The New Year is a time for reflection, and we can confidently say 2023 has been a challenging one as markets price in a recession that has yet to materialise. This is particularly pertinent among small caps, which have underperformed large caps for three year. For the £750m European Smaller Companies Trust we have the benefit of being able to invest across Europe, targeting the best small- and medium-sized companies we can find (typically around €500m-1bn, never over €7bn).

We’re long-term investors by nature and always aim to look beyond these kinds of challenging periods. This is why we employ a stock-picking approach that involves ignoring the short-lived noise from macroeconomic datapoints and instead gets to grips with companies’ fundamentals. Encouragingly, we are now seeing signs of the wider environment shifting to better suit our portfolio and potentially reward us for sticking to our (investment) guns.

An extreme valuation opportunity

Smaller companies tend to be more sensitive to periods of economic expansion or recession. The wider market has become nervous about the chances of the latter in Europe, and this has prompted many to sell off their small cap holdings, causing share prices to fall.

Small cap valuations relative to large caps are resembling levels last seen around the financial crisis of 2007-8. European small caps’ valuations are now at extreme levels, trading on average below 12x their price-to-earnings ratio (calculated by dividing a company’s share price by its earnings per share). This 12x figure is at the lower end of the historic range, and 37% cheaper than the US equity market.

In this kind of environment, we ask ourselves whether there are signals of a structural change, or if the economy is merely entering a new phase of the cycle. Our analysis suggests it’s the latter and this is positive for the trust. If the economy moves into a phase of expansion, small caps inherently benefit as they have more room to grow. Indeed, we are forecasting European small cap earnings to grow 16% over the next 12 months, compared to 8% for large cap stocks.

Additionally, we also anticipate a return of M&A activity in 2024. Private equity firms are sitting on large cash reserves and the current stage of the cycle could be an optimum time for them to start spending again. Companies are also repurchasing their own shares, with low valuations leading several CFOs of European companies to initiate buyback programmes. Notably, 30% of our portfolio’s companies are repurchasing their own shares.

Positioned for growth

Going into 2024, we are excited about what this potential change in the economic cycle could mean for the trust and its holdings. The three sectors that most stand out due to their valuations and recent underperformance are renewable energy, industrials and consumer stocks. The latter two sectors have been hit hard due to their dependence on economic growth but would likely benefit in a soft-landing scenario – if the European Central Bank manages to avoid a recession in its bid to bring down inflation. However, we are more selective in our stock-picking approach when looking at consumer stocks given the recent budget uncertainty in Germany, which is a major market for any pan-European investor.

Renewable stocks in Europe have experienced a significant shift in sentiment with a notable decrease in valuations since mid-2021. The inflated cost of materials and higher interest rates have impacted these projects’ profitability. Despite this, there is a collective understanding that significant investment in renewable energy is necessary and the recent increase in the price of energy in the UK is a cause for further optimism for investors.

Elsewhere, industrials are also poised to gain from a return to growth and especially a shift to the ‘nearshoring’ of supply chains. The pandemic exposed the vulnerability of global supply chains for many European companies, and we’ve seen wholesale changes as a result. In addition, 2023 opened investors’ eyes to the potential of AI and this could be a gamechanger in certain industrial sectors.

The past few years have not been an easy time to be an investor in European small caps. However, this is where stock-picking can really make a difference; taking advantage of valuation falls to initiate positions in companies with the most exciting long-term outlooks. Now, with signs there could be a change in market sentiment, this could be the time for these companies to shine so we’re excited to see what 2024 holds for them.

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.

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