Continuing her monthly article for Professional Paraplaner, Juliet Schooling Latter, research director at FundCalibre, picks another fund with a three year track record since launch, transition or manager change.
It does not take a rocket scientist to recognise the past few years have been challenging for smaller companies across the globe. The era of Magnificent 7 ‘mega cap’ tech dominance, coupled with interest rate increases, has meant small-caps have found it harder to borrow money and have fallen firmly off the radar of potential investors.
It is a similar story in Europe, where the market has been dominated by big players like the ‘GRANOLAS’. In each of the past four years, the MSCI Europe ex-UK SMID Cap has underperformed MSCI Europe ex-UK Index*.
However, there have been green shoots in the past couple of quarters with SMID-caps outperforming their larger peers*. Then there are the long-term factors which suggest investing further down the market-cap scale is the way to go in this part of the world.
For example, European small-caps on average have delivered a 4.5% per annum greater total return over large-caps since 1999 (1.3% greater for mid-caps over large)**. There are a host of reasons for this – these include small-caps being more likely to be part of a merger & acquisition; small-caps tending to have more cash vs. debt than larger companies; and the fact that despite being a larger universe (small and mid-cap represents 2000 companies vs. 160 large caps in Europe) they are under-researched.
European SMIDs are now trading on an 11% discount to large-caps (higher than during the 2008 Global Financial Crisis) and the all-time high price-to-book discount of 38%**. You can see the valuation opportunity.
“Over time you hardly ever get to buy all of your stakes in equities at the absolute bottom – so as long as you are picking them up in periods where the valuations are headline sensible, then the only thing that matters is the ability of companies to deliver on that and to grow.”
That’s the view of Alex Magni, co-manager of the WS Montanaro European Income fund. Alongside co-manager George Cooke, the team focus on building a well-diversified portfolio of 45 small and mid-cap companies, while also targeting an attractive yield.
Montanaro has a simple philosophy: invest in companies you can understand, buy things which are growing, back quality management, engage with your companies and don’t over trade. Wider macroeconomic factors are ignored. This fund is no different, buying quality mid and small-cap stocks from across Europe. This area of the European market is preferred because of the better dividend cover, growth, choice and upside on offer.
The process is built around two key tenets: identifying companies that are both good businesses and good investments. Montanaro is a specialist further down the market-cap scale and, as with all of their funds, has a strong ESG focus which excludes companies investing in the likes of tobacco, alcohol, weapons and gambling.
Alex says the sweet spot for the portfolio is companies worth between 1-3bn euros at purchase with “all the quality growth boxes ticked, decent liquidity and a runway for longer-term growth”. The focus is bottom-up, but the team do not want too much exposure to a sector or country. It also has an attractive historic yield of 3.8%**.
A tough period but an attractive upside from here
Performance has been challenging over the past few years, but since launch in 2015 the fund has produced an annual return just shy of 9%**. Two thirds of this is from total returns, while the remainder is from dividends.
The income returns vary significantly from company to company. Among the top 20 holdings, the fund has the likes of Norwegian electric utility solutions provider Elmera – yielding 7% – to German engine manufacturer MTU Aero Engines and Italian digital services, technology and consulting business Reply, yielding 0.9% and 0.8% respectively**.
The fund is currently operating at a P/E of 16.1x, well below the historical forward P/E of 18.8x**.
Alex says: “Valuations are not on their knees, but they are not as risky as we have seen in the past. For example, they were as high as 23.9x in August 2021 when the market went ballistic and valuation is all that mattered, rather than underlying operational earnings.
“You are now getting quality growth on a mid-teens multiple. We’ve spent the past three years improving the portfolio’s quality growth characteristics and we believe the portfolio is in a good position where if those companies continue to deliver you are in a zone that forms the basis for strong total returns going forwards.”
Alex does not believe we need to see a single catalyst for change in the market.
A true income diversifier
With a current yield of 3.5%, investors are being paid to wait to some degree** – diversification of this yield across companies and sectors is important to the team. It also makes the portfolio an interesting diversifier for those looking for alternate income streams.
“We’re one of a few European income strategies operating further down the market-cap spectrum. The large-cap strategies will be clustered in the same sectors – Swiss pharma’s, financials and oil & gas – all with traditional value tilts. We are giving you exposure to completely different parts of the economy – industrials, consumer discretionary, IT and some financials. We’re also very different in make-up to the UK market,” adds Alex.
Despite a tough period, this fund not only has the power of Montanaro’s well-defined philosophy and process behind it, but it is also a high conviction, well-diversified portfolio of companies with scope for strong, stable capital growth and a growing and very diversified income stream.
*Source: MSCI Bloomberg, total returns in pounds sterling, to 30 September 2024
**Source: WS Montanaro European Income fund update, Q3 2024
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Juliet’s views are her own and do not constitute financial advice.
Main image: usgs-inNzGtPrkHk-unsplash
