* Cheap central bank cash filtering down to smaller firms
* Investment in smaller companies slowly rising
* Earnings, valuation, M&A to drive outperformance
* Large/small cap correlation falling
By David Brett
LONDON, Feb 25 (Reuters) - Shares in Europe’s smaller companies are starting to attract fresh investors and should outperform larger firms this year as the continent’s relative minnows belatedly felt the impact of central bank stimulus.
Historically, small and mid-sized companies (SMIDs) -- with a market capitalisation of $500 million to $5 billion -- have outperformed the blue chips, taking off as soon as equity markets rise, because their better growth prospects and exposure to a broader array of business areas offer investors the chance of bigger gains.
This time, though, that outperformance is only just starting, as the unprecedented stimulus from global central banks -- which has lifted investor confidence and gradually driven them out of lower-risk assets -- is only gradually filtering down to the smaller firms.
“Investors had all this cash on the side and wanted to plug it straight into the market ... which inevitably meant trading into the big names because that is where the liquidity is,” Max King, investment strategist at Investec said.
“(But) investors are now saying: ‘I am in the market let us put on some orders in some SMIDs and we can finance that by taking some out of our (blue chip index) ETFs’.”
In the final six months of 2012, 5 billion euros ($6.6 billion) flowed into European equities, with the lion’s share going to the fewer than 1,000 large listed companies and just 1.2 billion euros invested in the 5,200 small caps, according to Lipper data.
But, with the EuroSTOXX 50 and other blue chip indexes hitting multi-year highs and no longer looking so cheap, that trend has started to turn. Regional numbers from data firm Markit shows money flowing into Exchange Traded Funds invested in British and German small and mid-caps, while those focused on large caps have witnessed outflows so far in 2013.
The divergence in price performance between European large caps and smaller companies has become stark since the start of February, according to a daily correlation chart. The MSCI European small and mid-cap index is up 3 percent this month , while the MSCI European large index has lost 0.2 percent, after the two gauges largely kept pace with each other in the previous seven months.
Although the European economy remains sluggish, expectations of recovery in the second half of 2013 are another reason investors are looking at the smaller companies.
“Small caps are the bellwether of the economy and the recent outperformance reflects the improved prospects ... This will continue as long as the economic outlook is brighter,” Simon Maughan, strategist at Olive Tree Securities, said.
Turning to the UK, he said that fuelled by central bank money printing, and with fixed income investment looking unatttractive due to ultra-low bond yields and with hints of economic recovery, the UK small cap index should test its record high at 4,207, reached in 2007.
That would represent a 14 percent gain from current levels, while the FTSE 100 is just 8 percent off its all-time high of 6,798 points reached in September 2000.
The case for SMID outperformance is also backed by earnings expectations, valuation and merger and acquisitions activity, with the combined value of deals worth less than $500 million recently hitting its highest since June 2011.
“Larger European companies ... are now looking more fully valued, so the potential for further relative positive performance in Europe now looks more likely in smaller companies,” Edward Bland, head of research at Duncan Lawrie Private Bank, said.
“This is set against a background when smaller companies’ earnings growth is starting to run faster than their larger rivals.”
Earnings among smaller European companies are expected to grow around 40 percent over the next 12 months, compared with a miserly 5 percent for the larger caps, according to Thomson Reuters I/B/E/S estimates.
A quarter of small and mid-cap stocks still trade at a market value below the stated worth of the assets on their books compared with 15 percent of blue chips, Starmine data showed.
But none of this means investors should take a scattergun approach to investing in the area.
“What we look for in this environment, is non-consensus plays with significant rerating upside,” Eduardo Lecubarri, Head of Small/Mid-Cap Strategy at JPMorgan, said.
Lecubarri sees such opportunities in Europe within what he labels “Affordable Growth” stocks, whose earnings are expected to grow at least 10 percent and that trade below 14 times earnings.
Another option is to seek “Quality Value”, or companies which trade below 10 times earnings but have positive free cash-flows, good balance sheets and are able to benefit from economic recovery.
His top picks include UK high street retailer Debenhams , developer Quintain, asset manager Jupiter and Spanish television company Antenna 3.