European small caps are outperforming. Here's how BNP Paribas AM says to play it.

European small-cap stocks have outperformed their large-cap peers in the second quarter. The trend has been supported by industrial reshoring, rising infrastructure investment, and a recovery in M&A activity. BNP Paribas Asset Management discussed in its Talking Heads podcast the risks that still face the sector and why a barbell strategy – combining stable income-generating investments with a limited allocation to higher-risk small caps – is particularly relevant in the current environment.

Since the start of the ongoing, second quarter, the MSCI Europe Small Caps Index has gained 9.6% in euro terms, versus 8.4% for the MSCI Europe Large Caps Net Return Index. Damien Kohler, head of European small-cap equities at BNP Paribas Asset Management, highlighted four key factors driving small-cap performance in the euro area.

Uncertainty is weighing on luxury brands

Large-cap indexes include global luxury names such as LVMH and Hermes. "In large caps, you have luxury global consumer names such as LVMH, Hermes, where there’s much more uncertainty in the Middle East, and you’ve got softer pricing power," Kohler said.

As a result, sell-side analysts have lowered earnings expectations for the sector. Combined with high valuation multiples, this has weighed on share performance and pressured large-cap indexes overall.

Less dependence on crowded market leaders

According to Kohler, small caps are less dependent on European market leaders whose valuations have risen sharply. "Last year was a year of defence companies. Defense companies performed significantly. But today you see that growth expectations are too high. Analysts have put too much high expectations on growth," he said.

Positive growth drivers in the European economy

Small caps are more exposed to domestic demand and benefit from structural trends such as industrial reshoring, infrastructure spending, and increased protectionism, Kohler said. At the same time, the euro area economy is beginning to show signs of improvement.

Both Kohler and BNP Paribas Asset Management Chief Market Strategist Daniel Morris pointed to positive developments in the manufacturing sector during the first quarter. According to Morris, manufacturing purchasing managers' indexes across Europe "perhaps surprisingly improved in April after the start of the war, when we might have anticipated a decline." In April, the global manufacturing PMI rose to 52.6 from 51.3 in March, while the euro area PMI increased to 52.2, its highest level in almost four years.

M&A activity

Depressed valuations in small caps continue to attract strategic buyers and private equity firms, Kohler said, citing Zurich Insurance's acquisition of Beazley in the first quarter as an example. "This reinforces the perception that parts of the European small cap universe remain undervalued," he said.

Beazley was one of the largest players in cyber insurance. The transaction was valued at approximately $10.9 billion, or about GBP8.0 billion. The offer represented a premium of about 40% to Beazley's previous all-time high. Notably, Beazley rejected several previous approaches from Zurich Insurance before agreeing to the deal.

Nevertheless, several broader concerns could weigh heavily on small caps, as noted by Kohler. They include:

“First, [it’s] very important to be selective in small caps – always remember the breadth of opportunities in small caps,” Kohler said. “In small caps in each country, we can have cyclical companies, companies with a much more resilient business model, or growth companies able to grow more than 10% per annum over [the] midterm in a consistent manner.”

According to the head of European small-cap equities, the current market environment is favorable for investors pursuing a barbell strategy. Such an approach combines two types of assets: on one side, companies returning capital to shareholders through dividends and share buybacks, as opportunities to reinvest remain limited amid subdued economic growth; on the other, growth companies with stronger earnings visibility and more predictable profit trajectories. By doing so, investors avoid the middle of the market and focus on segments that offer the most attractive balance of risk and return.