Stock market returns during 2024 have been dominated by companies in the US, specifically mega-cap US stocks, a trend which has been extended by the recent election of Donald Trump as president. It might be easy against this backdrop to overlook the European small cap segment of the market, where the JPM European Discovery Trust (JEDT) plies its trade. However, if one takes a longer-term view, there are plenty of reasons to be excited about European small caps.
Firstly, the long-term performance of European small caps rivals that of any equity market segment. Since 1999, the MSCI Europe (ex UK) Small Cap Index has returned roughly 10% a year on a compound annual basis, which means that in the past 25 years, European small caps have grown almost 10x, compared to just 3x for large caps.
This gulf in performance can be explained quite simply, it is just the difference in earnings growth. Smaller cap stocks, often at the start of their growth journey, can more easily take bigger leaps in size versus the larger cap peers. Short-term variances in performance can sometimes distort this trend, but the JEDT portfolio managers feel the dynamic is not going to change in the long term.
Examining the valuation gap
In contrast to many areas of the US market, European small caps are currently cheap, based on historical valuations. Moreover, they are trading at a discount to large cap stocks, which given their greater earnings growth potential, displays an opportunity.
The drivers of this valuation gap have been a numbers of consecutive crises; Covid-19 pandemic, the Russian invasion, and the inflation burst. These factors combined to push investors into large cap stocks, which are seen as relatively safer during times of uncertainty.
Another significant factor is higher interest rates, which central banks raised to combat spiralling inflation in the eurozone. These higher interest rates also served to slow the domestic economy, which small cap companies are relatively more exposed to. Furthermore, small cap companies tend to have higher levels of debt and lofty interest rates make it more expensive to service that debt.
What makes small caps compelling now
The portfolio managers believe that valuations have become overstretched and there are a number of factors that are turning in favour of small caps. One of the main factors is the normalisation of interest rates in the eurozone. The European Central Bank has already started its rate cutting cycle, with the latest 25 basis point cut delivered in the Bank’s December meeting. These reductions in interest rates not only alleviate some of the interest rate burden for corporates, but also strengthen economic conditions.
There are already some signs of an improving environment for consumers. Purchasing power is improving, with real wages on the rise, while consumer confidence is hovering around its highest levels since early 2022. Given their sensitivity to the domestic economy, this bodes well for small cap companies.
This isn’t to say that the picture for the European economy is universally strong. The manufacturing sector has been a large drag on growth, highlighted by the high profile issues in the German autos sector. This is why it is important to be selective when investing in European small cap.
Where the JPM European Discovery Trust is finding opportunities
The strategy behind the European Discovery Trust prides itself on stock picking rather than macroeconomic forecasting. It focuses on finding exceptional businesses, that are attractively priced and have strong long-term prospects.
One such company that the portfolio managers feel is right at the start of its growth trajectory is Finnish DIY retailer Puuilo. The company currently operates around 40 stores, but has ambitions to double its network over five years. This approximates to opening two stores every quarter.
Additionally, several small companies within the European market are demonstrating remarkable innovation. Danish biotech company Zealand Pharma has an exciting pipeline of treatments for obesity and diabetes that the portfolio managers believe can rival that of larger cap peer Novo Nordisk.
Conclusion
While recent focus has been on mega-cap US stocks, European small caps present a compelling long-term investment opportunity. Historically, they have delivered strong returns, and the current valuation gap with large caps highlights their potential. As interest rates normalise and consumer confidence improves, conditions are becoming favourable for small cap growth.
The JPM European Discovery Trust leverages this potential through strategic stock selection, focusing on companies with strong growth prospects and innovation. This positions European small caps as an attractive option for investors seeking diversification and growth in a dynamic economic environment.
NAV is the cum income NAV with debt at fair value, diluted for treasury and/or subscription shares if applicable, with any income reinvested. Share price performance figures are calculated on a mid market basis in GBP with income reinvested on the ex-dividend date. The performance of the company's portfolio, or NAV performance, is not the same as share price performance and shareholders may not realise returns which are the same as NAV performance.
Comparison of the Company's performance is made with the benchmark. The benchmark is a recognised index of stocks which should not be taken as wholly representative of the Company's investment universe. The Company's investment strategy does not follow or track this index and therefore there may be a degree of divergence between its performance and that of the Company. Prior to 01/04/20 the benchmark was Euromoney Smaller European Companies (ex UK) Total Return Index.