Value Column von Hans Peter Schupp

19 SEPTEMBER 2024

Is the small caps rally coming late ?

Hans Peter Schupp, managing partner of Fidecum AG and portfolio manager of the  Contrarian Value Euroland Fund (ISIN: LU0370217680) on the valuation and opportunities of second-line stocks.

After the difficult years of 2022 and 2023 with significant price setbacks, many experts gave the green light for the small and mid-cap sector at the start of 2024. “It will be the year of small-cap and mid-cap shares”, quoted the investor magazine Börse Online, for example, in a broker study. And the highly respected US financial magazine Barron’s announced: “Small-Cap Funds Are More Promising Than They Have Been in Years.”

A forecast that did not come true, at least in Germany. While the DAX (ISIN: DE0008469008) has climbed by almost 15% in the year to date, the MDAX index (ISIN: DE0008467416) is still down slightly. At first glance, second-line stocks have thus become even more attractive. Is the rally in second-line stocks now a year late?

Are second-line stocks really cheap at the moment?

A historical classification helps with the analysis. Both the Dax (ISIN: DE0008469008) and the MDAX were launched in 1988 with a price of 1,000 points. At the end of September, the DAX index stood at 19,000 points and the MDAX at 26,000 points. In the last 37 years, the DAX has therefore risen eighteen-fold (average return 8.3% p.a.), while the MDAX has risen by a factor of 25 (average return 9.3% p.a.).

In the very long term, an investment in second-line stocks has therefore yielded one percentage point more than an investment in large-cap stocks. And this was for a reason.  The returns of second-line stocks have also grown almost one percentage point faster than those of blue chips during this period. It is obviously true that the earnings and share prices of second-line stocks have risen faster than those of large companies. This is referred to in the literature as the small-cap premium.

It is particularly interesting for those who take a closer look. From 1988 to mid-1996, the DAX and MDAX ran more or less in parallel. During the Internet bubble up to spring 2000, the DAX then dramatically outperformed the MDAX, but lost its lead completely by the low point of the subsequent stock market crash in March 2003. After that, shorter periods of outperformance and underperformance of second-line stocks alternated. The decade of small caps then commenced in 2010. By the summer of 2021, the MDAX had climbed by a factor of 4.8, while the DAX had only climbed by a factor of 2.5. Since then, small caps have completely lost this lead again.

Four decisive factors for outperformance and underperformance

In addition to the long-term outperformance of second-line stocks, there are obviously phases in which this sector performs particularly well or particularly poorly. In order to determine the reasons for these cycles, we have analyzed a large number of academic studies and identified four key influencing factors: ETFs, geopolitical uncertainties, the economy and – above all – the central banks‘ interest rate policy.

1. as second-line stocks are less frequently represented in ETFs, the trend towards passive investing generally favors capital inflows into blue-chip stocks. This gives large caps an advantage.
2. small caps are often more affected by geopolitical and economic uncertainties. In times of crisis, investors become more risk-averse and favor blue chips, which are seen as comparatively safe.
3. small caps are often more affected by economic changes in the respective domestic economy, as they are more exposed to sector-specific or regional markets than large, globally diversified companies.
4. However, the most significant influencing factor appears to be the central banks‘ interest rate policy. In phases of restrictive monetary policy and rising key interest rates, the DAX has outperformed the MDAX over the past 24 years. Phases of falling key interest rates boost the small cap sector relative to the shares of large companies (chart below).

The current outlook for second-line stock

This analysis shows that there are indeed valid reasons for the poor performance of second-line stocks in the recent past. How should the four decisive factors be assessed with a view to the future?

The negative influence of ETFs and geopolitical uncertainties are unlikely to change much in the future. As far as the economy is concerned, the leading German research institutes are forecasting a slight upturn in the coming year after a weak 2024 – both in the Eurozone and in Germany.

On the other hand, the monetary side is clearly positive. Central banks around the world have now started the cycle of interest rate cuts. This should tend to boost the small cap sector. To summarize, there is a lot to be said for a positive underlying trend relative to the blue chips in the future. For us as stock pickers, this is reason enough to take a closer look at this segment.

Size does not matter

It is noticeable that today – unlike in 2021, for example – more and more individual stocks from the small cap sector qualify for investment according to our strict selection criteria.  When selecting stocks for our Contrarian Value Euroland fund (ISIN: LU0370217092), we examine, among other things, the average operating margin a company has achieved in the past. Using this “normal” margin and the current sales path, a plausible medium-term operating result can be calculated.  In relation to the current market value, this gives us an idea of how much return we could generate on the capital invested over a longer period of time. We start to buy the stock if this return is a) above twelve percent and if b) we are convinced that the company can achieve “normal” margins in the future again.

We have remained true to this investment philosophy for 25 years. We invest in undervalued companies with considerable upside potential and a comprehensible business model. In doing so, we act like an entrepreneur who wants to buy the entire company and – if necessary – deliberately swim against the prevailing market opinion.

About the author: Hans Peter Schupp, is a managing partner of Fidecum AG und the portfolio manager of the Contrarian Value Euroland Fund.

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