developed market asset class – excluding early 2002 and a brief spell between late 2024 and early 2025 – outpacing both the S&P 500 and global equities [1].

Recent years have been challenging with small caps trailing their larger counterparts. This has been due to numerous factors, including soaring interest rates, geopolitical uncertainty, and the phenomenal comparative performance of the ‘Magnificent 7’ tech stocks.

But the tables have turned. Since President Trump introduced his Liberation Day tariffs, smaller companies have surged. European small caps are up 23% in just two months. Why? Smaller companies are more domestically focused than their international large-caps peers, insulating them from tariff threats and supply chain disruption. Small caps, by their very nature, are more agile than unwieldy large caps and often more able to quickly take advantage of shifting market dynamics.

Importantly, we believe this rally could be a springboard for smaller companies to outperform in the years ahead.

Bumper bargains

After a period of underperformance, small-cap valuations are compelling. Across various sub-markets, small caps are trading at significantly lower price tags than their large-cap counterparts. Nowhere more so than in Europe, where small caps are the most undervalued globally, currently priced at a 12-month price-to-earnings (P/E) ratio of 13.7.

This level of relative price difference was last seen during the 2008 Global Financial Crisis. While risks remain, we believe today’s broader investment landscape is far more favourable than 17 years ago, making the current valuations particularly attractive for investors seeking long-term upside.

Rate-cut catalyst

Interest rates are falling, and history suggests small caps stand to benefit. Since June last year, the European Central Bank has cut rates eight times, bringing the key deposit rate down to 2%, Over the past 70 years, small caps have consistently outperformed large caps during periods of monetary easing. Historically, during the first 12 months of a new rate-cutting cycle, small caps have generated nearly double the returns of their large-cap counterparts [2].

Dig into diversification

Investor appetite for diversification is intensifying amid rising geopolitical uncertainty, with clients seeking broader exposure across regions, sectors, and investment styles. Small caps offer this kind of diversification.

Unlike large caps, small caps have a distinct sector composition and tend to be more locally focused. This tends to make them less susceptible to geopolitical developments. It also gives investors access to companies that simply don’t exist in the large-cap universe.

Interest in European small caps is also shifting. In recent months, we've had more discussions than ever with Asian investors looking to European small caps as a strategic way to expand their portfolios.

At the same time, American investor enthusiasm has perked up. At recent company conferences in London and Stockholm, a significantly higher number of international and US institutions indicated they were actively researching European opportunities – an encouraging development.

Beyond the macro

For years, Europe has experienced slower economic growth than much of the world. The picture looks set to improve. Germany’s €500 billion investment plan has the potential to provide a significant boost to smaller German and European companies. However, the best small caps don’t rely on a specific macroeconomic backdrop to succeed over the long term.

A great example from our portfolio is the UK construction company Morgan Sindall. From a top-down perspective, its sector and location might suggest sluggish growth, leading some investors to overlook it. But through a bottom-up approach – focusing on high-quality earnings, strong leadership, and high barriers to entry – we think Morgan Sindall emerged as a standout investment.

Germany offers another compelling illustration. Despite a prolonged period of low growth, several German companies have risen to the top of our portfolio, including CTS Eventim, Rational, and Nemetschek.

Let’s get active

Active and passive strategies have their place across asset classes. However, small caps often present unique inefficiencies that make active management particularly advantageous.

Research coverage for small caps is far more limited than for large caps. And the existing analysis tends to come from sell-side sector specialists, who often focus on broad industry trends rather than individual stock opportunities. A skilled active manager can unlock significant value.

There are additional considerations. Many passive small-cap solutions are not substantially cheaper than their active counterparts. Yet, they lack the flexibility to capitalise on market inefficiencies or access off-benchmark opportunities. Moreover, historical data suggests that only about a third of small-cap stocks outperform their index, meaning passive approaches inherently allocate to a large proportion of underperforming stocks. By contrast, active investors focus solely on high-conviction positions – selecting stocks for their potential not simply their inclusion in an index.

Institutional investors are increasingly complementing passive large-cap exposure with actively managed small caps. This marks a potential sea-change in portfolio construction, confirming the alpha and diversification benefits of smaller stocks.

There’s still significant room for growth among investors. For example, while small caps make up 14% of the European broad market index, most investors allocate only 7% to 10% of their portfolios to smaller stocks [3]. We believe many investors remain stuck in the outdated mindset that “Europe lacks growth and is cheap for a reason”. For those who take a fresh view, the benefits are clear.

Final thoughts…

After a challenging period, smaller companies have bounced back. For investors familiar with the asset class, this resurgence comes as no surprise. Tariffs and rate cuts have acted as short-term catalysts, but it’s the long-term fundamentals that catch the eye. Valuations are compelling, and underlying business strength remains robust.

Small caps continue to offer access to a diverse range of high-quality companies. The diversification benefits are undiminished. Encouragingly, these characteristics are attracting the attention of previously wary US and Asian institutional investors. Many now view small caps as a valuable complement to a large-cap passive strategy. In short, it’s once again an exciting time to be an active small-cap investor.

 

Companies are selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.
 

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