Deutsche Bank strategists are expecting smaller European stocks to significantly outperform their larger counterparts in the coming months, citing three key factors that could drive this growth. The bank maintains its positive outlook on the European small and mid-sized companies, despite their underperformance compared to larger companies during early 2024. An ETF tracking the MSCI large-cap index of European companies has gained nearly 11% so far this year, whereas a fund tracking the MSCI Europe Small Cap index has returned 7.4% in the same period. XXSC-DE EMUL^-IT YTD line The bank said three key catalysts could unlock “significant” value in these smaller companies’ shares. Lower interest rates Deutsche Bank said investors were nervous about higher-than-expected interest rates in 2024, and it was among the primary reasons for small and mid-cap companies underperforming their larger peers this year. “These worries seem no longer warranted,” Deutsche Bank strategist Maximilian Uleer said in a note to clients on Dec. 13, pointing out that the difference in the cost of borrowing for smaller companies, compared to larger firms, has fallen to its lowest level in several years. This development is particularly important for smaller companies, which often rely more heavily on borrowed money than their larger counterparts. Improving profits After experiencing a sharp 40% decline in profits during the last quarter of 2023, smaller European companies have shown a remarkable turnaround, according to the investment bank. Small- and mid-cap company earnings grew by 14% in the third quarter of 2024, with consensus expectations for even stronger growth of 25% in the fourth quarter, according to Deutsche Bank. “We expect this to bring back investor attention,” the bank’s strategists wrote. Manufacturing rebound While Deutsche Bank acknowledged that a rebound in manufacturing sentiment is the most unpredictable element of their three key drivers, they expect overall confidence in European companies to improve. The manufacturing sector in the eurozone showed rising weakness in November, according to the latest purchasing managers’ index figures from S & P Global. The euro area manufacturing PMI showed a faster deterioration across new factory orders, production, purchasing activity, and inventories. Employment declined at its sharpest rate since August 2020, particularly in Germany and Austria, while output prices were “discounted more aggressively” in light of sustained demand weakness. However, a reversal of the declining trend could be especially beneficial for smaller companies, which often have significant exposure to manufacturing activities, according to the bank. The bank said its economists anticipate a mild recovery in global manufacturing activity in the coming year, supported by lower interest rates globally. How big could the upside be? If the valuation metrics of smaller companies return to their historical averages, and assuming profits grow at their typical long-term rate of 12% per year, these stocks could deliver returns of 18% every year over the next three years, Deutsche Bank strategists forecast. “The upside potential from a rerating in valuations is significant,” the strategists noted. However, the bank cautions that investors will need patience. The strategists also admitted that they got their bullish on European small caps wrong earlier this year by arriving at the forecast too early. “We reiterate our positive stance on SMIDs but again stress the fact that this will require patience and is not meant as a short-term trade idea,” the bank said. — CNBC’s Michael Bloom contributed reporting.