European smaller companies turned in a strong performance in 2017, with returns of 19.03% from the MSCI Europe Small Cap index, comparing favourably to the MSCI Europe Index return of 10.24%*. Smaller companies have now performed strongly over a number of years following the financial crisis and have a history of strong relative returns over the long term. What are the main contributing factors to these positive returns, and will the outperformance that has been seen in 2017 be followed by further strength in 2018?
The merits of investing in smaller companies as part of a diversified portfolio are often overlooked by investors. Clearly smaller companies can be prone to slightly higher levels of short-term volatility, but long-term investors in a diversified portfolio are compensated by positive risk-adjusted returns. The smaller company universe has a higher exposure to more nascent, innovative and faster growing industries. Simply being smaller in size means that it is easier to produce stronger rates of growth in sales, earnings and cash flow from an often more focused and flexible business. And as small companies grow and become better known by the market they attract more attention from investors and liquidity improves, thereby helping the liquidity risk premium to contract. These factors can make for a powerful combination.
The smaller companies market is also relatively inefficient, with low levels of analyst coverage. This results in a less dynamic flow of information in the small-cap universe and greater levels of inefficiency, meaning that investors can benefit from price anomalies. With the onset of MiFID II creating some disruption around how analyst research is paid for, it is unlikely that we will see a higher level of coverage of small caps in the medium term. As a result that market is likely to remain a favourable hunting ground for active investors searching for interesting growth opportunities during 2018 and beyond.
2017 was an interesting year for smaller companies, following on from a year where larger companies outperformed slightly. The numerous political concerns faced by the market in Europe coming into 2017 (France and the Netherlands in particular) quickly abated during the first six months of the year, and a more synchronised European macroeconomic recovery took hold.
GDP forecasts were revised upwards in a wide range of European countries and business surveys such as the PMI pointed to continued strength in the underlying economy coming into 2018. This is important for the smaller companies because they have a higher weighting towards cyclical segments of the market: industrials, engineering, business services, and information technology. Smaller companies also have a slightly higher exposure to domestic Europe than their large-cap counterparts which has provided something of a support as the US dollar weakened during 2017.
Moving into 2018, many of the same underlying drivers that were seen in 2017 remain in place. Recent readings from manufacturing and service PMIs in Europe have remained strong, and both core European and peripheral European economies are making good progress. This bodes well for smaller companies which have seen a correlation to PMIs in the past. Market forecasts for smaller companies point to mid-teens earnings growth and valuations remain broadly in line with their large-cap counterparts when looked at on an equally weighted basis. French companies are particularly interesting for small-cap investors at present as business sentiment improves and corporates start to see the early benefits of labour reforms with further potential benefits from tax reform to come. Irish corporates continue to benefit strongly from an improving macroeconomic picture boosted by the early reforms put in place by the Irish government after the financial crisis. From a sector point of view, industrials, business services and IT should also remain well placed to benefit from the macroeconomic tailwinds in domestic Europe.
Small- and Mid-Cap Portfolio Manager, European Equities team