European Small-Caps: Focus on Companies, Not Countries

European Small-Caps: Focus on Companies, Not Countries

European Small-Caps: Focus on Companies, Not Countries  by Liliana Castillo Dearth and Alan Connery, Alliance Bernstein

Growth in the euro area has slowed sharply, but that’s not true for all companies in the region. We think worries about Europe’s recovery may offer investors the chance to buy quality, small-cap stocks for less than they would pay for similar-caliber companies elsewhere.

Investors are right to be concerned about Europe’s combination of low growth and low inflation. But here’s something to keep in mind: Even when the economy is struggling, some companies will continue to deliver sustainable and profitable growth. And if fundamentally attractive stocks can be had at a discount simply because of where they’re listed, that may represent an opportunity.

The key is figuring out where the best value lies. In our view, there is a compelling opportunity in the European small-cap segment, especially among what we define as “quality growth” names. The best of the bunch offer growth and quality at a discount.

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Quality Companies for Less
We recently analyzed a cross-section of nonfinancial companies from various regions, with market capitalizations below $7 billion. To identify a basket of “quality growth” stocks from each region, we used the extensive Credit Suisse Holt database to rank all companies based on EPS growth and excess returns, measured as return on invested capital over cost of capital. Only those companies that landed in the top 40% for both returns and growth made it into the regional baskets. To compare valuations, we relied on the economic P/E ratio, which measures a firm’s value relative to the cash flow it generates.

Here’s what we found: European “quality growth” companies, which include euro-area and non-euro-area firms, are trading at a significant discount to their smaller-cap peers in other regions. This doesn’t appear to be justified by the vast regional differences in quality or growth (Display 1).

In fact, expected earnings growth among “quality growth” small-cap European companies was second only to quality-growth small-caps in North America. It was in line with those in emerging markets and ahead of those in Japan and other developed Asian markets.

European small-caps also score higher on quality than small-caps from emerging markets and Japan. They were about on par with those in North America, but available at a cheaper price (Display 2).