European Small Companies – Strategy Update

Hi, everyone, and thank you for joining us for today’s webcast hosted by Janus Henderson Investors. If you wish to ask a question at any point during the webcast, please submit your question in the text box on your screen. Should you experience connection issues at any time, we advise you to refresh your browser. As a kind reminder, this webcast is intended for Janus Henderson clients only. If you are a journalist, we ask you to please contact your PR representative for journalist-specific events and information. I’ll now hand it over to Richard Brown, client portfolio manager at Janus Henderson.

Thank you, everyone, for dialling in this afternoon for this relatively short update on our Pan European Small Companies Strategy. I’ve got about ten slides that I’d like to run through, first of all covering how we see the small-cap universe at this point in time, then looking a little bit more deeply into the valuations that are on offer in this space. This is where we’ve seen really quite a marked move through the summer of 2023, pushing us to points and extremes that we haven’t really seen for a number of years. Then I’d just like to finish, talk about our strategy, where we’re looking to put our clients’ capital to work at this point in time to generate alpha over the course of the coming 12 months and the 36 months thereafter.

But first, let’s just start with performance in this space. Of course, what business are we in? We’re in performance for our clients and for your clients. Here, I’m just plotting here the European smaller companies universe versus their large-cap peers in Europe and also versus US equities since the turn of the century. What you can see here is, typically over the long term European smaller companies have tended to put you in a very good place with a return of close to 500% over that period of time.

00:01:57

But in many ways, what I think is more important and particularly important where we stand right now is actually the table that you see on the bottom part of this screen. So that’s each calendar year dating back to 2001 and what you’ll see is, each of those green boxes represents a calendar year where small cap has outperformed large cap. So you can see a lot more green than red. Roughly three in four years you’re seeing small-cap outperformance. But look in the bottom right-hand corner of this screen. You can see we’re in really quite an unprecedented third calendar year of small cap underperforming large cap and to a quantum of roughly just a little bit over 20% if you add up those three periods.

Now, we’ve only really seen that amount of underperformance from small caps dating back 07-08, the Global Financial Crisis, where of course we saw some really quite extreme conditions in markets. Had you taken a view, even at that difficult period at the end of 08 when it felt as though the world was ending, you can see actually you were very much rewarded for taking that view and small caps have performed really quite handsomely over the course of the coming years after that as we move towards recovery phase.

This is really the question that I would pose to most clients right now. This is very simple analysis. This isn’t taking into account any sort of economic forecasting. We can talk about that. But really, if you looked back through history and said to yourself, when we’ve reached these extremes in the past, it’s really been a case of holding your nose and starting to allocate a lot more to this space and you’ve tended to be rewarded over the longer term.

Why is that? Well, first let’s look at some of the structural reasons, which I can’t flick to. Sorry, guys. I’ve lost the flicker. Thank you very much. Here we are back. So I wanted to talk about some of the structural reasons as to why you’ve seen that small-cap outperformance over large caps over long periods of time. The really simple reason is growth. They can harness economic growth, I think, much more than large companies that tend to be much more mature. They already tend to be globally orientated and normally already really quite a vast product lineup.

00:04:25

The way I often think of it is a pure arithmetic point of view. We’ve got Apple of course, just about to launch its latest iPhone and watch. But for Apple to double its $400 billion worth of sales each year, I would think it’s so much more difficult compared to, say, a small German industrial stock that has got $2 billion of revenue but is actually geared into the energy transition or nearshoring and onshoring that we’re seeing. I always feel as though that German industrial stock has got a much easier task than the behemoth that is Apple to achieve those levels of growth.

That’s really evidenced here on the left-hand side of this chart where you can see that small caps in continental Europe and the UK have tended to deliver earnings growth between 75% and 80% higher more often than what you’ve seen in the large-cap space, so higher growth in the past. I think because of that small, immature company growing dynamic, I think that that continues.

But of course, as we stand here today, the leverage you get to the upside in small caps through economic growth is the real big question mark. Are we on the cusp of recession and will small caps suffer a good deal over the course of a recession? Now, the thing that gives me comfort on that side of things is the table you see here in the top right-hand corner. So what we’ve got is net debt-EBITDA, so a strength of balance sheets in this space, but also the percentage of companies that are net cash. So they’ve got more cash on their balance sheets than they do debt. You can see at this point in time, the small and mid-cap space in Europe… Leverage is not a problem. Cash levels are relatively high. Even if we see a weaker economic scenario coming through, we feel that the market and certainly the stocks owned within our strategy actually look fairly well placed to cope with that more difficult economic environment.

