The European Smaller Companies Trust — An attractive entry point to a small-cap specialist

Recession concerns are heavily reflected in the European small-cap equity market and 2023 is the third consecutive year where small-cap stocks are underperforming. Historically, they have outperformed due to smaller businesses’ higher growth prospects and strong balance sheets and they tend to be greater beneficiaries of M&A and capex spending.

European small-cap stocks are trading at a 20-year valuation discount to European large caps when they typically trade at a premium. The MSCI Europe Small Cap Index is also trading at a record P/E multiple discount versus the US S&P 500 Index since the data began in 2005. Hence, Beckett is unconcerned about a potential recession in Europe given the very attractive valuation multiples of European small-cap stocks.

Inflation in Europe, and elsewhere, has proved to be more resilient than investors originally anticipated. However, signs that the inflation rate is peaking could provide the catalyst for a significant rally in European small-cap stocks. Meanwhile, a European economic hard landing may be avoided as the labour market is not collapsing and real wages are starting to level off, which is positive for the consumer. The Q223 earnings season is underway, and expectations are low, partly due to some areas of inventory destocking, which should be worked through. Historically, European small-cap stocks outperform when purchasing manager indices bottom, which the manager suggests could occur in Q323. He notes that there could be significant pent-up demand for European small-cap equities due their valuation anomaly.

In line with ESCT’s investment process, Beckett remains very disciplined when it comes to valuation. Versus the competition, the trust has a more balanced portfolio and a longer list of stocks, and, in general, lower market caps. The manager reports that he is finding more ideas at the lower end of the capitalisation spectrum, which is overlooked by many investors.

Compared with its benchmark, the trust’s portfolio has a lower forward P/E multiple and a considerably higher return on equity. It has a lower forecast earnings growth, but Beckett suggests that the growth potential of portfolio companies could be underestimated. ESCT has a lower net debt to EBITDA multiple; but once inflation and interest rates peak the manager may increase the trust’s exposure to more leveraged businesses as they are very attractively valued.

A direct comparison between ESCT’s sector exposure and that of its benchmark, the MSCI Europe ex UK Small Cap Index, is not possible as the classifications differ. For example, the trust splits its financial exposure between core financials (7.1%) and financial services (5.7%), which, in aggregate, is currently not dissimilar to the index’s 13.5% financial weighting.

A notable difference between ESCT and its benchmark is the trust’s higher industrial weighting (40.2% versus 27.4%). This puts the trust in a particularly favourable position to benefit from European small-cap stocks being a geared play on global GDP. ESCT also has higher exposure to the consumer, both in services and goods, compared with the benchmark.

Exhibits 2 and 3 illustrate ESCT’s geographic and sector breakdowns. Important things to note are that generally there have only been minor changes in the portfolio’s construction in the six months to 30 June 2023 in terms of both its geographic and sector weightings.

Beckett comments that portfolio activity is very stock specific, and valuation driven. Purchases can be classified in one of four ‘buckets’: early cycle, quality growth, mature and turnaround. Recent new additions to the fund include an IPO: Italian Design Brands (early cycle), which is a collection of high-end furniture and design companies. Forklift truck manufacturer Jungheinrich (mature) is back in the portfolio as its shares became oversold. ESCT has some off-benchmark Greek exposure including the recent purchase of Athens stock exchange Hellenic Exchanges (turnaround). Wind turbine manufacturer Nordex (mature) operates in a loss-making industry, but due to its necessity in the switch towards renewable energy, the EU is supporting these companies to achieve profitability.

Sales can also be classified in one of four buckets: bid, got it wrong, profit taking or opportunity cost. IT services business Majorel Group (bid) was one of many failed IPOs in 2021. The manager initiated a small position in the offering and topped it up afterwards at a much lower price. Majorel is an example of small-cap companies benefiting from M&A. Thule Group (profit taking), which manufactures roof boxes and cycle racks, had only been in the portfolio for a short while. The company’s charismatic CEO was fired by its chairman, which led to a fall in Thule’s share price, providing an attractive entry point. Beckett locked in profits after the shares rallied as he expects further senior management departures.

There are just four funds in the AIC European Smaller Companies sector, of which ESCT is the largest. It has a commendable performance record, with its NAV total return ranking first over the last one, three and 10 years and second over the last five years.

The only fund that has outranked ESCT over the last five years, Montanaro European Smaller Companies (MTE), is likely to have more volatile performance as it has a higher top 10 concentration (c 40% vs c 20% at ESCT). Also, around a third of its portfolio is technology, which is a high-beta sector, whereas ESCT has a much lower c 12% in technology stocks. This suggests that MTE’s performance is likely to struggle in a market where value and cyclical sectors are in favour. While JPMorgan European Discovery Trust (JEDT) also has a bias towards industrial stocks, there is a large performance disparity between the two funds, with ESCT generating much higher NAV total returns than JEDT over all periods shown.

Despite its strong performance, ESCT currently has the second-widest discount in the sector, which appears to be somewhat of an anomaly and could be a very favourable entry point for long-term investors. The trust has the lowest ongoing charge, c 30bp below the peer-group average, although it is the only fund eligible for a performance fee. ESCT currently has the highest level of gearing, which should meaningfully add to the fund’s capital growth in a rising market. Its dividend yield is below the mean; however, the trust has the highest ‘natural’ yield in the sector as European Assets Trust pays part of its dividend out of capital.

Beckett comments that ESCT’s performance this year has been ‘okay’, especially considering that value and small-cap stocks have been out of favour. The manager suggests that if the situation changes, the trust’s performance ‘should be pretty decent’.

Positive contributors to ESCT’s performance in 2023 include: AMG Critical Materials (a speciality metals producer that is benefiting from strong demand for lithium oxide); eDreams (an online travel company with very strong 2023 bookings); Mytilineos (an undervalued Greek renewable energy and aluminium producer); and Van Lanschot Kempen (an overcapitalised asset manager with an attractive dividend yield). Negative contributors include: Recticel (an insulation company that is receiving lower than expected proceeds for an asset sale; the company is trading at a significant discount to competitor Kingspan); u-Blox (a manufacturer of wireless communication modules that is a top 10 holding and has recently posted positive results, so Beckett remains positive about the position); and Viaplay (a streaming company whose management was overly bullish; it implemented higher prices but customers cancelled the service; the CEO was fired and Viaplay is now in a cost-cutting rather than a growth mode).

ESCT’s relative returns are shown in Exhibit 7. Its NAV and share price total returns are ahead of the MSCI Europe ex-UK Small Cap Index over all periods shown apart from the last month. Its outperformance versus the broad UK market is even greater over the last five and 10 years, particularly over the last decade.