European equities, paticularly the small cap space, are undoubtedly being overlooked by investors according to Dale Robertson, fund manager at Chelverton Asset Management.
He makes the point that, in general, Europe ex-UK has never been the most popular region, given its association with lower GDP growth and a single monetary policy. Also, in the hunt for growth or exposure to tech, the usual preference is the US and Asia.
But Robertson argues that Europe should figure more on investors’ radar – and says, in the present climate, the place to be is in the small and even micro-cap universe rather in large caps.
“High quality companies such as L’Oreal, ASML and Nestle have been a good place for investors to be over a long period of time. But most of the valuations here are dependent on low interest rates – so they are looking vulnerable now.”
Corporate dinosaurs
Elsewhere in the large cap arena, Robertson is unimpressed by what he refers to as the ‘corporate dinosaurs. Government influenced, capital intensive, low growth companies with structural issues – he namechecks Électricité de France and Telefonica as prime examples.
His conclusion is that both these categories – high-quality large caps and corporate dinosaurs – are not overly attractive right now.
“All the excitement is in small and micro caps and bear in mind that 70% of the companies in Europe are small and micro caps.”
But he adds that the analyst coverage is inadequate in this area – with 16 analysts covering every large cap compared to four covering small caps and two covering micro caps.
Robertson explains that nearly half of companies in the micro-cap categories do not have any cash-flow estimates at all. And many European equity managers can’t invest in micro caps as they are a victim of their own success – they are not able to take meaningful positions in these stocks due to the size of their fund.
The Chelverton European Select fund does have the flexibility to mix large, mid and small/micro caps – and the current weighting is over 54% in small and micro group.
Indeed, as Robertson reveals, the current portfolio illustrates the significant opportunities and mis-pricings further down the market cap scale.
European tech exposure
“You can get good tech exposure in Europe in the small cap area of the market. We are very positive on IT services sector – 29% of our fund is there now. Digital transformation is very much a theme for us – IT service companies helping healthcare, telecoms, banks update their IT systems.”
He namechecks Intofel as a good example of what he is looking for. “Intofel is working with large corporates in France, such as BNP and Airbus, helping them with app development. The company is growing at a very good rate.”
Abrdn head of small companies Andrew Paisley takes the view that, if inflation does continue to exceed expectations and interest rates have to increase, this may well result in a trickier economic environment in 2022, particularly if supply chain issues persist.
In such an environment, he argues that investors should be positioned in higher quality smaller companies for several reasons.
“Higher quality smaller companies with strong management teams should be able to adapt more nimbly to any challenges, owing to shorter management reporting lines and greater flexibility than mega cap companies.
“We have seen this over the last two years with high-quality smaller companies and owner-managed businesses in particular coping relatively well with the challenges of Covid. Often as owner-managed businesses, the management teams of smaller companies have an extra incentive to ‘go the extra mile’ to ensure their company delivers in periods of increased challenge.”
Additionally, he suggests stronger pricing power should allow higher quality smaller companies to increase prices more effectively than commodity type businesses to compensate for any increase in raw material prices.
Paisley adds that newsflow from his smaller company investments has generally confirmed that good quality smaller companies have been able to cope effectively with the challenges of increased inflationary pressures and supply chain issues in second half of 2021 and he expects that to continue into 2022.
“The sell-off in smaller companies has been relatively indiscriminate providing those who are willing to do their homework the opportunity to buy into some high-quality growth companies at cheaper valuations than six months ago.
“We would expect the market to focus more on bottom-up fundamentals as we move through the reporting season and to discriminate more between those companies that are delivering in-line or ahead of expectations and those that are not,” he says.
‘Consumer staples look good’
While not specifically looking at small caps but more the issue of rising input costs already highlighted, Nick Edwards, portfolio manager on the Guinness European Equity Income strategy, currently favours the consumer staples sector.
“What interests us most in the consumer staples sector is the very strong track record for passing on inflationary costs to consumers, particularly for larger brands with dominant market positions. Goods are relatively low-cost, small unit sized and typically essential items, many of which possess a high level of consumer loyalty, enabling companies to add persistent small price increases to offset input inflation.”
In his view, commodity prices and supply chain issues will eventually abate, to the benefit of those names with the pricing power who have been able to put through and sustain price increases.
“As a result, when looking several years out we see a good chance of a reversal of the current situation and a healthy margin rebound. The wider global and European staples sectors are now trading not far off pre-2008 valuation multiples when interest rates were materially higher than they are today; and specific names such as Unilever, Danone and Henkel are trading at 15% – 30% EV/Ebitda discounts to the sector and peers.”
Edwards’ investment philosophy is to buy companies with wide-economic moats and sustainable competitive advantages, where scale and pricing power translates into long histories of persistent high cash returns.
“The current headwinds of higher input costs and rate expectations make 2022 a really good time to look at the sector,” he says.
