The elation that greeted news of a vaccine suggested markets believed it would deliver speedy economic recovery.
The reality has proved a little choppier, with the supply and distribution of vaccines inconsistent and mutant viruses unnerving scientists.
However, the path still appears to be towards recovery in 2021, which should favour more cyclical markets, such as Europe – and the more most domestically-oriented parts of those markets, such as smaller companies.
Historically, periods of recovery have been a fertile time for smaller companies.
In 2009, the MSCI Europe Small Cap index bounced 65%, around 21% more than its global peers.
It was a similar picture in 2012, when the index jumped 29.5% after a dismal year in 2011.
Each time European smaller companies have been hit harder, but recovered strongly after a downturn.
Can they pull off this trick as European economies emerge from the pandemic?
Different playing field
It is worth noting that previous rallies have tended to come after a period of weak performance. This hasn’t been the case during the pandemic.
European small caps were hit hard initially, but fared well for much of 2020.
Over the past 12 months, the average FO – Equity Small Cap Europe fund is up 14.3% (source: Trustnet, to 19/01/2021), which puts it well behind the average FO – China fund (up 36.1%), but some way ahead of the average FO – Europe ex UK fund (up 6.2%).
That said, there was a vast disparity of performance within the sector.
This might be expected with more than 5,000 companies from 25+ countries to choose from, but the gap between the top and bottom fund is an astonishing 55% over one year and 74% over three years.
Hugh Cuthbert, manager of the SVM Continental Europe fund, says: “It is really a stockpickers’ market. In 2020, there has been huge disparity between sectors and there remains a vast palate from which to choose.”
The diversity of stocks makes it difficult to generalise on valuations. On the one hand, the sector hasn’t obviously underperformed and it therefore doesn’t look as cheap as it has done during previous downturns.
However, neither does it look expensive.
In July, research group Fund Calibre pointed out that small and mid cap stocks in Europe were the cheapest they have been relative to large caps since 2002.
They have recovered somewhat since then, but there could still be further to run.
Diversity equals agility
Equally, smaller cap fund managers are in a good position to find bargains in the current environment.
Daniel Pereira, investment research analyst, Square Mile Investment Consulting and Research, said: “Some active small cap managers are tilting their portfolios away from areas such as technology to favour other more attractively valued areas of the market, that could benefit from a post lockdown environment.”
The diversity of the small cap universe should give them the ability to be agile as recovery emerges.
Small caps have undoubtedly been battling a difficult economic environment.
They tend to be more domestically-focused and, while many can thrive in different market conditions, a better economic outlook should help earnings.
Cuthbert says: “Small caps tend to have a more focused model and are therefore highly exposed to European domestic markets. In contrast a large European conglomerate has exposure to multiple markets. So if Europe has a political or economic shock, smaller companies will not be a great place to invest.
“However, if you believe in the recovery, small caps are a good place to be.”
Equally, Europe’s general weakness means that smaller companies have been overlooked by international investors.
Where they have invested, it has tended to be in larger companies, leaving plenty of room for good active managers to exploit mispricing in neglected small caps.
With that in mind, it seems likely that European small caps should be among the first beneficiaries of a recovery in Europe.
Pereira says the sector is sensitive to vaccine news as a result: “Smaller companies could struggle on a relative basis if Europe makes little progress with the roll out of a coronavirus vaccine.
“Indeed, upon the news of an approved vaccine in November 2020, European smaller companies outperformed their larger peers by some margin.”
Ewout van Schaick, head of multi-asset at NN Investment Partners believes recovery will come, but could be delayed: “The virus has worsened over the last few weeks, particularly in the US and Europe. Covid numbers have moved up and governments have seen the necessity for additional lockdowns.
“We are not in a period of strong recovery yet. We could see a setback to economic data in the first quarter and it could take us to the second quarter of the year before we really see that recovery pay off.”
The group believes that when recovery comes, it could be a mirror image of 2020.
Countries and sectors that have suffered most will recover most strongly and with real vigour. For countries, this may be Germany, which has been hit by its reliance on carmakers and other cyclical industries or retail. Small cap managers that get this transition right could thrive.
That said, in debating whether now is the right time for European smaller companies, there are plenty of reasons to support a longer-term allocation to the sector.
Its diversity is an advantage, allowing European equity investors access to new and emerging sectors only lightly represented in the major large cap indices.
Equally, says Cuthbert, the sector is characterised by a lot of family owned businesses.
“This means there is a long-term nature to them and long-term thinking process that is different. Sometimes with listed companies, the CEO is more of an administrator. Not best to take long term strategic decisions.
“Family can take very different decisions. They’re not scared for their jobs. They will also tend to have lots of personal money in the companies.”
A recovering European economy should be a fertile environment for European smaller companies, even if they haven’t followed their usual bust and boom trajectory in this downturn. Nevertheless, it is difficult to generalise about such as diverse sector in a year that has seen such polarisation.
Backing the right manager is key.