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A few months ago we wrote a blog illustrating how the degree of underperformance seen in European smaller companies over the last few years has been highly unusual and how we believed at some point the natural advantages that small caps have over larger companies (more focus, faster growing markets) would reassert themselves. Since then, the main pushback we have received from clients is them asking what could cause this situation to change.
Is the rotation underway?
The honest answer is that we don't really know but our best guess would be a combination of sentiment towards some of the over-crowded mega-caps souring plus falling European bond yields. This would turn what have been headwinds into a tailwind for smaller cap stocks.
Having seen the sharp market rotation over the past few weeks cause some pain in a number of well held mega-caps, this might actually be starting to happen.
The power of the crowd
One recurring thing we hear from our clients is that many European funds holdings are concentrated into a handful of mega-cap stocks. We investigated this further and the charts below show what we found.
Using the latest factsheets, we aggregated the top ten holdings of the fifteen largest European funds (which account for well over 50% of AuM invested in the market by open-ended investment vehicles). I'm sure it will come as no surprise that the three largest holdings are Novo Nordisk, ASML and LVMH.
What caught our eye was the degree of overlap. Twelve out of the top fifteen funds own Novo, thirteen own ASML. And the average weight in the portfolios are high - 7.3% in the case of Novo Nordisk and 6.2% for ASML.
Europe's market concentration European investors are crowded into relatively few large cap names...
Source: Downing Fund Manangers, Fund Factsheets and Bloomberg as at 30 June 2024
The second thing we noticed is the valuation of this top 10 portfolio has increased markedly over the last 18 months. Whereas it used to be valued around 15-20x forward earnings, it currently is close to 30x. In the case of Novo Nordisk and ASML, valuations are even higher on 41x and 52x respectively (albeit they have dropped a little since we ran this data a month or so ago).
The stocks held in this top 10 are very good companies and we like and admire many of them. However, the degree of crowding into some of these names combined with their elevated valuations means they are vulnerable to shifting sentiment. The last few weeks news flow in ASML and Novo Nordisk illustrates the risk that we see.
US keeps flexing its muscles
The rotation started with ASML, whose shares have fallen about 15% from their recent all-time high. Their Q2 results were actually very good, with orders better than many were expecting as the company continues to benefit from the ramp up in the equipment needed to produce AI chips. However, the stock was hit by the latest shot fired by the US in its ongoing battle to curb Chinese computing power as it considers imposing draconian trade restrictions which would effectively block ASML from selling its latest high-end machines to the country. Given that China accounted for 49% of sales last quarter, the impact over the medium term could be material. And this is before a possible Trump second term and a man who has vowed to impose even more tariffs on Chinese goods.
Net system sales breakdown (Quarterly)
Source: ASML Q2 presentation, 17 July 2024
Obesity drugs: the competition is fattening up
Similarly, sentiment towards Europe's largest stock, Novo Nordisk, is also starting to turn. Shares are down around 14% from recent high as Roche's obesity drug showed very promising results, heating up the competition in what is already one of hottest new pharma markets. Drug pricing remains very much in focus as well given the looming US election.
Small caps to the rescue
On the other side of the market, there are signs that small caps are stirring into life. In both the US and Europe, smaller companies have been quietly staging a comeback. Whilst the rotation last week was eye catching, this was actually just the continuation a trend that started in Europe at the end of April. What changed back then is open to debate but it may well have been the fact that the market started to factor in rates being cut by the ECB at its June meeting.
Small cap stocks are starting to recover… but a long way to go
Source: Bloomberg as at 25 July 2024. Past performance is not an indication of future performance.
A quick look at the last 25 years shows that changes in direction of bond yields have correlated well with the relative fortunes of smaller cap stocks. The chart below reproduces the point we made in our first blog - European small caps have been decimated relative to large caps over the last three years.
What is new is we have added the 10 year Euro bond yield (shown in green) and also marked in red the moment when bond yield start to turn down.
Small cap relative performance vs European 10 year bond yields
Source: Bloomberg as at 8 July 2024. Past performance is not a reliable indication of future performance.
The first line, of course, is the financial crisis where central bankers slashed rates to combat the chaos. This proved to be close to the turning point for small caps which subsequently outperformed nicely until mid 2011.
The second line in 2013 was the Eurozone crisis which saw bond yields turn negative. The outperformance of smaller companies persisted until late 2021 when rapidly rising rates saw small caps being left behind.
Falling yields a catalyst once again?
The last red line is the situation today where, after seeing inflation moderate after the Covid and Ukraine war supply chain disruptions, bond yields appear once again to be on a downward trajectory. Could this mark the start of a period of sustained outperformance for small caps?
As always, it is hard to say for certain but perhaps in a few years time we will look back to mid 2024 as the moment to be brave and back the scrappy underdogs!
Risk warnings: Please note that past performance is not a reliable indicator of future results. Capital is at risk. Investments and the income derived from them can fall as well as rise and investors may not get back the full amount invested. Investments in our funds should be held for the long-term and are higher risk compared to investments solely in larger, more established companies. Opinions expressed represent the views of the fund manager at the time of publication, are subject to change, and should not be interpreted as investment advice.
Important notice: This content is for information only and does not form part of a direct offer or invitation to purchase, subscribe for or dispose of securities and no reliance should be placed on it. This content contains information that is believed to be accurate at the time of publication but is subject to change without notice. Whilst care has been taken in compiling this content, no representation or warranty, express or implied, is made by Downing LLP as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. Downing does not offer investment or tax advice or make recommendations regarding investments. Downing is a trading name of Downing LLP. Downing LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference No. 545025). Registered in England and Wales (No. OC341575). Registered Office: 6th Floor, St Magnus House, 3 Lower Thames Street, London EC3R 6HD.
