The European Smaller Companies Trust — It is always darkest before the dawn

Beckett continues to believe that the investment environment for the next 10 years will look substantially different than the last 10 years. Inflation in the eurozone was 9.1% in August, with energy contributing over a third of the increase in prices. Given the geopolitical tensions around the war in Ukraine, there is scope for prices to continue to be volatile for the foreseeable future. In addition, Beckett believes there is likely to be a substantial inflationary impact when the Chinese authorities ease their policy of localised lockdowns, with potentially significant pent-up consumer demand driving further increases in raw material and end-user demand. Longer-term tailwinds for inflation are provided by secular trends to onshoring, reducing supply lines, transitioning to cleaner forms of energy and, more widely, ESG factors. In the medium to longer term, Beckett believes that inflation will moderate and settle in the 3–4% range, but this is still a sea change from the economic environment seen over the last 15 years. In the face of these changes, Beckett’s focus remains on those companies operating in secular growth niches, with strong balance sheets and pricing power while crucially ensuring that these traits are underappreciated and not priced in on acquisition.

From 1 July 2022 ESCT’s benchmark changed from the Euromoney Smaller European Companies (ex UK) Index to the more commonly used MSCI Europe ex UK Small Cap Index. Both indices share considerable similarity, and their long-term returns are similar (Exhibit 1). Beckett does not construct the portfolio with the benchmark in mind and the change will have no impact upon the investment approach. The performance fee (which is calculated on a rolling three-year basis), will continue to be calculated against the Euromoney index for FY21/22 and against MSCI for FY23. In each of the following years post FY23 the reference versus Euromoney will drop until the only remaining reference for the performance fee is MSCI.

European smaller companies have been weak in 2022 (Exhibit 2) returning -26% to 14 October 2022 with investor risk aversion driven by macro concerns, with notable underperformance versus large caps, which could be considered to be more robust, stable businesses, better placed to ride out volatility. Larger company performance in 2022 has also been buoyed by the higher weightings to energy and financials in this part of the market, which have performed better than other industries over this period. Growth as a style has sold off more aggressively in a rising interest rate environment, with value performing relatively better in 2022 to date. Looking longer term (20 years), European (ex UK) small caps have outperformed larger European (ex UK) companies by an annualised 3.5%. Over this period, smaller European growth stocks have edged value stocks by an annualised 1.3%, although at various times value stocks have outperformed growth.

The ESCT portfolio has intentional weightings to a diverse 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 follows and at the end of June 2022 were: early cycle 9%, quality growth 37%, mature 29% and turnarounds 35%.

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 an 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 its 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.

In aggregate there have only been very minimal changes to the weightings to these classifications (early cycle, quality growth, mature and turnarounds) since our last update in July. One of the key differentiators of this fund to the wider peer group is the valuation discipline (Exhibit 3) applied to the investment process.

The valuation discipline within the process is one of the reasons that the fund has outperformed in 2022, in our view. The peer group is in quite crowded trades in the more premium forward P/E rated stocks. In contrast ESCT has a foot in both growth and value camps, which means it is not beholden to the performance of any one investment style, with a majority of peers having a bias to growth stocks. Overall, the portfolio has 75.2% in holdings that Morningstar classifies as core or value, compared with 54.4% of peers (Morningstar Europe ex UK Small/Mid equity category) and 71.5% for the index.

Another potential attribute of the investment approach is the focus on the smallest of European small caps (Exhibit 4), with 50% of the portfolio invested in sub €1bn market cap companies.

The average market cap of the ESCT portfolio is around €1bn, which compares to €3.2bn for the Morningstar peer group and €2.2bn for the index. The smallest European companies are least well known and researched by both buy- and sell-side analysts and thus may provide opportunities for the true stock picker, added to which European small cap is an area that has become relatively unloved by asset allocators and investors. The exit of what might be termed investment ‘tourists’, or those that only invest in small caps occasionally may provide an abundance of opportunity for those specialists who remain in the market.

As we focused on in our last note, a strength of ESCT, in our view, is its balanced stylistic profile which is not overly influenced by either growth or value stocks. Exhibit 5 illustrates this diversity at the stock level and in aggregate at the portfolio level.

The differentiation in the investment approach applied to the management of ESCT which includes a stylistically balanced process with a strict valuation discipline is also manifested in the diversification benefits that ESCT provides both versus other European smaller companies funds and the index (Exhibit 6).

