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The case for investing in the European small-cap sector

Investors looking to diversify and add growth potential to their equity portfolios shouldn't be frightened by Europe's macroeconomic malaise

Dec 16, 2014 @ 6:30 am

By Liliana Castillo Dearth and Alan Connery

Growth in the euro area has slowed sharply but that's not true for all companies in the region. In fact, 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.

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 Credit Suisse Holt database to rank all companies based on earnings per share growth and excess returns, measured as return on invested capital over cost of capital. Only 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.

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.

Furthermore, our analysis suggests that European companies have the most potential to improve returns. Corporate profit margins and revenues relative to company assets are depressed everywhere, thanks to tepid global growth. But they are most depressed in Europe. That means returns should improve as a more sustainable European recovery takes hold.

More Monetary Stimulus

To be sure, Europe's economic health could get worse before it gets better — a risk that even the best-managed regional companies face. Fortunately, the European Central Bank seems to recognize this risk and has signaled its intentions to expand monetary stimulus. There are certainly execution risks but also ample room for economic stimulus, which could steer the euro area away from deflation.

A gradual recovery in Europe may provide further upside for the cyclical industrial and consumer-discretionary stocks that comprise more than half of the top-quality European SMID-cap companies in our analysis.

Investors looking to add diversification and growth potential to their equity portfolios shouldn't be frightened by Europe's macroeconomic malaise. With the proper fundamental analysis, investors can still find value in European small-cap stocks. The trick is to remember that, when it comes to stocks, you're buying companies, not countries.

Liliana Castillo Dearth is team leader and portfolio manager for the International Discovery Equity Portfolio, and Alan Connery is a portfolio manager for the International Discovery Equity Portfolio, both at AllianceBernstein.

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