Supportive environment for European small-caps
An extremely accommodative monetary policy by the European Central Bank, low interest rates, structural reforms in many countries to help drive competitiveness, low raw material prices, and a lower euro versus the US dollar should continue to make European small-cap equities attractive for the next few years.
The risk factors appear to be primarily political, including the ongoing Grexit issue, December elections in Spain, and a 2016 referendum in the UK regarding being in the European Union.
The MSCI Europe Small Cap Index delivered an average annual return of 14.43% for the three-year period ending 30 September 20151. It performed far better than the larger cap MSCI Europe Index at 6.60%1.
This can be explained by higher growth in small-cap earnings, historically and forward. As the MSCI Europe Small Cap Index has more cyclical stocks (approximately 60% versus 40%) and less defensive stocks (approximately 20% against 40%) than the larger-cap index, their earnings tend to accelerate more during economic recoveries.
But be aware that if and when the economy plunges into a recession, small-caps can underperform a lot, such as we witnessed in 2008.
Source: Natixis Asset Management, Bloomberg, from 31 December 2008 to 30 September 2015
Structural factors at play
There are also structural reasons why small caps are more attractive today in Europe. For instance, small companies often have a more innovative approach and are able to be more nimble than their large-cap competitors. Their management teams are typically committed to, and particularly involved in, the success of their company.
Together, these factors may result in stronger growth dynamics – albeit with lower liquidity – when compared to large caps, while experiencing historically similar levels of volatility.
Areas of attractiveness
We are finding a lot of good stock ideas in Germany. This country is rich in capital goods and technology stocks which we think are attractive during this economic recovery phase. Also, the country is well run and consumption should increase as the economy grows.
With regards to sector allocation, consumer discretionary stocks and some financials are the most attractive areas. The consumer discretionary stocks are cyclicals and this is an area we currently want to be overweight in.
For example, we have “buy” ideas in German auto components, UK house builders, and UK restaurants, media companies and specialty retail. London commercial and German residential real estate stocks, where the growth in rent and asset price is strong, are also attractive to us at this phase in the recovery cycle.
Opportunistic approach to investing in small caps
Our investment management team meets with the management of roughly 300 small-sized European companies each year to find the best equity opportunities across the region. The investment universe we look at is primarily European companies with market capitalisations between €300m - €8bn.
We take an opportunistic approach to investing with no style bias, utilising fundamental analysis to select stocks, searching primarily for companies with earnings that appear to be growing at a faster and more sustainable rate than the average company.
We follow a Growth at a Reasonable Price (GARP)-oriented investment approach, with stock selection the main source of alpha for the portfolio. Also, the risk against the benchmark is monitored by a limited bet for each position, sector and country.
1 Source: Bloomberg, as of 30 September 2015
This sponsored commentary was contributed by Thierry Cuypers, head of Natixis Asset Management’s European small cap team.