The European Smaller Companies Trust — Top of the peer group over short and long term

The European Smaller Companies Trust (LSE: ESCT)

Last close As at 18/05/2024

154.00

0.50 (0.33%)

Market capitalisation

616m

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Research: Investment Companies

The European Smaller Companies Trust — Top of the peer group over short and long term

The European Smaller Companies Trust’s (ESCT’s) manager, Ollie Beckett at Janus Hendersons Investors (JHI), remains very positive about the outlook for European small-cap companies, which is reflected in a relatively high level of gearing of c 15%. He considers the last three years, where small-cap stocks have lagged the performance of large-cap equities, an anomaly and a result of macroeconomic events and recession fears, which have led to elevated investor risk aversion. The manager believes that the current valuation of the trust’s benchmark, the MSCI Europe ex UK Small Cap Index, provides a very attractive entry point to the asset class. ESCT’s portfolio of reasonably valued stocks with exposure across the company life cycle has a commendable performance track record, with its NAV total return ranking first out of the four funds in the AIC European Smaller Companies sector over the last one, three, five and 10 years.

Melanie Jenner

Written by

Mel Jenner

Director, Investment Trusts

Investment Companies

The European Smaller Companies Trust

Top of the peer group over short and long term

Investment trusts
European smaller companies

21 November 2023

Price

152.0p

Market cap

£609m

Total assets

£807m

NAV*

176.8p

Discount to NAV

14.0%

*Including income. At 17 November 2023.

Dividend yield

3.1%

Shares in issue

400.3m

Code

ESCT

Primary exchange

LSE

AIC sector

European Smaller Companies

Financial year-end

30 June

52-week high/low

172.0p

136.0p

198.0p

160.4p

*Including income.

Gearing

Net gearing (at 30 September 2023)

14%

Fund objective

The European Smaller Companies Trust seeks capital growth by investing in smaller and medium-sized companies that are quoted, domiciled, listed or have operations in Europe (excluding the UK). The trust invests mainly in Western Europe with the portfolio typically holding more than 120 companies, with an average market cap of around £1bn and rarely above £3bn.

Bull points

The current discount offers an attractive entry point for long-term investors.

A truly diversified portfolio of interesting European smaller companies.

Exposure to the different stages in a company’s life cycle.

Bear points

Smaller companies can be higher risk and have limited liquidity.

Relatively high level of gearing will amplify capital losses in a falling market.

Risk of European economic weakness.

Analyst

Mel Jenner

+44 (0)20 3077 5700

The European Smaller Companies Trust is a research client of Edison Investment Research Limited

The European Smaller Companies Trust’s (ESCT’s) manager, Ollie Beckett at Janus Hendersons Investors (JHI), remains very positive about the outlook for European small-cap companies, which is reflected in a relatively high level of gearing of c 15%. He considers the last three years, where small-cap stocks have lagged the performance of large-cap equities, an anomaly and a result of macroeconomic events and recession fears, which have led to elevated investor risk aversion. The manager believes that the current valuation of the trust’s benchmark, the MSCI Europe ex UK Small Cap Index, provides a very attractive entry point to the asset class. ESCT’s portfolio of reasonably valued stocks with exposure across the company life cycle has a commendable performance track record, with its NAV total return ranking first out of the four funds in the AIC European Smaller Companies sector over the last one, three, five and 10 years.

Long-term NAV outperformance vs the MSCI Europe ex UK Small Cap Index

Source: Refinitiv, Edison Investment Research

Why consider ESCT?

European small-cap equities can be considered as a geared play on global growth, and with the prospects of peaking interest rates and moderating inflation, coupled with attractive valuations, could be well-positioned to resume their outperformance versus the shares of European large-cap companies. In Europe, the smaller companies universe is c 5x the size that of large-cap firms (in terms of the number of companies), and these businesses are often under-researched and can be mispriced. It is also the home of niche businesses that are unavailable elsewhere in the European market.

