As global economies emerged from the financial crisis at the start of the decade, the US and UK pulled ahead of its European cousins. Earnings for European companies lagged; growth teetered on the edge of deflation; the region’s politicians toiled with Grexit and Brexit and much in between.
But 2017 has seen a switch in fortunes – investors have started to recognise the tangible improvements in Europe’s economic backdrop, setting the stage for a catch-up trade. Gross domestic product growth seems to have gained traction, and company profit margins are improving. Europe is seeing the biggest rise in earnings in developed markets. Where the US and UK have become victim to populism, Europe has largely rejected it (recent concerns over Germany and Catalonia aside). This economic improvement has given the European Central Bank (ECB) President Mario Draghi the confidence to prepare the market for a withdrawal of the unprecedented quantitative easing (QE) program, most likely in the latter part of 2018.
The euro has also strengthened, and is now at levels last seen before the ECB commenced QE in the spring of 2015. This currency strength has been bad news for larger European companies, which have performed less well in recent months; their earnings tend to be harvested from across the globe, leaving them at the mercy of currency swings. Smaller companies, where we are invested, tend to have more of a domestic focus and so have been less affected by a stronger euro.
Small but mighty
We are cognizant of the risks that come with investing in much smaller firms: they are more susceptible to market swings than bigger businesses and their shares can be difficult to trade in large amounts. But as investors in larger companies in Europe have struggled to find value amid renewed enthusiasm for European shares, they have reset their sights further down the scale, targeting mid-sized businesses, which in turn have become more expensive. It means the smaller companies end of the market offers the best value, in our view, and it is an area that we have a long history of seeking exciting growth opportunities for our investors.
Seeking strong capital growth
We look for businesses with good management teams where we believe that their long-term growth potential can be realised, either by addressing something that is not working internally, or continuing to grow their earnings strongly, regardless of geopolitical uncertainties. Our strategy is broadly focused on three areas of investment: value, self-help and ‘growth at the right price’ (GARP).
Value is key to our investment strategy – we look for companies where we believe the market has not yet recognised the value of its assets, whether that comes from its leadership in a particular field, the quality of its products or technological advantages. GARP businesses are those where we believe that earnings can grow more vigorously than their peers or the wider market, but where this trajectory has not yet been recognised by the market, and therefore already reflected in the price of shares. Turnaround, or ‘self-help’ businesses are those that are unloved by the market but have the capacity to improve or recover, primarily through internal change.
Overlooked and undervalued?
Alma Media is a media owner of regional, local and free circulation newspapers for print – an old industry – and the market is pricing it as such. But what the market, in our view, should be focusing on is what the business is really about: online websites that deal in used cars, used equipment and in real estate – an area where it is a market leader. Axel Springer, a similar outfit in Germany, provides guidance in this respect, with the market placing significantly more value on its operations. In our opinion, other investors will catch up with this thinking.
Founded in 1993, Zur Rose is in the business of online drugs, operating a prescription mail order service under its DocMorris brand in Germany, as well as a market-leading online pharmacy in Switzerland under its Zur Rose brand.
Pharmacy is a market ripe for disruption in Europe: small, relatively high value non-perishable packages are extremely well-suited to e-commerce, which remains a very under-developed market for the industry, considering the 125,000 bricks-and-mortar pharmacies across Europe. What is more, the German market has recently been prised open by a European Court of Justice ruling and we believe market leader DocMorris will be a key beneficiary.
Van Lanschot (VL) is the oldest independent bank in the Netherlands, dating back to 1737. It is in the business of private banking, asset management and merchant banking. Back in April 2016, the management team presented a new strategy designed to reinvigorate the firm’s private banking arm. At the time the division earned around half of VL’s revenues, yet accounted for only 7% of total profits, indicating poor efficiency and an enormous scope for self-improvement. As part of its forward-looking strategy, VL is attempting to become more asset-light, while building up its capital ratios and returning cash to shareholders wherever possible. Its return on equity – a measure of profitability – is poor at present; we believe it should be much higher.
European smaller caps are still playing catch-up
All-in-all 2017 was a good year for European equities, and in particular European smaller caps. But we think they have much further to go: European firms have yet to catch-up to their counterparts in other developed markets, leaving greater potential to achieve a higher level of growth, on a relative basis. It is important to remember that, as noted above, there are additional risks involved in small-cap investing, but – in our view – 2018 should continue to see a range of attractive investment opportunities in this part of the marketplace, for the astute investor.
Deflation: a decrease in the price of goods and services across an economy.
Quantitative easing (QE): when a central bank print money to buy assets and stimulate the economy.
Capital ratios: the amount of liquid assets a financial institution holds against its risk operations.
Return on equity: the amount of net income relative to shareholders’ invested equity.
Grexit: a term coined to describe the potential withdrawal of Greece from the eurozone (the group of countries that use the euro as their primary currency).
Brexit: a term used to describe the UK’s departure from the European Union.
Catch-up trade: Where companies that have previously underperformed start to close the gap with those areas that have outperformed.
Smaller caps: Described here as companies with a market value of €4 billion or less.
This article represents the views of the authors at the time of writing. References made to stocks, sectors or asset classes do not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase them. Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.