Europe’s small cap stocks have the answer for growth, says Pioneer’s Matti

It’s time for investors to revisit Europe’s small- and medium capitalised stocks, says Cristina Matti, head of European Small Cap Europe at Pioneer Investments.

The worst may be over for Europe’s economies, which are showing signs of stabilising, while central banks indicate that borrowing costs are set to remain low for some time to come. Because of their sensitivity to the economic cycle, it’s no coincidence that small caps have outperformed blue chip shares by a margin of 4 to 5 percentage points this year.

With emerging markets weakening and US stock valuations start to look rich as they hover close to their pre-crash peak, the double-digit earnings growth that we expect European small cap stocks to generate does not appear to be priced in by the market. Values currently are trading at around 13 times average earnings per share, which is still comfortably below the 16 times multiple at the peak of the market in 2007 and early 2008.

Average annual earnings per share growth of 20.4% since 1990, compared with 17.7% for large capitalised stocks, underscores why small caps should form part of an institutional investor’s equities allocation. Small caps outperformed their larger peers in all but three of the years from 2001 to 2012.

As we approach the fifth anniversary of the collapse of Lehman Brothers, small and medium-sized listed companies are in much better shape. They have reduced their leverage, built up healthy cash reserves and have taken strides in improving their corporate governance to address a key concern of institutional investors.

Market momentum may also play a factor in driving European small cap values further, since most institutions are underweight in their allocation to the sector. We also expect M&A activity to be another key support for the sector as confidence about the business outlook improves among larger corporations. They tend to target acquisitions of small and medium-sized listed companies offering niche positions in global markets to help drive their own revenue and earnings growth.

The sheer number of companies means that institutions seeking to raise their European small cap exposure benefit hugely from the stock-picking skills of specialist fund management teams. Since whole swathes of the sector have little or no analyst coverage, it is the asset management companies that are best equipped to identify winning strategies through their direct contact with the management teams.

Five years of abnormally low interest rates are beginning to erode institutions’ “risk off” attitude to investment. Whilst volatility and liquidity will always be a factor in terms of small cap stock investment, we believe that the time is ripe to seek out the opportunity of locking in strong equity returns at this point in the cycle.

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