Best funds to invest in European Equity Small Caps

European Equity Small caps offer great investment opportunities for investors. Compared to large caps, small European companies which are in the in early stages of development have grown faster over the past 10 years, about 94% of all stocks in Europe are small caps. European Small Caps are an underestimated asset class with great growth potential.

We have spoken to the Portfolio Managers from SEB, Aberdeen Standard y Oddo BHF, which are some of the European Equity Small Caps with best returns 5 years annualised, based on the Morningstar ranking.

Source: Morningstar 10/09/2021 (SEB, Oddo BHF), 13/09/2021 (Aberdeen Standard)

SEB European Equity Small Caps Fund

Lars Knudsen and Anders Knudsen Portfolio Managers

The space offers a fertile ground of opportunity. About 94% of all stocks in Europe are small caps. Average analyst coverage drops as a company's market capitalization declines, leading to less thorough analysis and, in some cases, pricing inefficiencies.

Smaller businesses often focus on niches or operate in a single country. This means that they can decouple to a certain extent and be successful in a generally difficult economic environment. Overall, small caps are less dependent on global macro trends. They are driven by micro-level issues that are hard to find in large caps and traditionally have a more regional focus

SEB European Equity Small Caps Fund, SEB Asset Management is one of the largest and most respected financial institutions in Scandinavia. The firm manages in excess of EUR 100 billion worth of assets, making it one of the largest commercial asset managers in Europe.

The SEB European Equity Small Caps Fund launched in 1999 is an actively managed ‘long only’ fund focusing on European equity small caps, with a market cap below EUR 3 billion. The managers employ a fundamental stock-picking approach in the intersection between value and quality. It is currently a EUR 245 million high-conviction portfolio of approximately 50 stocks.

Lars Knudsen and Anders Knudsen, who manage the fund have over 30 years of combined experience in the space. The fund is rated five stars by Morningstar and invests in companies that (i) have sustainable earnings growth, (ii) can resist downturns in the business cycle, (iii) demonstrate compounding characteristics in terms of business performance and finally (iv) are market leaders, operating in niches, driving product innovation.

The strategy incorporates a long term investment horizon and looks for quality companies with compounding characteristics – in other words sustainable earnings growth. 

The fund ended 2020 with a sales growth for the portfolio of around 6% and strong operation margins of 10%. The revenue growth above 10% in both 2021 and 2022. This sets earnings growth up to be more than 20% for both years. So though is it certainly no guarantee, SEB thinks the fund performance will be driven by the earnings growth in 2021 and 2022. The strong performance in 2020 and YTD, is a reflection of the resilience in the portfolio, which has been driven by the companies delivering critical components to their value chains and strong balance sheets.

Aberdeen Standard SICAV II-European Smaller Companies Fund

Andrew Paisley, Portfolio Manager Aberdeen Standard SICAV II - European Smaller Companies

Particularly in certain sectors or businesses, which may have less appropriate cost structures and less adaptability.  Some of today's small caps will undoubtedly be tomorrow's big ones.

Within this context, Aberdeen Standard SICAV II - European Smaller Companies fund, with close to €1.8 billion in assets under management, builds its portfolio around four key parameters: quality, growth, momentum and strong ESG credentials. That means that we use a Quantamental approach in which we implement a bottom-up analysis backed by a 13-factor Quant Matrix, with price and earnings accounting for 60% of the quantitative model. The objective is to outperform the benchmark index, the FTSE Small Cap Developed Europe, by 3% with a target tracking error of between 4- 8%, and with a bottom-up investment process, as mentioned above.

The result is a high-quality portfolio (qualitative and quantitative), with companies with sustainable growth - structural trends and with a bias towards the momentum factor (the latter represented by different variables, and not only by the share price of recent periods).  We like companies with high ROEs and ROAs and lower leverage and we are constantly looking for sustainable competitive advantages, strong corporate governance and an experienced management team. On the contrary, we stay away from companies that are overly dependent on the economic cycle. In other words, we prefer companies that are able to grow independently of macro circumstances, many of them immersed in so-called mega trends.  In addition, we have historically had a bias towards family-owned companies from central and northern Europe.

In terms of performance, over 1, 3 and 5 years we have achieved annualised returns that outperform the benchmark in the range of 7-10% per year. Looking ahead, we believe that our quality-focused, long-term process and clear aversion to unprofitable businesses is well positioned in relative terms in what could be a highly volatile market in the coming months.

Oddo BHF Active Small Cap

Guillaume Chieusse, Portfolio Manager at ODDO BHF Asset Management

These companies are traditionally less covered by financial analysts, allowing us to generate alpha by selecting companies below investors' radar. Based on our recent research with Bloomberg, we estimate that, in the €1-3 billion market capitalisation segment, only 9 analysts cover a company on average, while there are almost three times as many analysts in the €10 billion and above market capitalisation segment. The M&A space is a driver of alpha and could continue to be so. For example, we estimate that M&A has contributed an average of 6-7% alpha per year since we initiated our small cap strategy. As the economy recovers and financing conditions remain favourable, many analysts believe that M&A could even accelerate as the crisis ends.

Growth can be a source of profitability**. In our view, Small Caps tend to outperform the market during economic recoveries. They have their own momentum and a wide range of themes. They are also traditionally the main beneficiaries of government stimulus packages, as these programmes traditionally target local companies.
Innovation is the creation, development and application of new products, processes or services. It helps to achieve strategic objectives, improve competitiveness and create value. Small and mid-cap companies are often the drivers of innovation.

A key factor of a promising strategy for Small Caps is the GARP approach, i.e. growth, but not at any price. This approach tries to avoid so-called "value traps", assets that are highly valued for a good reason, as well as growth stocks that are significantly overvalued.
The current market environment continues to be characterised by abundant liquidity and increased risk appetite, as the prospect of a "return to normal" approaches. However, there are some challenges on the horizon. Valuation levels are quite high by historical standards, the impact of the Covid-19 strains is still unclear, and the strength of the macroeconomic recovery is fuelling fears of inflation and possible interest rate hikes. In our view, European Small Caps offer an excellent diversification opportunity in a market environment where one needs to be very selective. However, it is important to bear in mind that these companies present a higher risk of capital loss, volatility and liquidity than large caps.

At this point, Small Caps tend to be growth companies, often focused on niche products with high barriers to entry. Active management is essential in this segment to select the most interesting themes and constantly monitor valuations. We believe our Small Cap strategy offers excellent diversification, as it is a dynamic stock-picking fund that follows the GARP approach, focuses on innovation and has an excellent track record** (Annualised return since inception for the ODDO BHF Active Small Cap: 15.05% to 31/07/2021 vs. 11.14% for the MSCI Europe Small Cap Hedged Euro (NR) benchmark).

*Source: Bloomberg, ODDO BHF AM SAS | Data as at 30/06/2021.
**Past performance is not a reliable indication of future performance and is not constant over time.