In 2022, European smaller companies investing felt the wrath of the asset allocator – Europe was a region to be ignored (“too difficult”) due to the energy crisis and the proximity to Ukraine. Indeed, European equity valuations reached discounts of over 40% in comparison to their US peers – an extreme differential. European indices fell below their historic long-term averages, and the traditional small cap premium vs large caps all but disappeared. Increasing interest rates also led to a fast change in market leadership – the“ value’’ factor outperformed “quality” and “growth.”
For investors focused on business fundamentals, however, this selloff created an attractive set of opportunities to invest in companies whose long-term outlooks are in fact improving.
S&P P/E premium vs. Europe
Source: Bloomberg as at 28.2.23. S&P 500 vs Europe Stoxx 600
Are small caps worth the risk?
Many academic studies highlight the benefits of investing in smaller companies:
- Higher growth – Higher growth potential than larger peers due to exploitation of global white space opportunities, scale economics, focused market exposure and agile innovation.
- Founder-led management – many are managed by their founders, who have vested interests and clear alignment with shareholders.
- More mispricing – often less researched and understood than larger peers, a “discovery” arbitrage can exist.
It’s important also to acknowledge that smaller companies can be more prone to single investment failure, with potentially lower liquidity and more stock trading volatility. However, the positive attributes have resulted in significant outperformance from smaller companies’ indices over the long term.
Small caps outperform larger companies over time
Source: Bloomberg, as at 23.03.23. MSCI Europe Large Cap, Mid Cap, Small Cap indices.
Therefore, at times of market stress, smaller businesses tend to be sold off due to a perception of being more risky. Lower liquidity can result in outsized stock moves. This can also give a longer-term investor an attractive entry point to pick up shares where the long-term business prospects remain strong, providing an asymmetric upside risk/reward potential. We believe that the recent macro-driven market has created an attractive entry point for quality European smaller companies.
Inflation is a concern for companies, so therefore understanding pricing power is arguably more important in the current environment. By analysing the fundamental building blocks of a business an investor can identify attributes such as network effects, brand strength or innovation that can provide pricing power, helping the company to succeed in differing market environments.
Business quality remains key. In tougher economic times, a business’s competitive advantages come to the fore. With well-capitalised balance sheets and sustainable business models, quality franchises are well positioned to succeed in tougher economic times. They will take share from weaker competition, invest through the cycle and emerge stronger. We believe we are beginning to see some of this fundamental divergence take shape. After a tough 2022 for quality, the depressed share prices and improving fundamentals have created a long-term opportunity to invest.
Sources of sustainable competitive advantage
Here are three examples of such opportunities, in our view:
Bachem is the leading outsourced peptide-based manufacturing company for the pharmaceutical industry. Peptides are an increasingly interesting aspect of modern medicine – the fundamental building blocks of drugs that fight, amongst other diseases, diabetes and obesity. We see Bachem at the centre of this dynamic industry, a company with decades of experience helping its customers develop and manufacture these products successfully. Bachem’s services are designed into the product at an early stage, meaning that, if the product is successful, the customer will rely on these services, potentially providing sticky, long term, and profitable revenue streams for Bachem. The founding family owns the company, and we believe that investing alongside them aligns interests. We also think the company’s entrepreneurial spirit will help it to capitalise on industry growth.
Carel is an Italian maker of electronic controls for heating, ventilation and cooling (HVAC). Increasing global energy prices have highlighted the importance of energy efficiency as have programs such as the EU’s European Green Deal and the industrial drive for decarbonisation. Carel’s products make HVAC systems smarter — reducing the energy requirement, increasing efficiency and optimising output. Carel does one thing, and does it very well, maintaining an edge over larger peers through a strong focus on research and development. The company has shown adaptability – it innovated to pivot between chip suppliers in order to complete deliveries to customers during the semiconductor supply shortage, taking market share in the process. Carel, like Bachem, has founder/family involvement, resulting in long-term thinking and efficient capital allocation.
Another highlight is Brunello Cuccinelli, which sits atop the luxury pyramid, where quality and exclusivity are key. Known for logo-free daywear clothing such as Facebook founder Mark Zuckerburg’s infamous grey t-shirt, the company’s culture is critical to its success, in our view. The founder’s name is on the door, and he remains actively engaged in the business. This “family-like” thinking, where employee well-being is as important as profit maximisation (the company retained all staff and didn’t reduce wages in the pandemic), gives workers a sense of ownership and retains intellectual property. This reduces labour friction and creates a drive to stay ahead in fashion. Store rollout remains a medium-term growth driver, and wealth creation should mean more consumers access the brand. This elevated subset of customers also tends to be less affected by economic downturns, providing an element of resilience to the brand.
These names provide an insight into the types of investments we like. The focus is not on sectors or countries but on business models.
A recent Bloomberg article highlighted that in Europe over the last decade there were 55 businesses with a market cap of +$1bn that increased their valuation by 10 times. To find these kinds of companies you need to do deep, focused research, understand the fundamentals and be patient enough to tune out the macro “noise”. That statistic highlights that Europe is a fertile ground for active investment managers and, we believe, even more so given the current valuation discount.
We will continue our relentless pursuit of opportunities for clients in the form of under-appreciated and undervalued businesses. Where we do, we want to hold these businesses for the long term, allowing the powerful benefits of compounding to ensue.
Please note: Stock examples are for illustrative purposes only and are not a recommendation to buy or sell.
The value of active minds: independent thinking
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.