Beckett is keenly focused on valuation, and he does not buy into top-down themes. ESCT’s strong absolute and relative performance is a function of bottom-up stock selection. The trust offers true small-cap exposure as more than 50% of its portfolio is invested in companies with a market cap below €1bn. There is a balance of growth and value stocks across the company life cycle: early cycle, quality growth, mature and turnarounds.

ESCT also looks attractive from a valuation perspective with a discount wider than its historical averages and those of its sector peers. While the primary focus is capital growth, the trust’s board employs a progressive dividend policy. The FY23 annual dividend of 4.70p per share was 8.0% higher year-on-year.

ESCT should benefit when investors less risk averse

ECST is a good route through which to participate in a recovery in European small-cap stocks. Any capital upside should be enhanced by a relatively high c 15% level of gearing. The trust has definitely proved its worth, with outperformance versus its benchmark, and best in sector NAV total returns, over the last one, three, five and 10 years.

ESCT’s upside/downside capture analysis

The trust’s upside/downside capture is shown in Exhibit 1. With an upside capture of 114%, this suggests that ESCT is likely to outperform in months of rising share prices, while its downside capture of 110% implies it will underperform, but to a modestly lesser degree in periods of share price weakness. The step-up in the downside capture between Q417 and Q120 reflects a sustained period of underperformance, which has been more than made back (see front-page chart).

Exhibit 1: ESCT’s upside/downside capture

Source: Refinitiv, Edison Investment Research. Note: Cumulative upside/downside capture calculated as the geometric average NAV total return (TR) of the fund during months with positive/negative reference index TRs, divided by the geometric average reference index TR during these months. A 100% upside/downside indicates that the fund’s TR was in line with the reference index’s during months with positive/negative returns. Data points for the initial 12 months have been omitted in the exhibit due to the limited number of observations used to calculate the cumulative upside/downside capture ratios.

Portfolio construction

ESCT’s portfolio of high-quality, attractively valued securities is diversified by stages in a company’s life cycle:

Early cycle – improving or forecast improvement in return on invested capital (ROIC) with strong (typically above 10%) sales growth (c 5% of the fund at end-September).

Quality growth – consistent ROIC above the cost of capital and above-GDP growth organically or via mergers and acquisitions (c 38%).

Mature – consistent ROIC at or around the cost of capital (c 24%).

Turnarounds – ROIC below the cost of capital, or significantly below industry peers, with forecast ROIC improvement (c 33%).

Exhibit 2: ESCT’s portfolio metrics (at 30 September 2023)

ESCT

MSCI Europe ex UK Small Cap Index

Dividend yield forecast (%)

3.7

3.7

P/E forecast (x)

10.6

11.2

Return on equity (%)

14.7

12.3

Three-year historical EPS growth (%)

21.3

17.3

Next 12 months forecast EPS growth (%)

15.6

21.3

Net debt/EBITDA (x)*

1.5

1.8

Source: ESCT. Note: *Data at 31 March 2023.

Compared with its benchmark, the trust’s portfolio has a lower forward P/E multiple and a higher return on equity. It has a lower forecast earnings growth and less leverage.

Portfolio is geared to an economic recovery

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. However, broadly, the fund is geared to an economic recovery with overweight positions in industrials, consumer discretionary and IT, while its underweight positions include the healthcare and consumer staples sectors, both of which are defensive.

Exhibit 3: Portfolio geographic (left) and sector (right) exposure (at 30 September 2023)

Source: ESCT, Edison Investment Research

Exhibit 3: Portfolio geographic (left) and sector (right) exposure (at 30 September 2023)

Source: ESCT, Edison Investment Research

Exhibits 3 and 4 illustrate ESCT’s geographic and sector breakdowns. Looking at the trust’s changes in geographic exposure in the 12 months to end-September 2023, there was a larger weighting to Germany (+3.7pp) with a lower allocation to ‘other countries’; this cannot be quantified as Norway was not broken out separately at the end of September 2022.

