Interactive Investor

Why small-cap stocks outperform, and latest buys and sells

8th December 2021 09:06

Kyle Caldwell from interactive investor

George Cooke, fund manager of the Montanaro European Income fund, a member of interactive investor’s ACE 40 rated list of ethical investments, explains why the small-cap effect is a trend that’s here to stay. Cooke also runs through latest portfolio activity, and names a theme he is backing that is ‘taking market share left, right and centre’. 

Kyle Caldwell, collectives editor at interactive investorHello. Today I am speaking to George Cooke, fund manager of the Montanaro European Income Fund. The fund invests mainly in mid-caps and small-caps that are listed in Europe with one of the key focuses looking for businesses with sustainable competitive advantages. The fund is top quartile in its sector over three and five years. What would you say are the main drivers behind that outperformance?

George Cooke, fund manager,  Montanaro European Income Fund: Yes. So I think firstly we’ve got the small-cap effect working in our favour. Historically smaller companies have outperformed their larger counterparts, and that has been true in Europe over the last three and five years that you reference. We exclusively look at small and mid-caps, many of our competitors have a larger cap focus, and so that’s provided a nice tailwind for us over the period.

There’s also quite good evidence to suggest that high-quality companies outperform low-quality companies over the long term and our process just binds us exclusively to high-quality companies. So again, that’s something which was acting, I think, as a bit of a tailwind for us and we expect it to act as a tailwind over the long term too.

Beyond that though, we’ve got a really big team. We think it is the largest team out there looking exclusively at small- and medium-sized companies in the listed space. And that’s essential because there are thousands of companies out there in small-cap land in Europe. They are under-researched and they tend to be, as a result, under-owned. And so we’ve got the resources to go out and find these hidden gems and it’s some of that discovery process, finding things before others have had the chance, that I think has helped to drive returns at the stock-specific level too.

Kyle Caldwell:  Given, as you’ve just mentioned there, that smaller companies tend to, over the long term, outperform large companies, given that’s the case, why is it then that you think that investors on the whole tend to neglect investing in smaller companies?

George Cooke:  Yes. So it’s a really good question and you would think that that effect would have been arbitraged away but when you look at the numbers there’s very little evidence to suggest that it has. I can give you a few guesses. I think firstly, the really big players can’t really consider small-cap in scale. Imagine if you running a $100 billion pension fund. Well if you put 10% of that pension fund into small-cap you would have more in small-cap than our company’s entire assets under management. You would very quickly run into liquidity issues, among other things. So if you’ve got those really big institutions, they’re quite limited in how low down the market cap spectrum they can operate.

I think as well it’s very, very labour-intensive. There are lots of small-cap stocks out there that have no research written by them, written by the investment banks at all, and so you have to have a big team. There are thousands of stocks so if you don’t have a big team, you just can’t cover them all. So there aren’t many people out there that have those big teams and, if you wanted to start one from scratch these days, it would cost you an awful lot of money and an awful lot of time. So I think that’s possibly another reason for the inefficiency.

I think to give another reason, I think there’s just a perception out there that small-caps are inherently very risky. And while that’s true for some small-caps, when there are so many of course, we would argue that there are some really high-quality, durable businesses out there too. And so it’s really a case of just finding those companies and we think that can help to reduce that risk.

I guess finally, there might just be a time-horizon point coming here too because small-caps do tend to have bigger drawdowns, when the market drops a lot, then small-caps do tend to have bigger drawdowns than their larger counterparts. And so if you’ve got a short-term horizon, that might put you off. But as we’ve spoken about already, that’s more than made up for over the longer term in all the other periods. And so, for me as a long-term investor, I actually think that the risk, given their track record, the risk is that you don’t own them and that you miss those exceptional long-term returns.

Kyle Caldwell: I wanted to now move on to portfolio activity. Has there been much portfolio activity of late and could you run through your latest buys and sells?

George Cooke: Well we are long-term investors and, as such, we try to keep our turnover as low as possible, so I’m afraid I can’t talk you through the 50 buys and sells we’ve made in the last couple of weeks because that it just not how we operate.

We have sold a couple of stocks and so we sold NOS, which is a Portuguese telecom operator, that was following a change in the regulatory stance, which we felt was going to increase the competitive threats and threaten their long-term returns as a result. More positively, Cerved (MTA:CERV), which was an Italian credit risk management services company, that was bought out earlier in the year and so we were able to sell it on that bid.

