By Peter Kraus, manager of the Berenberg European Small Cap fund
We have just witnessed the biggest drawdown in the European small-cap history. It took place from September 2021 to the end of 2023, with European small caps showing a relative underperformance of 23% versus large caps – an even greater drawdown than during the global financial crisis. Everything looked bad.
In October 2023 we witnessed a 10-year low in valuations for European small caps and saw the biggest small versus large valuation drop since 2008. Last year was a pretty poor year for mid and small-cap flows in Europe too. There has since been a slight recovery but valuations are still very depressed.
So, are there reasons to think European small caps could swing up and stop being seen as a wasteland?
This is an important question and not just for those who want to invest in small and mid caps. This is because small and mid caps are historically something of a canary in the coal mine.
They have tended to serve as reliable indicators of upcoming economic cycles, providing early signals of impending downturns or recoveries. This makes them valuable tools for investors looking to anticipate the next big market shift.
The big picture is that European manufacturing is in recession but there are early signs of a better economy. We are optimistic we will soon see an economic recovery, as interest rates are due to come down and inflation is coming under control.
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Small and mid caps will likely be at the forefront of the revival. Major setbacks such as the recent ones have historically always been excellent buying opportunities.
The truth is, a lot of the poor performance of small and mid caps in Europe is not due to the fundamentals of the businesses in question. Strong fundamental development in many companies was overshadowed by the general sell-off triggered by the crash in the bond markets and the economic downturn.
Companies that proved their pricing power through several price increases were only affected to a very limited extent by rising energy costs but still suffered big share price drops. This was also true of companies that hardly had to accept any additional burden from interest rate increases due to low debt.
There are still many high-quality growth companies in the European small-cap space, many of which are global market leaders. They are particularly concentrated in areas benefiting from global structural megatrends such as digitalisation in healthcare or the technology sector, progress in medical technology or the increasing demands for energy efficiency.
A number of the most resilient and fundamentally strong names at the moment are in Sweden, Denmark and Switzerland. These countries offer a highly innovative environment and a great hunting ground for long-term quality growth companies.
Such companies have solid balance sheets, high profitability, attractive returns on equity, high barriers to entry in their respective niche markets, and the ability to continue to grow profitably in the long term and emerge stronger from crises in most cases.
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When it comes to riding the digitalisation wave, one of the best names in the European small-cap space is Fortnox. Despite worries about the death of European technology and software companies, this Swedish-based company provides a range of software solutions for general business purposes, such as accounting, billing and sales. Despite a difficult business environment, Fortnox managed to significantly increase its customer base in the fourth quarter and is proving to be a very resilient business.
In the medical technology space, Denmark-based Chemometec is still putting in a very solid performance in a tough environment. The firm offers a range of analytical instruments for counting mammalian, animal, yeast and sperm cells. The instruments are based on technology that combines fluorescence microscopy with digital imagery and it mainly sells to the pharmaceutical, food processing and agriculture industries.
Strong growth coupled with margin progression and good returns, good visibility and differentiated market position is also found in Skan, a Swiss manufacturer of isolators for the sterile filling of injectable drugs. The underlying drivers are strong: 75% of all new drugs in future will be high-priced biologics/injectables that require Skan’s technology. The company’s strong position is reflected in high annual organic growth with increasing profitability, a net cash balance sheet and high returns on capital.
Breakthrough innovations in the technology such as software or semiconductor equipment and healthcare (ie medical technology, diagnostics) offer the highest potential in terms of earnings growth in the longer term and this is what drives share prices.
It is definitely true that many companies are not in the strong position of a Fortnox, Chemometec or Skan. However, the valuation gap between blue chips and small caps is so big that small-cap performance is almost certain to improve to a degree, even if we don’t take into account the fundamental strengths of many companies in the space.
Historically, small caps demonstrate robust growth compared to their larger counterparts. They just tend to more susceptible to temporary disruptions. The current discount in the small-cap space fits this pattern and so we anticipate a reversal. History shows that one should not wait too long to invest after major setbacks, because when the economy is doing well again, the market has long since priced in the better prospects.
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