Marketing Communication
July 2024
Smaller companies tend to offer more growth potential than larger ones, typically leading to higher equity valuations. The current environment is a rare exception—and could hold an attractive opportunity.
Small caps have been long-term winners
Smaller cap stocks have returned 2% more per year than large caps across all major global regions for over two decades, with European small caps leading the way. Since 1999 that’s driven cumulative outperformance of 16 percentage points for small cap stocks.1
The long-term performance of European smaller companies is impressive but not entirely surprising to the portfolio managers of the JPMorgan European Discovery Trust plc (JEDT). Smaller companies have some key structural advantages, starting with the potential to grow much faster than larger ones: doubling EUR 1 billion in annual revenues can be achieved more quickly than doubling EUR 100 billion. At the same time, it’s important to recognize that they might come with higher risks given their scale and stage of development. Hence using active management becomes crucial. Active management allows for continuous monitoring and adjustment, helping to mitigate these risks and capitalize on the potential growth of smaller companies.
That growth potential, combined with a smaller market capitalisation, is also attractive to larger companies and investors, prompting merger and acquisition activity in the small and mid cap market, where target companies are often purchased at a premium to their current valuations. Activity has been heating up in Europe this year, with two companies (Kindred and Sabadell) in the portfolio having received takeover offers. Over the last 20 years, the takeout premium has contributed to the outperformance of European small caps over large caps.
Another reason the portfolio managers find European small caps an attractive asset class is that they are less researched that large caps: 70% of stocks covered by fewer than five analysts. That gives well-resourced investment teams the chance to gain an information advantage for stock picking in this already attractive opportunity set. And the European small cap equity market is indeed home to many companies that have already become national champions, dominating pricing in their home markets, while also expanding internationally.
What’s driving the large and unusual discount to large caps?
Despite the strong long-term outperformance, European smaller cap companies have underperformed large caps in the last couple of years. These companies tend to be more sensitive to their local economies, including the impact of high inflation, rising interest rates and dampened consumer confidence. The European small cap space is also more weighted to cyclical stocks, particularly value-oriented ones, which has been a headwind in an environment where investors have been focused on exposure to the growth of artificial intelligence (AI), largely via large cap technology companies.
Critically, this underperformance has flipped the typical 10%-20% valuation premium that small caps command over large caps to a roughly 20% discount, when looking at cyclically adjusted price-to-earnings (CAPE) ratios. 2When looking at cyclically adjusted price-to-earnings (CAPE) ratios. The last time small caps traded at such a discount to large caps was during global financial crisis (GFC) in 2008-2009.
JEDT’s portfolio managers don’t believe the current environment is nearly as bad as the GFC era and see three key areas of improvement in the macroeconomic environment: real wages are growing, central banks are likely to cut interest rates cuts and global purchasing managers’ indices (PMIs) for manufacturing appear to have bottomed and are rebounding.
Positioned to capture Europe’s diverse leaders
While companies in the portfolio range in size from 350 million to 10 billion in market cap, the average market cap is 3.8 billion. The trust’s limited exposure to companies with less than a 2.5 billion market cap reflects the reality that this area of the market tends to underperform, while the mid cap segment drives a significant portion of outperformance.
Current positioning in the portfolio reflects several key investment themes, including sustainability and electrification. European decarbonisation and electrification goals mean that trillions of euros need to be invested this decade, supporting companies across a wide range of industries. The portfolio’s largest active position is in Bilfinger, a German industrial services company for heavy industries, which has a new management team making improvements. Another large position is SPIE, a French company that installs electrical cables, heat pumps, heating, ventilation and air-conditioning (HVAC) systems and charging stations. The company is supplying the thousands of kilometres of cable needed as Germany connects offshore windfarms from the North Sea to the grid. Related to this position is Fugro, a Dutch company that supplies geological data that is critical to installing offshore windfarms.
JEDT also has exposure to many high-quality companies outside of these themes. For example, CTS Eventim, a German company, is the largest online ticketing platform for live events in Europe. Every ticket sold is incremental margin, without incremental investment, leading to a highly profitable business model. Zealand Pharma, a Danish pharmaceutical company is developing a weight-loss treatment with potentially fewer side effects than existing drugs in this huge market. De’Longhi, the Italian coffee machine specialist, is leveraging its strong brand to drive higher spending.
Leveraging the strengths of the investment team and process
A new portfolio management team took the helm of JEDT earlier this year. Jon Ingram, Jack Featherby and Jules Bloch are seasoned portfolio managers with a collective 40 years of investing experience in European small caps. The portfolio managers expect the majority of the trust’s returns to come from stock selection, rather than macro positioning, and are focused picking high-quality companies with strong fundamentals that the trust can own for a long time.
The diversity of the portfolio’s current positioning reflects both the broad opportunity set of the European small and mid-cap market and the current environment, where the portfolio managers are finding extraordinary near-term valuations for compelling long-term positions.