According to Janus Henderson Investors, developed market companies’ capital expenditure across all industries is lower now than in any time over the past 20 years. Companies have been underinvesting and the energy transition will require vast investment over the coming years if the world is to reach net carbon by 2050. In addition, in May this year the European Commission announced its REPowerEU plan to counter the economic and social effects of the energy crisis caused by the Russian invasion of Ukraine and to transition quicker to sources of clean energy and away from fossil fuels. Smaller companies often are integral to the technology and supply lines enabling such development to happen and within the portfolio there are currently examples of leading companies in battery and energy storage, high voltage cable suppliers, energy and transformation systems, associated infrastructure and green energy generators (wind and solar parks). Key holdings in the portfolio addressing this theme are NHOA, MANZ, Nexans, Energiekontor, Grenergy, KSB Group and TKH Group. This investment theme in particular feeds into ESCT’s bias to domestic earnings versus those of the benchmark or peers (Exhibit 7).

The top 10 positions in the portfolio at August 2022 have shown only relatively modesty change since the start of the year, with Van Lanschot Kempen, TKH Group, DFDS, Flex LNG, BFF Bank, Criteo, Quadient and eDreams all retaining their top 10 status.

Positions that have fallen out of the top 10 in August include Aareal bank and Boskalis, which have been bid for and been subsequently sold from the portfolio, and German engineer Manz and Belgium building materials supplier Recticel, which have both been weak in share price performance terms.

M&A has been a historically supportive tailwind for mid and small caps, with 2,187 takeovers or 91% of total M&A activity in the £500m to £5bn market cap range versus 213 for £5bn and above (JHI: 2008–21). The current strong US dollar is an additional support and a potential catalyst for US buyers. When we last updated investors in July there had been no M&A activity within the portfolio, however since then three holdings within the portfolio have been bid for: Aareal Bank, Basware and Bobst.

Given Beckett’s contention that interest rates will rise, he has not been adding much exposure to early-stage growth names as these long-duration assets can be susceptible to rate rises. However, NHOA (previously Engie), a fast-growing energy storage business, was added. Aside from energy storage, it is moving into EV charging and is in a JV with Stellantis to roll out EV-charging facilities in Italy. Another new position at an early stage is Meyer Burger, which the manager believes could become the European market leader in providing equipment for solar-energy generation and as an alternative to reliance on Chinese manufacturers.

Beckett has been using recent market volatility and weakness to buy or add to positions in the good-quality (higher return on equity) growth companies bucket. The manager participated in the IPO of Technoprobe, a global leader in making probe cards and components that are used to test the integrity of semiconductors, which are becoming smaller and more complex; this, in turn requires better testing. The manager has also added Ipsos, a global leader in market research. He believes the stock trades on a wide valuation discount to the market and its own history on governance concerns, However, with a new CEO the manager believes the company is getting a grip on these concerns, which could unlock significant value for shareholders. He has also added Detection Technology, a Finnish market leader in X-ray technology, with applications in the medical, security and industrial sectors. Another addition is Dermapharm, a German pharmaceutical and drug company with vitamin sales; it also supplies a key molecule lipid coating to Pfizer/BioNTech for the COVID vaccine.

Within the mature bucket, AMS-OSRAM was added. It manufactures sensors and light solutions for the consumer, automotive, healthcare and industrial sectors. Momentum in the business in 2022 has been weak due to consumer electronics and automotive exposure. The company’s response is to sell off non-core operations and invest in high-growth areas such as microLED. A new position was also added in Andritz, whose hydro turbine sales are recovering and sales in its paper and pulp processing business are increasing. Norma (a previously held position) was added and is well placed to benefit from a recovery in demand for its automotive parts business, according to Beckett.

In the turnaround bucket, new positions were added to cinema operator Kinepolis, which, predictably, had difficult years during and after the COVID-19 pandemic, but it is well capitalised and has a good roster of upcoming films, according to Beckett. BOBST was added as it is benefiting from the shift away from plastic packaging. Finally, u-blox was added, as it manufactures Internet of Things wireless communication modules for the automotive, industrial and consumer markets.

