Europe represents nearly one-third of the world economy, however, European equities as an asset class are largely ignored.
For investors seeking diversification and opportunities in equities, the European Equity asset class provides an ideal stock-picking environment. Western/Developed Europe, and particularly mid-caps, is an equity universe that has the right balance between inefficiencies/returns and stability/quality. Given the extreme inefficiencies and price anomalies in European mid-caps, it can be a great diversification tool seeking above-market returns in high-quality assets. For example, if one would compare European mid-caps with U.S. small-caps, one would discover companies with similar return and growth profiles to their U.S. counterparts, but they typically trade at significant discounts, which inevitably results in higher, long term returns for the shareholder.
KEY TAKEAWAYS: PORTFOLIO DIVERSIFICATION & INCREASING RETURNS
Mid-Cap Europe is an ideal universe for investors seeking long term returns that outperform the market and geographic/sector diversification, which can be achieved through a true fundamental investment process.
The high-quality opportunity set in mid-cap Europe:
True fundamental investing works: An inefficient marketplace leading to very attractive valuations - high multitude and magnitude of mispricings.
Many cutting edge companies in Europe: Exceptionally specialized, uniquely high-quality, and growing companies with superb management teams. Companies with high returns, growth, predictable cash flows, strong corporate governance, etc.
WHAT IS MID-CAP EUROPEAN EQUITY?
Despite some short term volatility, ultimately the mid-cap European Equity universe includes exceptionally specialized, uniquely high-quality, and growing companies with superb management teams. These companies would be highly attractive to own for any medium to long term focused investor.
- Mid-Cap stocks in Europe are generally defined as companies with a market capitalization between $2 and $15 billion.
- Despite Europe being made up of over 50 countries, the European Equity Market is dominated by at most 10 countries (think Germany, Switzerland, UK, Scandinavia, etc.), all domiciled in Developed (Western & Northern) Europe.
Although Eastern & Emerging Europe (think Poland, Hungary, Czech, etc.) are important end markets for many of the corporates listed on the stock exchanges of developed Europe, they tend to lack stable legal and corporate governance frameworks. Additionally, those stock markets tend to be particularly illiquid.
WHAT SORT OF COMPANIES CAN ONE FIND?
At a high level, in almost any sector one can find global leaders that are considered the gold standard within their various industries. Those spanning a wide range from industrials, consumer, financials, technology, and business services to name a few. Different countries and regions in Europe are quite specialized (i.e., France = luxury goods, Sweden = software/engineering, Germany = robotics/industrials, Netherlands = semiconductors), which makes not only their businesses exceptionally efficient, but also their management teams extraordinarily experienced.
Additionally, and contrary to popular belief, there are many cutting edge companies in Europe. Some are high tech and groundbreaking in their own right, creating software to improve manufacturing, education, clean energy, and overall efficiency for many end markets. Most examples though are not the consumer-facing names we all know and love, however, they do support these darlings (i.e. Apple, Google, Netflix, Amazon). They are often integral in one or many pieces of their supply chains. For example, many of the best semiconductor businesses come out of Germany, Austria, and the Netherlands and they continue to grow as their clients do. Some specific examples of these unique, lesser-known companies, of which there are too many for the scope of this piece -
Sinch (Sweden) - Develops cloud communication platforms. Peer of Twilio (US) trading at 80% discount to Twilio while showing similar growth
Kahoot! (Norway) - a global leader in edtech partnering with Microsoft
Helios (UK) - Operator of mobile telephony towers, rolling out 5G in developing markets
Besi (Netherlands) - key supplier of Apple
The illustration below of European global leaders in their respective fields (just a handful & by no means an all-inclusive list), showing mostly large caps, proving the spheres of excellence within which these mid-caps are operating (think access to skilled personnel, technology, resources, etc.)
For every global leader listed above, there are multiple medium to small cap companies that operate within their respective spheres while exhibiting higher growth and more attractive valuations.
WHY SHOULD INVESTORS INVEST IN EUROPE?
Pros -
Diversification: The European economy and European equities are a significant and indispensable part of the global economy. Therefore, in addition to diversifying into different types of investments, it is also beneficial to diversify into various geographies. It is common to have US, emerging, and global exposure, however European exposure in and of itself is more infrequent in spite of the presence of a large number of high return, high quality, ESG friendly companies, especially in mid-caps.
The illustrative chart below as recommended by many of the large brokerage firms explains that roughly 30% international exposure results in an optimal balance between improved returns and acceptable volatility. Within this International bucket, mid-cap Europe is one of the most appealing, return generating areas.