The largest changes in terms of sector exposures were higher weightings in consumer services (+2.2pp) and real estate (+2.1pp) with a lower exposure to consumer goods (-3.9pp). Overall, ECST’s portfolio structure has not changed markedly over the year to 30 September 2023.

Exhibit 4: Portfolio geographic and sector exposure (% unless stated)

Geography

Portfolio end-Sep 2023

Portfolio end-Sep 2022

Change (pp)

Sector

Portfolio end-Sep 2023

Portfolio end-Sep 2022

Change (pp)

Germany

17.6

13.9

3.7

Industrials

39.1

38.3

0.8

France

13.6

15.0

(1.4)

Consumer services

12.3

10.1

2.2

Sweden

11.6

9.8

1.8

Technology

10.5

11.2

(0.7)

Italy

9.7

9.6

0.1

Core financials

7.5

8.8

(1.3)

Netherlands

9.6

8.3

1.3

Consumer goods

7.3

11.2

(3.9)

Switzerland

8.8

8.2

0.6

Basic materials

6.5

5.2

1.3

Spain

5.6

6.5

(0.9)

Financial services

5.2

6.6

(1.4)

Belgium

4.2

4.3

(0.1)

Energy

4.1

3.6

0.5

Norway

3.0

N/S

N/A

Healthcare

3.1

2.3

0.8

Finland

2.7

4.2

(1.5)

Real estate

3.1

1.0

2.1

Other

13.6

20.0

(6.4)

Utilities

0.7

1.7

(1.0)

Telecoms

0.5

0.0

0.5

100.0

100.0

 

100.0

100.0

Source: ESCT, Edison Investment Research. Note: Numbers subject to rounding. N/S is not stated separately.

Recent portfolio activity

In September 2023, Soitec re-entered the portfolio. It is a leading provider of silicon-on-insulator wafers for the semiconductor industry. The manager considered that the company had become attractively valued following a period of share price weakness. However, he is mindful that other areas of the industry look overvalued given expected earnings downgrades. The holding in Meyer Burger Technology was sold, as its business remains under pressure despite the company’s position as the only Europe-based manufacturer of solar cells and modules.

Merlin Properties, a Spanish real estate company, was added to the portfolio in August 2023 as Spanish inflation has declined more than in other Western European economies. This could benefit the office sector by a reduction in vacancy rates. Merlin is also building out its data centres, which could become an income generator in 2024. Sales included Barco (a Belgian screen manufacturer) and HusCompagniet (a Danish homebuilder).

In July 2023, the manager initiated a position in Borregaard, which is a biochemicals producer, as he believes that some speciality cellulose prices will normalise this year. The CTS Eventim (German concert ticket platform) position was sold to lock in profits.

Potential for European small-cap recovery

Over the last three years, European small-cap stocks have given back some of their long-term outperformance versus their large-cap peers (Exhibit 5). Longer-term data from ESCT show that in the prior two decades, European small-cap stocks outperformed in 14 out of 20 years, and in one of the six years where they lagged the performance differential to large-cap European stocks was negligible. Investors have had significant issues to grapple with in recent years including the global COVID-19 pandemic, war in Ukraine and now in the Middle East, rising inflation, higher interest rates and the increased risk of recession, so it is unsurprising that there have been higher risk aversion and lower appetite for small-cap stocks. Also, rising oil prices have been beneficial for energy stocks, while higher interest rates have boosted bank net interest margins. Both energy and bank stocks have greater representation in large-cap rather than small-cap indices.

History shows that stock markets move in cycles, so when there is less volatility, investors are likely to move back down the capitalisation spectrum in search for higher growth opportunities. European small-cap stocks benefit from global GDP growth, generally have strong balance sheets and are more likely to be bid for than larger companies, while the investment universe is larger and less well covered, offering the potential for undervalued securities.