Other, perhaps more cyclical areas the manager has been adding to include Swedish northern European housebuilder Bonava, which trades on a price to book of below 0.5, Swedish recreational and outdoor lifestyle specialist Dometic and Italian motor bike and moped manufacturer Piaggio. The portfolio is overweight financials, with the manager adding to Spanish savings bank Unicaja Banco. Financials are a favoured hedge against rising interest rates, with key holdings in Van Lanschot Kempen, AIB Group and Credito Emiliano. There is a substantial underweight to commercial real estate within the portfolio with only Immobel (real estate development) and VGP held. The manager believes that it is difficult to be a real estate investor in the current interest rate and potential recessionary environment, but it is worth having some exposure to the sector. Beckett has been taking profits in energy, with the holding in Gaztransport et Technigaz being reduced. Other disposals included Vetropack, whose earnings were significantly affected by the war in Ukraine, and the online trading platform Swissquote was sold on valuation grounds.

2022 has been a difficult time for European smaller companies investing. ESCT has done a marginally better job at preserving capital in this environment compared with peers (especially when considering the level of gearing employed) returning -26% in NAV terms vs the benchmark return of -26.0% and the Morningstar Europe ex UK small/mid-cap peer group return of -27.4% (YTD to 14 October 2022).

The top five contributors to performance, relative to the index to the end of August 2022, were Saipem (not owned by ESCT), Flex LNG (liquid natural gas shipping), u-blox Holding (Swiss wireless connectivity for autonomous vehicles), Boskalis (Dutch maritime infrastructure) and Aareal Bank (German based global property credit and banking), with the latter two holdings bid for and subsequently sold. Flex LNG and Aareal Bank were also top 10 contributors in 2021. The largest five relative detractors were HelloFresh (meal kit delivery), eDreams (online travel agency), Westwing (homecare products), ams-OSRAM (light and electrical components) and Cherry (computer input devices). eDreams was a top 10 contributor for the fund in 2021. One area for the portfolio that has not performed well in 2022 has been its participation in recent IPOs, which have all by and large underperformed. Examples of this include Bike24 Holding.

While European smaller companies are not normally associated with high income, the investment process that focuses on good-quality companies at an attractive price provides the fund with dividend income. Revenue per share increased in FY22 (ending 30 June) to 5.16p from 2.59p in FY21, while revenue reserves at 30 June 2022 were £30.46m or 7.59p versus £23.19m or 5.78p per share at the end of FY21. ESCT paid an interim dividend of 1.25p per share and the board is recommending a final dividend of 3.1p per share to be put to shareholders at the AGM in November 2022. If authorised, the total income for FY22 will be 4.35p per share, which is a 39% increase on FY21. The current dividend yield for ESCT is 3.3%.

The limit for net gearing within the fund is 30%, which is applied via a flexible HSBC facility. ESCT stands out within the AIC category for its consistent and relatively high use of gearing (presently 11%). Beckett believes that the opportunity and potential for returns from smaller companies is currently compelling, which supports its continued use. The use of gearing in an inherently volatile asset class such as European smaller companies may raise eyebrows with some investors, however the diversification provided by ESCT via its balance of investment style and valuation discipline may mitigate to some extent the potential risk of its use.

ESCT currently trades on a discount to cum income NAV (debt at fair value) of 13.5%, which is wider than both its longer-term average and that of its unweighted AIC category. The board retains the authority to repurchase up to 14.99% of shares or allot shares up to the equivalent of 5% of the share capital, in order to manage a discount or a premium. In practice, these powers are used sparingly, and there have been no repurchases since the summer of 2016.

As a closed ended fund, ESCT’s portfolio is clearly affected less by the investor flows and stock liquidity than an open-ended fund would be. However, the manager cannot simply ignore liquidity concerns even within this structure, and he likes to run a relatively long list of stocks within the portfolio to mitigate liquidity risk to some extent. In addition to ESCT, Beckett also manages the Janus Henderson European Smaller Companies and Janus Henderson Horizon pan European Smaller Companies open-ended funds. At May 2022, ESCT and the Janus Henderson European Smaller Companies fund shared c 50% commonality, while the commonality with the pan European mandate was c 70%. Investor fund flows into these strategies have been relatively robust (ie with positive net inflows), and in any case the differences between the three funds helps limit the potential contagion risk from wholesale investor redemptions in the open-ended vehicles. In addition, we believe ESCT via its differentiated approach, should have an element of resilience in the event of investor flight from the sector.

ESCT has demonstrated an excellent performance for investors over Beckett’s tenure (since July 2011), with competitive performances over one, three, five and 10 years. 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 to date in CY22 given the selloff in growth stocks. Despite solid performance, ESCT trades on a wide discount. With lower fees versus peers, significant net assets and a blended stylistic approach, ESCT stands out as the ’core’ offering within the AIC cohort and as such is worthy of consideration as part of a buy and hold strategy for investors.