Europe has been described as ‘out of favour’ to investors over the past decade. The region suffered from a high degree of volatility over the course of 2022 in particular, arising from the war in Ukraine and ballooning inflation, accompanied by ECB rate hikes. But with the continent trying to wean itself off Russian energy by 2030 and a recession looming, are small caps a good place for investors to find some opportunities?
James Penny (pictured), chief investment officer at Tam Asset Management, says: “European smaller companies have, like many asset classes in 2022, suffered at the hands of a broader bear market and the fact that its often small caps, with a greater degree of volatility in their earnings, who are hardest hit when positivity gets sucked out of the market.
“The compounding factor in the case of European smaller companies has been the war in Ukraine and the fear instilled in European investors around inflation, rate hikes and a broader ‘winter of discontent’, all of which have buffeted European smaller companies into some very attractive value opportunities.
“I think the main call from here is, yes; there is a deep level of value and quality to be found in European smaller companies, but the next year could prove uncertain with the devastating war in Ukraine and the war on inflation. However, over the longer term I think investing after 2022 would be viewed as a good entry point to capture some long-term compounding growth from this sector.”
Despite the gloom engulfing the continent last year, Iboss CIO Chris Metcalfe observed that smaller companies began outperforming larger companies towards the end of the year.
He says: “Since the end of September 2022, we have seen European small caps outpace their large-cap peers. This turnaround coincided with European equities starting to outperform global indices dominated by US assets. Until then, the news surrounding Europe and its economy was incredibly pessimistic.
“With little new decisive news on the war in Ukraine and long-range weather forecasts bringing a sense of relief over the energy crisis, a new wave of optimism has quickly developed. As hopes have grown of Europe avoiding a recession as deep as the one widely feared, European small caps have led the recovery, which has been very similar to what has transpired in the US. Often in times of crisis, smaller companies suffer regardless of relative valuations; they are perceived as more vulnerable than their larger counterparts.”
“Overall, we remain neutral on Europe but retain limited exposure to the small-cap space. We feel that the relief of avoiding the worst-case scenario is now in the valuations for both small and large-cap stocks. On the positive side, we don’t think that many international investors fully realise the potential impact of the China reopening, hence a neutral stance overall.”
Smaller companies returning to traditional outperformance
Longer term, Chelverton’s Dale Robertson believes this is a return to smaller companies’ traditional outperformance when compared to their large-cap peers.
This was illustrated by the MSCI European ex UK small caps index posting total returns of 11.3% over the decade to 31 January 2023, while the overall MSCI ex UK index returned 8.71%.
Over the last five years, however, the trend has reversed.
The Chelverton European Select fund invests in companies of any size, with 70% of its portfolio currently made up of small caps.
Robertson says: “The context for small caps is really quite interesting because Europe, as a region, has been quite out of favour in the last five to 10 years. One of our most simple messages from the last five years is that the more we have researched small-cap Europe, the more excited we are about it.
“You can see that in our allocation to small and mid-cap. When we started the fund five years ago, we were at 40-45% allocation to smaller cap Europe, and now it’s 75%. The opportunities are so significant that it’s really a bottom-up allocation. If you look at what’s happened in Europe over the very long term, 20-25 years, small caps have significantly outperformed large caps.
“There are various reasons why small caps have underperformed in the last five years or so. One part of Europe which has been very much in favour has been the so-called high-quality growth companies, such as L’Oreal and LVMH. They’ve driven the performance of European indices and left small caps especially trailing in their wake, despite what to us are very obvious attractions of smaller companies – which are very good long-term growth dynamics, safe balance sheets, and good valuation.
“So, we actually think that right now is a very good time to be looking at European smaller companies. In terms of allocating long-term capital, now is a very good time to be looking at small caps in Europe.
He added: “When we look at the valuation of large-cap, mid-cap and small-cap, we find them on very similar levels overall, but you are getting much better long-term growth from the small companies. We think that is a big inefficiency in markets at the moment in Europe – the market’s long-term growth prospects of small companies are not being recognised and that is really quite exciting, because for the same valuation, a large cap may be growing at 5%, you can get a small cap growing at 10%, or even 15%.”
However, Ben Griffiths, portfolio manager of the T Rowe Price European Smaller Companies Equity Fund, warns that Europe is not out of the woods yet. “The investment environment continues to be marked by a high degree of geopolitical and economic uncertainty. Economies have begun to slow down, but the depth and duration of a likely recession are hard to gauge, as is the response of central banks.”
He added: “In these uncertain times, we must be prepared for market dislocations triggered by events. The market rotation and volatility are presenting us with new opportunities. We are also focused on defending those holdings that become derated but where the business remains fundamentally robust and may even be stronger after recent events.”
Energy and tech proving attractive
Within the European small-cap universe, managers are finding opportunities in the technology and energy sectors in particular.
Trevor Gurwitch, senior portfolio manager of American Century Global Small Cap Equity, says: “We believe one of the key benefits of an active approach to small caps is the ability to identify focused businesses that are beneficiaries in a wide range of environments. For example, the portfolio has increased its exposure to Europe’s energy innovators – companies benefiting as Europe seeks to reduce its dependence on Russian energy, accelerating the need to find alternative power and enable more efficient uses of electricity.
“We believe that some of the current headwinds will turn into tailwinds over the next year and beyond. Companies including Golar LNG, an energy company targeting stranded gas fields; Aker Solutions, an energy solutions provider with an expanding renewables business; Nexans, a provider of high voltage cables connecting offshore wind farms to the grid; and Acciona, an infrastructure and renewable energy developer, are benefiting from increasing capital spending on renewables and natural gas which we believe will be a long-term structural tailwind.”
Meanwhile, Chelverton’s Robertson highlights the technological transition brought about by the pandemic as another opportunity for small-cap investment. European firms were largely less equipped to transition online following the imposition of lockdowns than in the UK and US. According to the fund’s latest factsheet, 31% of its holdings are in the technology sector.
He says: “These are companies that are staffed by IT consultants, who go to their clients in the public or private sector and help them with all those projects – getting onto the cloud, cybersecurity etc. There are lots of really interesting small cap IT service companies, and that’s the major theme that we’re playing, the client of these firms need to keep investing in technology or they’re going to fall behind competitively.”
Robertson added: “In a small business, you can get a lot of very good exposure to companies which are driven by the energy transition, which is such a dominant theme. Over the last year we significantly increased our exposure to this energy transition. Part of the reason was that the world woke up and realised it needed to concentrate more on energy transition. Very specifically, the EU wants to wean itself off Russian oil and gas by 2030. Last year was a catalyst for us to think and rethink and increase our exposure.
“We can pick a lot of companies that have got really strong structural tailwinds behind them. Both of those themes – digitalisation and energy – you can get very good exposure to small caps. The overall point we want to make is that these companies have very strong long-term growth prospects, and it’s not being recognised in valuations currently.”
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