Three reasons to stay invested in European small caps

Small cap
Key takeaways
Strong growth rates in Europe expected over the next few years
European small cap valuations attractive
Climate change and digitalisation big portfolio themes

We see three main reasons why the outlook for European smaller companies is favourable versus other regions. Firstly, we think growth rates in Europe will be strong for a few years to come. Secondly, we think valuations are reasonable and, lastly, Europe has a number of big themes that will attract investment flows.

We have seen a remarkable first half of the year in European small caps in which they have generated higher returns for our shareholders in six months than we usually see in a full year.

These returns come on top of a strong recovery in markets last year from the March 2020 lows. We tend to refrain from commenting on the overall market and whether our funds will go up or down over the next few months as our goals are to generate long-term capital growth.

We do, however, have strong views on the stocks we own and how attractive they are as investments today, where we see value emerging and which parts of small- and mid-cap markets we are getting more cautious on.

Given most of us will break over the next few weeks for the summer we thought it made sense to provide a short update on some of our key thoughts.

1. European growth rates remain strong

In western Europe vaccination rates are high and hospitalisation rates have come down sharply. Vaccination rates are similar to the US and the UK. Furthermore, large portions of the population have tested positive for Covid at some point over the last year, which should lead to smaller and smaller spikes of outbreaks going forward.

The European consumer meanwhile is in a very strong position. Low unemployment means spending power is high but, added to that, the saving rate has ballooned over the pandemic as consumers were not spending money on travel and leisure activities.

The European stimulus program still has to kick in and should provide a big tail wind, especially for Southern European countries and companies (see below). This stimulus should be seen in the context of a region that, over the last decade, managed to only show marginal GDP growth. This makes the incremental change here very significant in our view.

Figure 1. EU recovery fund grants breakdown by country

Source: J.P. Morgan Note: Includes grants under minor EU facilities

Table 1. Italy and Spain - recovery fund schedule

% of GDP Italy Spain
2021 1.4 1.8
2022 1.8 1.9
2023 2.1 1.4
2024 1.8 0.1
2025 1.3 0.0
2026 1.0 0.0
Total 9.4 5.3

Source: J.P. Morgan Economic research

2. Based on 2023 estimates European small caps look attractively valued

In the early stage of a recovery, the valuation of individual securities is always a tricky concept. As the earnings and revenues of the companies have gotten a beating, it makes little sense to value companies based on current earnings. Our favoured method was to estimate new mid-cycle earnings and value securities based on those numbers.

As the recovery progresses, we enter the growth phase, typically the multiple that the market trades on contracts but the earnings upgrades are offsetting this and driving the market higher.

Obviously, not every stock or sector gets equal earnings upgrades. Cyclical areas of the market tend to get significantly more earnings upgrades than the less economically sensitive sectors.

In this phase, we focus a lot of our analysis on the ‘earnings over-delivery’ that we expect from the companies we invest in. We believe European small caps are attractively valued based on 2023 estimates (mid-cycle) and have focused the portfolios on companies that can over deliver on the current expectation in the market.

Figure 2. Eurozone Cycle-adjusted P/E* relative to the US

Source: Datastream, J.P. Morgan Note: Current price divided by 10-year average EPS

3. Big themes are creating a growth narrative attracting international flows

We continue to believe that climate change, energy transition and the decarbonisation of everything remain the main investment themes of our time. We think Europe is taking a leading role in the fight against climate change and global investors actively seek European investments to increase their exposure to this powerful investment theme.

European companies have already invested significantly in the green economy. The EU recovery fund will add additional ‘fuel to the fire’ as it is specifically targeting the ‘Twin transition’. That is, the transition to a sustainable economy and the transition to a digital economy.

Within our portfolios, we have a lot of exposure to the decarbonisation theme, we see most value in the enablers of this decarbonisation. We like the spades and shovels that enable the energy transition at this point.

We see great opportunities for wind turbine makers and smart LED light producers but also makers of industrial scale compressors needed in hydrogen production, one of the key ingredients in energy transition in Europe.

The second big theme that runs through our portfolios is the digitalisation of everything. As we have noted in previous comments, we see digitalisation driving tremendous growth in the semiconductor industry.

Coming out of the Covid-related demand hiatus and production stoppages in the automotive industries, the semiconductor industry has struggled to meet demand. This has led politicians and the business community to realise the strategic importance of having local production capacity of semiconductors.

In time, this may lead to over supply but for the next few years this will drive significant capacity expansion, which helps semiconductor equipment makers. Within the semiconductor industry, we have reallocated some investments to these equipment makers which we believe are now more reasonably valued, away from the semiconductor companies.

Where we struggle to see value is in the new issuance (or IPO) market. In general, IPOs in Europe are more than fairly valued at the moment. In certain cases, our valuation assessments pointed to significantly lower prices than where the banks placed the stock.

We have not participated in the SPAC market and continue to maintain discipline in terms of valuation in all investments we make. The good news is that some of the hot air has left the bubble, making valuations somewhat more reasonable as seen in the charts below.

Figure 3. SPAC performance

Source: Bloomberg Finance L.P.

Figure 4. Renaissance IPO Index relative to S&P500

Source: Bloomberg Funance L.P.

Figure 5. JPM Global Hydrogen index relative

Source: Bloomberg Finance L.P.

Figure 6. Bitcoin

Source: Datastream

We don’t know what the summer will bring for markets and volatility never seems far away if previous years are anything to go by. However, we think we are in a ‘buy on weakness’ market in European small cap rather than a ‘sell on strength’ market.

Within a global small cap context, we believe a European overweight is sensible given valuation, earnings prospects as a whole and that the region is likely to be one of the earliest ‘post-covid normalisation’ beneficiaries.

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  • The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Important information

  • Data as of 31 July 2021 unless stated otherwise.

    This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.

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