Investment Trusts

Europe 2019: A bright first half for small caps

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July 2019

Sam Cosh

Director, Portfolio Manager, European Equities

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Risk Disclaimer

Past performance should not be seen as an indication of future performance. Stock market and currency movements mean the value of, and income from, investments in the strategy are not guaranteed. They can go down as well as up and you may not get back the amount you invest..

The taps are back on

 

The final few months of 2018 were particularly weak for the market, largely driven by liquidity concerns as the US pressed on with its monetary tightening cycle, coupled with the drag on global growth from the on-going US-Chine trade dispute.  Half a year on and not only have these liquidity concerns abated, they have completely reversed, now with expectations of further monetary support from central banks globally. Expectations now are that the US Federal Reserve will cut rates, while the President of the European Central Bank (ECB), Mario Draghi, has indicated further monetary stimulus if growth or inflation fall short of the ECB’s expectations.

 

While the trade tensions rumble on, a further dose of liquidity has been enough to fuel the recovery, extending this market cycle, which has arguably been driven more by the exceptionally low rate environment than economic growth. 

 

But we cannot predict when they will be turned off

 

The monetary stimulus that has led to the ultra-low interest rate environment that has persisted since the Global Financial Crisis back in 2008, has been the defining factor of this prolonged market cycle. And the first half of 2019 has been no different. Central bankers have felt that their economies are in need of further support and this has led to a welcome recovery in assets thus far this year.

 

We do know that there are US presidential elections next year, that a shake-up of posts at the ECB, and a new prime minister for the UK will all have a material impact on decisions that will affect corporates, economies and interest rate policy. What we cannot predict is what decisions will be taken, as recent history has shown us the potential for surprise outcomes of political events.

 

Small cap, big potential

 

Within this environment, where stock markets are so sensitive to news flow, investors can tend to get jittery and revert to ‘defensive’ household names. However, smaller companies have fewer layers of bureaucracy and, as long as they have the right managers in place, can far more efficiently reallocate capital compared to larger companies, and this allows them to better navigate volatile periods.

 

Smaller businesses also have the potential to benefit from larger, early-stage growth rates that their larger-cap more established counterparts have already reaped the benefits in previous years.

 

Not all small caps are equal

 

But not all smaller companies are equal, and so we believe that active stock picking can produce outperformance. Producing fundamental research on individual companies means that we can select stocks with characteristics that give us the best opportunity to deliver good returns for our shareholders throughout the various stages of the market cycle. 

 

We want to hold quality companies, run by able management teams, but we don’t want to pay too much for these businesses. Recognising when stocks appear unfairly valued by markets is a key determinant of outperformance, and rigorous proprietary research will help to uncover undervalued good businesses.

 

Where have we performed?

 

It is perhaps no surprise that our best performance in the first half of 2019 came from our stocks in the consumer discretionary and industrial sectors – sectors that tend to do better during rising markets.

 

Our holdings in financials also performed well. This is noteworthy given that the prevailing rate environment is not necessarily supportive for the sector.  

 

It is pleasing that this performance has not come as a result of leverage or a portfolio highly geared to a rising market, but from the operational performance of our holdings, which in aggregate, has been very encouraging. The pattern of our performance illustrates this with our relative returns being strongest during the months when the companies released their results, and in May when the markets fell significantly. Whilst our relative returns were weaker during the months that saw strong rallies but little stock specific news.

 

The limited turnover within our portfolios also highlights our confidence in the business we own and our continuing philosophy of investing for the longer term. 

 

In terms of outright sales, we only sold one holding, where the shares had performed well for us since we bought the stock in 2013. We decided to sell the position following a strong recovery in the share price at the start of the year, due to a change in the investment case. The company now needs to invest a substantial amount of capital to reposition the business in the light of the changes in the automotive industry.

 

Risk Disclaimer

Past performance should not be seen as an indication of future performance. Stock market and currency movements mean the value of, and income from, investments in the strategy are not guaranteed. They can go down as well as up and you may not get back the amount you invest.

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