Why European small caps are back on investors’ radar in 2025

The period from 2021 to 2024 proved challenging for European small-cap stocks. Amid a prolonged phase of tight monetary policy in the eurozone and underperformance relative to the U.S., investors largely overlooked the Old World's smaller companies. Over that period, the MSCI Europe Small Cap index rose just 2.6%, including a nearly 27% drop in 2022. By comparison, the iShares STOXX Europe 600 UCITS ETF gained 39.7%, while the MSCI World index advanced 46.0%.

In 2025, however, there are signs of a trend reversal. The MSCI Europe Small Cap index is up nearly 11% year to date, outpacing the 7% gain in the MSCI Europe Large Cap index. According to Berenberg, more than half of European companies with market capitalizations between EUR60 million and EUR6 billion were trading above their 100-day moving average in June, a signal of renewed investor interest in the segment.

Small and mid-sized European companies represent a compelling investment opportunity over the next one to three years, says analyst Aldiyar Anuarbekov. Currency fluctuations, trade tensions, and evolving central bank policies have created a rare set of conditions in which small-cap companies are gaining an edge.

The U.S. trade war and higher tariffs on imports to the U.S. – up to 15% for the EU – have pushed investors to seek stocks with lower exposure to external shocks. Another factor has been the strengthening of the euro: Since the beginning of 2025, the currency has appreciated nearly 11.5% against the dollar. A stronger euro usually weighs on exporters by reducing their competitiveness abroad.

However, for European companies focused on domestic markets, the currency's rise may prove beneficial. As of April, roughly 68% of revenue for companies in the MSCI Europe Small Cap index was generated in Europe, and just 18% in the Americas, according to the asset manager Amundi. This highlights the segment's high reliance on domestic demand and lower sensitivity to currency swings.

Despite the recovery in valuations, investor capital has yet to return to the segment. According to Berenberg, after a prolonged capital outflow from 2022 to 2024, withdrawals from European small-cap funds have slowed in 2025. In the first half of the year, cumulative outflows totaled EUR4.3 billion. By comparison, EUR8.2 billion exited in the second quarter of 2022 alone, and EUR4.5 billion in the second quarter of 2023.

That said, the positive economic momentum is visible at the company level: Demand is increasing, and revenues are becoming more stable, particularly in the tech sector. For example, industrial equipment manufacturers such as STIF and medical software providers like RaySearch have reported double-digit sales growth.

Overall, investment activity in the segment is beginning to recover, supported by easing inflation, more stable economic policy, and a rebound in production orders.

According to a Barclays report, the MSCI Europe SMID Cap index is less volatile than the Euro Stoxx 50, which tracks large European companies. Its sensitivity to market movements, or beta, relative to the Euro Stoxx 50 is 0.86. This means that, on average, the index moves 0.86% for every 1.00% change in the broader market. By comparison, the U.S. Russell 2500 index is more reactive, with a beta of 1.03 relative to the S&P 500. For investors seeking diversification with moderate risk, this makes European small and mid-cap stocks more attractive.

As of March 30, nearly 46% of the world’s small-cap companies held a net cash position, meaning they had more cash and cash equivalents than debt, according to data from Janus Henderson. By comparison, only 30% of large-cap companies were in the same position. While small caps are traditionally more leveraged, the opposite is true in the current market cycle, with smaller firms now exhibiting greater financial robustness and flexibility. This is particularly significant during a period of shifting interest rates. The ECB has cut its key interest rate eight times over the past year, lowering it by a cumulative 2 percentage points. As a result, debt servicing has become less burdensome, improving the net profit outlook for companies.

Historically, European small caps have traded at a premium to their large-cap peers. This is partly due to their higher growth and partly because investors demand compensation for their higher risk and lower liquidity. Despite elevated volatility, many long-term investors continue to favor high-growth segments, anticipating that their return potential will ultimately outweigh short-term fluctuations, according to research by State Street Investment Management.

Shares of European small and medium-sized companies are now trading at a record discount to large-cap stocks, a discount that has not been seen in 20 years. The MSCI Europe SMID Cap index is valued about 10% cheaper on a forward-looking P/E (price/earnings) ratio than the MSCI Europe Large Cap index, according to a report by Amundi. This is a marked deviation from the historical norm: previously small-cap companies, by contrast, traded at a premium of around 10% - due to higher growth rates. If the market returns to its previous valuation with a 10% premium to large-cap companies, as it has historically, the upside is about 20 percentage points. 

In addition, small and mid-sized companies tend to deliver higher earnings growth. Amundi estimates that 12-month EPS growth in this segment will outpace that of large caps. This is because small and medium-sized firms are more concentrated in cyclical sectors, such as industrials, consumer discretionary, and materials, which are particularly sensitive to economic cycles and typically respond more quickly to recoveries.

Nevertheless, risks remain. A strengthening euro could undermine the competitiveness of European exports and reduce the revenues of companies operating in international markets. More importantly, earnings reports will be the decisive factor in determining whether the current rally can hold and whether a more sustained recovery in valuations can take shape, Barclays notes. If EPS growth falls short of expectations, investor interest in the segment may fade once again.

Barclays also highlighted key risks facing smaller European companies, including their greater sensitivity to economic cycles and more limited access to large-scale funding compared to leading market players.

The STOXX Europe Small Cap index is currently trading at a 12-month-forward P/E multiple of 13.4, compared to 14.3 for the large-cap index. This means small-cap stocks are trading at a 6.5% discount. If EPS growth forecasts in the small and mid-cap segment materialize and the macroeconomic backdrop remains stable, the STOXX Europe Small Cap index could rise 15-20% from current levels. Investments in clean energy players, medtech firms, and specialized industrial manufacturers look especially promising.

The AI translation of this story was reviewed by a human editor.