One Small Stock For Europe, One Giant Leap For Your Portfolio?

One Small Stock For Europe, One Giant Leap For Your Portfolio?
Milou Beunk

about 3 years ago3 mins

Mentioned in story

What’s going on here?

At the risk of sounding repetitive, stocks are starting to appear rather expensive in some parts of the world. Already-lofty valuations might leave less room for markets as a whole to move much higher – and so it might just pay to be a bit more selective this year. Several opportunities in smaller European stocks have caught my eye…

What does this mean?

Small- and mid-capitalization stocks – those with a market value of, say, under $10 billion – are by their nature a stock-picker’s paradise. Their relatively small size means fewer analysts and investors focus on them, leaving open the possibility of errant pricing – and therefore chances to profit.

Small-cap stocks also tend to outperform during economic recoveries thanks to their greater cyclicality: their earnings growth is highly sensitive to the state of the broader economy. That explains why such stocks have done better than their large-cap contemporaries since announcement of effective coronavirus vaccines late last year.

Percentage moves of European small-cap and large-cap stocks since February 2019
Percentage moves of European small-cap and large-cap stocks since February 2019 (Source: Bloomberg)

But while European small-cap stocks have, unlike large-cap ones, surpassed their pre-crisis peaks, they may still present an attractive entry point. European small-caps only appear expensive if you look at overall indexes – which shows them valued at a 15% premium to large-caps on a key price-to-earnings metric.

Strip out sector biases, however, and it’s a different story. The European small-cap index contains fewer banking and energy stocks than its large-cap equivalent, and these slow-to-recover industries are dragging down large-cap performance overall. If you compare index valuations without this weighted sector bias, then Europe’s small-cap stocks are actually 34% cheaper than the continent’s large-caps.

Price-to-earnings valuations of small-cap stocks vs. large-cap stocks
Price-to-earnings valuations of small-cap stocks vs. large-cap stocks (Source: Goldman Sachs)

Why should I care?

This revelation merely underlines my opening point: that you may need to be more selective about which stocks you’re picking in 2021, rather than simply buying an entire continent-wide index. Luckily, I’ve got a few ideas on that front.

My approach to putting this idea into practice involved running a simple stock screen with the following variables:

1️⃣ Western European stocks in the STOXX 600 Europe index

2️⃣ market value below $10 billion (which also includes “mid-cap” companies)

3️⃣ share price remains below pre-pandemic peak of February 19th 2020

4️⃣ at least 10 analysts following the stock, with an aggregate “buy” recommendation – in order to filter out structurally struggling stocks

5️⃣ at least 10% upside implied by the median analyst price target.

The result? These 28 cheap-looking smaller European stocks:

Screen of European small- and midcap stocks
Source: Bloomberg

Of course, less-traded small- and mid-cap stocks are more risky, with the potential to see greater swings down as well as up. I’d encourage you to do some more homework to figure out whether these sorts of stocks are suitable for your portfolio. If they are, then you might want to consult Stéphane’s recent Insight for help on sizing any investment.

You could also, of course, minimize risk and hassle by taking investment bank Goldman Sachs’ advice and just buying UK and German small-cap indexes in particular. Exchange-traded funds (ETFs) like the iShares MSCI UK Small Cap ETF and the iShares MSCI Germany Small-Cap ETF offer a simple solution there.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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