00:06:23

Then, finally, you can see on the bottom right-hand corner here… This is us covering off M&A activity. So of the 2,500 acquisitions that have taken place between 2008 and 2022, you can see that roughly 90% of those have involved a small-cap stock being acquired. So we can talk a little bit more about valuations as we go through, but what I would say is, at this point in time small caps are much more likely to be acquired and especially so at the valuations that we’re seeing at this point in time. It’s great for us as stock-pickers when we’re possibly fortunate enough to walk in on a few mornings and see certain stocks we own up 30%, 40%, 50% as those bid premiums come through.

So they’re some of the more structural reasons. Let’s talk a little bit more about the now, the here and the now. I think first and foremost we need to talk about valuations and that’s because we have reached really quite dramatic levels through the course of this summer as the market and sentiment has grown so much more cautious on the cycle. So let me just explain these two charts. So the first one we’ve got on the top here is European small caps again versus their large-cap peers just in terms of price-to-earnings discount. What you can see is, over the course of the last decade or so, small caps have tended to trade on a decent premium, roughly 16% more expensive than large caps. As we stand here today, they’re trading on a 5% discount versus large caps, really quite unusual. You can see the lowest point on that chart, even going back as far as 08 and the extremes that we saw there.

Equally, if we compare it against US large caps, you can see on the bottom chart here that the valuation discount is yet even more extreme. So in the US, you’ve tended to see small caps trading at a very small discount versus their US peers. Actually, as we look here, you can see that that’s actually widened really quite dramatically to a 38% discount as we stand here today. So really quite a dramatic dislocation we’re seeing within valuations at this moment in time on a relative basis but also in terms of an absolute basis.

00:08:41

So here we’ve got MSCI Europe Small Cap forward P/E over time. On the far right-hand side you can see we’re trading at just a little bit above 11 times price to earnings at this moment, so right towards the lower end of what we’ve seen in the past. We decided to carry out an analysis. We said to ourselves, okay, how many times have we reached this level in the past? Had I just ignored the macro, ignored everything else that I’m seeing on my screens, and bought the small-cap index at that point in time and held it for the next three and five years, what sort of return would I get? This is the table in the top right-hand corner of this chart. So, on average, over the next three years you would have got 50% return, over a five-year period almost a 90% return. So that hold-your-nose moment, buy into small cap, and see yourself into a better place over the long term… That’s certainly true when we’ve reached these valuations in the past.

Even more important than that, look at the very first buy signal that trading activity would have given you. It was July 2008. So that was before we really entered the real difficulties of 08 in the September of that year. So it actually offered you a very bad timing, a very bad buy signal, but even there you can see over the subsequent three and five years you generated a plus-10% and plus-30% return. So you still ended up in relatively short order to be back in a good place, even buying at almost the worst possible time. So I think actually, when you look at these valuations today, that’s why we think that they look particularly attractive.

Moving on, let’s speak a little bit about what we’re seeing from the macro environment but also, more importantly, what we’re hearing from corporates. A big part of what we do all day, every day, is meeting CEOs and CFOs. I would say by far and away the biggest and most consistent bit of feedback we’re seeing at the moment is that pricing is getting a little bit more difficult to push through. What I mean by that is, if I were to rewind 12 months and we were seeing a CEO, they would say, I’m speaking with my clients right now, I’m telling them I’m having to put prices up by 10%, and they’re saying, okay, I see what’s going on in the world, I get that, and accepting it.

00:10:55

Now, those discussions have become a good deal more difficult, which has two main impacts on us. First of all, it means we’ve certainly got to do our work on what that means for margins and the margins of the stocks that we own, but it also helps reinforce our view from what we’re seeing on the macro side of the equation at the moment that CPI is going to roll. Inflation will not stay at these elevated levels you’re seeing on slide eight at this moment in time. So we will see that roll.

I think as you see that happen, it’s going to ultimately end up being a clearing event, especially for debt markets. It’s at that point in time, history tells you, that markets will start to try and price a recovery again and say, okay, what does this mean for corporates and the equity market as we begin to move out of this more troubled period caused by this aggressive inflation and aggressive interest rate cycle we’ve seen over the last 12 or 18 months? I think that’s when you see those dislocations that I’ve just shown you in terms of valuations begin to narrow once again.

Now, it’s important to say, our view around that is that inflation doesn’t go back to zero. We don’t think we’re going back to a zero-interest-rate world that we’ve seen over the course of the last decade. We think we’re in an environment where inflation is probably 2% to 4%, depending on where you are in the world, and interest rates probably settle in a similar manner. That’s particularly important for us, looking to have exposure across value and growth styles, as I think value stocks… You’ll see a few more winners from the value area, the value cohort of stocks, when we look ahead to the next market cycle versus what we’ve seen over the course of the last ten or 15 years. So CPI to roll but not to go back to zero is our view.

