European small caps have declined by 13% since the end of 2021, while large caps have risen by 11%, a shift driven chiefly by a derating since central banks began their rate-hiking cycle.
Now, small caps trade at a 4% discount to large caps, marking one of their lowest relative valuations since the Global Financial Crisis, strategists at Goldman Sachs (NYSE:GS) highlighted in a Wednesday note.
As the first European Central Bank (ECB) rate cut approaches – which Goldman economists expect in June – and with stronger-than-anticipated Q1 GDP growth and rising M&A activity, investors are questioning whether it's time to invest in small caps.
However, with economists delaying Bank of England and Federal Reserve first cut forecasts to August and September, respectively, Goldman strategists said they “doubt that the timid sequential growth acceleration will be enough to support Small caps outperformance.”
Still, the team pointed out four areas where investors may seek opportunities within small-cap stocks.
Firstly, they pointed to leveraged buyout (LBO) targets, identifying two specific screens within this group.
The first screen includes small and mid-cap companies (market cap under €10 billion) that have lower net debt to EBITDA, a lower valuation premium than usual, and a higher return on equity (ROE) compared to their sector median. The second screen focuses on companies with lower net debt to EBITDA, a lower-than-usual valuation discount, and a lower ROE compared to their sector median.
Moreover, strategists believe there is potential in real estate and technology laggards. If bond yields fall further, these sectors, which are more sensitive to interest rates, could see notable upside, the team noted. Real estate small caps, in particular, have shown strong performance when bond yields dropped earlier this year.
Also, the strategists identified UK small caps as a catch-up trade. The UK small-cap index has underperformed since the end of 2021, largely due to its exposure to consumer discretionary sectors and the delay in expected rate cuts by the Bank of England.
As UK economic activity improves and bond yields potentially fall, UK small caps, especially in real estate and consumer discretionary sectors, could outperform.
Finally, for the fourth area, strategists highlighted small caps with the highest price upside based on 12-month target prices from their equity analysts.