European small-cap stocks are often ignored as they can be difficult to sell in a downturn, but being overlooked can be helpful for investors looking for long-term returns in the sector.
Around 3,000 to 4,000 companies with a market capitalisation of less than €3.5bn (£3bn) are listed on continental European exchanges. And because analysts often fail to assess their prospects with vigour, some attract scant attention. As a result, their valuations tend to be reasonable.
“Inefficiencies in the small-cap market have been increasing for some time as fewer and fewer analysts have been deployed to cover this area,” says Nick Williams, manager of Baring’s £214.1m European Select trust.
“And despite market volatility, a significant proportion of Europe’s smaller companies have come out with results that have exceeded overly-negative expectations. There may be some profit-taking in the near-term but we think there are some excellent long-term opportunities.”
Since January, the European small-cap sector has enjoyed a strong run, reporting a 19 per cent return against a gain of 1.3 per cent by the wider European market, according to Morningstar.
UK-listed European small-cap funds are up 9.8 per cent on average over the period – with particularly robust performances recorded by Baillie Gifford European Small cap fund (up 21.1 per cent); Ignis’s European smaller companies fund (+15.49 per cent); and Insight Investment’s European smaller companies fund (up 16.8 per cent).
Favoured holdings vary widely by industry, country and popularity and range from Turkish Airlines to Irish Life and Permanent, Ryanair, Wire Card, a German online payments group, and Jumbo, the Greek toy retailer.
Liquidity poses concern. While outperformance is more likely to be achieved by the sector, so too is underperformance. Looking for protection against balance sheet erosion and sharp share price falls, a number of small-cap managers choose to keep large, diversified portfolios of, say, 90 to 110 stocks.
“Smaller companies are more vulnerable to events than larger ones,” reports Andy Lynch, who heads Schroders’ European dynamic growth fund, which has a 20 per cent allocation to small caps.
“If the CEO of Vodafone gets run over by a bus, a strong management team will be able to step up and continue the company’s successful path, but management changes and other business problems are more difficult at a smaller company.”
Lynch is overweight in healthcare, energy and utilities, but also holds stakes in Azimut, the Italian fund management group, Rosenbauer, the Austrian fire- engine maker with a “sound balance sheet”, as well as Acino, the Swiss drug maker.
He chooses not to hedge against sterling’s rise against the euro though his currency exposure extends to the euro, Swiss franc, Norwegian and Danish krone and Swedish krona. “I found my ability to forecast currency movements is atrocious, so I just don’t worry about it,” he says.
Philip Dicken, who oversees both Threadneedle’s pan-European £115m small- cap fund and its £570m small-cap European fund which excludes UK holdings, claims that UK small caps hold appeal as they tend to be more liquid than European stocks.
When investing in Europe, Dicken prefers industrial groups with considerable market share to financials. “Barriers to entry give companies pricing power,” he explains. Two German picks are the optician Fielmann and Stratec Biomedical. “Fielmann has about 50 per cent of the market share for the sale of glasses and contact lenses in Germany, but they are the lowest-cost provider. It’s a well-managed company,” he points out.
A bout of overselling has narrowed the gap between the valuations of the continent’s large and small caps and some fund managers running money across the wider European market have not restocked their portfolios with small caps since 2007 when holdings of smaller companies were slashed as they grew more expensive. Concerned about liquidity, just four of the 50 stocks in the portfolio of Kevin Lilley – manager of Royal London’s European growth trust are small caps, for example.
“When I’m very positive, I have 20 to 25 per cent of my fund in small caps. I’d rather have a large proportion in large caps because with small caps, you have a liquidity issue. If I try to sell a similar size position in small caps, it can take a week,” Lilley reports.
But given the recent poor performance of European large caps, views on the appropriate spread between the continent’s bantam and heavyweight classes vary. The 15 per cent fall in the value of the euro against sterling hit investment trusts sharply in the first six months of the year. And a number of those invested in European large caps performed poorly. Among those reporting the worst falls were Gartmore European (which lost 15 per cent), BlackRock’s Greater Europe trust (down 13 per cent) and Fidelity’s European Values (off 10 per cent), according to Oriel Securities.
By comparison, the performance of small caps was far better. Defying the expectations of analysts who predicted Europe’s small-cap sector would underperform in the first quarter, a number of companies reported results that exceeded estimates, according to Williams of Baring. This performance, coupled with the dearth of research by analysts, throws up opportunities for patient stockpickers who are willing to sift through the market.
“Institutional buyers often take a more cautious approach to liquidity than they need to,” concludes Williams.
