In the biographical romantic drama ‘Eat, Pray, Love’, Julia Roberts stars as Elizabeth Gilbert, who finds herself searching for what she really wants in life. So, she embarks on a journey around the world that becomes a quest for self-discovery.
In her travels, she falls in love with Italy, the culture, the wine and, of course, its pizza. In a similar way, across our European small-cap strategies, we are on a quest for discovery. And much like Elizabeth, we’re always open-minded to find what we’re searching for in unlikely places. For us, this has often led us to Italy – sometimes perceived as a dull, low-growth market.
Italy: Unloved but beautiful
When many investors think of Italy, they think of low GDP growth, bureaucracy and near-constant political turmoil. And yet, if you’re searching for excess returns, we can’t think of anywhere better than Italian small caps – many of whom beat their global peers when it comes to innovation, engineering prowess and growth. Companies like Bulgari, Campari and Ferrari were all Italian small caps once, countering the widespread misperception that Italian equities can’t deliver great returns to investors.
Today, we continue with our long-held overweight in Italian equities in our European and Pan-European small-cap strategies. Not because we have a strong view on Italian macroeconomics, rather because we can find lots of stocks that fit neatly into our “DNA” stock selection framework. This means finding durable companies, where we can find a non-consensual investment thesis that gives rise to price asymmetry.
Italian holdings in our European small cap strategies today include espresso coffee machine maker De’ Longhi, plastics recycler Piovan and GVS – a manufacturer of filter solutions for applications in the healthcare and mobility sectors.
Apart from being listed in Italy, what they have in common is that they’re all leaders in their respective fields, benefit from a highly skilled workforce steeped in engineering history thanks to world-class universities like Bocconi in Milan, have large global growth opportunities ahead of them and have generated excellent returns on capital.
Finally, they are all family-owned businesses. With permanent “skin in the game” we often find these businesses have incredible focus, strong cultures, clearly defined purposes, excel at capital allocation and possess strong balance sheets to weather downturns. For our Italian small caps “la vita” truly is “bella”.
Whilst it might surprise some, the small-cap FTSE Italia STAR index has delivered a 12.1% return per annum in US dollar terms over the past two decades, even better than the S&P’s 9.4% and MSCI Europe’s 7% over the same period. Across our small-cap funds, Italy has been the richest source of alpha over the past decade, as low market expectations have been more than offset by the excellent fundamentals mentioned above - long may this continue.
Small caps: An unloved and misunderstood asset class
Outside of Italy we continue to find great opportunities in what’s still a relatively unloved, unknown and misunderstood asset class – small caps more broadly. Investors tend to shun small caps for many reasons, the three most common being: 1) a lack of liquidity; 2) mostly unfamiliar names, which makes investors wary; and 3) perceived higher risk (‘small caps will always underperform large caps in market drawdowns’ is what we often hear).
Let’s take these points in turn. Whilst individual smaller companies can be less liquid than their larger peers, the breadth and depth of the asset class can more than compensate for this. Secondly, it is true that small caps are less well-researched by the sell side, but this increases the odds of them being mispriced, making the asset class well-suited for fundamental investors who rely on their own research capabilities to find the best opportunities.
Finally, when it comes to a perception of higher risk, as we demonstrated in a July 2021 blog called “Global Small Caps – Volatility overestimated, diversification potential underestimated”, we showed that over the past four bear markets, small caps didn’t underperform large caps on average, meaning that small caps can outperform in both upturns and downturns, thereby potentially delivering not just higher through-the-cycle returns than large caps but importantly higher risk-adjusted returns too.
Crucially, the results are similar whether you look at global, European, US, Japanese or emerging market small caps vs large caps.
Great companies aren’t born, they’re grown
All the stock market giants of today started life as a small company – sometimes, even founded inside a garage. In our view, it makes sense for investors to cast their eyes on the often ignored small-cap sector to find the hidden gems.
We believe that the European small cap space provides a fertile hunting ground for active managers like us.
James Matthews is a European equities fund manager at Invesco. The views expressed above are his own and should not be taken as investment advice.