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Small is mighty

15 January 2018

TR European Growth Trust manager Ollie Beckett examines the opportunity of European small-caps.

Europe became the flavour du jour

As global economies emerged from a searing financial crisis at the turn of the decade, the US and UK seemed to pull ahead of their European cousins. Earnings there lagged; growth tinkered on the edge of deflation; its misaligned cadre of politicians toiled with Grexit and Brexit and much in between.

2017 switched fortunes – Europe became the poster-child for its cousins and the catch-up trade. GDP growth was strong. We believe margins improved with the biggest earnings upgrades in developed markets. Where the US and UK became victim to populism, Europe rejected it.

The strength did not go unnoticed by the European Central Bank (ECB) with President Mario Draghi beginning to prepare the market for a withdrawal of their unprecedented quantitative easing (QE) program, most likely in the latter part of 2018.

The euro also strengthened to levels last seen before European QE started in spring 2015. It meant larger European companies, whose earnings tend to be harvested from across the globe leaving them at the behest of currency swings, performing less well in 2017. Smaller companies tended to have more of a domestic focus and performed better.

Small is mighty

TR European Growth Trust is a truly small company trust, with a large slice of the portfolio – over 50% - invested in firms under a £1bn market capitalisation. As investors in larger companies in Europe have struggled to find value amid renewed enthusiasm for European shares, they’ve reset their sights further down the scale and targeted mid-sized businesses, which in turn have become more expensive. We believe it means the smaller end of the market is one of the last remaining places to find relative value, and it’s an area that we have a long history of seeking exciting growth opportunities for our investors.

We’re cognisant of the risks that come with investing in much smaller firms: they are more susceptible to market swings than bigger businesses and can be difficult to trade in large amounts, but to offset this and diversify the risk we run a longer stock list than most funds, at around 140 holdings.

What to buy

So how do we find the sorts of investments that have the potential for strong capital growth?

We look for businesses with management teams that will continue to take the right decisions to either fix what is broken internally or continue growing their earnings strongly, regardless of geopolitical uncertainties or potential adverse market reactions to more hawkish central banks. It broadly translates into three areas of investment.

‘Value’ is one – companies that we believe the market is pricing below their intrinsic value. The next is growth-at-the-right-price (GARP): firms whose earnings are perceived to be growing more vigorously than their peers or the wider market, but the trajectory of which is being undervalued by the market. The final is turnaround stories or ‘self-help’ as we call it – businesses that have been underperforming and are unloved by the market but striving to change their destinies. Below are some portfolio examples.

Self-help

Van Lanschot - Dutch banking

Van Lanschot is the oldest independent bank in the Netherlands, dating back to 1737. It’s in the business of private banking, asset management and merchant banking, and in the process of running off a loan portfolio it serves to corporate clients.

Back in April 2016 it presented a new strategy designed to reinvigorate the private banking arm – at the time the division earned around half of VL’s revenues yet accounted for only 7% of total profits, indicating poor efficiency and enormous scope for self-improvement. Looking forward, it is attempting to be more asset-light and build up its capital ratios, returning cash to shareholders wherever possible. As it stands, its return on equity – a measure of profitability – is poor at around 7%; this we believe should be much higher.

Value

Alma Media

The trust has taken a number of positions in Finland as we are finding undervalued businesses there which we think will perform well amid an improving economy.

Alma Media purports as a media owner of regional, local and free circulation newspapers for print and online, and the market is pricing it as such. But what it should be focusing on is what the business is really about: online classifieds - websites that deal in used cars, used equipment and in real estate – of which it is a market leader. Axel Springer, a similar outfit in Norway, provides guidance in this respect, with the market placing significantly more value on its operations. In our opinion other investors will catch-up with this thinking.

Growth (at the right price)

Zur Rose

Founded in 1993, the group is in the businesses of online drugs, operating a prescription mail order business under its DocMorris brand in Germany, and a market leading online pharmacy business in Switzerland under its Zur Rose brand.

Pharmacy is a market ripe for disruption in Europe: small, relatively high value non-perishable packages are extremely well-suited to e-commerce, which remains a very under-penetrated market considering the 125 thousand bricks and mortar pharmacies across Europe which have operated as such for 500 years.

What is more, the German market has recently been prised open by a European Court of Justice ruling and we believe market leader DocMorris will be a key beneficiary.

Outlook for 2018

While 2017 was another strong year for European smaller companies we remain cautiously optimistic for the year ahead. European economic growth is at its highest levels for over a decade, much needed inflationary pressures are beginning to build, and European earnings are growing at a higher rate than the US for the first time since 2007. Valuations are elevated versus the past but we do not see excessive levels of optimism from the investment community and we are still finding stocks that excite us. Thus, we continue to look for the best small cap investments in Western Europe.

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