The European Smaller Companies Trust — Does what it says on the tin

European smaller companies have outperformed their large-cap brethren in 16 of the last 21 calendar years (underperforming in 2007, 2008, 2011 and 2018 – source Janus Henderson Investors (JHI) – in local currency returns) and have delivered significant outperformance of European large companies and global markets over the past 22 years (Exhibit 1). They are riskier in terms of volatility, but investors have historically been rewarded for accepting higher levels of risk when compared to European large caps and global equities (Exhibit 2).

Small caps may not be generally associated with robust balance sheets, but JHI points out that 37.8% of European ex UK small- and mid-cap companies have net cash on their balance sheets compared with 19.7% for large caps. European small caps have also historically grown their earnings faster most of the time (c 80% of occasions) when compared with large caps. Currently small- and mid-cap valuations are broadly in line with large caps on a trailing P/E and price to book basis and are much cheaper relative to their own history over recent years.

The opportunity set for mid and small caps (£100m to £5bn) is some 2,500 companies, which compares with 475 for those with a market cap of £5bn or above. M&A has been a historically supportive tailwind for mid and small caps with 2,187 takeovers in the £500m to £5bn market cap range versus 213 for £5bn and above (JHI: 2008–21). In addition, the opportunity set is not staid, with on average 190 companies per year listing in western Europe with an average market cap of €780m. There are also niche, underrepresented and attractive industries in the cohort such as warehouse automation, e-commerce, fintech and the circular economy. In addition, the opportunity set is not well covered by the sell-side analyst community. Of the c 2,500 companies with market caps between £100m and £5bn, the average analyst coverage is six versus 19 for the much smaller universe of 475 companies with market caps exceeding £5bn. This should be an area where good active managers are able to add value, uncovering under researched and possibly misunderstood and mispriced companies.

European smaller companies are arguably a niche area for investment and will not appeal to all investors. However, the combination of faster growing companies and an under researched and large opportunity set makes it a potentially attractive area for good long-term active investor returns. On the other hand, there appear to be more risks than usual facing investors and historically small caps are an area that can fall out of favour with investors in a risk-off environment. We can see that in the current pessimistic investor environment, the exiting of the sector by many investors (Exhibit 4) has resulted in discounts within the AIC peer group moving out wider. Within this context ESCT trades on a wider discount relative to its long-term average and to its AIC category peers (Exhibit 3). However, we think its more stylistically balanced, diversified portfolio (Exhibit 9) gives ESCT a good opportunity to perform well in what are likely to be choppy markets.

Beckett contends that the investment environment for the next 10 years will look completely different than the last 10–15 years post the global financial crisis. He believes that inflation will moderate from the current high levels but remain in the 3-4% range in the longer term. The effects of pandemic lockdown easing – still to come in China (and the associated release in pent-up consumer demand) – and loose monetary policy (eg true helicopter money in the US) around the world will likely lead to higher and more persistent inflation than has been the case since the global financial crisis. Other more structural trends will also be tailwinds for rising costs. Here he identifies the trend to onshoring to bring distant supply lines closer to home markets for security reasons and the move for companies to incorporate more ESG factors into their operations, including more expensive forms of alternative energy (in the medium term). In addition, there is wage price inflation, which is particularly sticky. All of these factors will, he believes, combine to keep prices higher for longer. It is somewhat of an alien environment for many investors used to very low levels of inflation and interest rates over the past 15 years, but those companies able to pass through increased input costs to customers, while retaining margins via economic moats, should continue to be resilient and cash flow positive. As ever, the trick is to identify those companies with attractive fundamentals while avoiding overpaying. ESCT aims to square this circle by looking in areas that are under researched or neglected by other investors and to maintain market exposure through a variety of stylistic characteristics.

The portfolio has intentional weightings to a range of stylistic buckets, with the manager seeking to hold exposure to a number of drivers of return within the portfolio. These buckets are classified as Early Cycle, which is currently 9% of the portfolio, Quality Growth (38%), Mature (28%) and Turnarounds (34%).

Early Cycle companies are in the foothills of accelerating growth with a recent record of, or where the managers expect to see, improving return on invested capital (ROIC) and strong increases in sales growth. They will have a clear strategy to grow and have operating leverage. The preferred valuation method is EV/sales with a reappraisal triggered by disappointing growth, narrative drift, management sale of shares or a lack of operational leverage.

Quality Growth companies have a ROIC above the weighted average cost of capital (WACC) and above average levels of growth when compared to competitors. Their margins are typically sustainable and there are barriers to competitor entry. The manager uses P/E, EV/EBIT and EV/invested capital (EV/IC) as their preferred valuation metrics. Positions will be sold if margins are compressed, there is unjustified M&A or the balance sheet weakens.

