JPMorgan European Smaller Cos — Finding exciting investment opportunities

Since early 2015, the Euromoney Smaller Europe ex-UK Index has outperformed the FTSE World Europe ex-UK Index by c 20% in sterling terms. This may be as a result of an improving economic backdrop, which is illustrated by the European Union Economic Sentiment Indicator in Exhibit 2 (left-hand side). European equities have experienced a positive rerating in recent months as investors shook off a series of macro concerns such as Brexit and European political uncertainty. European small-cap equities continue to trade at a forward P/E premium to global equities, have a modestly lower dividend yield, but a lower price-to-book multiple. However, for investors wishing to gain exposure to smaller European companies that have the potential to benefit from an improving economic backdrop, a fund with a good medium- and long-term performance track record may be of some interest.

Launched in April 1990, JESC aims to generate long-term capital growth from a diversified portfolio of European small-cap equities (excluding the UK). It is benchmarked against the Euromoney Smaller Europe ex-UK Index, which comprises 1,000 companies (with market caps up to c €5.5bn as at end-May 2017) across 14 countries. JESC has been managed by Jim Campbell since 1995, Francesco Conte since 1998 and Edward Greaves since 2016 (Campbell is currently on personal leave). Small-cap European equities tend to be under-researched by sell-side analysts, so the managers are able to draw on the wide resources of J.P. Morgan Asset Management’s European equities team. Over the last 20 years to the end of March 2017, JESC’s NAV has achieved annualised total returns (net of fees) of 14.1%, which is 4.2pp per annum ahead of the benchmark’s annual total return. There are no individual stock or geographical constraints and a maximum 35% of the portfolio may be invested in a single sector. Currency exposure is not hedged. JESC may gear up to 20% or run up to a 20% net cash position; as at end-May 2017, the trust had a net cash position of 3.6%.

The managers are positive on the macro environment for European equities. They point to global purchasing manager indices, which indicate that there is a synchronised upswing in global economic activity. They comment that this is especially important for Europe given that it is an “exporting powerhouse”. The economic improvement is reflected in corporate earnings; the managers state that Q117 was the strongest quarter in the last five years and one of the best on record. They point to strength in both sales and earnings, in addition to positive estimate revisions across the board, especially for cyclical companies. The managers suggest that this improving economic environment is especially positive for European small-cap equities. They also highlight that European political risk has diminished following the success of Emmanuel Macron in the French presidential election. While there were huge political concerns in late 2016, the managers suggest that Europe has taken a step back from the brink with the election of more pro-European candidates. As a result, the backdrop, both politically and economically, is viewed as very attractive, although the managers acknowledge the strong performance of European equities since late 2016, which means that economic momentum will need to be maintained for the investment backdrop to remain supportive.

Conte comments that it is a very exciting time to invest in European small-cap equities, as so much is changing due to technological advancement. He cites Italian company Datalogic, which is a world leader in barcode readers for retailers. Its business was growing steadily at 2-3% per year but following the introduction of new technology, which it is selling to logistics experts such as DHL and UPS, Datalogic is now growing revenues in the high single-digit range. The manager also points to the dramatic changes in the retail industry due to the shift to online rather than bricks-and-mortar operations. Companies such as Ikea are revamping their warehouses to enable fulfilment of online orders, which benefits companies such as German forklift manufacturer Jungheinrich. Like Datalogic, Jungheinrich has seen a material uptick in its revenue growth, helped by offering more high-end products such as warehouse-management systems. The managers are focusing on companies that are embracing technological change and say they are finding investment opportunities across a wide range of industries.

JESC’s investment philosophy is that attractively valued, high-quality companies with positive operating momentum have the potential to outperform the broader stock market. The managers employ a bottom-up stock selection process, starting with a screen of the benchmark using a proprietary multi-factor model. Stocks that pass the screen are subject to rigorous fundamental analysis. The resulting portfolio of 50-75 holdings is diversified by sector and geography. Holdings tend to fall into three buckets: companies that can grow organically regardless of the economic environment; those that are benefiting from secular growth; or companies that are currently out of favour, where the managers believe that the business can be turned around. Position sizes are determined by the level of the managers’ conviction and a company’s trading liquidity. Positions are sold if a company’s market cap has significantly outgrown the benchmark index, on valuation grounds, or if the outlook for a company’s operating environment has deteriorated.

At the end of May 2017, JESC’s top 10 positions comprised 20.5% of the portfolio, which was a lower concentration than 23.5% at the end of May 2016. The managers state that portfolio holding Stabilus is a good illustration of the investment process as the company possesses value, quality and momentum attributes. Stabilus is an automobile supplier with a dominant global leadership position in its market niches. For instance, Stabilus controls c 70% of the global automotive gas spring market and is c 15x larger than the number two player. Stabilus’s scale and high degree of production automation allows the company to benefit from lower costs than its peers, and its high quality is illustrated by its leading return on invested capital. Strong operational momentum is driven by increasing vehicle penetration of its products as customers demand additional safety/comfort features such as automatic tailgates. Stabilus is also growing in adjacent industrial end-markets, such as woodworking and printing machines, which is helping to diversify sales further. In addition, the company has financing capacity to continue selectively adding bolt-on acquisitions. Its valuation is attractive as a result of Stabilus’s strong free cash flow generation, especially given the high quality and growth prospects of the company.

