European small caps have provided rich pickings for investors in recent years. However, with political uncertainties and elevated valuations looming over the region, most conservative investors believe that European stocks in 2018 may not be as optimistic as they were in 2017. As the award winner of Best-in-Class in Europe Equity, Aberdeen Standard Investments is highly qualified to enlighten our readers. We talked to Andrew Paisley, Fund Manager – European Smaller Companies, to find out whether the tailwinds still exist and how they manage to uncover small caps with huge potential.
BENCHMARK (BM): Congratulations! Could you tell us about your investment approach and how it added value to your portfolio in 2017?
Andrew Paisley (AP): Sure. We generally look to invest in high-quality companies with sustainable business franchises that can deliver repeatable growth. Our bias is toward profitable and cash-generative companies. Over the years, this approach has allowed us to identify many world-beating European businesses, often market leaders in their niches, that were underappreciated by the market.
BM: As far as I know, small companies are generally more sensitive to the health of the economy than their larger counterparts. After the strong run in 2017, what do European small caps say about the European economy? Do you expect the rally to extend into 2018?
AP: Actually, we tend not to focus much of our time worrying about the macro outlook. Rather, we focus on the individual, bottom-up company fundamentals of our investments. From a portfolio perspective, we look to take as much of our risk as possible at a stock-specific level, rather than at a factor level. Currently, the level of stock-specific risk in the portfolio is over 80%, which is where we like it to be. In our opinion, we don’t have a particular edge when it comes to macro factor movements, but we believe we do have an edge and can add value at the individual-company level. So, as long as the macro scenario isn’t deteriorating sharply, we believe that the companies we invest in should be able to grow in line with their plans.
BM: On the flip side, what kinds of risks will European small caps be subject to in 2018? And how is your portfolio positioned to weather these volatilities?
AP: Smaller companies tend to be driven more by company-specific risks than macro factors, and we think our approach of focusing on high-quality smaller companies provides investors with a significant degree of downside protection during market downturns while still outperforming over the long term. As bottom-up fundamental stock pickers, we are not trying to time the market or predict macro events but rather focus our attention on finding the smaller companies that have resilient business models and are in control of their own destiny.
BM: With nearly one-third of your portfolio allocated to the UK, how will Brexit negotiations affect UK small caps, as well as your portfolio, in 2018?
AP: The ups and downs of the Brexit negotiations are likely to prompt some volatility from time to time. Of course, there is a range of potential Brexit scenarios, and any sense that the UK is facing a higher probability of leaving on unfavorable terms would be likely to have a large impact on more domestically-focused companies. However, the UK small cap universe also contains numerous companies that look overseas for the bulk of their earnings, and these companies should prove more resilient to such swings in sentiment.
Our process has uncovered a number of UK-quoted high-quality companies with excellent growth prospects and good momentum. Our in-house quantitative tool – the matrix – has highlighted a number of them as potentially interesting investments. Generally, they are UK-quoted companies with a high degree of international earnings rather than domestically focused companies. BM