Exhibit 5: Performance of MSCI Europe ex UK small- vs large-cap indices (last 10 years)

Source: Refinitiv, Edison Investment Research

European small caps are attractively valued

The MSCI Europe ex UK Small Cap Index is trading on an 11x forward P/E multiple, which according to the data in Exhibit 6 has proved to be a favourable entry point for future returns. Since 2007, data from JHI show that European small-cap stocks have traded at an average 16% premium to large-cap stocks, due to their higher growth potential, and only moved to a discount in H123; in mid-September 2023 the discount was 5%.

Exhibit 6: MSCI Europe ex UK Small Cap Index returns following 11x forward P/E (%)

Date index hit 11x P/E

Subsequent three-year return

Subsequent five-year return

4 July 2008

10.6

28.4

26 September 2008

8.1

78.4

5 August 2011

69.0

108.2

18 May 2012

109.3

135.8

Average

49.3

87.7

Source: ESCT

Beckett opines that the price paid for a share really matters and says that the period of free money since the global financial crisis is over. While the manager expects inflation and interest rates to come down, he suggests that interest rates will not be zero and could settle in the 3–4% range, so company valuations will be more important in the next 10 years than they were in the last decade.

The catalyst for a European small-cap rally

While investors have been concerned about a recession, which has negatively affected the performance of European small-cap stocks, the manager suggests that if there is no hard recession, these stocks should outperform. He adds that European small-cap stocks tend to outperform once purchasing manager indices have troughed, which looks likely. Beckett suggests that a European economic hard landing would imply mass unemployment, which he considers unlikely due to demographic trends and signs of real wage growth. As inflation moderates, the manager believes that economic confidence will increase, leading to higher demand for European small-cap stocks.

Performance: Top of the pops over all periods shown

ESCT has a commendable performance record as its NAV total returns now rank first out of the four funds in the AIC Europe sector in all periods shown in Exhibit 7. Despite this, the trust has the second-widest discount, which appears to be somewhat of an anomaly and could be an attractive entry point for small-cap investors.

In terms of broad diversification, ESCT’s closest peer is JPMorgan European Discovery Trust (JEDT), but there is a marked performance differential between the two companies. These two funds along with European Assets Trust (EAT) all have their largest sector exposure in industrial stocks. With its highest weighting in IT stocks, which is a high beta sector, Montanaro European Smaller Companies (MTE) has the potential to experience higher performance volatility than its three peers. This fund also has the highest percentage in its top 10 holdings.

ESCT has the lowest ongoing charge, at c 25bp below the peer-group average, although it is the only fund eligible for a performance fee. The trust currently has the highest level of gearing, which should meaningfully add to the fund’s capital growth in a rising market. ESCT’s dividend yield is modestly below the mean, however, while ESCT, JEDT and MTE pay dividends out of revenue, EAT pays part of its dividend out of capital.

Exhibit 7: AIC European Smaller Companies sector at 20 November 2023*

% unless stated

Market
cap £m

NAV TR
1 year

NAV TR
3 year

NAV TR
5 year

NAV TR
10 year

Discount
(cum-fair)

Ongoing charge

Perf.
fee

Net gearing

Dividend yield

The European Smaller Cos Trust

608.5

7.7

23.0

64.0

192.8

(14.2)

0.7

Yes

114

3.1

European Assets Trust

296.7

3.5

(5.3)

20.1

87.0

(9.3)

1.0

No

100

7.0

JPMorgan European Discovery Trust

615.1

0.8

(6.8)

17.7

110.6

(12.4)

0.9

No

107

2.3

Montanaro European Smaller Cos Tr

231.1

0.1

0.1

57.7

178.1

(15.5)

1.0

No

102

0.8

Simple average (4 funds)

437.9

3.0

2.8

39.9

142.1

(12.8)

0.9

106

3.3

ESCT rank

2

1

1

1

1

3

1

1

2

Source: Morningstar, Edison Investment Research. Note: *Performance to 17 November 2023. Based on ex-par NAV. TR, total return. Net gearing is total assets less cash and equivalents as a percentage of net assets.

