Small caps are trading at a historically wide valuation discount to large caps, creating a potentially attractive long-term opportunity even as the valuation gap has proved a poor timing indicator. For Tapio Koivu, portfolio manager at Finnish pension insurer Veritas, the conditions are becoming more supportive as Europe’s economy shows signs of recovery, although higher interest rates remain a near-term headwind.
Koivu describes the current environment for small caps globally as “somewhat mixed at the moment.” Over the longer term, however, he sees the segment as increasingly attractive, particularly because of its valuation gap relative to large caps. “The valuation gap, or discount, versus large caps is historically wide,” he says. “Historically, small caps have traded at a premium to large caps, although it depends somewhat on the region and index. Today, they are trading at a discount, and relative to large caps, valuations are historically cheap.”
“Historically, small caps have traded at a premium to large caps, although it depends somewhat on the region and index. Today, they are trading at a discount, and relative to large caps, valuations are historically cheap.”
Tapio Koivu, portfolio manager at Veritas.
Koivu is quick to point out that this argument is not new. “This argument has been around for quite some time, and the valuation gap has continued to widen,” he points out. As a result, he does not regard the valuation differential as a useful signal for timing an entry into the asset class. “It is not a particularly useful timing indicator, but it does make the segment attractive from a longer-term perspective.”
“This argument has been around for quite some time, and the valuation gap has continued to widen. It is not a particularly useful timing indicator, but it does make the segment attractive from a longer-term perspective.”
Tapio Koivu, portfolio manager at Veritas.
The economic backdrop is also becoming more supportive, particularly in Europe. Koivu sees signs of a broader recovery that could eventually benefit smaller companies. “The environment is becoming more supportive on that front as well.” The main near-term concern is the direction of interest rates. “Interest rates have been moving higher, which is typically a headwind for small caps,” acknowledges Koivu. “That is the main factor making me more cautious in the short term, and it could delay the recovery.”
Diversification beyond the AI trade
The dominance of large-cap technology stocks in the current market narrative also affects how investors view the small-cap universe. Much of the attention surrounding artificial intelligence has been concentrated in mega-cap companies, but Koivu sees small caps as a potential source of diversification. “The companies attracting most of the attention from the AI theme are large caps,” he observes. “Small caps can provide useful diversification away from the AI trade.”
“The companies attracting most of the attention from the AI theme are large caps. Small caps can provide useful diversification away from the AI trade.”
Tapio Koivu, portfolio manager at Veritas.
For Veritas, geographical diversification is another important consideration. The global small-cap universe is broad, and the opportunities available in different regions can vary considerably over time. “The opportunity set differs across regions and over time, so regional diversification is valuable,” argues Koivu. “A broader investment universe allows us to take advantage of opportunities as they emerge, since they can vary significantly across markets and over time.”
This fits into Veritas’ broader regional approach to equity portfolio construction. Rather than viewing global small caps as a single allocation, the team considers their attractiveness within the context of each regional portfolio. “It follows from our broader portfolio construction methodology. I find it more natural to assess small caps from a regional perspective, particularly when taking an active view.”
A European preference
Within that framework, Koivu currently sees more attractive opportunities in European small caps, with the Nordics forming part of the broader European exposure. “We do not have a dedicated Nordic allocation. Instead, Nordic markets are covered within our broader European framework,” he explains. “There are attractive opportunities, and many of the same arguments apply to the Nordics as to broader Europe. Overall, I am positive on small caps from a European perspective.”
“There are attractive opportunities, and many of the same arguments apply to the Nordics as to broader Europe. Overall, I am positive on small caps from a European perspective.”
Tapio Koivu, portfolio manager at Veritas.
Veritas combines several vehicles to build its small-cap exposure: direct equity investments form the core of its European and Nordic allocation, ETFs are used to express tactical views, while selected active managers provide additional alpha potential in the strategic allocation. “We use some external managers, and we use ETFs on the side, especially to express tactical views,” Koivu explains. “If I had a tactical view on European small caps, an ETF would probably be the preferred vehicle. They are liquid, easy to trade and capture the investment idea effectively.”
“We use some external managers, and we use ETFs on the side, especially to express tactical views.”
Tapio Koivu, portfolio manager at Veritas.
External active managers, by contrast, are more relevant for strategic, long-term allocations. Koivu sees a stronger case for active management in small caps than in large caps because of the relative inefficiency and lower level of analyst coverage in the segment. “That way, you can capture some alpha potential that is especially strong in small caps compared with large caps,” he says. “It is inherently a less efficient and less-followed market segment.”
Tactical views through ETFs
While Veritas is willing to adjust its exposure, Koivu is cautious about making persistent factor tilts or frequently moving in and out of small caps based on short-term signals. “There has been a prolonged period of small-cap underperformance,” he says. “There have also been strong periods, particularly for US small caps this year. But factor tilts can remain out of favour for extended periods and can therefore backfire.”
That makes the choice of investment vehicle important. While strategic exposure can be managed through direct investments and selected active managers, Koivu prefers ETFs when implementing tactical views. “I am not generally a fan of moving in and out of active managers,” he says. “I would rather implement those changes through a liquid vehicle such as an ETF.”
“I am not generally a fan of moving in and out of active managers. I would rather implement those changes through a liquid vehicle such as an ETF.”
Tapio Koivu, portfolio manager at Veritas.
The rationale is partly practical. Veritas’ broader allocation contains a meaningful index-like component, making ETFs a straightforward way to introduce tactical changes without altering the strategic structure of the portfolio. “ETFs make it easier to express certain tactical views through ready-made instruments,” Koivu explains. “Part of our allocation is relatively index-like, and ETFs are well suited to implementing tactical views within that framework. There is also a broad range of products available.”
“Our allocation to active managers consists primarily of managers with whom we have established long-term relationships and a strong track record. We see them as a valuable addition to the portfolio, but they are not the core of our approach in Europe.”
Tapio Koivu, portfolio manager at Veritas.
Active management plays a more selective role in Europe. “Our allocation to active managers consists primarily of managers with whom we have established long-term relationships and a strong track record,” notes Koivu. “We see them as a valuable addition to the portfolio, but they are not the core of our approach in Europe.”
Interest rates remain the key variable
The balance between direct investments, external active managers and ETFs ultimately depends on Veritas’ broader market outlook and its conviction in the small-cap opportunity. “The decision is driven by our overall market outlook, together with standard considerations around macroeconomics, valuations and market dynamics,” Koivu says.
Among those factors, interest rates currently stand out. “Interest rates are probably the most important factor I am following at the moment,” he confirms. “Beyond that, it is the broader economic landscape: how the economy is performing and the financial conditions we are operating in.” The reason is that smaller companies tend to be more sensitive to the economic and financial environment. “Small caps typically require a relatively favourable environment to prosper.”
“Small caps typically require a relatively favourable environment to prosper.”
Tapio Koivu, portfolio manager at Veritas.
Market sentiment is another consideration, particularly while investor attention remains concentrated on the AI trade. “Market sentiment is another factor, given how much attention the AI trade is attracting,” Koivu concludes. “If performance becomes more broad-based, that would also be supportive for small caps.”
