The change in monetary policy and the improved outlook for earnings growth indicate an interesting time for this asset class, which has been neglected for several years.
The European small- and mid-cap sector has struggled over the past five years, with prices severely depressed by rising interest rates and unfavourable comparisons with the technology sector. J. Safra Sarasin Sustainable Equity European Smaller Companies (ISIN: LU1859216464) has rebounded by more than 30% since the lows reached in October 2022, and Marcel Voogd (fund manager) believes it is not too late to get into this theme.
Performance drivers
“Small caps are relatively more affected by the rise in inflation because they rely more on financial debt to support their expansion and generally have more debt,” Marcel Voogd notes. “In contrast, they have everything to gain from a more accommodative monetary policy that lowers their interest costs. He points out that the first direct interest rate cut recently announced by the European Central Bank is a positive signal for this asset class as a whole. “
“This long period of underperformance has also pushed the valuation of small and mid caps to very attractive levels”, at a discount to large caps not seen since the great financial crisis of 2008. He also points out that European small caps tend to outperform large caps over the long term. “Since 2001, the MSCI Europe Small Cap index has outperformed the MSCI Europe Large Cap index by more than 300%.”
Outperformance
Marcel Voogd also points out that the investment universe is much more diversified, with almost 900 companies in the small- and mid-cap index compared to less than 200 in the large-cap index. Earnings growth for small & midcaps has historically tended to be higher, with an expected growth rate of 15.1% by 2025, compared to 7.6% for large companies. “It is also one of the factors that explains the long-term outperformance of this asset class.
“Besides having a much broader universe from which to choose our positions, these smaller companies are also much less well followed by stock market analysts,” with an average of only nine analyst opinions for companies in the MSCI Europe Small Cap index, compared to 24 for the MSCI Europe Large Cap index. “This gives us many more opportunities to find gems that the rest of the market ignores.”
Two examples
It points in particular to reinsurance company Conduit Re, which is trading at a significant discount to its competitors due to its relatively recent entry into the stock market. “The company flies under the radar of investors despite its solid balance sheet, which has not been affected by difficult years such as 2016 or 2020. Insiders have also recently bought hefty shares in the company.”
Another example is the distributor of seals and valves Diploma, which specialises in the quick delivery of parts crucial to the smooth running of its customers’ operations, a service for which they are generally willing to pay an extra price. Thanks to this positioning, the group has outperformed by more than 18% year-on-year over the past decade.
Questioning
However, investing in this asset class carries risks, despite the more favourable medium- and long-term outlook. “Small & mid caps are traditionally at an earlier stage of their life cycle. Any doubts about their growth prospects will therefore have a sometimes severe impact on their share price. Against this backdrop, Marcel Voogd stresses that stock selection in the portfolio will be particularly important for long-term performance. “Periods of higher volatility, peculiar to this asset class, often provide buying opportunities for investors with a long-term approach.”
J. Safra Sarasin Sustainable Equity – European Smaller Companies invests in European small- and mid-caps with a sustainable approach. “We have a rigorous assessment of the sustainability of the various companies we invest in, with high scores on the various ESG (Environment, Social, Governance) criteria and a low carbon footprint.”
Sustainability and concentration
The investment strategy also focuses on companies with a high return on equity, reasonable long-term growth and high-quality management teams. “Our goal is to take long-term ownership of the companies we have identified as tomorrow’s winners so that they can increase their profits and contribute to the performance of our strategy.”
The fund also aims for concentrated positioning, with the ten largest lines accounting for almost 45% of assets under management. “Our job is to thoroughly analyse the different companies so that we can develop a strong conviction. We then prefer to hold large positions in these companies to avoid diluting our performance by diversifying into companies in which we are less confident,” Marcel Voogd concludes.
