European smaller company valuations are at historic lows across the board. In this environment, we cannot simply look to companies trading on low valuations to generate return.
There is no rationality in the current market environment. Passive buyers are a growing market constituent, while the pool of long-only equity buyers for smaller companies is shrinking. Economic conditions – economies broadly steering clear of recession and experiencing falling inflation – should be positive for smaller companies. Instead, larger caps and thematic investments remain in favour, attracting ever more investors.
Given this, a valuation uplift on the back of a positive earnings report has not been a route to near term investment returns. So, where do we look for returns?
We turn to management. Corporate activity may not be the hottest topic when it comes to investing. However, in lean times it can make all the difference for companies and investors, like ourselves. In this context, capital discipline – the practice of improving the financial value of a company through careful management of a its assets – is vital.
One example is share buybacks. Given the valuations they are currently trading at, the cheapest thing a lot of companies can buy is themselves. A third of our portfolio is now engaged in buyback activity.
We look for companies on low valuations with plenty of cash on the balance sheet. We know that these stocks have the capacity to pay us out in this way over time.
A good example from our portfolio is Danish shipping company DFDS Ferries, which is engaging in consistent share buybacks. Similarly constructive in its buyback programme is Irish drinks distributor C&C. It owns Bulmers and Tennants, among other brands, and saw strong sales during the hospitality recovery.
Criteo is a Nasdaq-listed French online advertising operator. It has been the subject of attention from an activist shareholder and is now strategically engaging with this activist, offering a seat on the board. It is also continually buying back shares and has committed to returning $150m to shareholders in 2024.
Another route to generating value in a malign market environment is to make significant strategic changes. An example of this in our portfolio is German-headquartered KSB, a longstanding holding that manufactures pumps for multiple industries.
The company has always had a resilient client base. However, a change of management led to a streamlining of the business’ product offering. Its shares have risen dramatically over the last year (by over 12% as at 18/04/2024), as the market perceives the company as “doing something” to improve its value.
Other examples of this phenomenon in our portfolio are French cable manufacturer Nexans, which has reduced its product offering and the markets it operates in. Elsewhere, spring manufacturer Stabilus has used acquisition activity to move into new markets. This type of proactive activity is often the core route to generating a share price uplift in smaller companies.
Past performance does not predict future returns.
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Glossary
Balance sheet – A financial statement that summarises a company’s assets, liabilities and shareholders’ equity at a particular point in time. Each segment gives investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. It is called a balance sheet because of the accounting equation: assets = liabilities + shareholders’ equity.
Earnings per share (EPS) – EPS is the bottom-line measure of a company’s profitability, defined as net income (profit after tax) divided by the number of outstanding shares.
Portfolio – A grouping of financial assets such as equities, bonds, commodities, properties or cash. Also often called a ‘fund’.
Share buybacks – Where a company buys back their own shares from the market, thereby reducing the number of shares in circulation, with a consequent increase in the value of each remaining share. It increases the stake that existing shareholders have in the company, including the amount due from any future dividend payments. It typically signals the company’s optimism about the future and a possible undervaluation of the company’s equity.
Share price – The price to purchase (or sell) one share in a company, not including fees or taxes.
Valuation metrics – Metrics used to gauge a company’s performance, financial health and expectations for future earnings, eg. price to earnings (P/E) ratio and return on equity (ROE).
Value investing – Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase. One of the favoured techniques is to buy companies with low price to earnings (P/E) or price to book (P/B) ratios. See also growth investing.
Disclaimer
References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
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