Why this asset class could have promise and why many Canadians don't access it
It’s the worlds second-largest economy. It has some of the largest, best-capitalized, and most recognizable businesses in the world. It’s the undisputed centre of the luxury goods industry and boasts a track record of innovation. Its companies file around half a million patents every year, a roughly equivalent number to US companies. Its leading pharmaceutical company has launched perhaps the greatest drug boom of our age. Its leading semiconductor company has roughly kept pace with the Magnificent Seven over the past five years. It’s Europe, and it’s an area that the founder of one portfolio management firm believes Canadian investors need to be exploring now.
Desmond Kingsford is the Founder of Highwood Value Partners, a Whistler-based boutique firm focused on European equity markets. He outlined some of the core dynamics driving European equities now and pointed out a few reasons why this geography doesn’t show up on Canadians’ radar as much. Within the broad universe of European equities, Kingsford pays special attention to Europe’s small-cap and mid-cap names, companies which he believes offer significant value and growth potential now.
“Of the roughly 8000 stocks with a market cap of over $200 million in developed markets about one in 20 of those did three times money or better over any rolling five-year period going back to 2010. These are what I would call the true alpha opportunities,” Kingsford explains. “About 80 per cent of those were companies with that are mid and small-cap stocks with market caps between $500 million and $10 billion. About 95% of those true alpha opportunities were outside Canada. The region with the largest share of those true alpha opportunities has been Europe consistently. Europe is home to between 50 and 60% of the equities that did three times money or better over any of these rolling five-year periods.”
So why don’t Canadians see this remarkable growth when they look at European markets? Kingsford explains that index performance in Europe tends to be far more mixed. Especially compared to the US market where an index like the S&P 500 occupies a huge amount of investors’ attention. Kingsford argues, though, that these smaller names in Europe offer an opportunity for investors to beat indexes, not just mirror them.
Key, also, to understanding European markets is the fact that they are more federated. Novo Nordisk would be listed in Copenhagen, ASML is listed in Amsterdam, Siemens is listed in Frankfurt, and Shell is listed in London. Those are large-cap names, so unearthing small and mid-cap gems requires sifting through a significantly larger array of markets and nations.
Kingsford notes that this has become more challenging for Canadian asset managers after European regulators took steps to unbundle market research from trading commissions for investment banks. As a result many once-great sources of market research have pulled back their research in Europe, to largely focus on large-caps. This has left the mid and small-cap space somewhat uncovered.
So why should asset managers wade into this murkier space? Kingsford notes that in addition to the true alpha opportunities that have emerged from Europe, its smaller-cap names offer some additional benefits. Namely currency exposures. Higwood’s allocations are split, roughly, into one-third Euro, one-third dollars, 20 per cent Sterling, and 10 per cent Scandinavian currencies. This can introduce new currency offsets into a portfolio. Moreover, you can get greater geographic diversification at a smaller-cap level. Where a US company with a $5 billion market cap is likely still a domestic business due to the size of the US economy, Kingsford says that a similar sized company listed on a European exchange likely has business lines extending far beyond its national borders and even the borders of Europe.
The attractiveness of this market segment, Kingsford says, comes most apparent in the context of a US market now trading at significant multiples. With the S&P 500 averaging around 28x earnings, many investors are looking to pick up value. European mid and small-caps, Kingsford says, are trading around 12-13x earnings. European equities as a whole are at around 15x. That value comparison, Kingsford says, makes an almost textbook case of European stocks with a likelihood of stronger returns and a better margin of safety.
Perhaps the greatest challenge in these European allocations is the fact that the areas Kingsford has identified are not captured in indexes. He suggests a portfolio of 10-15 “well-chosen, high-quality businesses in Europe,” instead.
“You want business with returns on capital north of 20 per cent and an economic note that protects those returns, you want the ability to redeploy cash flow and you want them run by well-aligned, capable, honest management,” Kingsford says. “I would not buy an index. I don’t think you want to be betting on the average. I would pay for performance.”