The managers were defensively positioned in Q416, as they were concerned about political risks. As a result, investment performance lagged the index as cyclical stocks meaningfully outperformed. As political risks have dissipated and the outlook for cyclical companies’ earnings has improved, the managers have increased JESC’s cyclical exposure. It is the first time in many years that they have invested in areas that had underperformed for a long time, such as offshore oil services. Other new positions in sectors that had been cyclically depressed include Danish cement plant manufacturer FLSmidth & Co, and Swiss agricultural machinery manufacturer Bucher Industries.

The managers have increased their exposure to the financial sector in recent months following signs of stabilisation in the industry. One of the new holdings is Skandiabanken, which is a Swedish challenger bank. It does not have legacy concerns unlike many of its competitors; the company is digitally enabled, cost efficient and has modern IT systems. Skandiabanken has very high customer satisfaction ratings and is able to undercut traditional banks. Low pricing plus high customer satisfaction means that the company has a growing market share. JESC’s managers believe that Skandiabanken’s stock is looking very attractive.

Recent sales include defensive companies that became too large as a result of outperformance, such as pharmaceutical companies Recordati and Ipsen. Other companies with limited growth prospects and more defensive business models that were sold include Swedish retailer, KappAhl, Finnish information technology services company, Tieto, and Swedish bus operator, Nobina.

Over the last 12 months, absolute total returns for UK-based investors in overseas assets have been boosted by sterling weakness (Exhibit 5). JESC’s share price and NAV total return of 38.6% and 35.1% respectively are behind the benchmark’s 39.9% total return. Factors include conservative portfolio positioning due to political uncertainties and some stock-specific weakness, such as Flow Traders (a Dutch financial company, where investors were concerned about market share losses) and Beter Bed (a Dutch bedroom furnishing retailer, which had weakness in its German operations due to a poor portfolio of products). Top contributors to performance include Oriflame (a Swedish cosmetics retailer, which has benefited from emerging market demand) and Maisons du Monde (a French furniture maker, which has been successfully operating its multi-channel distribution strategy since its IPO in May 2016).

In relative performance terms, JESC’s long-term positive record remains intact. Its NAV and share price total returns have outperformed the benchmark over three, five and 10 years. Of interest to UK investors, JESC has significantly outperformed the FTSE All-Share Index over one, three, five and 10 years. Its NAV has also outperformed the FTSE Europe ex-UK Index over three, five and 10 years, while performing broadly in line over one year.

JESC’s current 10.3% share price discount to cum-income NAV compares to the 8.7% to 18.4% range of the last 12 months. It is narrower than the averages of the last one, three, five and 10 years of 14.5%, 12.1%, 12.8% and 14.8%. There has been a noticeable narrowing in the discount since mid-November 2016 and there is scope for it to narrow further if JESC can build on its positive medium- and long-term investment track record, or if there is greater investor appetite for European small-cap equities.

JESC is a conventional investment trust with one class of share; there are currently 160.0m ordinary shares in issue. The trust has a €100m lending facility with Scotiabank, which is split 50:50 between a fixed and floating rate. The board’s policy is to limit gearing within the range of 20% net cash to 20% geared; at the end of May 2017, JESC had a net cash position of 3.6%.

Over time, the management fee has been reduced. Prior to 1 April 2015 it was 1.3% of net assets, which was then reduced to 1.0%. On 23 February 2017 it was announced that the fee structure would be reduced further. Effective from 1 April 2017, the management fee is 1.00% of net assets up to £400m and 0.85% of net assets above £400m. In FY16, the ongoing charge was 1.18%, which was a 14bp reduction versus the prior financial year.

JESC’s investment objective is capital growth rather than income; however, the board’s dividend policy is to pay out the majority of income, which will fluctuate from year to year. Between zero and two dividends are paid each year; interims, when paid, are in January and finals, when paid, are in July. In FY17 (if the final dividend of 3.5p is approved at the July 2017 AGM), the annual dividend of 4.7% will be a 46.9% increase versus the prior year, while FY16 was flat with FY15. Based on its current share price, JESC has a prospective dividend yield of 1.2%.

JESC is the largest trust in the relatively small AIC European Smaller Companies sector. Its NAV total return is ranked highest out of the four funds over 10 years, second over three and five years and third over one year. JESC has one of the widest discounts in the sector and the second-highest ongoing charge, although no performance fee is payable. Reflecting its mandate for capital growth rather than income, JESC has a lower than average dividend yield; however, the average is skewed by European Assets Trust, which pays out an annual distribution of 6% of year-end NAV.

There are five directors on JESC’s board; all are non-executive and independent of the manager. Chairman Carolan Dobson was appointed in September 2010 and assumed her current role in 2013. The other board members and their dates of appointment are: Stephen White (April 2012), Ashok Gupta (January 2013), Nicholas Smith (May 2015) and Marc van Gelder (August 2016).