By Lucy Raitano

LONDON Investors are turning their attention back to European small and mid-cap stocks as low valuations spark long-term interest even as the immediate economic outlook remains gloomy.

Europe’s smaller companies have seen relative valuations sink as concerns about an economic slowdown have favoured defensives over cyclicals, while banking turmoil stoked credit crunch fears and an AI boom boosted mega-caps.

The MSCI Europe SMID index of European small to mid-cap firms is trading near 2008 lows versus the wider market in terms of valuations, including both price/earnings and price-to-book ratios.

While economic slowdown concerns persist, investors say much of the risk is factored into the price of so-called SMIDs, meaning they will have less downside than big stocks if Europe finds itself in a prolonged recession.

"Small and mid-caps are more advanced in pricing in a recession than large caps. You can get them at fairly low multiples and a cheap valuation," said Emmanuel Cau, head of European equity strategy at Barclays, whose team upgraded small caps to overweight on June 8.

The bank's small cap basket is invested across sectors, or 'sector neutral', to make it "less prone to the ups and downs of cyclical acceleration and deceleration."

Among Barclays’ higher conviction overweight-rated SMID stocks listed in a note on May 24 are German online food delivery platform Delivery Hero and UK oil and gas producer Harbour Energy. Their shares are down 18.5% and 17% respectively since the start of this year.

TURNING POSITIVE

Europe's largest asset manager Amundi recently noted that its clients, after sidelining smaller caps following years of high volatility and weak performance, have turned more positive.

"Clients are more interested than usual in small and mid-caps, recently we got a couple of requests specific to this asset class," said Cristina Matti, a portfolio manager at Amundi.

Still, investors will be highly selective.

As well as being more cyclical, SMIDs tend to be less liquid than bigger caps, counting against them when investors want assets that are easier to sell in a pinch.

Jitters around the availability of credit after March's banking turmoil has also been a concern, with small and mid caps seen as more sensitive to credit crunches. But M&A remains a supportive theme, said Amundi's Matti, as big players seeking external growth can look to the small cap sector for niche expertise to add to their portfolios.

"When people are trying to find alpha to add to their portfolio, small caps tend to be the place to look at," said Matti.

AI RALLY FAVOURS MEGA CAPS Breakthroughs in generative AI have kept investor attention on mega-cap stocks recently. "We are seeing a winner takes all, large cap quality angle coming through," said Graham Secker, chief European equity strategist at Morgan Stanley.

Yet that is also prompting scrutiny of SMIDs from an AI perspective. Some mid-cap software companies could start to benefit while many small and mid-caps that don't have the resources to invest in AI will be at a disadvantage long term.

“We see the opportunity now from here in terms of finding the smaller and mid cap companies which are going to be both positively and negatively influenced by these trends,” said Bernie Ahkong, co-CIO at O’Connor Global Multi-Strategy Alpha, part of UBS Asset Management.

TIMING IS EVERYTHING

The clincher for a revival of small caps will be economic data bottoming out, as that could signal the start of a rotation back into cyclical stocks.

"If we’re right and the European economic data gets worse over the next three months, now is not the time for investors to buy, rather they will want to get close to the turn, which hasn’t happened yet," said Morgan Stanley's Secker.

Data last week showed the euro zone fell into a technical recession over the winter.

"You have to be absolutely certain that the prospect of the economic outlook 5-6 months from now is already well reflected in that [valuation]," said Thomas McGarrity, head of equities for RBC Wealth Management.

"Ultimately, they (small caps) are a rich hunting ground for long-term investors."

(Reporting by Lucy Raitano; Editing by Susan Fenton)