In terms of the purchases, we are always looking for new ideas. We’re always trying to find some sort of hidden gems. And so a couple of the buys that we’ve made into the portfolio have been Shurgard (EURONEXT:SHUR), so they operate self-storage units, it’s an industry we know relatively well. And Shurgard, very good operators and one of the market leaders in Europe, providing a solid and growing dividend.

And then we’ve got Kid, which is a Norwegian designer and retailer of soft furnishings, and they sell those to both stores and online. That’s a company with a very good financial profile but also a very attractive dividend yield with a dividend growth profile too.

Kyle Caldwell: And are there any sectors or themes that are of a particular focus at the moment?

George Cooke: Yes. Well we’ve got a really eclectic mix of companies in the portfolio. We don’t actually want to have over exposure to one particular theme or one particular demand driver and we really seek to actively avoid that to the extent that we can, while keeping a quality and growth profile to the portfolio.

Having said that, if we think about a couple of the major talking points at the moment, I think one of them would be on some of the supply chain issues and nowhere is this more apparent than in the electronics industry. And that actually plays to the direct benefit of one of the largest companies we own, a company called NCAB (OMX:NCAB).

NCAB, they sit between printed circuit board, PCB manufacturers, who tend to be in China, and the consumers of those PCBs. These are companies in the West that need PCBs to make their products work, whether the product be a high-end scientific instrument, all the way down to a lawnmower, they tend to all need PCBs.

So what NCAB do, they sit in the middle here and they group the orders from all of their customers and then they send them to their PCB suppliers, as I said, mostly in China. But they make sure that they are the number one customer of those PCB suppliers. And what that means is that they get priority, so when there are supply constraints it’s NCAB’s customers that get the product first and if you’re not a customer of NCAB, you don’t.

NCAB are the largest player in this market and because of the advantage they have with scale, they are taking market share from their competitors, as well as enjoying the growing market as well. And in fact, it’s been such a successful year for them, they very recently announced a special dividend.

Perhaps one of the other themes out there is the ESG (environmental, social, and governance) theme and I think this applies both from a demand perspective and also an investor positioning perspective. So whether you agree with the environmental theme or not, I think you have to accept that green technologies are taking market share left, right and centre, whether that be combustion engines in cars changing to EVs, oil and gas being replaced by renewable energy sources and so on and so forth.

So we really play this in two ways. First, by avoiding the dirty parts, if you like, of the economic engine. So we don’t invest in oil and gas exploration and production companies, for example. But more positively than that, we do try to own companies that are at the forefront of the energy-efficient technologies or that help to enable them.

So a couple of examples there would be MTU Aero Engines (XETRA:MTX), they make components that go into one of the most efficient aircraft engines in the world. Or Kitron, they are an electronic manufacturing services company involved, among other things, with battery management and electric vehicle charging units.

So yes, there’s, for whatever theme there is, there are usually some interesting companies in the small-cap world that you can use to get exposure to.

Kyle Caldwell:  And finally, do you have skin in the game?

George Cooke:  I do. And in fact everyone at Montanaro has skin in the game, from the CEO to the receptionist. A material part of our remuneration is invested in the funds that we manage and as a fund manager, three-quarters of your allocation there, as a minimum, has to go into the fund that you manage. So we’ve got other incentive mechanisms too but I think the key point to get across is that we’ve all got skin in the game. We all work together to make these funds perform as well as they possibly can. We’re all incentivised to do that.

Kyle Caldwell: George, thank you for your time today.

George Cooke: Thank you.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.


We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.
Please note that this video on these  investments should not be considered to be a regular publication.
Details of all recommendations issued by ii during the previous 12-month period can be found here.
ii adheres to a strict code of conduct.  Contributors may hold shares or have other interests in companies included in these portfolios, which could create a conflict of interests. Contributors intending to write about any financial instruments in which they have an interest are required to disclose such interest to ii and in the article itself. ii will at all times consider whether such interest impairs the objectivity of the recommendation.
In addition, individuals involved in the production of investment articles are subject to a personal account dealing restriction, which prevents them from placing a transaction in the specified instrument(s) for a period before and for five working days after such publication. This is to avoid personal interests conflicting with the interests of the recipients of those investment articles.