European small caps could continue to do well in the prevailing economic and political environment
- Small-cap effect: pension funds are under invested
- Positive economic backdrop gives small-caps a boost
- MIFID II makes sell-side research uneconomic, putting the onus on in-house capabilities
- Regional disparities are very strong even for bottom-up approaches
- Brexit uncertainties make the UK unattractive for many
Last year was an exceptional one for European small caps, and one that will prove difficult to beat in 2018 (figure 1). Yet as confidence in the strength of the European economy and its political environment continues to grow, there is a strong case to be made that European small caps should outperform large caps.
By nature, argues Mark Denham, head of European equities at Carmignac Risk Managers, interesting small companies are often entrepreneurial disrupters that are fast-growing and successful. He points out that in Europe there has been a rapid increase in the number of entrepreneurial companies with IPOs and spin-offs from large companies. Denham says: “There was a time when innovative technologies were all just coming out of the US. Now we see that happening in Europe as well.” That creates opportunities for investors, especially in positive economic environment. IT companies represent 11% of the small-cap universe (figure 2).
Eric Labbé, European equities manager at Paris-based CPR Asset Management, expects further M&A activity, with a good earnings outlook for small and mid-caps. As he argues, the economic backdrop is also supportive, with higher growth, low inflation, and the continuance of an accommodative monetary policy. “We expect outperformance against large caps, but with a smaller spread compared to previous years as valuations are starting to increase,” Labbé says.
The equities bull market entered its tenth year this year following the nadir of March 2009 – with a return to volatility in February 2018. Although some investors are wondering whether they may have already seen the final hurrah for equities, Ed Heaven, product specialist at Montanaro Asset Management in London, believes there are reasons to believe that European small caps can continue to do well in the current environment.
Small caps represent about 15% of the MSCI investable universe and a market of over €2trn, covering 90% of quoted European stocks on a numerical basis. Leaving aside micro-caps with a market cap of less than €100m, the universe has about 2,300 companies less than €5bn (figure 3). But institutional investors generally have typical allocations of only between 3% and 5%. This is particularly surprising, given reasonably strong evidence of persistent outperformance by small caps – the so-called small-cap effect.
The view of the ‘rational’ school is that investors may be compensated for taking hidden risks linked to company size – the size premium might be a proxy for greater bankruptcy and liquidity risk. As Montanaro points out, research has shown that the small-cap effect exists independently of the liquidity premium. Another reason could be that it reflects behavioural biases – institutional neglect, inlcuding lack of investment resources, lack of research and consultants not playing their role – as well as career risk or a ‘safety in numbers’ effect, and the distorting role of benchmarks, which may only include large and mid-cap.
While academic researchers might continue to wonder why the small-cap effect has not been arbitraged out, Heaven argues that opportunities will exist for investors with the time to sift through this vast universe and uncover Europe’s hidden gems.
For active managers, European small caps can pose a dilemma. They are more inefficient than large caps, so should provide greater opportunities for alpha generation. However, the sheer number of stocks and the limited investment capacity in any specific stock, makes the asset class expensive to research. MiFID II is likely to exacerbate the situation as brokers will find it increasingly unprofitable to produce small-cap research on individual companies. This is likely to favour small-cap specialists willing to invest in large in-house teams rather than spend money on purchasing undifferentiated external research.
European active small-cap managers are inevitably bottom-up investors. Listed small caps – as with private-equity-owned companies that overlap in some of the same market-cap ranges – are heavily exposed to the strengths and weaknesses of management teams. The Shells and Unilevers of the world are such large and complex organisations that senior management inevitably have less direct control on their fortunes. Despite this, there are clear, observable geographic distinctions.
The UK is the largest and oldest small-cap market in Europe, representing 33% of the universe with many niche companies in different sectors and over 600 names (figure 4). But opinion is polarised. Carmignac, for example, has almost zero exposure. Denham says: “We expect to see a slew of profit warnings in the UK and we don’t want any exposure to the UK domestic economy.”
Brexit is having an enormous impact on many other small-cap managers, who also see little incentive to take a chance with the UK market. The problem, according to Cristina Matti, portfolio manager at Amundi , is that Brexit has not yet been defined: “The issue is not that domestic names are bad companies but that it is difficult to make assumptions and to do our job to create the right valuations of a company as we don’t know how to play the different scenarios of a soft Brexit, hard Brexit, no deal, and so on.”
“We expect outperformance against large caps, but with a smaller spread compared to previous years as valuations are starting to increase”
However, there is willingness to invest once there is clarity on the path the UK will follow. But Montanaro, points out that despite the risks associated with a highly uncertain Brexit outcome, valuations of UK small caps are still attractive relative to those elsewhere in Europe. As such, the firm believes that some of the best opportunities in the sector will no longer be available once the market has full clarity on Brexit.
Regional diversity by market cap
Germany is the next largest small-cap market by market cap – but it is less than half the size of the UK at 14%. The country’s Mittelstand provides the backbone for its economy but has historically been driven by bank financing. Companies tend to be extremely conservative and remain private, according to Marcus Ratz, a partner at Lupus Alpha Asset Management in Frankfurt. Opportunities, though, do exist in sectors such as industrials or autos.
Sweden represents the third-largest European market by capitalisation, although France has more companies. The Nordic countries, like Switzerland, are always seen as a safe haven for the markets according to Matti. As a result, the high-quality companies that exist there are fully priced and have rich valuations: “We have some exposure to the Nordics, but valuations have restrained us from investing more.”
Italy is a prominent market with a very pronounced regional variation. Lupus Alpha’s exposure to the country is 95% driven by northern Italian companies. Ratz sees them as conceptually part of central Europe, alongside Austria, Germany and Switzerland: “They even speak German, their mind-set is very much middle European, with an industrial focus [that is] very well developed and strong niche companies in each and every sector.”
While France may have more companies listed than Germany, it represents only a third of Germany by market capitalisation. For Ratz, France has always been difficult. Historically, France has been missing a lot of mid-sized companies analogous to the German Mittelstand: “The major reason for that is the dominance of the Grandes Ecoles in their education system. Their graduates move either into politics or into the large companies.” Small companies are very often family-owned and founders usually created their businesses without support from the state.
Spain has been suffering for the last few years and domestic companies focused on the Spanish market in areas like construction were often highly leveraged and suffered in the aftermath of the financial crisis. But successful companies generally have more exposure to Latin America.
European small caps may be ideal territory for bottom-up active stock managers, but the macro-economic and political backdrop does give an overlay to fund managers’ portfolios. For institutional investors seeking European small-cap exposure, understanding those biases may be worthwhile, particularly given the Brexit-induced uncertainties in Europe’s largest small-cap market.
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