European small and mid-cap equities are entering a potentially more constructive phase as Europe’s push for economic and strategic sovereignty coincides with improving domestic growth prospects. After years of relative underperformance and subdued investor attention, the segment offers a broad opportunity set at valuations that remain attractive. At DWS, this opportunity set is approached through two complementary lenses: “Mispriced Inflection”, targeting companies where fundamental change is not yet reflected in valuations, and “Quality-Growth-at-a-Reasonable-Price,” focusing on businesses with durable competitive advantages and long-term growth potential.

Europe’s sovereignty agenda

For Christian Schindler, Deputy Head of European Small & Midcaps at DWS, one of the key catalysts for the European small and mid-cap universe is the region’s growing focus on strategic sovereignty. “The big topic in Europe right now is the EU sovereignty agenda. It goes well beyond defense. There are numerous initiatives aimed at strengthening sovereignty and strategic independence, not only politically but also from a supply-chain perspective,” Schindler says. He points to initiatives including the European defense package, the EU Critical Raw Materials Act and the Steel and Industrial Accelerator initiatives.

With more capital potentially flowing towards European industries and businesses, the resulting investment could support domestic economic growth. “This means more GDP growth in Europe, which should benefit European companies. European small and mid-caps are particularly relevant because they have around 20 percent more sales exposure to Europe versus large caps,” he argues. Schindler also points to improving economic data, including the City Economic Surprise Index, which has shown stronger readings for Europe relative to the U.S. “The improvement in economic data is supportive of cyclical stocks. Small and mid-caps have significant cyclical and export exposure, which should benefit from this environment.”

“Europe is not expensive relative to its own history and relative to the U.S. Within Europe, small and mid-caps are also trading at historically low valuations versus the broader market. That gives a double-layer valuation argument.”

Christian Schindler, Deputy Head of European Small & Midcaps at DWS.

The macro backdrop is complemented by valuations that remain relatively undemanding. “Europe is not expensive relative to its own history and relative to the U.S. Within Europe, small and mid-caps are also trading at historically low valuations versus the broader market. That gives a double-layer valuation argument,” Schindler says.

Two complementary opportunity sets

The six-member team behind DWS Invest ESG European Small/Mid Cap divides the investment universe into two broad opportunity sets. The first focuses on companies combining quality and structural growth with reasonable valuations. The second targets companies undergoing fundamental change that the market may not yet fully recognize.

Since the fund’s launch in 2018, the portfolio has typically had 50-60 percent of its exposure in the ‘Quality-Growth-at-a-Reasonable-Price’ bucket, with the remainder in ‘Mispriced Inflection’ opportunities. Today, the balance is the opposite. “Around 60 percent sits in ‘Mispriced Inflection’ because the opportunity set varies depending on the market environment,” says Schindler.

“Around 60 percent sits in ‘Mispriced Inflection’ because the opportunity set varies depending on the market environment.”

Christian Schindler, Deputy Head of European Small & Midcaps at DWS.

The inflection opportunities are typically companies or industries approaching a turning point following a specific catalyst. These catalysts can take several forms, ranging from regulatory changes and management transitions to restructuring and strategic repositioning. Once the team identifies the catalyst and establishes a credible investment case, it builds its own detailed models, with timing playing an important role. “You need to see EPS upgrades relative to consensus. That is where the alpha comes from as the market catches up through earnings revisions.”

The challenge with inflection investing is distinguishing a genuine turnaround from a company that is simply cheap for good reason. A struggling business can remain inexpensive for years, making the identification of a credible catalyst central to the investment case. “A struggling business can become a value trap,” Schindler acknowledges. “You need a catalyst that is already visible,” he emphasizes.

Quality, competitive advantage and ROIC

The second bucket, ‘Quality-Growth-at-a-Reasonable-Price’, is built around companies with durable competitive advantages and the ability to grow faster than their underlying markets over an extended period. “We have a quality component and a structural-growth component. It is not simply growth; it is structural growth,” Schindler stresses. “We look at whether the company has historically been able to grow above nominal GDP or above its industry, and whether that is likely to continue. In other words, it is a market-share taker.”

“We have a quality component and a structural-growth component. It is not simply growth; it is structural growth. The key question is whether that competitive advantage can be defended over the long term.”

