Smaller companies as an exciting source of growth opportunities
Smaller companies in the context of coronavirus
The big story in 2020 has been the coronavirus pandemic and its impact on the global economy, government finances and corporate earnings, leading to heightened levels of equity market volatility. Smaller companies have been no exception to this rule and suffered in particular during the first quarter of the year. Nevertheless, the MSCI Europe Small Cap Index has rebounded strongly from the market lows seen in March 2020, returning 51.69% compared to a gain of 32.74% for the MSCI Europe Index. It is remarkable that during such a turbulent period for equity investors, the MSCI Europe Small Cap Index has outperformed the MSCI Europe Index by 2.6% since the start of the year (figures to 09/10/2020, source Bloomberg Finance LP).
This outperformance can be partly explained by the polarisation of returns in European equity markets and the sector composition of the smaller-company universe.
More growth-oriented segments of the market, which stand to benefit from long-term trends that have been accelerated by the “new normal”, have performed strongly.
Other sectors, conversely, that have seen a disproportionately negative impact on their earnings and cash flows from the continued lockdowns and disruption to operations, have lagged. Compared with large-cap European indices, the European smaller-company universe has greater exposure to more innovative and disruptive companies in sectors such as technology, healthcare equipment, engineering, clean tech, communication services and online retail. It is also less exposed to more traditional old-economy areas of the market such as banks, insurance, oil and gas, telecoms, utilities and automotive.
The Europe Small Cap Equity team’s investment approach
Our approach has always been to invest in sustainable, high-quality growth business models: well funded, well managed, competitively advantaged companies delivering strong or improving returns and exposed to strong secular growth drivers in their end-markets. Our detailed screening process involves our own watchlist of candidate companies as well as extensive use of systems such as Holt and Bloomberg to identify specific features. Examples of what we are looking for are: quality growth, under-covered gems, improving returns and large-scale, highly productive R&D.
Existing and potential portfolio companies are exposed to a range of enduring secular growth drivers:
- Technological progress
- Healthy living
- Disruptive industry shifts
- Solutions for a better planet
- Consolidation
As part of our fundamental research process we actively engage with management teams and carry out integrated ESG analysis, working with research partners such as MSCI ESG Research, Sustainalytics and ISS. For stocks that are not covered by ESG rating agencies, we have an enhanced, proactive ESG engagement process that helps provide additional insights about the company’s DNA and moral compass, as well as its progress on ESG and sustainability matters.
Smaller companies have traditionally delivered higher growth rates and investment returns over the long term. It is a simple fact that stronger growth is easier to achieve from a smaller base. Small companies benefit from greater exposure to sections of the market that are contributing to higher levels of innovation, disruption and R&D spend, driving stronger growth. They tend to provide investors with pure-play exposure to important secular growth trends. In addition, as small caps grow and become larger companies with higher market capitalisations, the liquidity risk premium that investors attach to them when they are small reduces over time, contributing to superior returns.
A selective approach is critical when assessing smaller companies, to identify those that will become larger companies in future from a broad investment universe. Low analyst coverage levels and the lack of maturity in this asset class in Europe lead to inefficiencies, which can enable experienced investors to take advantage of attractive entry points for quality growth businesses.
One of the positives for the smaller-company asset class in recent months is that well positioned companies have had fairly seamless access to capital despite the prevailing circumstances and continued market uncertainty. Interestingly, 2020 has been a busy period for fundraisings among listed small and mid-cap companies, as they seek to shore up their balance sheets against the ongoing uncertainty arising from the coronavirus pandemic. The current IPO market in Europe is mainly focused on growth-oriented and innovation-led areas of the market such as medtech, clean tech and fintech. An influx of new listing opportunities should help to shine a positive light on a market segment that is often overlooked as Europe’s growth engine.
Karim Salame
Investment Specialist
