By Anna Lunden, Equity Portfolio Manager, Pan European Small Cap Equity Fund, Wellington Management

In Europe, the small cap effect – where smaller companies outperform their larger peers – is very much alive and kicking. Within the Wellington Pan European Small Cap Equity Fund, we aim to identify the very best long-term opportunities across the breadth and depth of the European small-cap universe, investing in businesses with sustainable competitive advantages that can help them become the mid-caps and large caps of tomorrow.

Smaller European companies consistently outperform larger stocks by a significant margin1. Why? To answer that, we need to look at the sector composition of Europe’s stock markets. Our large-cap universe is dominated by traditional sectors such as chemicals, materials, consumer staples and traditional banks – where growth has been relatively slow. By contrast, the small-cap market in Europe comprises nimble and innovative companies that continue to grow faster from a smaller base.

In fact, across Europe, smaller companies continue to disrupt established business models, for example, within Fintech, where we are seeing really interesting consumer-driven disruption of the traditional banking sector, driven by consumer demand. Then there is automation, where some great smaller industrial companies are transforming a number of industries. The pandemic has highlighted the need for much more efficient healthcare systems around the world. We’ve identified disruptive companies in these areas that we believe will continue to grow and that through innovation are able to meet the growing the need for better healthcare services around the world.

How we identify the mid-caps of tomorrow

The fund’s investment strategy is first and foremost about identifying high-quality companies, in particular those that benefit from structural growth drivers. High-quality businesses can be found in both cyclical and defensive industries so it’s not all about the latest flavour of the month, be it med tech or consumer staples. To succeed in the long term, a company needs to have some kind of sustainable competitive advantage – a way of protecting its dominant position. That can come down to its product but will also depend on a number of other factors. So, we spend a lot of time trying to identify companies’ competitive positions. One of the things that I learned very clearly in my years in the pharmaceuticals industry is that it makes a lot of sense to operate in an environment where you’ve got patents to protect your position and are serving a fundamentally growing market. That rationale informs some of the key holdings that you’ll find across my portfolio.

How do you research a universe of more than 2,000 companies?

Having been an investor and a researcher in this field for the last 20 years, my screening methodology has evolved over time and I now use a proprietary model which ranks companies across over 20 different financial ratios. It helps me to order the universe by the quality metrics that we’ve identified as well as assessment from an Environmental, Social and Governance (ESG) perspective. That narrows down the opportunity set to around 400 companies. We maintain and update a consistent view on these and as we navigate a market cycle, we’ll take input on their valuations relative to the opportunity set.

In doing this, we draw very heavily on the internal investment debate at Wellington. There are hundreds of experienced investors within the firm and a key part of Wellington’s ethos is sharing our perspectives and ideas with each other. That means I can get strong ideas from Asia or the US to help me narrow down interesting thematics that are playing out in Europe too.

Operating in Wellington’s ecosystem of very long-tenured investors also means I rely less on sell-side input from brokers and investment banks and more on our own research. And with the advent of new MIFID II regulations a couple of years ago, we have seen a considerable scaling-back of research coverage of the European small cap space by investment banks. This means that from a research coverage point of view, the inefficiency of the small cap market is as high as it ever has been in my experience, with many areas of the market either not covered or not covered in any depth.

The importance of ESG

ESG principles are a key part of the fund’s investment process, not as an extra layer of screening but because we believe a business that is not being managed sustainably is not being managed well. Large businesses are often adept at publicising their ESG credentials, smaller companies less so. But my experience has been that there is actually a huge amount of ESG activity and innovation going on within small European businesses, which companies simply haven’t had a chance to report to the outside world. By engaging with companies, we help them to improve their disclosure, highlight the good they are doing and get the appropriate credit for it. This involves digging a little bit deeper than one would need to with larger companies and doing a little more work yourself. But in that sense it’s no different to any other aspect of small cap. That is to say, I view it as a market inefficiency that thanks to our size, resources and experience on the ground, we are able to exploit.

It’s also important to know how not to invest in ESG. There are some obvious ESG darlings in the market, and it’s much easier to go out and buy anything that’s related to renewable energy or recycling than it is to engage directly with companies about what they are doing. Some of these stocks have been bid up very aggressively. I believe a better approach is to have a broader pool of companies from which to pick investments when it comes to ESG. Plenty of companies are achieving true innovation in fields like energy efficiency, while others may be suppliers to the more obvious ESG names.

The outlook for small caps

During the pandemic, we saw merger and acquisition activity drop off a little as due diligence was harder for companies to do. In the meantime, companies have been shoring up their balance sheets and are ready to pounce and I think we’ll see businesses that have been covid winners put that capital to work as we move forward.

Looking ahead, as vaccinations are rolled out and European economies emerge from pandemic, I believe the small cap market is geared to the recovery. The largest sector within European small caps is industrials, at 25% of the universe, followed by financials and the consumer sector2. The rate of household savings has been exceptionally high during the pandemic so there’s a lot of pent-up demand amongst consumers that I expect will be released as economies re-open. In my view, while there is always the risk of volatility in equity investing, the higher weighting among small caps to consumer-oriented sectors should help deliver a boost to the strong long-term performance of Europe’s best small companies.

1 Between 1 January 2001 and 31 December 2020, the compound annual growth rate of the MSCI Europe Small Cap was 8.2%.  Over the same period, the compound annual growth rate of the MSCI Europe Small Cap Index was 2.4%, in local currency. Source: Morningstar.

2 MSCI AC Europe Small Cap Index, 31 March 2021

To find out more visit our Pan European Small Cap Equity Fund page.

Investment Risks

Capital: Investment markets are subject to economic, regulatory, market sentiment and political risks. All investors should consider the risks that may impact their capital, before investing. The value of your investment may become worth more or less than at the time of the original investment. The Fund may experience a high volatility from time to time.

Currency: The value of the Fund may be affected by changes in currency exchange rates. Unhedged currency risk may subject the Fund to significant volatility.

Hedging: Any hedging strategy using derivatives may not achieve a perfect hedge.

Equities: Investments may be volatile and may fluctuate according to market conditions, the performance of individual companies and that of the broader equity market.

Small and Mid Cap Company: Small and mid-cap companies’ valuations may be more volatile than those of large cap companies. They may also be less liquid.

Manager: Investment performance depends on the investment management team and their investment strategies. If the strategies do not perform as expected, if opportunities to implement them do not arise, or if the team does not implement its investment strategies successfully; then a fund may underperform or experience losses.

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