Christian Schindler, Deputy Head of European Small & Midcaps at DWS.

Quality is assessed through a range of fundamental characteristics. The team looks for businesses with strong or growing market shares and seeks to understand the source of their competitive advantage and, crucially, whether that advantage can be sustained. “The key question is whether that competitive advantage can be defended over the long term,” reiterates Schindler.

“There are many aspects to quality. But return on invested capital is the most important because all the fundamental characteristics – market shares, high barriers to entry, high margins and high asset returns – ultimately feeds into one KPI.”

Christian Schindler, Deputy Head of European Small & Midcaps at DWS.

The analysis incorporates cash conversion, balance-sheet quality, management quality and ESG factors, among other considerations. But one metric stands out in the team’s assessment of business quality: return on invested capital. “There are many aspects to quality. But return on invested capital is the most important because all the fundamental characteristics – market shares, high barriers to entry, high margins and high asset returns – ultimately feeds into one KPI,” he elaborates.

ESG as part of fundamental analysis

ESG is integrated into the team’s stock-selection process rather than treated as a separate overlay. DWS’s broader ESG infrastructure provides the team with detailed company-level information that feeds into its fundamental analysis. “At DWS, we have a substantial ESG infrastructure. We subscribe to all the major ESG data vendors, and we normalize and harmonize the data. We receive a detailed report covering every aspect of ESG,” Schindler says. “ESG is an integral part of our investment analysis.”

“Governance has always been part of fundamental analysis because, in small and mid-caps, companies can run into serious difficulties as a result of poor governance.”

Christian Schindler, Deputy Head of European Small & Midcaps at DWS.

Governance receives particular attention in the small and mid-cap universe, where management decisions and ownership structures can have a material influence on outcomes. “Governance has always been part of fundamental analysis because, in small and mid-caps, companies can run into serious difficulties as a result of poor governance,” Schindler says.

Quality at a reasonable price

A focus on quality and structural growth can naturally lead investors towards companies trading at premium valuations. For DWS, therefore, valuation remains an essential part of the investment case rather than an afterthought. “We focus on quality, strong growth and reasonable valuation,” Schindler reiterates. The team uses a range of approaches, from relatively straightforward multiples such as enterprise value to EBIT through to more detailed discounted cash-flow models. “We assess valuation from different angles to determine whether it is reasonable.” 

The objective is not to identify the cheapest companies, but businesses where the valuation provides sufficient support for the underlying fundamental thesis. “We identify companies that meet these criteria and where the valuation provides additional support for the investment case,” he says.

A concentrated portfolio with differentiated holding periods

The team maintains a relatively concentrated portfolio of around 50-60 holdings, allowing individual positions to have a meaningful impact on performance while keeping the portfolio manageable from a monitoring perspective. “Think about having 300 names. In that case, top-down macro simply overrules your bottom-up stock-picking,” argues Schindler. “A portfolio of 50-60 holdings fits the opportunity set, the potential for alpha generation and the monitoring requirements.”

“Think about having 300 names. In that case, top-down macro simply overrules your bottom-up stock-picking. A portfolio of 50-60 holdings fits the opportunity set, the potential for alpha generation and the monitoring requirements.”

Christian Schindler, Deputy Head of European Small & Midcaps at DWS.

The expected holding period depends on which of the two investment buckets a company falls into. “For quality and structural growth, it is a buy-and-hold strategy,” Schindler says. The team continues to monitor earnings revisions and returns on capital, among other indicators. “If you see negative revisions or a deterioration in return on capital, you have to act. But generally, this is a long-term investment strategy.”

The ‘Mispriced Inflection’ bucket has a more defined time horizon because the investment case is linked to specific operational or strategic milestones. “It is a one- to three-year investment horizon because you establish clear KPIs,” Schindler explains. “Once those KPIs have been met and the developments you expected from the company have materialized, the investment case has played out and you sell.”

For DWS, the European small and mid-cap universe offers an unusually broad opportunity set precisely because companies can be driven by very different forces. Europe’s sovereignty agenda and a potentially stronger domestic economic backdrop may provide a supportive macro environment, but the investment case ultimately rests on identifying companies where the fundamentals can improve faster than the market anticipates, or where structural growth can be sustained without an excessive valuation premium.