Attractive valuations and strong earnings growth in Europe, and its small-cap sector in particular, could tempt investors to take another look at closed-end funds focused on the region after a solid recent run, according to Winterflood Investment Trusts analysts.
“Europe is back in favour. Economic growth has been accelerating and the political uncertainty which dominated the headlines earlier in the year has largely subsided,” said research analysts Kieran Drake and Emma Bird.
“Companies are benefiting from the improved economic environment and earnings growth in the small-cap sector is strong.”
Indeed, over one year the average IT European Smaller Companies trust has outperformed the average IT Europe trust, returning 39.33 per cent to the latter’s 28.3 per cent, as the below chart shows.
Performance of sectors over 1yr
Source: FE Analytics
“In our opinion, investment in European small-cap companies is suited to the closed-ended fund structure due to the ability to invest in smaller, more illiquid companies and to utilise gearing,” Drake and Bird noted.
“The breadth of the opportunity set is, in our view, reflected by the low overlap between the holdings of the four investment companies in the sector.
“Given the very strong performance of the sector, in our view, the case for investing in European small-cap [trusts] is now more finely balanced than it was a year ago, when it presented a clear value opportunity,” they said.
“Political uncertainty, it seems, is never too far away, with a mutually acceptable resolution to calls for Catalan independence proving elusive thus far. Another near-term concern is that the prospect of the European Central Bank tapering its QE next year could precipitate some profit taking.
“Nevertheless, the sector offers strong earnings growth at valuations that do not appear stretched relative to other developed markets.”
Below, the pair consider European smaller companies investment trusts in greater detail.
European Assets Trust
Managed by FE Alpha Manager Sam Cosh, the £447.9m European Assets Trust has risen by 35.63 per cent so far this year, compared with a 22.41 per cent rise in the Euromoney Smaller European Companies (Ex UK) benchmark.
Cosh invests in a high conviction portfolio of small and medium-sized European companies, which have a market capitalisation of less than €2.5bn.
Performance of fund vs benchmark over 1yr
Source: FE Analytics
Drake and Bird noted that historically the trust had been too small for investors to consider but had now grown to a size offering decent secondary market liquidity.
“The fund currently trades at a 2 per cent premium and consequently does not offer particular value relative to its peer group, which trades at an average discount of 3 per cent,” the pair wrote.
“However, we would expect it to continue to trade at premium to its peers due to its attractive yield of 5.5 per cent in the current low interest rate environment.”
Indeed, the fund is one of a handful in the investment trust universe that pays out enhanced dividends from a combination of income and capital gains.
The trust has ongoing charges of 1.16 per cent, according to the Association of Investment Companies (AIC).
JP Morgan European Smaller Companies
The £663.1m JP Morgan European Smaller Companies trust has been managed by Francesco Conte and Jim Campbell since 1998 and 1995 respectively; they were joined by Edward Greaves in 2016. During 2017 the fund has returned 42.79 per cent, making it the second best performer in the sector.
The closed-end fund’s largest sector exposures include industrials (28.3 per cent), consumer discretionary (27 per cent) and IT (17.5 per cent).
“JP Morgan European Smaller Companies benefits from an experienced management team, which has delivered strong performance,” the Winterflood analysts noted.
“The fund is differentiated from its peers by the managers’ very active use of gearing [the fund is currently 4 per cent geared], which we consider to be a key attraction of the investment trust structure.”
The Winterflood analysts added: “Although the fund’s discount has narrowed this year, we believe that at 8 per cent it offers relative value within the European smaller companies sector and could tighten further if investor interest in Europe continues.”
Writing recently, the managers remain bullish on the outlook for the European small-cap sector, highlighting strong global purchasing managers’ indices data, supportive first and second quarter earnings, and few signs of aggressive rate hikes by central banks.
The fund has ongoing charges of 1.13 per cent.
Montanaro European Smaller Companies
The three crown-rated £139.6m Montanaro European Smaller Companies trust has been managed by George Cooke since 2012, over which time it has returned 160.81 per cent. However, it has lagged its sector peers and MSCI Europe ex UK benchmark. So far this year the fund has returned 37.39 per cent, placing it just ahead of European Assets.
Performance of the trust vs benchmark in 2017
Source: FE Analytics
The trust has an emphasis on quality growth stocks, which is likely to lead to periods of underperformance when the style is out of favour, according to Winterflood, although it will also provide some downside protection.
The trust’s largest country exposure is to Sweden, which makes up 22 per cent of the portfolio, followed by Germany and Italy. The largest sector weighting in the fund is industrials, which represents 23 per cent of the portfolio.
“There are reasons for optimism as we enter the final quarter of the year,” wrote Cooke in the trust’s latest factsheet. “In addition to the unfolding economic recovery, it is possible that the relentless appreciation of the euro versus the US dollar may stabilise soon.
“The Federal Reserve is increasingly hawkish, while the doves of the ECB are merely considering a tapering of asset purchases.”
He added: “If peace reigns in Catalonia, these may be reason enough for investors to continue reallocating funds to Europe during the final quarter of the year.”
The trust has ongoing charges of 1.25 per cent, is 2 per cent geared and is currently trading on a discount of 9.3 per cent.
TR European Growth
The final fund in the sector is Janus Henderson’s four crown-rated TR European Growth trust, managed by Ollie Beckett.
The trust is Winterflood’s preferred option in the sector (although it should be noted that it is or has been a corporate broking client of Winterflood Securities in the past 12 months) and analysts think highly of its managers.
In 2017, the trust has been the sector’s best performer returning 62.36 per cent. Over five years it has also performed strongly also, returning 314.04 per cent.
Performance of trust vs sector in 2017
Source: FE Analytics
The trust has a diversified portfolio of more than 140 holdings, with a significant position in industrial stocks.
However, it is also the most highly geared of the sector with borrowing in the trust currently at 13 per cent, which the analysts warned could be a downside risk in the event the sector suffers a setback.
“TR European Growth is a genuine small-cap fund, with an investment approach that places an emphasis on companies that the managers believe are undervalued by the market,” the Winterflood analysts noted. “The portfolio includes a mix of companies with strong growth prospects and companies with the potential to improve through self-help.
“Ollie Beckett has developed a strong performance record since taking charge of the fund in 2011 and this has led to a significant re-rating of the fund’s shares.”
The trust has ongoing charges of 0.78 per cent and is currently trading on a premium of 2.4 per cent. It also carries a performance fee of 15 per cent of positive performance between the average annual net asset value total return and average annual total return of the benchmark – Euromoney European Smaller Companies Index (ex UK).