Mature companies are operationally solid, generating consistent cash flow with many years of steadily compounding their ROIC at or above their WACC. The manager looks at EV/IC, EV/EBIT and free cash flow (FCF) yield in terms of valuation measures. Positions will be reappraised if the value becomes overly expensive, if the competitive environment increases eroding margins and cash flows or if the business is fundamentally damaged as a result of new entrants or disruptive technology.

Turnaround opportunities are in recovery, with depressed earnings, and below peers in terms of ROIC. Here the manager expects a reversal in the company’s operational performance and profit margins via cost cutting and disposals, which should lead to a share price re-rating. Again, the managers will use EV/IC, EV/EBIT and FCF yield to value the company where appropriate. A trigger for selling the holding may arise from a lack of improvement in margins or rapidly falling sales.

Taking a closer look at these buckets, HelloFresh is an example of an early cycle stock. The meal kit company, which operates in 13 countries, has, the managers believe, significant potential to gain market share, especially in the US where it currently is used by only 1.9% of households generating around €1bn in revenues. The potential market is up to 40% of US households and there is also scope for the roll out of further product offerings catering for different price points and diets.

TKH is an example of a quality growth company with what was previously a relatively mature fibre optic cable operator and tire manufacturer, but from the turn of the 21st century its strategy was tilted towards smart vision, connectivity and manufacturing, which propelled it into a high technology security leader in many end markets.

An example of a turnaround stock is Quadient, which specialises in communication equipment and software including online and physical mail and parcels. The increase of online purchases supports the strong cash flow from the traditional mailing business as the business focuses harder on SME services to help it communicate with its customers and there is a growing parcel lockers business. Revenues have fallen from a peak of €1.2bn in 2016 to c €1bn in 2021. The manager believes that revenues are set to increase and on a consensus P/E ratio for 2023 of 7x, there is a margin of safety.

Finally in the mature camp, Danish shipping and logistics business DFDS is an example of an established (founded in 1866) company. It carries both freight and passenger traffic in the North Sea and English Channel as well as routes further afield such as Turkey. The company is transitioning to a greener footprint, initiating green ‘corridors’ between Denmark and the UK.

ESG considerations are an important and fully incorporated factor when Beckett and his colleagues determine the opportunities and risks of an investment. In 2015 the UN established 17 sustainability development goals that are designed to be a ‘blueprint to achieve a better and more sustainable future for all’. As at March 2022, JHI directly mapped all 131 holdings within the portfolio into 13 of these goals with the most (30) stocks in ‘industry, innovation and infrastructure’ followed by 23 holdings that directly address ‘affordable and clean energy’. There was also significant exposure to ‘quality education’ and ‘sustainable cities and communities’.

In aggregate the investment process results in a portfolio that has a higher dividend yield forecast compared to the index, which might be expected given the more balanced weighting to value and growth characteristics. The portfolio’s historical return on equity (ROE; proxy for quality) is a little lower than the index, but Beckett is looking for inflection points in a company’s trajectory, so he will be hoping that ROE picks up over and above historical levels. Both historical and forecast portfolio earnings growth is higher than the index, and in aggregate the portfolio is at a discount in terms of P/E when compared to the index and has less debt overall via lower net debt/EBITDA than the index. This frames the portfolio’s balance between growth, value, yield and quality factors.

In CY21 there were 35 new additions to the portfolio throughout the four buckets, with the majority in Quality Growth (14) and Turnaround (10), which illustrates the balanced approach to investment here. In a generally robust equity market through CY21 (following on from the strong returns seen in CY19 and CY20), there were a number of bids (7) within the portfolio, but the majority (20) of the 30 positions that were sold were driven via realising profits. Thus far in CY22 (to 25 May) in materially less benign market conditions there have been 12 purchases with four each in the Quality Growth and Mature buckets and two in Turnaround and Early Cycle respectively. There have been no bids in the portfolio and a modest number of sales from profit taking (2) with the remaining 10 disposals a combination of opportunity cost or where the investment thesis has not played out. This sounds like quite a high level of turnover, but historically the portfolio has had an annualised turnover figure of c 67% over the past three years, which is around average within its four-constituent AIC category. On this measure, it ranks seconds lowest within the cohort with ranges of between 31% and 131% observed. In general terms there is often less emphasis given to the sell discipline within an investment process description, but in smaller companies investment arguably it has even greater importance than in other markets, given the speed with which deteriorating fundamentals or operational performance can have an impact on share prices and capital structures. While frustrating, it is better to cut underperformers quickly.

