European smaller companies have rebounded after a disappointing 2022. Growth stocks are also back in favour following last year’s pronounced value rotation. Nonetheless, the current investment backdrop is challenging. Economic data is generally weak, inflation is high and central banks are hiking interest rates. Geopolitics are also weighing on sentiment.
The question now is: can the European smaller companies’ recovery remain on track?

A quick recap

Let’s look at the economy. The Eurozone returned to growth in the first quarter of 2023 as output expanded by 0.1%. However, this was hardly a number to write home about and missed analysts' expectations. Germany’s stagnation was the main negative, which offset growth elsewhere in the 20-country bloc.

Despite the disappointing results, the European Central Bank (ECB) raised rates by 0.25 percentage points to 3.25% in May. To be fair, the ECB didn’t have an option but to raise. The headline rate of inflation in the eurozone rose from 6.9% in March to 7% in April. That’s well over the ECB’s 2% target. The increase was less than previous hikes of 0.5 percentage points, though. Many hope this could signal the ECB is nearing the end of its rate-hiking cycle.

A focus on quality

In the current climate, we believe investors will increasingly focus on bottom-up fundamentals. That means discriminating between businesses that are delivering on their growth plans and those that are not. Avoiding loss-making or speculative companies will remain of paramount importance.

Quality growth companies should also continue to bounce back following last year’s value rotation. During periods of stress, investors usually favour businesses with robust profitability, good cashflow, strong management, and sound ESG (environmental, social and governance) standards. High barriers to entry, unique growth drivers and pricing power are also attractive characteristics. By contrast, businesses with elevated debt levels or that rely on external factors to succeed could fall by the wayside.

Current valuations could therefore represent an attractive entry point for long-term investors

A strong hand at the helm

Most management teams have been in crisis mode for the last three years. The global pandemic, supply-chain disruptions and soaring raw material costs have tested many business models. Demand has fluctuated, while rising rates have weighed on balance sheets.

Throughout this time, however, forward-looking management teams with the necessary firepower have continued to invest. We believe this will bear fruit in 2023 and over the longer term, as the strong get stronger and the weak flounder.

An attractive entry point?

Then there are valuations. European smaller companies have historically traded at an average premium valuation of around 8%1 to large caps thanks to their superior growth and earnings potential. Following last year’s performance, European smaller companies currently trade at a discount to their larger peers of around 20%. The pronounced market rotation in 2022 also means growth stocks are trading below their historical average. These valuations could therefore represent an attractive entry point for long-term investors.

History is on our side. While past performance is not a guide to future results, evidence shows that smaller companies tend to outperform large caps as we exit recession or sooner. Furthermore, as our table shows, following periods of relative underperformance – 2001-03, 2007-09, and 2019-20 – global smaller companies delivered strong outperformance in the three subsequent years (longer in the case of the early 2000s). We see no reason why this time will be different.

Strong recoveries from market drawdowns.

Source: Morningstar, USD, 1 January 2000 to 31 December. Costs may increase or decrease as a result of currency and exchange rate fluctuations. This may affect what you get back.


Final thoughts…

These are tough times. European economic growth is weak, while inflation remains stubbornly high. We continue to favour structural growth companies where there is a higher degree of earnings predictability. Those with strong management teams, high barriers to entry, and unique growth drivers should also do well. We’re already seeing quality growth companies bouncing back from last year’s rout. Valuations, meanwhile, are attractive. We believe these factors provide an opportunity for active, bottom-up stock pickers, with a proven investment process to outperform.

  1. Bloomberg, long-term price earnings ratio, valuation of MSCI Europe Small Cap to MSCI Europe, 01 Jan 2008 to 31 Mar 2023.