Consistent Long Term Returns: A well-selected portfolio of European companies has the potential to consistently generate above-market returns over the medium and long term. Some of the benefits one can discover, apart from the ones mentioned above are, solid legal frameworks, developed economies, strong corporate governance, and predictable cash flow generative businesses.
Access to Management: A particular advantage of investing in mid-caps is the ability to develop close relationships with management teams and a deep understanding of how they operate/run their companies.
Market Inefficiency: One of the most appealing reasons to invest in mid-cap Europe, particularly today, is because of the multitude and magnitude of mispricings. They are so significant that for managers doing deep research, the opportunities are near endless. Some of the reasons for the mispricings/inefficiencies mentioned below -
MiFID II was an EU legislation implemented by the European Union in 2018 to improve protections for investors and regulate financial markets. In short, what it did was decrease investment firm budgets for sell-side research from banks. This required small and large banks to cut their stock research capabilities in half and almost completely obliterated the sell-side community covering European mid-cap names making way for firms like Lucerne who do deep, fundamental research to uncover value.
Currently, only approximately 10% of the daily traded volume in the mid-cap European universe is from fundamental, single stock strategies like Lucerne’s. This increases the inefficiencies driven by the fact that there is less deep research, allowing for more alpha-generating opportunities. It is the growth of short term, non-fundamental products (i.e. quant, algos, factor-driven), which disregard bottom-up, fundamental stock-specific qualities, and contribute to causing valuation anomalies and significant price arbitrages.
Cons –
Value Traps (cheap stays cheap)?: Given the extreme inefficiencies and lack of news flow in the mid-cap European universe, there is the risk of a lag in the crystallization of value in the equity markets. However, that can be offset by a proactive approach taken with management. Additionally, for investors taking a longer-term time horizon, growing cash flows will ultimately benefit the value of their equity even without any rerating of the stocks. A focus on companies whose management interests are aligned with those of the stockholders is also critical.
Complex Region: Europe is a complex region to invest in that consists of different cultures, languages, business practices, legal systems, etc. Additionally, overall economic growth generally tends to be lower in Europe than in the US. The complexity in particular, however, makes it an ideal area for active stock selection. For example, unlike in the U.S. where most information is easily accessible, in Europe, it is more opaque and fragmented, allowing an active, research-driven investor to gain an edge.
THE GENERAL EUROPEAN INDICES MISREPRESENT UNDERLYING PERFORMANCE
Many investors trying to make money in Europe, tend to take a passive approach by investing in index or sector European ETFs or other similar products (i.e. Stoxx 600). However, it rarely works given that the main indices are largely dominated by low return, low growth constituents like regulated utilities, banks, commodities, etc., while the US indices (i.e. S&P 500) have a larger representation of higher growth, higher return names.
THE WAYS TO INVEST IN EUROPE
Index versus Active: Europe Requires Active
Rather than index investing, a better way to generate long term sustainable returns is through active stock selection. More specifically, the most attractive opportunity lies in the mid-cap area where one can find the superior companies, which are well-positioned, well managed & leaders in their designated fields while being mispriced by the markets. Europe is one of the few developed areas in the world where active stock-picking actually makes a lot of sense and creates significant alpha-generating opportunities as a way to create long term and consistent above-market returns.
The chart below is an example of how much higher company-specific returns can be than those of the general indices. Even in Europe, there are a multitude of companies with returns far outstripping those of the S&P 500.
However, finding Active Managers with a strong track record is not easy…
When looking at the landscape of European Equity managers, it is relatively small with not as many options as with many other asset classes. For example, European equities as a whole do not have many options when it comes to high quality, active managers. After narrowing that down to just mid-cap options and managers that do thorough and fundamental research that number/pool of options shrinks to even less. Finally, to find a firm with managers that have a long, strong, and reliable track record with a myriad of C-level connections in this universe, there really are just a handful of choices.
Special Thanks to our Contributor
Pieter Taselaar & Thijs Hovers
Co-Partners & Portfolio Managers at Lucerne Capital Management
irelations@lucernecap.com
Phone: +1 203.983.4400
www.lucernecap.com
Founded in 2000, Lucerne Capital Management is an SEC-registered alternative investment firm specializing in fundamental, bottom-up stock selection with a focus on mid-cap European markets. The investment philosophy reflects a private buyer’s perspective of owning high-quality assets at attractive prices for the long-run.