2023 presents a rare and unique opportunity within the European Small Cap space.

Having historically traded at a premium relative to European Large Caps due to their greater growth potential, European Small Caps have been trading at a near 20-year discount throughout much of the year. This provides an extraordinary opportunity to participate in a diverse market filled with high-quality companies priced well below their intrinsic value.

This pricing anomaly was prompted by a series of market events over the past several years that had placed significant stress on the sector. While recent periods have clearly been challenging for all asset classes, European Small Caps have been particularly sensitive to the ongoing volatility in markets, which has impacted company earnings, and the war in Ukraine which has exacerbated inflation and driven interest rate rises upwards. As a result, having outperformed their Large Cap equivalents for fourteen of the past twenty-one years, European Small Caps have been underperforming since 2021.

Europe is now forecast for a recession this year, the severity of which remains debatable. Regardless, this outcome has drained much of the positivity out of the sector, with investors instead seeking refuge in Large Cap stocks. However, historically Small Cap stocks outperform in a recovery environment, due to their inherent flexibility and ability to pivot as the economic environment evolves. Large Caps are typically slower to react to such changes and have historically been slower to recover following a recession.

While acknowledging the challenges of the past two years and the potential for further short-term pain for investors, we view this pricing disparity as an exceptional entry point for investors seeking exposure to the continent’s smaller companies. We feel that any recession in Europe will be softer than many analysts have predicted and that inflation peaking over the coming months will serve as an inflexion point for European Small Caps.

What are we buying and why?

We believe that the next ten years of financial markets will look very different to the previous decade, where cheap finance has been abundant. While inflation is expected to cool in the coming months, it is unlikely to disappear entirely, and therefore it is increasingly important to consider valuations when screening for opportunities.

This does not mean that we are anti-growth, in fact within the portfolio we retain a healthy balance across the growth-value spectrum, but the valuation of any given stock must make sense to warrant inclusion. We are happy to consider the more neglected areas of the market, so long as our principal considerations of reasonable valuations and earnings momentum are in place. It is not enough for a stock to simply be cheap, we need to understand the company’s trajectory and the conditions required to trigger growth.

Our willingness to go down in market capitalisation allows us to identify opportunities at an earlier stage, which affords ample time to conduct our in-house analysis and where necessary, liaise with company management teams. We aim to take exposure across a company’s life cycle, so it is important to understand a company’s long-term prospects as opposed to simply buying into short-term growth.

Some topical examples of our market activity include our holding in Italian Design Brands, which was a recent IPO. The company, which was listed on Euronext Milan in May, acts as a hub for a selection of high-quality companies that specialise in furniture, lighting, kitchen, and luxuries and provides the infrastructure necessary for these companies to sell into international markets (particularly in the Middle East). We see this as an interesting and relatively underpopulated corner of the market with a niche audience that is willing to buy at a premium.

A broader example of our willingness to explore the more unloved areas of the market has been our exposure to Greece. Admittedly, this is an off-benchmark (MSCI Europe ex UK Small Cap Index) exposure, although it may re-enter the index next year should it receive another rating upgrade.

We know that Greece has endured a challenging period but there are many positive signals to consider, not least that it is currently the fastest growing economy in Europe. Having had a largely positive impact in its first term in office, we take comfort in the recent re-election of the New Democracy Party and anticipate a raft of privatisations across the country in the coming months, which will be a tailwind for the Greek Stock Exchange. With this in mind, we hold several Greek companies within the portfolio, including Hellenic Exchanges, Alpha Bank and Mytilineos, an aluminium producer which has been one of our top performers.

These are just a handful of examples that demonstrate the fertility of the European Small Cap market, which relative to the UK, remains under-researched by analysts. For experienced, active stock pickers such as ourselves, this dynamic paired with the lower valuations of 2023, represents an incredible opportunity to add value to an investment portfolio.

In conclusion, while there’s no denying that European Small Caps have had a troubled few years when viewed across the longer term, we see that this short term pain has opened a brief and tantalising window of opportunity through which to add quality companies at significant discounts. We believe the sector is positioned to flourish once European inflation peaks, at which point the fundamental value of these companies will be realised.

 
Past performance does not predict future returns.

 

Disclaimers

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.

Not for onward distribution. Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial adviser. This is a marketing communication. Please refer to the AIFMD Disclosure document and Annual Report of the AIF before making any final investment decisions. Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change. Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment. We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes.

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