“If we see light at the end of the tunnel,” American poet Robert Lowell wrote, “it’s the light of the oncoming train.” This sentiment might just resonate with investors who have backed Europe’s smaller companies during the past few years.
Historically, small-caps have regularly outperformed their larger counterparts over time. Of late, however, many have struggled amid high interest rates, elevated financing costs and general macroeconomic uncertainty.
Rate cuts offered a glimmer of hope in 2024. Unfortunately, reflecting Lowell’s bleak outlook, optimism was duly flattened on the tracks. A weak euro, an enduring preference for US businesses and meagre growth across Europe – “gradual expansion”, as the European Union delicately described it – were significant drags.
Fast-forward to the present day and – Liberation Day notwithstanding – we have renewed talk of something twinkling in the gloom. Germany’s decision to unleash a record-breaking stimulus package centred on defence and infrastructure has been widely tipped to herald a new dawn for the region.
Smaller companies are likely to prosper, the logic goes, as they tend to have greater domestic exposure than their larger peers. A combination of higher growth and lower inflation could also trigger a broader re-rating of stocks whose valuations have been notably depressed for several years.
Meanwhile, the tailwinds that have long propelled America’s biggest businesses have fluctuated – and in some instances even dissipated. Fears over the likely impacts of US president Donald Trump’s trade tariffs have repeatedly rattled the S&P 500 and other US indexes.
So does all this really mean European small-cap investors might finally stagger out of the shadows and into the daylight? Or would they still be wise to steel themselves for the possibility of a head-on encounter with the 12.26 from Berlin?
Long-term thinking and proven processes
We should perhaps first acknowledge that many of Europe’s smaller companies have not performed badly during these supposedly dark days. They might have been outstripped by large-caps – a relatively rare event, as previously remarked – but they have not tanked.
Rather, they have ticked over. They have shown resilience. Some have continued to grow in the face of the severest challenges, including the Covid-19 pandemic and its lingering economic effects.
This has underlined the importance of bottom-up stock selection. In other words, it has emphasised the value of looking beyond the bigger picture and assembling a portfolio of holdings on a business-by-business basis.
In tandem, it has highlighted why long-term investors should not be unduly swayed by noise. Whenever it is tempting to think the grass is greener on the other side of the fence – as may have been the case recently – it is worth recalling there is much to be said for a proven process.
For our fund, for example, we begin with an investment universe of around 5,000 stocks. We reduce this to approximately 2,800 by discounting loss-makers and then keep applying screens until we are left with a focus list of between 160 and 180 companies.
From these, through in-depth research and direct engagement, we seek to identify high-quality businesses that have good management, sound operating models and a capacity for growth. Needless to say, low valuations are an added attraction.
This approach has served us well over many years. Accordingly, we have stuck with it even on the sporadic occasions when small-caps have fallen out of favour. We never lose sight of the light.
Staying on track
We all appreciate nothing is a given in the world of investing. Yet there does appear to be encouraging evidence that European small-caps are genuinely poised for a renaissance.
Germany’s ambitious plans arguably represent the most meaningful attempt to bring about fiscal expansion in decades. They could signal a long-awaited shift towards a new growth cycle.
A rotation out of US stocks is also under way. This is not a development to be sneezed at, even though we know market directions can zigzag and flip-flop rapidly under a Trump presidency.
In addition, the lending environment on which smaller businesses rely is likely to improve if interest rates remain stable or are cut further. Valuations may at last start to rise, too.
As a result, those investors who feel they have been stuck in a tunnel could soon once again feel the sun on their faces. At the very least, Lowell-like pessimism seems unfounded. There is little reason to expect to be squashed into the ballast at present.
Even so, we should always remember the macroeconomic backdrop is only part of the equation. Supported by in-depth research and direct dialogue, it is eminently possible to invest in robust, well-managed, growth-oriented European smaller companies in both good times and bad.
It is obviously comforting to survey the headlines and infer Europe as a whole might be heading in the right direction. In our experience, though, assessing every business on its own unique merits is the best way of ensuring an investment portfolio stays on track.
David Walton is manager of the IFSL Marlborough European Special Situations fund.