By Neil Johnson
A collective sigh of relief could be heard among European small-mid cap equity fund managers in March, when Mark Rutte retained his position as prime minister of the Netherlands. An even louder sigh of relief followed in May, when Emmanuel Macron won the French presidential election. Angela Merkel remained Europe’s leading lady in Germany’s September elections too.
It has been, then, a less topsy-turvy year for European politics than many had expected.
Smaller companies don’t like shocks, political or otherwise, so the run of mild results in Europe’s busy election season, backed by strengthening regional and global economies, was certainly welcome.
‘Small caps have had a good run in 2017, with European small caps outpacing their larger brethren at 12% through the end of July, 5 to 6 points ahead of large caps,’ said Citywire + rated Edward Rosenfeld, manager of the Lazard European Smaller Companies and Pan-European Small Cap funds.
‘As the economy has improved and political risk has dissipated, this has led to an increasing desire for risky assets in the market, with small companies benefitting from this.’
Citywire A-rated Francesco Conte (pictured above), manager of JP Morgan’s JPM Europe Small Cap and Europe Dynamic Small Cap funds, added that high earnings forecasts for European companies are supported by the positive economic backdrop, driven by a ‘synchronized global economic upswing.’
‘This is reflected in the first quarter European earnings reporting season, which was one of the strongest on record. To date, the second quarter earnings season indicates a continuation of this positive trend,’ he said.
Citywire AAA-rated Sébastien Lagarde, manager of the high performing Mandarine Europe Microcap fund, points out that more good news comes from the fact that several European governments have enacted measures in favor of small-, medium- and intermediate-sized companies over the past few years in an effort to boost job creation.
‘On the stock market, this has placed the spotlight on companies with very small stock market capitalization (below €500 million or $585 million), which we refer to as microcaps. These companies deliver more growth than large caps and the investment universe still offers lots of inefficiencies. European microcaps outperformed European large caps in 2015 (a “growth” year) and in 2016 (a “value” year), and I think there is still potential for outperformance in 2017. With a 17% median expected growth, I remain optimistic for European microcaps.’
So too does Nicolas Walewski (pictured below), the highly ranked manager of the Alken Fund – Small Cap Europe strategy, who sees plenty of upside in neglected stocks.
‘Take a look at French auto manufacturers. They trade on low multiples with positive news flow, and yet the stock loses €1 billion ($1.2 billion) in market capitalization on the back of a negative global sector call. This to us looks like an outstanding opportunity. Understanding real exposures and companies’ fundamentals remains a key factor for outperforming active managers,’ he said.
Walewski is finding ideas in consumer discretionary, including firms such as Peugeot, Renault, Valeo and B&M European Retail. However, industrials such as Ryanair, Volvo, Alstom and Wirecard take the top positions in his fund. ‘We are also overweight materials, through Glencore and Arkema,’ he said.
‘We find it harder to find strong investment ideas in consumer staples, utilities, large telecoms, and energy. We are neutral on banks at present, as we struggle to find opportunities overall in financials, most specifically in larger European banks and insurance companies.’
Small stocks, big themes
Bottom-up stock selection is vital for European small cap equity investing, but this doesn’t mean that themes are ignored, especially when the fundamental outlook for the asset class is positive.
Conte’s JPM Europe Small Cap and Europe Dynamic Small Cap portfolios are both currently positioned pro-cyclically on the back of this positive outlook. This is reflected in the sector positioning for industrial engineering and automobiles and parts – two of the largest sector overweights. Real estate accounts for the largest underweight.
Conte is currently playing aging populations through stocks such as Amplifon – an Italian company that is the global market leader in hearing aid retailing. With the baby boomer generation nearing the peak age for buying hearing aids (72 years), this tailwind for growth should remain strong over the next 5 to ten years, he said.
Then there’s logistics networks optimisation, which Conte is playing with selections such as Datalogic, an Italian data capture firm, and Jungheinrich, a German manufacturer of forklift trucks, which is the global leader in lithium-ion rechargeable battery powered trucks.
‘With the growth of omni-channel retailing (retailing via both physical stores and e-commerce), the complexity of logistics networks is rapidly increasing. Logistics has historically been purely a cost centre for companies but is quickly becoming a new source of competitive advantage. Both Datalogic and Jungheinrich are ideally placed to benefit from this trend,’ he said.
‘For example, Datalogic is benefiting from regulations requiring more sophisticated traceability of products through their global supply chains, and Jungheinrich is benefiting from its warehouse automation expertise.’
Lastly, Conte cites disruptive fintech as another strong play, with stocks such as internet-only banks Skandiabanken and Finecobank. These companies benefit from their modern IT systems and lack of physical branch networks. The resultant lower cost base and more user-friendly customer interface provide a clear competitive advantage versus traditional banks.
Lagarde agrees that small caps are ripe for thematic analysis. ‘If you want to play one theme with one stock, it’s easier to do it with microcaps – which are generally pure players – than with multinational companies.
One of his favorite themes at the moment is digitalization, which he is targeting with Groupe Open, a €220 million market cap French IT company. Health foods are another of Lagarde’s top picks; he has now invested in Berentzen, a €105 million market cap German company selling machines for fresh orange juice.
Balance and strength
Preferring stock selection over taking macro, top-down or sector bets, Erik Esselink and Oliver Collin’s Invesco Continental European Small Cap Equity and Invesco Global Smaller Companies funds are overweight cyclicals versus defensives given the positive European outlook.
‘The ratio is around 60:40 when accounting for our financial holdings,’ the duo said. ‘However, within our cyclical exposure we are getting more positive on European growth versus global growth. We have increased our exposure to pure banks within our financials holdings as we see a continued normalization of European monetary policy as a positive for this sector.’
Meanwhile, Rosenfeld likes that there is plenty of balance sheet strength in small caps, giving them extra flexibility and M&A possibilities. ‘European small caps have only very modest debt levels, which in a low interest rate environment gives management the opportunity to use the balance sheet to grow companies via acquisition or by shrinking their equity bases via dividends or share buyback,’ he said.
‘A recent example would be Rightmove in the UK, which has been buying back shares consistently over the years, and Patrizia, a German real estate management company, which has sold historic levels of real estate, allowing it to announce a tender auction offer for 2.5% of the company. It’s just another example of the balance sheet optionality that many of these companies have.’
This article originally appeared in the Citywire Americas September 2017 issue. If you would like to recieve our magazine, click here.