Do European small caps have that bouncebackability?

The decision to invest in European smaller companies seems a daunting one. However, when we look a little closer, we believe long-term investors will find reasons for optimism. 

European smaller companies had a dreadful 2022. The MSCI Europe Smaller Companies Index slumped -22.5%, tailing large caps, which fell -9.5%1. This represents the worst yearly performance since comparative data began. Risk-averse investors abandoned the asset class as they contended with high inflation, rising interest rates, a slowing economy and the ongoing Russia-Ukraine conflict. Meanwhile, high-quality growth stocks suffered as investors rotated into lower-quality value names.  

With many of these factors still in place, the decision to invest in European smaller companies seems a daunting one. However, when we look a little closer, we believe long-term investors will find reasons for optimism. 

Which companies might you want to own in 2023?

Encouragingly, recent economic indicators suggest inflation may have peaked. The December Eurozone reading was 9.2% in December, down from 10.1% in November1. This is partly in response to European Central Bank rate hikes, which have taken the borrowing cost from -0.5% in July to today’s 0.75%. Additional hikes are forecast. Unfortunately, tackling inflation by raising rates was always going to come at a cost and the economy has weakened as a result. That said, recent data – from German industrial numbers to record-low unemployment – suggest the coming recession could be milder than previously thought. Nonetheless, 2023 will remain challenging.

Against this backdrop, we believe investors will increasingly focus on bottom-up fundamentals. That means discriminating between businesses that are delivering on their growth plans and those that are not. Avoiding loss-making or speculative companies will remain of paramount importance. 

Quality growth companies should also find themselves back in favour after last year’s severe value rotation. During times of stress, investors usually favour businesses with robust profitability, good cashflow, strong management, sound ESG (environmental, social and governance) standards, high barriers to entry, unique growth drivers and pricing power. By contrast, businesses with high debt levels or that rely on external factors to succeed could fall by the wayside.

A strong hand at the helm

Most management teams have been in crisis mode for the last three years. The global pandemic, supply-chain disruptions and soaring raw material costs have tested many business models. Demand has fluctuated wildly, while rising rates have weighed on balance sheets. 

During this time, however, adroit management teams with the necessary firepower have continued to invest. We believe this outlay will bear fruit in 2023, as the strong get stronger and the weak flounder. 

An example of a company continuing to invest for growth is the Swiss-quoted peptide pharmaceuticals business Bachem. It’s planning a significant expansion in capacity over the next couple of years, investing over CHF 500 million (€504 million). This highlights the high degree of confidence management has in the firm’s growth prospects. Another name from Switzerland is automated wire processing firm Komax. It’s undertaking significant capacity expansion and purchased the number two global player in the wire processing space. This comes at a time when we’re seeing growing demand for wire content in vehicles and increased automation of the wire process.

An attractive entry point?

And then there are valuations. European smaller companies have historically traded at an average premium valuation of 21%1 to large caps thanks to their superior growth and earnings potential. Following last year’s terrible performance, the differential currently stands at 9%. The pronounced market rotation in 2022 also means growth stocks are trading below their historical average. These valuations could therefore represent an attractive entry point for long-term investors. 

History is on our side. While past performance is not a guide to future results, evidence shows that smaller companies as an asset class tend to outperform large caps as we exit recession or sooner. Furthermore, following periods of relative underperformance – 1999, 2007-08, 2011, 2018 – European smaller companies delivered strong outperformance in the two subsequent years (longer in the case of the early 2000s)1.  We see no reason why this time will be different.

Final thoughts…

Do European smaller companies have that bouncebackability? In our view, the answer is 'yes'. True, short-term pressures will remain as the continent contends with a potential recession. However, many of the components for recovery further out are now in place. Quality companies have been investing, which should allow them to continue taking market share. Valuations are also supportive.

We’re already seeing tentative signs of a rebound. European smaller companies far outpaced both global and US equities in Q4 last year. The magnitude of the outperformance – 10.9% versus the MSCIS World Index return of 0.8%1 – was impressive.

That’s why we think smaller companies are a compelling opportunity for investors with a sound grasp of history and a long-term mindset.

Companies are selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance. Past performance is not a guide to future results.

1 Bloomberg, 31 December 2022

Andrew Paisley is Head of Smaller Companies at abrdn

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