European shares may have risen over the last twelve months but there’s been a wide dispersion of returns within that. Domestic consumer-facing sectors have been relatively strong as consumer confidence in Europe has rebounded, while resources companies and traditional automakers have underperformed due to weakness in China. Go a little deeper and you realise that large caps have outperformed small caps as investors have looked to “hide” in size.

More recently we are hearing a change of tone from companies compared with three months ago. New orders for some capital goods companies aren’t as strong as they were, potentially signalling a weakening global backdrop. This is probably to be expected as higher rates begin to take their toll. However, many companies still have large order backlogs which is potentially masking the underlying health of their businesses.

Inflation concerns refuse to abate too. Europe is a net energy importer so worries around war in the Middle East and the higher cost of energy generally mean capital continues to flow, to safety, towards the US, specifically Big Tech.

This slower global growth coupled with stubborn inflation may lead to a strengthening of “recession-based investing” in the European market, as investors hunt for safety, looking for companies that will be resilient through the cycle.

For us, we talk about building resilience in portfolios – investing in companies that can weather whatever the economic climate may be. We’ve been impressed with the companies that we own so far and how they’ve dealt with the inflation issues over the last 18 to 24 months. Many have shown pricing power, as we expected, and have protected margins in the high inflation environment. If the economy continues to weaken, then quality characteristics like sustainable competitive advantages, solid balance sheets and the ability to generate strong recurring revenues become even more important.

From a valuation perspective, Europe continues to offer the opportunity to buy companies at attractive prices versus their global peers. Why is Europe trading at such a discount? There are worries about Italian debt, for example, or whether the European Central Bank will make a policy mistake, and these worries have an impact on valuations. Smaller companies are disproportionally hit on this basis as they are often viewed as more domestically orientated, with a higher level of risk around their operations due to size. Valuations of smaller companies have derated to the level that there is no longer a premium for investing in this area of the market. Volatility and weakness in our investment universe can create opportunities for us as active investors. We have added a number of holdings over the last year in high quality, well capitalised, unique assets within the European small companies’ universe – and we will continue to hunt for more.
Small company performance