There are many reasons to consider an allocation toward smaller companies, most notably their higher growth potential and historic outperformance of their large cap counterparts. In addition, smaller companies tend to be less well researched by analysts and can therefore be mispriced by the market, leading to some exciting investment opportunities. Any such price dislocation is particularly tantalising in Europe, where smaller cap companies have historically traded at a premium.

However, one of the more overlooked benefits to smaller companies is that they also tend to be more specialist, and therefore can move more nimbly to become leaders in their respective niches.

For the European Smaller Companies Trust (ESCT), we have identified three innovative niches within which smaller European businesses are well represented.

Generative AI-related businesses

Artificial intelligence has been one of the big stories in 2023, particularly in the US where companies such as Nvidia and Meta have gone from strength to strength on the back of a strident news cycle. In a recent McKinsey Global survey a third of respondents revealed their organisations had frequently been using generative AI in at least one business function.

But while these core providers may capture the headlines, there are a host companies spread across the supply chain that are enabling AI solutions. For example, we own SÜSS MicroTec, a German business that provides the equipment necessary to help chip makers like TSMC and Samsung with bottle necks in producing high bandwidth memory. Elsewhere, our Spanish holding, Merlin Properties, is adding data centres to its portfolio , leveraging Spain’s geographical advantage for transatlantic data transfers. In a similar vein, Swedish company Munters is a leading provider of cooling technology for data centres.

These companies provide the technology and services that underpin the AI giants and, as smaller companies, they have been better equipped to meet order demand than their large-cap peers, for which AI won’t significantly impact their earnings for a few years. Crucially for investors, their shares trade at significantly lower valuations than those of their larger, better known counterparts.

Semiconductor materials

Another key trend in technology development has been the materials for semiconductors.

The industry is increasingly moving towards the use of silicon carbide, a chemical compound otherwise known as carborundum. Demand for these materials has risen dramatically in recent years, in large part owing to the global uptick in electric vehicle production, which make use of the compound. Silicon carbide has been in mass production since the late 1980s but has more recently risen to prominence due to its superior conductivity.

Within the portfolio, we own two of the largest producers of synthetic silicon carbide outside of China: Mersen, based in France, and SGL Carbon in Germany. Despite their position as among the larger suppliers of silicon carbide, these two companies trade on significantly lower multiples than their global peers. In addition, we have completed this allocation with a holding in French company Soitec, which has created an alternative technology that lowers the cost of using silicon carbide by layering it with insulating materials.

Healthcare technology

Finally, continuing our approach of seeking innovative companies along the value chain is our holding in Swiss manufacturer, Daetwyler.

Along with other healthcare stocks, Daetwyler was disproportionally re-rated following the Covid-19 pandemic, which allowed us to add to our existing position on the basis of a strong pipeline. The company manufactures the rubber seals used for pre-filled syringes. Drugs are approved in their practicable product format, which means that demand for these seals is sticky and indeed they are crucial to the approval process. Daetwyler has been able to meet the requirements of governing bodies through their high-end clean rooms and should benefit from growing pipelines among their customer base, including weight loss drugs.

All these companies help illustrate that, although the US and Asia may be seen as the forefront of innovation, the roots of such ingenuity may be found across smaller companies in Europe. These companies are well placed to meet growing demand, position themselves as leaders in their respective niches, and provide investors with exposure to the building blocks of headline technologies from healthcare to AI.

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