European small-caps are outperforming the market. What strategy does BNP Paribas AM advise?

European small-cap stocks outperformed large-cap stocks in the second quarter. This is due to the return of production facilities to Europe, the growth of infrastructure investments and the revival of the M&A market. BNP Paribas Asset Management spoke to Talking Heads on the BNP Paribas Asset Management podcast about the risks that remain in this segment and why the barbell strategy, which combines stable investments with a limited share of high-risk small-caps, is particularly relevant in this environment.

Since the start of the current, second quarter of 2026, MSCI Europe Small Caps are up 9.6% (in euros), while MSCI Europe Large Caps Net Return is up 8.4%. Damien Kohler, head of European small-cap equities at BNP Paribas Asset Management, identified four main factors that have affected small-caps stocks in the eurozone. These are:

- Uncertainty is weighing on luxury brands

The large-cap indices include global luxury brands such as LVMH and Hermes. "It is in this sector that the greatest uncertainty now remains due to the situation in the Middle East, and the ability of companies to raise prices has somewhat weakened," says Damien Kohler. Against this backdrop, analysts have lowered earnings forecasts for companies in the sector. Combined with high valuation multiples, this had a negative impact on stock dynamics and put pressure on the indices of large companies in general.

- Less reliance on overheated leaders

Kohler says small-cap companies are less reliant on European market leaders, whose valuations have risen markedly. "Last year was the year of defense companies, but today we see that investors' expectations were inflated," he says.

- Positive growth drivers in the European economy

Small companies are more focused on domestic demand and benefit from such structural trends as the return of production to Europe, the growth of infrastructure spending and the strengthening of protectionist policies, says Damien Kohler. At the same time, the eurozone economy is beginning to show signs of improvement.

Both Kohler and BNP Paribas Asset Management Chief Market Strategist Daniel Morris highlight the positive momentum in the manufacturing sector in the first quarter. According to Morris, manufacturing business activity indices (PMIs) across Europe "unexpectedly improved in April already after the war began, although we had expected a deterioration." In April 2026, the eurozone's manufacturing PMI rose to 52.6 points, the highest level in almost four years.

- Mergers and acquisitions

Low valuations in small-cap continue to attract strategic buyers and private equity, emphasizes Damien Kohler, citing an example: insurance company Zurich Insurance acquired UK-based Beazley in the first quarter of 2026 - "this confirms that part of European small-cap remains undervalued".

Beazley was one of the biggest players in cyber risk. The total purchase price was approximately $10.9bn (about £8.1bn), meaning the premium was about 40% to the previous all-time high of Beazley shares. Notably, the company rejected Zurich Insurance's offer several times.

Nevertheless, there are global causes for concern that could seriously affect small-caps, notes Damien Kohler:

- inflation, the rise of which could hit the growth forecasts of many companies,

- government bond yields are already starting to compete with small-cap yields,

- uncertainty in the Middle East pushes up transportation costs.

"It is important to keep in mind the breadth of opportunities in the small company segment," says Kohler. - Here in every country you can find cyclical businesses as well as companies with a sustainable business model or growth stocks that can increase performance by more than 10% per year."

According to the head of European small-cap equities, the current market situation is favorable for investors using the barbell strategy. This approach involves a combination of two types of assets: on the one hand, companies that return capital to shareholders through dividends and share buybacks, as reinvestment opportunities are limited in a weak economic growth environment. On the other hand, growth companies with clearer and more predictable earnings dynamics. At the same time, the investor avoids the "middle" of the market, betting on the most attractive segments in terms of risk and profitability.