Exhibit 8: Investment trust performance to 31 October 2023

Price, NAV and benchmark total return performance, one-year rebased

Price, NAV and benchmark total return performance (%)

Source: Refinitiv, Edison Investment Research, Morningstar. Note: Three-, five- and 10-year performance figures annualised.

Exhibit 9 shows ESCT’s relative returns. It is ahead of the MSCI Europe ex UK Small Cap Index over the last one, three, five and 10 years in both NAV and share price terms. The trust also has a notable outperformance versus the broad UK market over the last five and 10 years, particularly over the last decade.

Exhibit 9: Share price and NAV total return performance, relative to indices (%)

 

One month

Three months

Six months

One year

Three years

Five years

10 years

Price relative to MSCI Eur ex UK Small Cap

(1.6)

(4.5)

(2.2)

2.9

5.7

14.0

20.3

NAV relative to MSCI Eur ex UK Small Cap

(0.8)

(3.2)

(1.7)

2.7

10.7

16.0

21.8

Price relative to MSCI Europe ex UK

(3.5)

(7.9)

(6.5)

(4.8)

(7.9)

1.4

30.8

NAV relative to MSCI Europe ex UK

(2.8)

(6.7)

(6.0)

(5.0)

(3.6)

3.2

32.4

Price relative to CBOE UK All Companies

(2.2)

(9.8)

(7.1)

0.2

(14.1)

18.9

66.2

NAV relative to CBOE UK All Companies

(1.5)

(8.5)

(6.6)

0.0

(10.1)

21.0

68.2

Source: Refinitiv, Edison Investment Research. Note: Data to end-October 2023. Geometric calculation.

Exhibit 10: Five-year discrete performance data

12 months ending

Total share price return (%)

Total NAV return (%)

MSCI Europe ex UK Small (%)

MSCI Eur ex UK (%)

CBOE UK All Companies (%)

31/10/19

2.6

3.1

5.6

11.9

6.9

31/10/20

15.1

11.3

3.7

(4.2)

(20.2)

31/10/21

52.6

53.2

42.0

33.2

36.0

31/10/22

(24.9)

(21.5)

(21.4)

(11.0)

(1.6)

31/10/23

6.3

6.1

3.3

11.6

6.1

Source: Refinitiv. Note: All % on a total return basis in pounds sterling.

General disclaimer and copyright

This report has been commissioned by The European Smaller Companies Trust and prepared and issued by Edison, in consideration of a fee payable by The European Smaller Companies Trust. Edison Investment Research standard fees are £60,000 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

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General disclaimer and copyright

This report has been commissioned by The European Smaller Companies Trust and prepared and issued by Edison, in consideration of a fee payable by The European Smaller Companies Trust. Edison Investment Research standard fees are £60,000 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2023 Edison Investment Research Limited (Edison).

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Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

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This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

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London │ New York │ Frankfurt

20 Red Lion Street

London, WC1R 4PS

United Kingdom

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Research: Financials

AGBA Group Holding — Year-to-date pre-tax result in line

AGBA’s Q323 results continued to be affected by the weak recovery in China and consequent subdued mainland demand for Hong Kong health and wealth products. As a result, revenues were flat year-on-year at US$13.2m, but down from US$17.4m in Q223. The pre-tax loss was US$12.9m, putting the company on track to meet its US$49m projected loss for FY23. AGBA also announced that it has entered into term sheets for a US$6.2m private share placing with a new institutional investor, AGBA’s group president and AGBA management at US$0.70 per share plus warrants with an exercise price of US$1.00/share. The amount could expand subject to ongoing conversations with additional potential investors. The significant premium to the current share price signals management’s confidence in AGBA’s long-term value. The capital will go towards funding organic growth, strategic acquisitions and managing liquidity until projected material profitability in FY25.

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