European small caps surged this year — and could have further to run, Goldman Sachs strategist says

European small-cap stocks are significantly outperforming, with indices like the German SDAX up 32% year-to-date, driven by a weak dollar, euro strength benefiting domestic earners, and attractive valuations relative to stretched large caps. Goldman Sachs and Bank of America strategists anticipate continued outperformance, citing a potential pick-up in M&A activity as a key catalyst. This sentiment marks a substantial shift in investor outlook, with a net 44% of fund managers now expecting small caps to outperform large caps over the next 12 months. While the outlook is positive, some experts advise a selective approach, emphasizing that not all small caps offer the same value or growth trajectory.

Analysis

European small-cap stocks have demonstrated significant outperformance year-to-date, a trend supported by several fundamental drivers. The MSCI Europe Small Cap Index has gained approximately 13% and the German SDAX has surged nearly 32%, substantially outpacing the 7.9% rise in the pan-European Stoxx 600. According to Goldman Sachs analysis, this momentum is fueled by a weak U.S. dollar and strong euro, which benefits domestically-focused, euro-earning small caps while creating a negative translational effect for large-cap, dollar-earning multinationals. Valuations provide another key tailwind; small caps are described as cheap relative to large caps, which are at "all-time highs and extremely stretched in valuation terms." This valuation gap makes smaller firms attractive M&A targets, with expectations of increased deal activity potentially bidding up the entire sector. This bullish thesis is reinforced by a dramatic shift in investor positioning, with a Bank of America survey showing a net 44% of fund managers now expect small caps to outperform large caps over the next 12 months, a stark reversal from just 7% one month prior. However, experts caution against treating the segment as a monolith, emphasizing the need for a selective approach to find companies offering both value and a strong growth trajectory.

Key Decisions for Investors

• Investors should consider increasing allocation to European small caps to capitalize on favorable currency dynamics and their attractive valuation discount relative to large caps.
• Monitor M&A activity and deal pipelines closely, as an acceleration in takeovers could serve as a significant catalyst for valuations across the small-cap landscape.
• A selective, stock-picking approach is crucial; investors should prioritize identifying companies with strong fundamentals and growth potential rather than pursuing broad, passive index exposure, given the varied quality within the asset class.