Skip to main content

The ‘SmallCap Effect’: Is now the time to buy smaller companies in Europe?

No comments

14 May 2014

George Cooke, Manager, Montanaro European Smaller Companies.

View the Montanaro European Smaller Companies company profile page

History is littered with examples of investment strategies that were designed to exploit market inefficiencies, only to find the opportunity disappeared when they were discovered and copied.  So it is unusual to find sources of alpha that have stood the test of time and continue to endure despite widespread recognition. The “SmallCap Effect” is one of them.

Over the past 60 years, UK-quoted smaller companies have outperformed their larger counterparts by 3.5% per annum* (the “SmallCap Effect”).  This has led to investors enjoying six times greater returns as a result.  While the data does not go back as far in the case of Europe, research suggests that the SmallCap Effect here is even larger, with excess returns of 7% per year since 2000.  Despite this, according to Mercer, 96% of Europe’s pension funds have no direct exposure to the asset class. Why?

There are a number of possible answers, but perhaps the most frequently heard is that quoted smaller companies are both risky and illiquid. Although this may be the case in some instances, with a universe of over 4,000 companies, it is a gross and costly generalisation. The reality is that a plethora of “hidden gems” are waiting to be discovered by stockpickers who have the resources, skills and dedication to find them.  These secure, growing, market-leading companies can present compelling investments precisely because they are not widely known or followed.

For example, most investors do not know what a transducer is, let alone the fact that Switzerland’s LEM has a 50% global market share in this niche electrical measurement market.  Likewise, many of us enjoy probiotic drinks and yoghurts. But the majority will not know that there is a high probability that the active ingredients come from Denmark’s Christian Hansen.

Europe, then, is a fertile ground for those seeking the highest quality smaller companies due to the vast number of quoted businesses, thriving across a broad range of different sectors and countries.  But is Europe worthy of investment now? There are several considerations.

Firstly, investors must review valuations. European SmallCap trades on a 12-month forward price / earnings ratio of 15.3x. This is above its long-term average of 13.2x, but well below the peak levels currently being experienced in the UK and US, and below its own historical peak of 18x. Meanwhile the premium being paid for SmallCap relative to LargeCap in Europe is at long term average levels.

Secondly, investors need to consider the macro-economic outlook, since this will determine if companies are likely to grow. Following a period of contraction over the past two years, from the middle of 2013 forward-looking economic indicators began to signal a resumption of growth in Continental Europe.  There are now clear signs that the worst may be over for peripheral countries such as Spain and Italy.  This is encouraging.

Thirdly, the political, fiscal and monetary outlook needs to be considered too.  In the face of extremely low inflation, the European Central Bank is likely to retain its highly accommodative monetary policy for the foreseeable future.  Elections may bring media attention and some uncertainty, but the individual with the most influence on European investors is Mario Draghi, the President of the ECB. His position is extremely secure.

Overall, therefore, we believe that the environment remains supportive for investing in European equities generally and in SmallCap specifically, since this asset class has historically done well in periods of economic growth and recovery.

At Montanaro, however, we do not spend our time debating politics or estimating payroll numbers.  We are bottom-up investors.  We have one of the largest teams dedicated exclusively to researching and investing in quoted European smaller companies, with no less than eight nationalities among our 28 investment professionals.  This enables us to thoroughly research the companies in which we invest.

We are mindful of our “circle of competence” and focus on companies that we can understand - typically niche franchises with good and experienced management, sound finances, simple business models, good order visibility, high barriers to entry, a strong, normally dominant market position and a competitive advantage that ensures pricing power. In other words, the “hidden gems” mentioned earlier. We will not invest in a company that does not pass our stringent checklist, which has been developed and refined over 22 years.  We have our own money alongside that of our investors and we like to sleep at night.  Stock market and economic cycles may come and go, but truly great business franchises endure.  This is where we invest your and our hard-earned money.

Of course, high quality, blue chip, growth companies are not always in favour.  Indeed, the past two years have seen investors rush into the higher risk, lower quality, value stocks, particularly in peripheral Europe.  However, with earnings growth likely to drive future returns, and the premium for quality growth now below its long term average for the first time in several years, we believe that now is a good time to consider taking advantage of quality SmallCap in Europe.

* Total return of the NSC Index versus the FTSE All Share Index.

Learning zone

Visit the AIC's new Learning Zone and enrol in online training courses.

Start now