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The past 18 years has been a period of unprecedented reward for European small cap investors, with persistently higher earnings growth and steady outperformance relative to their large caps peers. But having fallen gradually since the turn of the millennium, the cost of debt is no longer on the decline; in fact, that trend is now reversing. Meanwhile, for the first time in a long time, certain areas of the small cap market look expensive: is the European small cap winning streak coming to an end?
A CHANGE IN THE WEATHER
There are a number of factors that have contributed to the almost two decades of relative joy for small caps: rising equity markets; attractive valuations; earnings upgrades; and, all importantly, a decline in the global cost of risk. Indeed, it’s the cost of risk that has driven down the equity risk premium and which has had a disproportionately large impact on small caps.
But which of these factors remain intact in 2019?
Well, equity markets have stopped their heady ascent and the cost of risk has finally started to rise. Conversely, valuations are already more attractive in light of the sell-off we saw during 2018, while earnings have continued to grow, which we expect to continue in 2019. Dull but steady European and global economic growth, moderate expansionary government budgets, accommodative European Central Bank policy and a weak euro are all supportive of the asset class going forward.
In the small-cap world, top-line company growth has traditionally been at a higher rate than nominal GDP growth; with the European economy expected to grow at 3% next year, this remains a perfectly realistic expectation for the region’s smaller companies.
NEW LEADERSHIP REQUIRED
A rise in the risk premium tends to hit those already expensively valued companies whose growth is expected to materialise over the longer term, more than others, and many of them now have extreme valuation premiums relative to the market and, importantly, their own recent history. Meanwhile, in some cases, when growth rates moderate due to the maturity of a business or the cost of debt rises, acquisition-led growth models increasingly feel the pinch. A change of small cap leadership may be in the air.
So where can European small cap investors go in this environment?
The investment universe doesn’t contain a huge number of companies with traditional “defensive” qualities, so we expect to see greater focus fall upon those companies where valuations are already pricing in a bleaker outlook. Such areas of the market include the consumer sectors, domestic industrials and technology.
And in many cases, it feels like the market is moving very quickly towards pricing the worst-case recessionary scenarios for these companies. We think this is premature at best, or misguided at worst.
As such, we believe there is a good opportunity to invest in high-quality businesses with strong earnings growth, and at relatively attractive valuations.