Can we really trust European equities? That’s been the question for much of 2021, as the market has demonstrated its resiliency to bounce back from the challenges of a slow post-Covid recovery and continued political wrangling.
Year-to-date the European stock market has returned almost 20%, but investor distain remains stubborn given that investing in European equities has proven exceptionally challenging since the financial crisis.
Over the past 10 years the S&P 500 has returned almost three times that of European equities, with the sovereign debt crisis and Brexit two of the many issues holding the continent back in recent years.
Unfortunately, European smaller companies appear to have been tarred with the same brush, despite having comfortably outperformed their larger peers in the past decade, returning 281% (vs. 206% for the IA Europe ex UK average).
The opportunity is immense for an area of the market which is under-researched when compared to its larger counterparts. There are some 2,500 quoted European stocks with a market capitalisation of between £100m and £5bn, compared to circa 400 with a market cap of over £5bn.
Small-cap companies can also give investors better exposure to an individual country, allowing them to really respond to cyclical differences across Europe – something that cannot be underestimated in this recovery phase in markets.
There are a host of other reasons why European small-caps are attractive over the longer-term. For one, they represent a unique blend of industries and companies that are less prominent in other regions.
I recently read an article from JP Morgan Chase that also highlighted the fact that cyclical sectors have generated far superior returns for small-cap stocks in Europe. What’s more, they have much greater exposure to real estate, which has been booming in Northern Europe in recent years.
Smaller firms in Europe also have a much greater exposure to the technology sector, which continues to benefit from strong secular tailwinds courtesy of the pandemic – think of the likes of fintech, e-commerce, computer gaming and green energy.
Marlborough European Multi-Cap manager David Walton currently has 50% of his portfolio in companies with a market-cap below £1bn. He says there is greater scope for companies to go under the radar in Europe, citing that there is typically just one analyst from a bank covering companies in Europe with a market-cap of £250m, compared to four or five in the US or the UK.
Short-term trends also offer hope
There are also short-term indicators that suggest positives for European small-caps. For example, economic data across Europe has come in considerably better than expected in recent months.
The IHS Markit Eurozone Manufacturing PMI has ranged between 58.5 and 63 between March and October 2021, not bad considering anything higher than 50 implies growth.
The interesting point here is that historically small-caps outperform after PMI troughs (PMI was as low as 35 at the height of the pandemic).
Research from Janus Henderson also shows that roughly 40% of European small-caps are currently net cash, double the amount in the large-cap space (39.3% vs.20.6%) while small- and medium-sized firms are also trading at an attractive valuation of four times price-to-book.
As is the case in the UK, merger and acquisition (M&A) activity is also on the rise in Europe. Year-to-date we’ve seen 425 IPOs take place in Western Europe alone (the highest in the previous 12 years was 290 in 2017).
History shows that in that time around 91% of all M&A activity in Western Europe ex-UK has been in the small-cap market with 1,954 companies between £500m to £5bn (vs. 182 above £5bn) being targeted.
Ultimately, one of our main investment beliefs is that small and mid-caps outperform large-caps over the longer-term. It was only last year that I saw some research from Credit Suisse that showed European Smaller Companies were trading at their cheapest level relative to large-caps since 2002.
A principal reason for that was the benign economic conditions and central bank liquidity within markets, making all stocks more expensive. However, larger companies have been driven higher by structural headwinds and by herding from investors.
I believe European smaller companies is a sector where good active managers can offer strong levels of growth, at a time when any growth comes at a premium to investors.
Those looking for pure exposure might want to consider the likes of the Jupiter European Smaller Companies fund, managed by Mark Heslop, which invests in a concentrated portfolio of 50-60 holdings, while the Barings Europe Select Trust and the T. Rowe Price Responsible European Smaller Companies Equity have also produced excellent returns in recent years.
Other alternatives worth considering include the LF Montanaro European Income fund and the Marlborough European Multi-Cap fund.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre. The views expressed above are his own and should not be taken as investment advice.