Why now for Europe's smaller companies?

US equities, driven largely by the ‘Magnificent Seven’ tech giants, have powered ahead in 2024, with the S&P 500 up just over 22% year to date*.

However, with the US market hitting a series of new highs and many companies looking richly valued, prudent investors may now be looking to lock in some of their gains and identify fresh growth opportunities elsewhere.

In our view, there is a strong case for taking a closer look at Europe’s smaller companies. As the chart below shows, European equities look cheap compared to their US counterparts, with the difference in P/E multiples at its highest for more than 15 years.

^{*Morningstar data, 01/01/2024 to 30/09/2024.}

At the same time, after a couple of years in which European large-cap companies have delivered stronger performance in comparative terms (as shown in the chart below), Europe’s small-cap companies look attractively valued relative to their larger counterparts.

Indeed, research by J.P. Morgan has shown that European small and mid-caps are trading at higher-than-average discounts to the region’s large caps on a range of measures, including P/E multiple, enterprise value to sales and price-to-book ratio.

So, relative valuations of European smaller companies look low in historic terms. But what about their prospects? It is no secret that economic growth is sluggish in Europe, with the European Commission’s Spring Forecast projecting GDP growth this year of only 1% in the European Union and 0.8% in the eurozone.

However, despite the anaemic economic backdrop, Europe has no shortage of quality companies with high-calibre management and strong long-term growth prospects.

We see particular opportunities at the lower end of the market cap spectrum, where companies tend to be under-researched, underappreciated and – crucially – undervalued.

Stock example: Vossloh

One example is German company Vossloh, which makes railway track equipment such as ties, switches and fastening systems. The business, which has a market cap of €850m, holds the global number one or two position in its chosen markets.

Train travel is viewed as greener than flying or driving, and in many major economies new rail infrastructure programmes are already underway or have budgets allocated.

Usually contracts span multiple years, and customers tend to be bluechip companies, for example, Deutsche Bahn, Amtrak and SNCF. The nature of the markets Vossloh serves means it has good visibility on sales and ensuing maintenance and service programmes.

In addition, specialist products such as concrete ties for high-speed lines in China, the US and Europe are contributing to increasing margins.

However, Vossloh’s valuation remains modest compared to historic levels. Despite increasing margins and strong strategic focus, the company is currently trading on a P/E multiple of 14x compared to a seven-year average 17x.

Outlook

Recent profit downgrades from some cyclical companies in Europe, such as carmakers Volkswagen and Stellantis, have prompted caution among some investors. However, there are positive signs too, with expectations that interest rate cuts in Europe and around the world will support stronger economic growth and increased company earnings in 2025.

Our meetings with company management teams, and initial signs from third-quarter results, indicate those in cyclical sectors are still expecting an increase in business activity – but that this is now likely to be pushed back into next year.

In this environment, valuations – particularly those of smaller companies – continue to look attractive. For investors like ourselves, who take a long-term perspective, short-term earnings disappointments are likely to create what we believe to be interesting buying opportunities in the months ahead.

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This communication is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.