The future of European Small Caps

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Hello, I’m James Yardley, and today I’m joined by Phil Macartney of the Jupiter European Smaller Companies fund. Phil, thanks very much for joining us today.

[00:11] Thanks for having me on James, to discuss what I think is a really interesting bit of the market right now.

Yes. European smaller companies. We’re excited to learn more. So I was reading on your website recently that re-shoring and the Inflation Reduction Act is actually helping to benefit some of your companies. Can you tell us a bit more about that?

[00:35] Well, I think this is kinda of geopolitics in action, so, you know, the kind of stuff that we read in the papers is genuinely is happening in kind of real life to the companies that we invest in and that we speak to on a regular basis.

I think one of the key things that came out of Covid was about looking for supply chain security. You know, clearly lockdowns all around the world led to a lot of disruption in supply chains and so companies had to think about where they got alternative sources of components. So I think that kind of kickstarted this kind of ball rolling as it were. And then obviously as we’ve kind of come out of that period and governments have kind of a bit more protectionist, you’ve seen a bit more of this near-shoring need as it were.

And Europe is actually quite uniquely placed in that regard because it doesn’t really sit on either side, you know, kinda sits in between those two divides of the US and China, which is I guess where the real critical source of the debate is, it does position some of these smaller companies in quite good stead.

And also, you know, it’s reducing a bit of the competitive aspect that we may have seen from Chinese companies in the past, which I think may also help in time with margins. So we are seeing real evidence of investment stepping up in terms of nearshore and we see new plants being built in various industries. We’re seeing big order wins for some of our companies in terms of components for companies, and new customers arising as they look to reorganise the supply chain.

Specifically healthcare is one of these key places that we’re seeing that, and we’re seeing, you know, there’s a BIOSECURE act out there in the US which is stipulating a reduction in the use of Chinese-manufactured ingredients in drugs. And that is therefore bringing more and more production facilities to the West that had, over time, moved East. And that’s benefiting companies up and down the supply chain. So, you know, we look at a company called Bachem in Switzerland that makes the active ingredients for a lot of these drugs that you hear about in obesity, in diabetes, but also in a plethora of other drugs. And it’s also benefiting from some of this reassuring that’s going on as it’s getting reclassified into drugs that it previously wasn’t in as the Chinese supply is winding down as it were.

So, you know, we’re seeing some real benefit to the companies from this kind of from this protectionism I guess that you’re seeing across the world.

Yeah, very interesting. I mean, it’s the nature of smaller companies funds that we haven’t heard of many of the actual companies. So can you give us a few more sort of gems in your portfolio and and tell us what they do?

[03:32] Well, I think it’s one of the joys of investing in smaller companies is that you can go out and find these, you know, really interesting, high quality businesses across Europe that aren’t covered by many of the kind of big banks, that we know. So we’re always looking for those under-researched ideas. That’s where we feel that we can add some real value through our experience in smaller companies. And, some of these companies are actually in incredibly familiar probably to you on the street or you wouldn’t actually know that you’ve been using a lot of their services even though you’ve been using them.

So, one of my favourite examples is a company called Rational, which is the global leader in what you call a combination steam oven which is a long way of saying it’s a cooking device. It’s a very smart cooking device, and actually it’s used in a lot of restaurants, it’s used in a lot of canteens, it’s used in a lot of fast food restaurants as it were. So, you’ve probably eaten out of a Rational oven, even though you don’t even know that you have used one of these things. It’s about a seven, seven and a half, 8 billion market cap company, so it’s not small by any means. It would be in the FTSE 100 if it was quoted in the UK. It’s actually quoted in Germany. And it’s ovens are, you know, they’re so ubiquitous. They’re in every three star Michelin restaurant, the White House and Buckingham Palace. So it’s a very well known brand name, but it’s also an incredibly quality company in the way that it’s run.

So, this company has very attractive profit margins. It’s grown roughly 7-8% compound for the last 20 years. It’s got a lot of white space to grow into and why its products are so critical is that it takes staff, it takes energy, and it takes water consumption out of the kitchen. And so if you want to run your kitchen more effectively, installing one of these Rational ovens gives you a very quick payback period. And not only that, it’s very, very versatile. So it can cook a a whole range of foods very simply. I’ve actually been to the factory and I’ve had a product demonstration and I’ve been able to cook fish with a touch of a button much better than I ever could at home.

So it’s one of these things that I think, you know, you find these companies in Europe that aren’t that well known that are reasonably large, very well funded, very good balance sheet, very good cash generation that have very long runways of growth ahead of them that can really stand out in the portfolio. And we’ve got loads of those companies in the portfolio that are covered by maybe three or four people, not that well known, but are ubiquitous within our lives on a day-to-day basis.

I feel like I’m missing out now, I wouldn’t mind one of those Rational ovens in my own house.

[06:16] Well, they’re not quite branched out into residential, but you never know.

And another thing I was looking at, looking at your portfolio, I mean, you’ve got a a bit of a position in real estate. I think it’s only about 3%, but what is your thinking there? What’s that?