New positions in CY22 include Detection Technology within the Early Cycle bucket; it is an airport X-ray facility supplier. There are significant untapped markets outside Europe (where X-ray detection is more sophisticated), particularly in the United States. Within Quality Growth, Dermapharm was added; it is a German pharmacy and drug retailer that is in high-margin businesses such as vitamins as well as manufacturing COVID-19 jabs for BioNTech. Other new additions in Quality Growth included Inficon (semiconductors), Technoprobe (a semiconductor firm which recently listed) and Thule, which is in a growing segment of the consumer discretionary market and a beneficiary of the trend to more outdoor recreation. It is also a play on electric bikes and has transport storage facilities specifically to cater for such consumer needs. Within the Mature bucket, Andritz, Aurelius and Ipsos were all added in 2022. Ipsos has a strong position within many industry sectors in market research and data analytics and is increasingly using the data it collects to help clients navigate macro trends such as ageing demographics, fake news, rising inflation and ESG trends. In the Turnaround bucket, Glanbia (nutrition) and Unicaja Banco, a Spanish bank, were added. Beckett believes that Unicaja Banco is an improving governance story and should benefit from the tailwind of better economic conditions in the region post the end of lockdowns, especially with tourism returning.

The portfolio is built from the bottom up and as such there are not many identifiable trends at play, but one that is evident is around energy transmission. The recent events in Ukraine have brought front and centre the need for energy security. The is much investment required to meet these objectives and the portfolio has three holdings in Flex LNG, GTT and Boskalis that in one way or another play into the increased demand for alternative sources of energy. This is a growth area, but one perhaps not regarded traditionally as such (unlike software/technology for example). While LNG is not clean energy, it is far better than coal and oil and as such will be a stepping stone within the transitioning process. LNG Flex manages a flotilla of boats that store LNG, GTT has the technology for the membranes within the tanks for storage and Boskalis is a dredging company whose services are in demand to create docking, terminals and logistics hubs at new port facilities for the shipping of this form of energy.

Over 12 months to the end of May 2022, the fund returned -10.8%, which compares with the Morningstar category average return of -7.7% and the MSCI Europe ex UK Small Cap Index return of -5.8%. Within the AIC peer group, the average decline in NAV over this period was 13.5%. Over 12 months to 28 June, growth stocks sold off by around a quarter with the index and value stocks outperforming on a relative basis (Exhibit 8). the use of gearing in weak markets will likely be a contributor to underperformance. At the start of the calendar year the AIC cohort were on average 4.1% geared, which peaked at c 6% in February of this year. ESCT has been the most highly geared of the four trusts in its AIC category with an average of a little over 11% year to date (end of May 2022).

Specifically in sector terms, the overweight position to consumer discretionary stocks (average portfolio weight 26.1% vs 14.9% for the EMIX Smaller European Companies ex UK Index) was the largest detractor, with financials being the best performing sector within the portfolio on a relative basis. Within consumer discretionary, retailers were especially weak, with leisure and household goods also detracting. Specifically, holdings such as Westwing Group (homeware), Stillfront Group (gaming) and Bonava (northern European residential development) detracted. Within financials, the top 10 position in Van Lanschot (wealth manager/private banking) was the biggest contributor to performance. Overall sector allocation detracted more from relative performance than stock selection.

Performance over three, five and 10 years is stronger thanks in part to a bumper year to the end of May 2021 (Exhibit 10 and 11), but there has been a strong showing at times from the more growth orientated funds in the AIC peer group, most notably Montanaro, although this strategy has been especially weak in CY22 given the selloff in growth stocks as outlined in Exhibit 10.

One year is quite a short time frame in which to judge performance of a fund, so it is pleasing to see that over three and five years, while stylistic or sector positioning has varied in its contribution to returns, stock selection has been overwhelmingly the primary driver of returns for ESCT. This is what we would hope to be the case given the strong pillars of process and team at play within an under researched and arguably less efficient market.

Unusually ESCT exhibits very little commonality with the Janus Henderson European smaller companies open-ended vehicle (October 2021: 60% commonality). We think that it is advantageous for the manager to play to the strengths of the investment trust structure to invest in slightly less liquid, potentially higher growth names versus those that are prudently able to be help within a daily dealing vehicle. As is evident in Exhibit 12, ESCT has the lowest average market cap within the AIC European Smaller Companies category, which makes it the purest small-cap play in the sector. As previously mentioned, it is also more balanced in its weightings to growth, value and core investment styles. We feel that this could give the strategy a more ‘all court’ game versus some of its peers who tend to be willing to invest in higher-rated growth companies. Given the focus on the smallest companies within the investment universe, we think is prudent that the fund has a long list of companies and at 128 (at October 2021) it has the most investments in the AIC peer group. The focus on the smallest companies would also explain higher levels of portfolio volatility, however it is pleasing to see that historically investors have been rewarded for accepting this higher risk with higher risk-adjusted returns.