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Summary

We explore how the smaller companies sector in Europe offers a rich source of investment opportunities.

3 min read

Coutts has seen European equities as good value for some time, particularly in the smaller companies sector.

The smaller companies sector can offer a rich source of investment opportunities for a variety of reasons. It represents a wide universe of businesses, many of which have huge potential for growth because they are often nimble, dynamic and innovative, giving them the flexibility to expand quickly into new areas. Some may even flourish into tomorrow’s global leaders.

We believe that there is good value to be found for investors in this under-researched area of the market. Large companies tend to be followed by many analysts and fund managers so their share prices usually represent a fair reflection of their prospects. But with smaller companies, there are fewer analysts covering them and the market can be inefficient. As a result, there can be more opportunities to spot mismatches between a company’s prospects or performance and its share price.

Although broad index returns show that the share prices of smaller companies can outperform larger companies over the long term, the market tends to be volatile over shorter periods. Liquidity is also an issue – it can be difficult to sell shares during times of stress and the spread between bid and offer prices can be substantial. These potential risks deter most large funds, leading to a less crowded market.

“Europe’s economy is enjoying an uptick after a prolonged period of weak growth and the outlook has brightened considerably ”

RETURN TO GROWTH

Since the 2008 financial crisis, Europe has been overlooked by investors put off by the region’s economic problems and political challenges that have dominated the headlines. Its smaller companies have been overlooked further still. Yet long-term investors who have been willing to ride out periods of volatility in this sector have been rewarded with decent returns over the past few years.

More recently, Europe’s economy is enjoying an uptick after a prolonged period of weak growth and the outlook has brightened considerably. Fears of deflation have faded and the unemployment rate has dropped to 9.5%, the lowest since May 2009. Company earnings are growing again, with profits driven by increased demand rather than cost cutting.

There are many interesting smaller companies in Europe that are trading at attractive valuations because the region has been out of favour with investors for so long.

 

A SPECIALIST APPROACH

At Coutts, we continue to like European equities based on compelling valuations and positive macro-economic drivers. Within our investment portfolios we typically hold about 49% in equity and this includes around 6.5% invested in European equity.

We prefer to gain access to this sector through actively managed funds, where the fund managers have the specialist knowledge, resources and experience to build and manage a diversified portfolio in a specialist area.

We gain exposure to European large and midsized companies such as Siemens and Roche through funds like the JOHCM Continental European Fund, which has a tilt to Germany, France and the Netherlands.

For exposure to European smaller companies however, we use the Barings Europe Select Trust. The fund operates in a universe of around 5000 companies, which includes some world leaders across a range of industries from financial technology and banking software to automotive components, fashion and alternative energy. It uses a bottom-up stock selection process to identify companies with the potential for superior growth that is not fully reflected in the valuation of the shares.

As an example of how the fund uses negative sentiment to find opportunities, it currently has the most exposure to France. While other investors have been avoiding the country due to political and economic uncertainty, Barings has identified strong companies with low valuations. Some of these businesses have limited exposure to the French economy; they are simply based there and earn the bulk of their profits overseas.

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“Within a balanced investment portfolio, exposure to European smaller companies provides diversification away from large-cap stocks and the potential to enhance returns”

The managers of the Barings fund also like Italy for opportunities at a stock-specific level. Although the eurozone’s third-largest economy has been weak for 10 years, it is home to many companies that have managed to grow consistently through this period. This reflects the fund’s approach of investing in well-run businesses with strong balance sheets that have the resilience to grow regardless of domestic issues.

Within a balanced investment portfolio, exposure to European smaller companies provides diversification away from large-cap stocks as well as the potential to enhance returns. In Europe, smaller companies are often family-run or the management team have a substantial stake in the business. If the directors own plenty of shares, they have a decent incentive to drive the business forward. The sector has performed well recently and we believe it should continue to do so.

KEY TAKEAWAYS

  • The smaller companies sector can offer a rich source of investment opportunities
  • Europe’s economy is enjoying an uptick after a prolonged period of weak growth
  • Within our investment portfolios we typically hold about 49% in equity and this includes around 6.5% invested in European equity

About Coutts investments

With unstinting focus on client objectives and capital preservation, Coutts Investments provide high-touch investment expertise that centres on diversified solutions and a service-led approach to portfolio management. Our investment process is as disciplined as it is creative – ensuring tailored solutions with robust results.

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