As Europe finds itself in a climate of lackluster growth and political volatility, with an equity market that has been on an unprecedented 10-year bull run, investors are searching for pockets of value. A long-term allocation to small-cap equities is one potential solution.
European small-cap equities have proved an attractive asset class over the last 20 years, delivering significantly higher annualized returns than their larger counterparts.1 More recently, reduced profits growth forecasts and an uncertain economic outlook have weighed on investor sentiment and led to some questions about whether the long-term outperformance of this asset class has reached its culmination. In our view, European smaller companies can still play a valuable role in a portfolio, but selectivity will be key to successfully navigating the asset class going forward.
Strong Long-Term Performance
Broadly speaking, smaller companies tend to generate a large portion of their sales and profits domestically, and this is certainly the case at the index level. In fact, this domestic exposure is one of the reasons that profit growth forecasts have been downgraded this year across European indexes—especially in more cyclical sectors such as construction, automotive parts and chemicals—as Europe seems to be headed for another year of stagnant economic growth.
But domestic economic growth trends do not solely determine the performance of small-cap companies. While small-cap companies, on average, tend to be more sensitive to domestic economic trends, many benefit from leadership in either domestic or international growth niches. Often, these companies also have strong global market shares. In these instances, a company’s stock-specific characteristics and qualities are a more meaningful driver of their future growth, in our view, than local economic conditions. The smaller size of these companies also enables them to be nimble in the event of a market slowdown, often giving them the flexibility to make meaningful adjustments to their business models with greater ease than their larger counterparts.
European smaller companies’ ability to quickly restructure during more challenging periods has contributed to the index’s strong performance over the long term. For instance, although the smaller company index underperformed in 2009 and 2012—two recent recessionary periods in Europe—the index delivered significant outperformance versus large caps in the two years after the slowdown.2
SMALL COMPANIES HAVE OUTPERFORMED THEIR LARGER COUNTERPARTS OVER THE LAST 20 YEARS
Sources: Barings; Factset; MSCI Europe ex-U.K. vs. MSCI Europe ex-U.K. Small cap. Data from January 1, 2000-November 7, 2019. Past performance is not indicative of future results.
Access to Niche Markets
Small-cap companies span a wide range of industries and sectors, offering access to a number of potential growth opportunities. Unlike larger companies or conglomerates, smaller companies tend to be focused in specific, niche areas. In this capacity, small-caps can offer investors direct access to what are often fast-growing industries—from renewable energy to payment services to medical technology.
Looking across the small-cap space today, we see a number of attractive opportunities, particularly in companies that are building out innovative products on an international level. In some cases, these are well-known companies—fashion leader Moncler, or warehouse truck group Kion, for instance. Other times, the companies are less well-known but still leaders within their industries: Tomra, the recycling equipment group, GTT, the LNG tank insulation specialist, and medical technology companies Elekta and Evotec are a few examples.
In Germany, as is the case across Europe, there are a number of attractive small to mid-sized companies. While the contribution of the “Mittelstand” to the German economy is well understood, the companies themselves tend to be less well known and are often overlooked. Nonetheless, the innovation and entrepreneurialism that characterize these companies, and others like them across Europe, can be important long-term growth drivers.
Active Management is Key
While there are a number of potential benefits to investing in small-cap equities, the opportunity is not without risks. Due to the sheer size and breadth of the space—there are roughly 1,000 companies included in the index—there is markedly less sell-side research available to market participants, and what is published often focuses on the shorter term. This can create information gaps and subsequent price inefficiencies. Small-caps have also demonstrated more extreme returns over time—European smaller company indexes have exhibited greater volatility and drawdowns than their larger counterparts.3
For these reasons, bottom-up stock selection and active management are paramount to successfully navigating the small-cap universe. An approach that targets higher-quality companies can control, as far as possible, the level of volatility in a portfolio, as more risky stocks can be excluded. This approach also presents a chance for active managers to hand-pick companies they believe exhibit strong growth potential, but that may be overlooked or undervalued.
The Barings Approach
At Barings, we focus on our Growth at Reasonable Price (GARP) investment process. We take a long-term view of the companies we research—typically five years—and aim to identify those with well-established business franchises, proven management and strong balance sheets, and a credible strategy to further improve their profitability. We believe this approach helps us identify companies with the highest growth potential, and avoid those with weaker profiles.
In our experience, these higher-quality companies offer increased transparency—greater access to information such as company financials, for example—as well as greater earnings and share price stability. Such stocks are more likely to score more favorably in our consideration of Environmental, Social and Governance (ESG) factors, which play an integral role in our investment process. In our view, investments in more sustainable businesses can reduce overall portfolio volatility, and enable managers to more accurately forecast a company’s long-term prospects.
1. Source: Barings, Factset, MSCI Europe ex-U.K. vs. MSCI Europe ex-U.K. Small-cap. Data from Jan. 1, 2000-Nov. 7, 2019.
2. Source: Barings, Factset, MSCI.
3. Source: MSCI.