Europe’s small- and mid-cap stocks, together with the wider market, have experienced something of a rally of late.
On Friday, the MSCI Smallcap Index was up 11 per cent from the six-year low reached on March 9th. But which way is it heading?
JP Morgan’s smallcap team has taken a decidedly bullish view. Their reasoning:
There are a number of reasons that support our positive stance on Pan-European SMid-Caps and could extend the life of the current rally (on an absolute return basis; remember we are UW vs Large-Caps and Credit):
• First, demand drivers are reaching historical lows (i.e. ISM and Cons. Confidence).
• Second, you have macro margin drivers, all in favor of equities (i.e. lower interest rates, lower commodity prices, lower capacity utilization, lower unit labor costs), which should help to at least offset part of the margin pressure coming from declining top-line, deteriorating pricing power, and in some cases, higher borrowing costs.
• Third, you have valuations that suggest equities are a buy on absolute terms. Pan-European equities trade at an average P/B ratio of 1.4x (a 46% discount to historical avg valuations), with 48.8% of all Pan-European SMid-Caps trading below book value (a total of 890 stocks to be exact).
• Fourth, easier comps and expectations ahead. In terms of comps, 4Q09 will be the first quarter where YoY comps could be positive. As for sell side estimates, they still need to be revised down in our view (IBES 09E EPS Grw is still only – 2.7% for Pan-European SMid-Caps), but nevertheless, we remain firm believers that the buy side discounts more than the sell-side does and sell side estimates this time around are already much more realistic (Yr+1 IBES Est. EPS Grw was 20.3% in Jan 08!).
• Fifth, investor fatigue. It is fair to assume that many, including us, are tired of ‘seeing red and feeling blue’. We are approaching the 2-yr anniversary of the beginning of the correction and therefore we believe that time is starting to be on the side of equities as well.
• And sixth, from a technical point of view, the current rally seems likely to run for at least another 2 weeks (although an immediate breather is overdue). Figure 3 & Figure 4 below show the absolute performance of Pan-European SMid-Caps (using the MSCI Small Cap Europe and the Dow Jones Stoxx Small indices as proxies) during each of the >10% rallies we have had during this correction (i.e. since Jun 1, 2007). As we can see, according to the MSCI index, only one of the 5 prior rallies was shorter lived than the current one, but it was a lot more significant in magnitude (+19.3% vs the current +11.9%); the next shortest lived rally (that of Jan 08) was 2 full weeks longer than the current one; and the latest rally (Nov 08) was a) longer in length (29 days), and more significant in magnitude (16.3%). In fact, 4 of the last 5 rallies have delivered greater gains than the current 11.9% move, which is worth noting given that we are now starting from a much lower base.
Prior smallcap rallies (chart below) have reached 81 per cent of their gains within the first 12 trading days, according to JPM. They’ve sold off from the interim peak during the next five days, losing an average 4.4 per cent, before rallying to new highs. So, while JPM see a sell-off near term, they’re still forecasting the rally will continue, and what’s more, it may be bigger than previous ones.
But the potential for further gains is more significant this time around given that the recent rally is so far one of the weakest in magnitude which is surprising given that we are coming off a lower base (the MSCI Small Cap index is up +11.9% vs an avg gain of 14.5% in prior up swings).
The bank is accordingly recommending 101 European small- and midcap stocks including Barratt Developments, DSG International, Premier Foods, Legal & General and Aer Lingus on the basis that they “could outperform if the rally continues”.
Make of this what you will.