[06:31] Well, again that’s kind of a quirk of the index and why a name sits in a certain sector. You know, from a high level perspective, real estate for us is a sector that we don’t tend to invest in. We find it hard to find competitive advantages or differentiation in the products. It’s also quite a cyclical industry. It kind of comes and goes with economic cycles, with interest rate cycles, and therefore they’re hard shares to hold and invest over a long period of time, which is what we like to do here. So, the name that we actually own that correlates to that 3% is a company called Hemnet [Group] which is a company that no one in the UK will have heard of. And again, it’s one of these names I think that you can find in small cap land that isn’t that well known.

So, Hemnet is actually very famous in Sweden. It’s actually more famous than YouTube. It’s a very ubiquitous name in Sweden. Why is that? It’s because if you sell your home in Sweden, you sell it on the Hemnet platform. So, it’s the equivalent of, of Rightmove here in the UK. But the difference between Hemnet and Rightmove is that actually in Sweden as a house seller, you actually pay Hemnet to advertise your property. It’s not the estate agent who pays for the advertising. And so you are incentivised to pay money to try and get your property recognised on the portal. And we’re talking, a couple of thousand pounds maybe to advertise your property in Sweden: average house prices in Sweden aren’t much above the average in Europe, so it’s not a huge amount of the overall value of the sale to advertise your property. And they’ve created a very competitive portal where the more you pay, the more your property gets recognised which gives them a lot of pricing power when it comes to recognising your property.

And the other quirk about the Swedish property market, which I think makes the portal very interesting, is that on average it takes about 28 to 29 days to sell your property in Sweden. So, it’s a very fast turnaround if you can get your property recognised. And part of the reason why that is because of this portal that exists. And so it’s very difficult for anyone to go elsewhere and advertise their property in other places because Hemnet is so good at selling your property for you. And therefore we see it as a very defensible business model, a very necessary business model in Sweden and a business that has a lot of pricing power when it comes to getting that price out of the consumer.

And you know, the last point is, there’s not very many people that work at Hemnet. It’s basically a technology platform, so it’s very, very asset light, and that makes it very profitable. So you’ve got a business that can grow double digit, it’s very, very profitable – more profitable than the average business that’s out there – and that’s not covered by very many people. And we believe that gives us some, a really nice kind of alpha-generating opportunity in real estate as it were.

Yeah, that sounds like a very good business, very, very powerful network effects there by the sounds of it.  And I know you are, obviously, you are predominantly bottom up investors rather than top down looking at the macros and so forth, but what is your outlook for the second half of the year? I mean, what is your general feeling? I mean, what are you thinking in terms of valuations, that sort of thing?

[09:54] Well, I mean, if I had a crystal ball and I could tell the future, then it would be a different game altogether, wouldn’t it?

But you know, there’s obviously a lot of uncertainty out there in the worlds we sit here today. But you know, politics I think is obviously at the very forefront of people’s minds across the world. It’s a very heavy political cycle in 2024, specifically in the second half. You know, we obviously have got elections in the UK but the big election really is in the US and what happens there. And right now we don’t really even know who might be running for the US presidential election. So, you know, guessing the outcome of that I think is a bit of a fool’s errand.

But I think what is, you know, what I think is becoming increasingly likely, and what we are seeing, I guess, is, is, and for Europe specifically, is obviously interest rate cuts. And inflation is falling in the Eurozone. There’s quite a lot of pessimism in the Eurozone when you go around it at the minute because of a lot of the you know, the car companies are under pressure from Chinese competition, the chemical companies are under pressure because of inflation in the oil price and the Ukraine and Russia war. So, and those are big employer employers, certainly in northern Europe. And so there’s a lot of pessimism in northern Europe as we sit here today. And that’s resulting in a bit of consumer confidence waning. And I think you’re beginning to see that reflected in inflation beginning to fall in the Eurozone. And that’s going to lead to ECB cutting rates.

Now, that’s interesting because I think for European equities as the first region to see rate cuts, that could add to a bit of optimism in the stock market certainly versus maybe the US as we sit with a bit more uncertainty in the political cycle and interest rates over there. And when you come from the valuation perspective of Europe being at such a wide discount, you know, a discount as wide as the great financial crisis as it sits here today. And I think you’ve got a very interesting setup for European equities and for European small caps that could be very powerful because they tend to correlate very well with interest rate cuts in the Eurozone.

So, as rates fall, you tend to see European small caps do quite well in that environment as risk gets repriced. And so, you know, European small caps are trading at a slight discount to their large cap counterparts. That doesn’t happen very often. So again, I think you’ve got a real trifecta, I guess of positive reasons to own European small caps at this point. And that’s why I’m a bit more positive and constructive, I guess on the second half outlook, certainly for European equity markets. Maybe not necessarily for European mainstream, but certainly for European equity markets as we sit here today because of the setup that we have from a valuation perspective and potentially some benefit from rate cuts in Europe.

Brilliant. Well, thank you very much, Phil. That’s been really enjoyable. I think I’ve learned quite a lot there. So thank you very much.

[12:51] Thanks a lot.

And if you’d like to learn more about the Jupiter European Smaller Companies fund, please visit FundCalibre.com.