00:12:39

The other consistent bit of feedback we’re getting from corporates at the moment is around nearshoring, deglobalisation, a theme that I guess in our industry we’ve been speaking about for a really long period of time, but it’s been a concept over that period of time. Now we actually begin to see it hit P&L and we’re seeing CEOs and CFOs talk about it an awful lot more. No CFO is saying, we’re going to put more production in place in China to serve Europe or the US, for example. They’re saying, we’ll put production facilities in China to serve Asia but not to serve the rest of the world. We’re going to go to Eastern Europe. We’re going to Mexico or Central America to serve the US.

Again, that has a couple of profound impacts on us looking to generate alpha for our clients. Of course, that’s huge costs for those companies trying to reposition some of their production facilities nearer home. But actually, also the companies that are built around automation, building things, something that Europe is actually very good at, not so good at tech but very good at building things, the picks and shovels of the capex cycle, I think, is actually something that is coming through and is going to be certainly a benefit to the small caps in continental Europe as we look ahead. Here we’re just showing you that capex to sales has been falling. We think that changes as we see that nearshoring secular theme really take hold over the course of the next couple of years.

Moving onto our strategy, speaking about that in a little bit more detail. Here are the three areas that we think that ultimately we’re quite different from the peer group. So the first is, we believe we’re giving you true small cap. So 40% of our exposure within our strategy is below €1 billion market cap exposure. So that’s the area of the market that we think is least efficient. It’s where we can find the best alpha-generating ideas. We’re willing to go down the lower end from a liquidity perspective and we do that by running a relatively long-list strategy, so roughly 120 stocks within the portfolio.

00:14:45

Where else are we different? We’ve always had a valuation-conscious approach. That’s been very unfashionable for a long period of time, but it’s something that we’ve persevered with because it’s really at the heart of our philosophy and our DNA within this particular product. So you can see that on the right-hand side of this chart actually where you can see our strategy is represented here by the blue dot right in the middle of blend. The majority of the funds in our peer group have a much stronger growth orientation.

Let me just expand on that point in a little bit more detail on this next slide. Excuse me, I sometimes feel as though it looks as though I’m trying to give some sort of economics lesson when I present this slide. I’m not, but this is ultimately how we view the small-cap universe and it’s through the lens of a typical company life cycle. So a company is born, entrepreneur or launched or spun out of somewhere. It’s early-cycle. We call that particular area of the market normally loss-making as they’re getting going, but then see exponential levels of growth as that operating leverage comes through within a business model.

00:15:53

You then see returns gradually competed away over time and that’s represented by the quality growth area here and you can see the ROIC of this theoretical company is gradually moving down there until you reach either the mature phase, which is companies still making their cost of capital, but aren’t particularly exciting. They’re in very mature industries or businesses. Then some companies end up in that, in some ways, dreaded turnaround area where they’re no longer making their cost of capital. Either something changes and they follow the blue line here and recover and that can be quite a powerful story for shareholders that are willing to go with them on that journey or you follow the dotted line of doom there to be irrelevant and ultimately go out of business, which of course is one that most management teams and certainly us as shareholders are looking to avoid.

The reason we show this is, we want to invest across this spectrum of stocks whereas it feels like the majority of our peer group are very focused in that quality growth quadrant that you see there in the second bar. The reason we do that is, different stocks work at different times. If I look back to the very start of the COVID pandemic, a lot of the early-cycle stocks were Internet-based, platform models, gaming stocks, online delivery platforms, recipe meal kits, for example. Also, their business model was accelerated by four years in the space of three months of that initial lockdown. That did a lot of heavy lifting for us there.

Now, when I compare that over the course of the last 18 months, it’s been much more the mature or turnaround stocks that have been doing the work for us because they’re the stocks that actually… If they don’t benefit from higher rates, they are insulated from higher rates much better than those much more expensive quality growth stocks that we have and other portfolios have in much higher measure. So for us it’s about risk management, it’s about diversifying your source of alpha, and investing really across this style spectrum, even within the small-cap universe. You can see the percentage weights there. If we total those up, the first two are a little bit shy of 50%, the second two, mature and turnaround, a little over 50%. You can see there the balance between value and growth that we have within our strategy.

00:18:07

Some people have turned to me and said, Richard, are you not finding yourself buying a lot of these growth stocks that have fallen out of bed over the course of the last 12 or 18 months? And in some instances that is true, but it’s not true wholesale. The main reason for that is, you can see here that actually, although we’ve seen a lot of them come back, they’re not as cheap as what we’ve seen in previous periods where interest rates have been 3% to 5%.

