By Kiran Nandra, head of equities at Jupiter Asset Management
European shares may have risen over the last 12 months but there has been a wide dispersion of returns. Domestic consumer-facing sectors have been relatively strong as consumer confidence in Europe has rebounded, while resources companies and traditional automakers have underperformed due to weakness in China.
Look a little deeper, and it is clear that large caps outperformed small caps as well, as investors flocked to size as a perceived haven. The Russell 2000 small-cap index has underperformed large-cap peers this year, currently lagging the larger Russell 1000 by 1,800 basis points since 1 January 2023. In Europe specifically, the Stoxx 50 is up 14% versus just 4% for the MSCI European Small Cap index.
See also: “Perils of a narrow rally“
Larger companies are generally viewed as safer options in times of economic weakness because they tend to have well-established operations and a larger financial cushion to weather a contraction in consumer demand. Smaller companies are hit harder at times by economic fragility as they have more concentrated exposure to single, domestic economies and a higher level of risk around their operations due to size. Valuations of smaller companies have derated to the level that there is no longer a premium for investing in this area of the market. Small and mid-cap companies in sectors including technology, financial services and healthcare are trading near 10-year lows relative to larger peers.
We are under no illusion that the coming months will continue to be tough fundamentally as higher rates begin to take their toll and inflations concerns refuse to abate. Europe is a net energy importer, so worries around war in the Middle East and the higher cost of energy generally mean capital continues to flow to safety, so towards the US and specifically big tech.
But an actual recession has yet to materialise. Many companies still have large order backlogs that are potentially masking the underlying health of their businesses. And even a “softer” hard landing could boost risk-on sentiment, perhaps drawing some pent-up demand back to less favoured asset classes.
From a valuation perspective, Europe continues to offer the opportunity to buy companies at attractive prices versus global peers. European stocks appear to be pricing in an EPS contraction and trading at a heavy discount to the US. Both value and growth are looking cheap in Europe. Stocks in the region typically trade at 85% the forward price-to-earnings ratios of those in the US, but the level is now closer to 65%. While it is challenging to identify the trigger that will close the gap, the discount is high enough to observe that less is required to get it moving up again.
Why is Europe trading at such a discount? This is due in part to the macro backdrop – the US is expected to grow 2.1% for 2023 versus 0.7% for the Euro Area, and the IMF upgraded its growth outlook for the US for 2024. This lifted sentiment, which was further boosted by the relatively strong US labour market. Local concerns, including worries about Italian debt or whether the ECB will make a policy mistake, have impeded European valuations, on the other hand.
Volatility and weakness can create opportunities for active investors. Small and medium-cap companies can offer higher growth potential than larger peers and, with founders still often at the helm, there can be better alignment of shareholder interest. There are also more opportunities for market mispricings at the smaller end of the investment universe because these companies tend to be less well covered by research.
The key is to build a resilient portfolio of smaller companies that have enduring growth characteristics, are market leaders in their respective fields, have solid pricing power and/or recurring revenues and have low levels of debt to avoid an increasing interest burden.
These are the characteristics of well capitalised businesses that can weather whatever the economic climate may be. If the economy continues to weaken, factors like sustainable competitive advantage, solid balance sheets and the ability to generate strong recurring revenues become even more important.
Crucially, these attributes also allow companies to thrive on the other side of the economic cycle. It is to be expected that smaller companies de-rate under threat of looming recession. Not all will survive, but those that do will thrive as they take share and gain a stronger foothold in their industries. Historic research has shown these stocks begin to start performing as a recession begins – this is because the worries of the market are priced in and the news simply acts as confirmation.
The market is a discounting mechanism and soon it will look to price for better conditions on other side of the cycle. Recessions tend to last nine-to-12 months and so, with one potentially approaching, now is a good time to begin to think about owning quality European small caps.
