European Equities – Small caps lead recovery

The COVID-19 pandemic may have precipitated a 40% crash in European small caps last March but by January 2021 they had doubled from their low point. In so doing, they surpassed the recovery of European large caps by some margin (see figure). 

The two markets differ substantially in their sector composition as well as the revenue sources and risk profiles of their constituent companies. As a result, in a post-pandemic world, the opportunity set for investment in European small caps looks different from that available in European large caps.

European large caps are – with some exceptions – dominated by structurally-challenged segments such as energy, financials and lower-growth industrials. Marcus Ratz, a partner at Lupus alpha, an independent asset manager based in Frankfurt, points out that these have faced substantial regulatory and structural pressure over the past two decades. 

As a result of this, says Peter Kraus, head of the small-cap team at Berenberg equity fund management, the European-equity space has suffered a huge disappointment on an index level over the past 20 years. Compare, for example, the Euro Stoxx 50 with the Dow Jones Industrial Average, its nearest US equivalent. The main reason for this discrepancy, he argues, is that Europe’s large-cap sector lacks structurally-growing companies in technology and healthcare. 

“You cannot compare European large caps to the S&P 500, let alone NASDAQ,” Kraus says. “However, the real bull market in Europe continues in innovation leaders in the micro/small/mid-cap space where you can find extremely attractive niche companies.” 

Europe’s large companies are not entirely restricted to the old economy of traditional firms. Europe has a few dynamic large caps in the IT sector that can benefit from the digital economy that was already in the midst of a transformation before the pandemic. German software company SAP is a prominent example. But even among Europe’s few tech giants, a prominent prospect, Wirecard, a German fintech firm, filed for insolvency after being mired in scandal. 

Driving structural change
Among European smaller companies the story is different. Many new names, be they e-commerce or online digital companies, are on the verge of becoming large firms. It is Europe’s smaller and mid-sized companies that are driving the digitalisation and structural changes in the European economy. 

Ratz says these smaller and mid-sized companies are comparable in dynamism to the large internet and e-commerce companies the US. “Sweden, for example, has a phenomenal number of these tech stocks which are very comparable to what you can see in the US,” he says. This structural difference in European small caps is driving the outperformance of European small and mid-caps,  Ratz says. “We consider this to add roughly 200bps on an annual basis, versus large caps.”

Germany’s Mittelstand firms are often seen as an ideal for success for smaller companies. Francesco Conte, a European smaller companies specialist at JP Morgan Asset Management, argues that the introduction of the euro led to adoption of “Mittelstand characteristics” by small companies across Europe. “What the euro did was to impose a discipline on European companies where they basically had to behave like the Germans,” he says.

In the past, French and particularly Italian companies would only remain competitive through currency devaluation. The euro forced a convergence on quality upon companies because there was no devaluation to help them out. As a result, German auto-manufacturers may be assembling cars in Germany but the parts are produced by small companies across Europe. The barriers to trade for European small caps have fallen for years. Even language is less of a barrier with the widespread adoption of English in business.

Those European small caps that manage to survive the pandemic-induced downturn may have good prospects. However, their survival depended on government support at a time of mass confusion and panic. In Europe, small and mid-cap indices dropped by an additional 7% compared with large-cap indices in March as investors desperately searched for liquidity, says Bertrand Faure, portfolio manager at Eric Sturdza Investments. 

At the time, few facts were available about the likely government support. It did come in the end, ranging from furlough schemes, to company loans and grants. But Faure says small differences in lockdown rules and support packages made a big difference to companies. Rexel’s results for the first two weeks of April 2020 showed its French business declined by 59.8%, while at the same time its German activity increased by 2.6%. That dichotomy of returns was entirely caused by the variations of lockdowns that were imposed across different countries says Faure. 

“The euro imposed a discipline on European companies where they basically had to behave like the Germans”  - Francesco Conte

Yet for investors, choosing companies on how well they performed with government support holds dangers. As Isabelle de Gavoty, head of small cap, at AXA Investment Managers ponts out, that support should stop at some point in time. Investors need to ensure their companies will survive without government support. As a result, AXA IM has a focus on the credit ratings and access to credit by small companies to minimise risks of refinancing. 

Winners and losers
The pandemic has clearly created winners and losers both in the short term and longer term. Some industries, such as hospitality, have been short-term losers. The sector as a whole may recover but Anna Lundén, small-cap equity portfolio manager at Wellington Management Company, says restaurants and hotels operate in extremely competitive markets with a low level of differentiation between businesses. “In order to stay ahead of the game you’re constantly needing to reinvent yourself, which I find quite unattractive,” she says. 

Lundén would rather own shares in services providers to the industry such as suppliers of table linen, laundry services and distributors of fresh produce. It is clear that when normality returns there will be a return to eating out. However, the most popular venues after the pandemic may not be the same as those in favour before.

Healthcare is an obvious winner. Not only has it enjoyed strong performance but it requires a lot of investment to avert future repetitions of the crisis. Technology, similarly, has shown strong performance, as have consumer staples and elements of the consumer sector, says Lundén. 

For Kraus, the opportunity in European small caps lies in growth stocks in sectors such as technology, software and IT services and semiconductors. Some healthcare diagnostics and laboratory equipment and industrials, he points out, have also benefited from the crisis. 

Sectors such as business travel, argues de Gavoty, might not recover to pre-pandemic levels for some time. Companies may decide they can function well via online meetings at far cheaper costs.  

But some companies in niche sectors that have struggled under lockdowns have such a strong economic moat around them that they are well positioned to bounce back. Lundén sees ski resorts in that category. “These stocks have been badly beaten up with this ski season all but cancelled, so those shares are trading on depressed levels but there’s no way they are not going to be around in five years’ time, or  longer,” she says.

Other sectors include holiday travel. Airports, points out Conte, may have no earnings during the crisis but once normality of some sort is returned, they should be closer to normalised earnings, even if business travel levels are lower.  

As with their large-cap counterparts, European small-cap companies may be well positioned in relation to the US in riding the wave of interest in creating more sustainable economies. They have a strong focus on ESG, renewable energy and positive, or at least less-negative, environmental impacts by companies. Lundén views ESG as another source of inefficiency in small-cap valuations along with a lack of broker research coverage: “There is an information gap when it comes to ESG that will improve over time because companies are really upping their game in terms of their sustainability reports and the amount of data that they’re providing,” she says. With increased attention coming from both institutional and retail investors, particularly the millennial generation, the focus on ESG and sustainable investment will not go away.

The idea of building back better after the pandemic resonates well in Europe. Perhaps renewable energy is where European companies are really making their presence felt, albeit with strong government support. Wind power companies, points out Lutz, are invariably not large caps. But, as he warns, it is not only the EU but also China that is moving ahead towards a zero-carbon target. Europe’s small companies are faring better than Europe’s large companies in adapting and riding the opportunities in the new digital economy. 

But the stronghold of Europe, Ratz argues, is in the “real industries… If we talk about energy transition, the Europeans could again take a lead, especially on opportunities that are more asset-heavy.” But he warns that there is also a danger of an ESG wave of thoughtless investment, exacerbated by passive investment in ESG-labelled funds or in new, but as yet unproven, technologies based on hydrogen, for example. What is required is the ability to separate the truly sustainable companies from those that are merely greenwashing. For European small caps that could provide a competitive advantage.