So this is just some work that shows the difference between the most expensive stocks in the market and the least expensive, so how far the elastic band has been stretched between expensive and cheap. You can see a lot of them moving to very extreme levels 18 months, 24 months ago and then a bit of reversion, but none of them are of the level that you saw maybe in the 2000s, which is the last time we had a similar rate environment. So for us, a lot of the expensive growth stocks are still too expensive for the market we find ourselves in, even given the heavy falls that we’ve seen over the course of the last 12 or 18 months.

That is also represented here in terms of the activity within the portfolio and you can see the purchases along the top half of the screen. Again, we’ve split it out by those different buckets that we look at the universe through. So you can see that it’s a spread again. We’ve added an early-cycle name in EuroGroup Laminations, a stock that does rotators and stators for electric motors and electric vehicles, so a huge growth opportunity but a relatively immature company.

00:19:45

Then we’ve complemented that with some quality growth names that we’ve got there but also in the mature and turnaround space. We’re finding opportunities on both sides of the book, is what I’m trying to say there. So, whereas the last market cycle was really less about stock-picking and more, do you have enough growth in your portfolio, we think this new market environment… There’s going to be some value winners, some value losers, some growth winners, some growth losers and that’s represented here by us actually, I think, picking the best opportunity set from both areas of the market.

Maybe looking at the turnaround area, that’s probably the area our strategy is most unique versus peers. I know a lot of fund managers just wouldn’t look at stocks in this space because by their nature they can be a little bit troubled, but maybe Nordex and Marel there that you can see, just two stocks we’ve added on a year-to-date basis. So Nordex onshore wind farms, Marel food processing automation machines, so two areas that you would undoubtedly say should see huge growth over the next ten years.

Renewable energy, energy transition most definitely coming. Food automation is going nowhere. Wages have gone up dramatically. The more that companies can automate their production lines clearly offers a much more attractive cost-saving at this moment in time. Both have really struggled with the cost inflation in their supply chains, which has led them to be troubled companies and troubled P&Ls over the course of the last 12, 18, 24 months. Actually now we think that those companies are going to begin to come out the other side of that and actually harness a lot of that big-picture growth that their particular industries represent at this moment in time.

00:21:27

On the bottom there you can see some of the stocks that we’ve sold, got it wrong. Unfortunately, as stock-pickers, when you run a 100-stock portfolio, there are plenty of stocks that you get wrong almost daily and we’ve listed a few there, but what I would say that the fund managers in this particular strategy are good at is recognising when it’s gone wrong and taking their leave and recycling that capital into more attractive areas. You can see we’ve had one bid so far on a year-to-date basis done at a 50% premium to the share price, so something that’s particularly attractive. Like I say, I think in this market, when valuations have reached the extremes that they will do, if we don’t see that narrow over time, you’ll see that bid box, I think, increase quite dramatically as we get a number of private equity and trade buyers come into this space and look to add to those particular stocks.

So to conclude, I think smaller companies… If you look back through history, if you’ve held them for the long term, they’ve put you in a good place and it’s because of those structural growth reasons that I discussed earlier on. So I think if you are a believer in those higher levels of growth achieved in this space, I think it makes an awful lot of sense to look at it when it is as out of favour as we are right now. I’ve seen a huge amount of clients over the course of the last four weeks, six weeks who are looking at this space and haven’t yet allocated.

The main bit of pushback I get is that rule number one is, don’t own small caps during a recession. Day one of asset allocation school, don’t own small caps during a recession. I completely understand that. If you look back through history, that has held true very strongly. But what I would say is, this cycle is very unusual. It’s not a typical market cycle. This is probably the most well-signposted recession that has never arrived or is yet to arrive and still may not arrive. In fact, on the team at the moment we’re very much leaning towards a soft-landing scenario and we expect to see markets rerate as a result of that. So it might be a point where you actually have to look at this space a little bit earlier in this market cycle than you do in others.

00:23:46

The other thing I would say is around inflation. We do expect that to roll over but not go back to that zero-interest-rate world we’ve seen over the course of the last ten years. I think that plays particularly well to a blended portfolio because there’s going to be some value winners that we can find and there’s going to be some growth winners that we can find. Opening up your portfolio to both of those stocks, I think, looks like a good thing to be doing when we look ahead to the course of the next market cycle.

But, please, thank you for your time. I’m going to wrap up there and hand back to Kayla. I think we may have run out of time for questions today, but please do submit them to your Janus Henderson representative and we will most certainly reply to those in written form or in an extra call. I’ll just finish there by saying, thank you very much for your time, and I’ll go to the disclaimer chart so that my compliance department don’t get too upset with me. Thank you and best of luck for the few months that are ahead.

And that concludes today’s presentation. You may now disconnect.