Mr. Kraus, small caps have recently faced significant losses in the markets. What’s behind this?

Over the past two years, small caps have seen their steepest decline relative to large caps in decades. European small- and mid-cap growth stocks, in particular, were hit hard by rapid interest rate increases and a recessionary environment. It was an extreme scenario.

Following the COVID-19 lockdown—which was prolonged by disrupted supply chains—along with inflation and interest rate shocks and the onset of the Ukraine crisis, we are now seeing the lowest valuations in a decade. Small caps, in particular, are currently more attractively priced relative to large caps than they were at the peak of the 2008 financial crisis.

What makes small caps poised for a comeback in market terms?

The economy has recently displayed signs of weakness, with leading indicators on a downward trend for nearly three years. This suggests we may be in a bottoming phase before markets start to recover, a trend that could also benefit small caps. Additionally, inflation rates are dropping, and central banks are at the beginning of a rate-cutting cycle.

«This Is the Hour of Small Caps»

The economic recovery is still in its early stages—this is the moment for small caps. We are confident that the long-term outperformance trend seen in small caps over decades will persist.

However, there’s a difference in recovery potential: although rates have recently started to fall again, they remain considerably higher than in previous years, posing challenges for highly leveraged companies.

Why is net debt such a critical factor for small caps?

Highly indebted companies needing refinancing are at a disadvantage. At Berenberg, we focus on high-quality companies with strong returns on capital and robust balance sheets that benefit from structural growth trends. Such companies are more likely to boost earnings and cash flow per share above market levels as recovery indicators become clearer.

«Stars in the Second and Third Tier Rarely Appear on the Radar»

Another unique feature of European small caps is their limited analyst coverage. Unlike the U.S., where numerous large and mega-cap firms like Louis Vuitton or ASML dominate analysts’ and investors’ attention, stars in the second and third tier rarely appear on the radar.

Many of these companies, with market caps up to €5 billion, are global leaders within their niches. Their innovation capabilities benefit from digitalization, shifts in healthcare, and sustainable technologies, often achieving mid-term growth rates of 20 percent or more.

«Well-Positioned Innovators Like These Are the Companies of the Future»

Throughout the past two challenging years, we have maintained our commitment to a long-term investment strategy, undeterred by a tough market environment. For instance, our portfolio still does not include banks, insurers, or real estate firms.

Instead, we have selectively capitalized on downward adjustments in sectors like semiconductors, healthcare, software, discretionary consumer goods, and certain industrials.

Which hidden champions are of particular interest to you right now?

Currently, we find European hidden champions in sectors like technology and healthcare. Companies like Switzerland’s Inficon and Germany’s Atoss Software meet our requirements with strong margins and international leadership, enabling them to absorb inflation-driven price increases and invest significantly in R&D. These well-positioned innovators are the companies of the future.

We are also finding attractive opportunities in other sectors, such as Skan, a Swiss manufacturer of isolators for the sterile filling of injectable drugs. The underlying drivers are solid from our perspective; 75 percent of new drugs will be high-priced biologics/injectables requiring aseptic isolators. Skan demonstrates strong growth alongside rising margins, high returns, and a net cash position.

«This Is What Makes Sweden So Interesting»

Furthermore, we frequently discover promising opportunities in Scandinavia, particularly in Sweden. The Swedish market is relatively small, both in terms of its economy and country size—Germany, for example, is about ten times larger. Yet Sweden is a leader in healthcare and technology innovation.

New investors generally face challenges accessing this market due to a limited number of brokers, especially local ones. This makes the country particularly interesting. Sweden currently represents 31 percent of the geographic exposure in the small-cap fund and 37 percent in the micro-cap fund.

Peter Kraus is Head of Small-Cap Equities at Berenberg Wealth and Asset Management.