- After three years of high interest rates holding back the performance of Europe’s smaller company stocks, we believe that declining rates mean the storm has ended
- Even though their stock prices were suppressed by high rates, the best smaller companies have continued to grow earnings
- The outlook is sunnier, boosting the prospects for high quality growth companies held in European Assets Trust (EAT)
High oil prices, inflation and interest rates heralded the perfect storm for Europe’s smaller company stocks over the past three years. Battered, their returns have under-performed those of large capitalisation stocks. And the European Assets Trust (EAT) has not been immune.
Even though many of the smaller companies held by EAT continued to report operational successes, their valuations took a knock. In 2022, the height of the storm, the type of small cap stocks the trust owns – with predictable and sustainable business models generating high and growing returns – were hit especially hard.
Yet now we can feel confident that the storm has blown over and calm should return. The macroeconomic environment may revert partially to previous trends, small cap growth stocks may once again warrant superior valuations, and high-quality companies should regain their premium.
Inflation now appears under control and interest rates have been falling. More than anywhere else, lower rates improve the prospects for small caps and their valuations.
High quality businesses continued to grow
Recent events have brought to an end three years of severe headwinds. Bottlenecks in supply chains after the lifting of Covid-19 restrictions stoked inflationary pressures, exacerbated by the Ukraine war effect on gas prices. The small cap universe also suffered relative to large caps from including few oil companies that profited from higher oil prices. Banks which were able to widen interest margins in a higher rate environment are also a smaller part of the smaller company universe.
In such a market environment, investors cut allocations to smaller company stocks, viewing them as more volatile. That compounded the outperformance of larger companies.
But high interest rates did not affect the operating performance of Europe’s best smaller companies. In some cases, the stock price fell despite the underlying business continuing to prosper. This created interesting opportunities for us and for EAT’s portfolio. If a company can continue to expand, bucking the trend in the wider economy, it is likely to prove a profitable investment.
Falling interest rates make valuations attractive
Confident that inflation in the euro zone is more under control, the European Central Bank has been steadily reducing interest rates. At the time of writing, it has cut rates three times since the start of 2024, so its benchmark rate is now back down to 3.25%.
The level of rates and cost of capital are key for fast-growing smaller companies. Growth companies are usually valued using discounted cashflow models, where interest rate assumptions are an integral part of the equation. Just as higher interest rates reduce the value of longer-term future earnings, so lower interest rates increase their value.
Europe’s smaller companies now appear relatively inexpensive, especially as their earnings are growing. In a sign of positive momentum, analysts continued to upgrade their forecasts for corporate earnings growth through 2023 and 2024.
A sunnier outlook
Looking forward, we’re entering this time of better weather for small caps and we have all had much to learn from the tests over the last few years. Our process has always been flexible, playing to the strengths of our investment team. But we now use extra rigour to reassess companies where bad news may have prompted share price falls, and we do this working alongside other European investment colleagues in one of the largest and best resourced teams available.
What’s more, EAT’s share price is trading at a discount to its net asset value (NAV) of more than 10% at the time of writing, unusually high compared with history. Effectively, this puts the underlying small cap stocks at a double discount.
If the storm has truly blown over for small caps, EAT approaches sunnier times with the advantage of low stock valuations, a wide discount to its NAV and a portfolio that’s gained from the last few years’ stock selection opportunities.
Investment risks
The value of your investments and any income from them can go down as well as up and you may not get back the original amount invested. Gearing is used for investment purposes to obtain, increase or reduce exposure to an asset, index or investment. The use of gearing can enhance returns to investors in a rising market, but if the market falls the losses may be greater.
Issued by Columbia Threadneedle Management Limited and approved for distribution 15/11/24.
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