Better times ahead for European smaller companies?, March 2023

Managers of European smaller companies funds appear increasingly optimistic that better times lay ahead for the sector after a challenging 2022.

A combination of factors hit European markets last year, including the energy crisis, rising inflation, and the wider effects of Russia’s invasion of Ukraine. These punishing geopolitical factors took their toll on many businesses operating in the region. In turn, this made life tough for managers of smaller company portfolios. In fact, the average fund in the IA European Smaller Companies sector fell 21.08% during the year*.

However, smaller businesses look well-placed to outperform their larger capitalisation stocks, according to the four-strong team behind the Barings Europe Select Trust. In an update, the managers emphasised how the asset class stands to benefit, despite its very nature making it susceptible to short-term volatility.

“Smaller companies tend to be more nimble than larger companies and conglomerates, affording them the flexibility to react and adapt more quickly to changing market conditions,” they wrote. The co-managers – Nicholas Williams, Colin Riddles, Rosemary Simmonds and William Cuss – favour companies that can grow, regardless of the economic backdrop. However, they won’t overpay.

David Walton, manager of IFSL Marlborough European Special Situations agrees. “Economic forecasts for Europe have edged up in recent months, with the IMF forecasting 0.7% GDP growth in 2023 for the Euro Area,” he said. “The market valuation is overall quite modest with small company shares trading at a discount to large company shares, suggesting that if the economy can avoid a prolonged downturn returns could be quite attractive from here,” he added.

Withstanding headwinds

The team at Barings sees smaller companies as industry leaders in many niche areas, with a presence in everything from building companies to industrial automation. “While the current environment in Europe remains challenged by geopolitical risks, we continue to believe that there is long term value in selecting those companies that can withstand headwinds, becoming stronger and increasingly competitive in the process,” they noted.

Looking ahead, they believe company earnings revisions are set to become an increasingly significant driver of relative performance. “Our bottom-up, quality growth at a reasonable price investment approach remains unchanged, and we believe this process is well placed to capture these attractive opportunities,” they added.

Recession on the cards

However, there are still ongoing risks in this region and the mild winter will only delay Europe’s recession, not prevent it, according to Tomasz Wieladek, chief European economist at T.Rowe Price.
“Although gas prices have come down, other risk factors have emerged that we expect will weigh on the eurozone economy later in the year,” he said. “So, while the fall in gas prices will support a rebound in the short term, I believe a recession in the second half of the year is still likely.”

He pointed out that the European Central Bank (ECB) had recently begun tightening monetary policy at “an unprecedented pace”, meaning the cost of capital for firms is on the rise. “Governments, firms, and households became more indebted during the era of low interest rates, which makes them more susceptible to these financial shocks,” he added.

Discovering companies early

This backdrop emphasises the need for experience and Ben Griffiths, manager of the T.Rowe Price European Smaller Companies Equity fund, has many years under his belt. He focuses on high quality, durable franchises with good capital allocation and high standards of corporate governance. Finding attractive companies at an early stage is key to his approach. The fund consists of a diversified portfolio of 70-100 small and mid-cap European companies, with environmental, social and governance (ESG) factors taken into consideration.

Mix of exposures

One of the interesting parts of smaller companies is the diverse range of industries and companies chosen by fund managers covering the area. For example, Mark Heslop and Phil Macartney, who manage the Jupiter European Smaller Companies fund, have exposure to nine sectors**. The most significant is industrials, which accounts for a 26.9% allocation, followed by 16% in financials, 14.6% in technology, and 14.3% in health care*. There is also broad country exposure. Switzerland has the largest share of 23.3%, followed by Italy with 19.3%, Germany on 15.8%, and France with 10.8%**. The fund, which was only launched just over three years ago, looks to buy and hold high quality companies that are experiencing secular growth. These growth trends include ageing populations, emerging wealth, automation and supply chain efficiency, the environment, and data/digitisation.

Equities should be in a better place

Looking to the future, Ollie Beckett and Rory Stokes, the co-managers of the Janus Henderson European Smaller Companies fund, are relatively upbeat. In their most recent quarterly update, they highlighted how European equity markets had found some support during the final few months of 2022. Investors were weighing up a number of factors, they noted, such as the extreme valuation discount of European equities and US dollar strength offering earnings support for European multinationals. “We think equities should be in a better place by the end of 2023 as easing interest rates could open the door to a degree of normalisation in terms of share price valuations,” they wrote.

However, Ollie and Rory acknowledged that this cycle might look considerably different from the last 15 years with interest rates likely to settle above the average since the global financial crisis. “We continue to deploy capital in a portfolio of what we see as Europe's most attractive small companies, balanced between opportunities across both value and growth-style stocks,” they noted.

*Source: FE fundinfo, total returns in sterling, calendar year 2022
**Source: fund factsheet, 31 January 2023

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.