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European small-cap stocks enjoy a number of structural advantages over large caps. They have historically exhibited significantly higher earnings growth, stronger balance sheets and better shareholder returns on average (on an absolute and a volatility-adjusted basis) than their larger peers. Stocks in this relatively — and increasingly — under-researched universe also have a significantly wider dispersion of returns than large caps, underlining what I believe is a rich opportunity set for active management. Yet, with a higher overall beta than large caps, the European small-cap universe is sometimes regarded as too volatile a proposition for investors with a moderate risk budget, particularly during down markets and late-economic-cycle periods when market volatility tends to rise. The lower levels of corporate disclosure among small caps compared with larger companies also present a challenge for the increasing number of investors wishing to invest in line with environmental, social and governance (ESG) objectives.
I believe Wellington’s Pan European Small Cap Equity strategy allows investors to tap into the return potential of the European small-cap universe while also benefiting from the defensive qualities associated with large-cap investing. What’s more, having ESG considerations as a core part of our investment process can enhance rather than hinder our strategy’s return potential.
I believe the key to reducing volatility in small caps is a focus on quality. Wellington’s European small-caps team has found that when companies that do not meet specific quality criteria are filtered out of the small-cap universe, the beta of the high-quality segment of the market (measured using an average of profitability, growth, safety and payout) is lower than that of the overall market (Figure 1). Simply put, by stripping out value traps from the small-cap universe, it is possible to harness the potential of the opportunity set without having to take on substantial market risk.
In my view, one of the barriers to stable growth among smaller companies is their tendency for cyclicality, with gains made in periods of economic expansion given back in the later stages of the economic cycle.
The small-cap universe typically outperforms large caps during economic recovery and expansion periods and underperforms them in late-stage and bust periods. However, we’ve found that the high-quality segment of the small-cap universe does not give its outperformance back in the late and bust stages. Instead, it matches large caps in the late stage and marginally outperforms in the bust stage.
A way to further reduce the cyclicality of European small-cap returns in my view (again underpinned by an emphasis on quality) is to group investments into categories: high growers, stable growers and cyclical growers. These allocations can be adjusted based on expectations for the economic cycle. By thus opportunistically layering in and scaling back the portfolio’s cyclical exposure, we believe it is possible to deliver attractive downside mitigation across market cycles.
The ESG angle
From a sustainability perspective, too, focusing on high-quality companies — together with those that benefit from structural growth drivers — tends to strip out many of the companies with the weakest ESG scores.
Lower levels of ESG information among small caps are nevertheless a reality. But they can be seen as a market inefficiency and an opportunity to add value as an active manager. For me, ESG considerations are a crucial input to successful long-term investing. Failure to incorporate ESG principles can constitute a threat to the viability of a business, while positive action on ESG can support its growth. When investing in a business, I believe it’s vital to know it inside out — including from an ESG perspective. This involves proactive engagement with management and boards to understand not only the business model and market, but also their process for establishing the “materiality” of ESG concerns. We make bespoke site visits to observe the production process, engage with employees and get to understand the company’s culture and, in this regard, are fortunate to be able to leverage Wellington’s scale and depth of research.
Investing in small caps is research-intensive. But we believe the wealth of our firm’s resources allows us to call on multiple research perspectives — for example, from our ESG research analysts, our Fixed Income Credit Research Team and our global industry analysts.
As Europe emerges from a steep recession, there is much uncertainty ahead. But we believe European small caps can and should be a long-term strategic allocation for equity investors. In our view, an emphasis on the higher-quality, lower-beta portion of the market can potentially help to deliver alpha throughout the economic cycle.
- Common stock
- Equity market
- Smaller capitalization stock