Swiss small and mid-caps at an all-time high: a sustainable rise?

LOcom_AuthorsLO-Monier.png   By Stéphane Monier
Chief Investment Officer
Lombard Odier Private Bank


Buoyed by strong earnings growth, Swiss small and mid-caps have outperformed large caps by over 11.8% year-to-date. This trend has also been observed in the European markets, and has recently started in the United States. Here, we analyse the potential of this important sector of the Swiss economy.

The burning question for investors interested in equities is whether they should continue to invest capital in this asset class, when the markets seem expensive at their current levels? The S&P 500 is trading at close to 21.8x the price/earnings ratio, the Stoxx Europe 600 at 21.3x, the SMI at 24.7x and the SPI at 17.3x1. Some commentators would put the figure for the SMI higher, given that its performance was penalised by the decline in the three heavyweights that make up 60% of the index: Novartis, Nestlé and Roche. Does a historic multiple equal an expensive asset class? Not necessarily. There are two aspects to an equity valuation. The first, future earnings growth, allows listed shares to enter into a prolonged rise for as long as companies can maintain sustained earnings growth. The second is relative valuation. Compared with the expected return on other asset classes, the return on equities is appealing. In Switzerland, the dividend yield is 3.2% for the SMI, 2.9% for the SPI and 2.1% for the SPI Extra2, attractive levels in the universe of low returns on financial assets. In the current macroeconomic environment, and based on the global economic outlook, it would therefore seem that the equity markets are not overheating but have achieved a cruising speed in sync with global growth. For investors attracted by Swiss securities, the small and mid-cap segment looks particularly interesting.

The outperformance of listed small and mid-caps stands out in the developed markets. In Switzerland, they have been outpacing large caps by 11.8% year-to-date3. The same trend can be seen in the Eurozone, where the performance of the 200 smallest companies in Stoxx Europe 600 has exceeded that of the 200 largest by 7.3%4. In the United States, companies with a market value of less than USD 2 billion are embarking on a cycle of outperformance buoyed by expectations about future tax reform. This should help them navigate with the wind at their backs in the medium term.

Small and medium enterprises (SMEs)5 make up the backbone of the Swiss economy. Most of the listed SMEs are export firms. For these companies, external market growth sets the pace for their earnings outlook. And they have good reason to be optimistic. For the first time since the financial crisis in 2008, the global economies have engaged this year on a path of a synchronised and stable recovery. Balanced growth, subdued inflation and an affordable cost of capital are the hallmarks of this “soft goldilocks” economic environment. Our contacts confirm that the economic recovery in Europe and the rest of the world is clearly setting the pace for the performance of Swiss small and mid-caps. While most of them are reluctant to publicly disclose too many details about the expected figures – as traditional conservatism dictates – they are quietly confident about their future activities. In terms of sectors, companies operating in construction materials are mainly counting on the Eurozone’s economic recovery and a constructive tone emanating from China. Names associated with the automotive industry continue to benefit from the positive trends in Europe. In the oil and gas industry, although the firms appear cautious, their order books are stabilising. Companies in the agricultural sector are holding up well. Overall, Swiss companies continue to fund innovative products and implement pioneering business models in the health, technology, automation and supply chain optimisation sectors, and many more.

Admittedly, Switzerland’s growth rate is currently more modest than that of the Eurozone and the United States. To boost growth, economic players cannot afford to shy away from making crucial investments as savings excesses could stifle domestic growth. Nevertheless, the country does have some major advantages. Switzerland is top of the World Economic Forum (WEF) competitiveness index, and is consequently very well placed to benefit from the fourth industrial revolution. This ranking attests to its sophisticated economic activity, efficient labour market and innovation capacity. The WEF describes Switzerland as one of the world’s most fertile innovation ecosystems, and identifies the SME sector as a part of the economy that is very active in innovation and well known for the quality of its products and services6. Switzerland nurtures companies with global reach and has historically produced leaders in numerous industries, while its innovation has stimulated economic growth. Growth supported by advances in technology – i.e. structural forces rather than cyclical factors – is particularly desirable, as it is by nature defensive. It tends to protect corporate earnings when the economy enters a cyclical downturn. The small and mid-cap segment is well placed on this path of structural transformation: the technology sector now represents 11% of the SPI Extra, and the industrial sector 26%.

The global economies and markets are still vulnerable to certain risks, and investors would be well advised to look closely at those that might jeopardise the global economic upturn: deteriorating global financial conditions, inflation no longer under control and geopolitical risks that weigh on a number of markets. While the Swiss stock market is trading at high levels in the short term, we think that there are pockets of opportunities in the small and mid-cap segment, a high-quality sector that is well placed to benefit from the solid fundamentals supporting the global economic upturn.

 

Performance of the SPI Extra versus the SMI

Year-to-date 2017

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Source: Bloomberg

1 The SMI (Swiss Market Index) measures the performance of 20 star-performing listed Swiss stocks. The SPI (Swiss Performance Index) includes all Swiss companies listed on the SIX Swiss Exchange and some primary listed foreign companies (source: SIX Swiss Exchange). Figures as at 3 November 2017, Bloomberg.
2 SPIEX – SPI Extra, the Swiss Stock Exchange index that measures the performance of small and medium-sized enterprises (companies that are not included in the SMI).
3 SPIEX versus SMI, figures as of 31 October 2017, Bloomberg.
4 A performance of 15.57% for the 200 smallest companies versus 8.27% for the largest companies year-to-date. Source: Bloomberg.
5 99% of Swiss companies are SMEs. Source: Swiss Confederation https://www.eda.admin.ch/aboutswitzerland/en/home/wirtschaft/uebersicht/wirtschaft---fakten-und-zahlen.html (last updated 18 August 2017).
6 The Global Competitiveness Report 2017-2018, K. Schwab, World Economic Forum, 26 Sept. 2017.

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