A lot has been made of the concentration in the US market, but the concentration of European markets has been less widely discussed. Just as the S&P 500 has been focused on a handful of large cap companies linked to a narrow theme, the MSCI Europe also has a significant weighting to Novo Nordisk and ASML, linked to the growth of weight loss drugs and AI.

The two companies are now almost 10% of the index between them[1] and their strong performance over the last 12 months has been an important part of market performance. ASML is up 35% over the past 12 months[2], while Novo Nordisk is up 40%[3]. It replicates the vogue for larger capitalisation stocks seen elsewhere, while other parts of the market have been widely neglected.

This has created some clustering among European trusts. Over the past year, in NAV total return terms, Henderson European Trust, Fidelity European Trust, BlackRock Greater Europe and JP Morgan European Growth & Income[4] have all been within a single percent of each other. They all have ASML and Novo Nordisk as their top two holdings and all hold a weighting of more than 10% across the two stocks. BlackRock Greater Europe is the highest, with almost 20% across both stocks.

Baillie Gifford European Growth holds ASML, but at a lower weight, while European Opportunities Trust has a 14% weight in Novo Nordisk, but does not hold ASML. Performance for both trusts has been weaker than their peers over one year, albeit better than their recent history. This is reflected in discounts, with Baillie Gifford European Growth on 14.6%, European Opportunities Trust on 10.8%, but Fidelity European and BlackRock Greater Europe on just 5.3% and 5.9% respectively.

Small caps have remained firmly out of vogue. Although performance has markedly improved for small cap trusts – with Montanaro European Smaller Companies and JPMorgan European Discovery Trust up 18.2% and 20.2% in NAV terms over the past 12 months[5], discounts have remained persistently higher. Montanaro European Smaller Companies is currently sitting at 13.1%. As with US market, it has been hard to move away from the mainstream in Europe.

Revaluation?

The question is now whether this situation might change. The economic backdrop gives few clues. By some margin, Europe remains the slowest growing economic area. The IMF forecasts growth of just 0.9% in 2024, behind the US (2.6%), Asia (5.4%) and even Latin America (1.9%)[6]. The economic data remains distinctly mixed. There is private sector growth, but it is confined to certain countries, and the region’s largest economy – Germany – remains mired in difficulties.

Inflation is slowing and the European Central Bank (ECB) has now enacted two rate cuts, which ought to boost economic growth. This might have created a buzz around European equities had the Federal Reserve not now stolen its thunder with a 0.5% cut. Equally, as far right parties gain ground, the uncomfortable political situation may also deter some investors. This has been evident in the weakness of the French market during its hotly contested parliamentary elections.

Both George Cooke, manager on the Montanaro European Smaller Companies trust and Luca Emo, co-manager on the European Opportunities Trust, are clear that they do not need economic growth to come through for their companies to do well. Cooke says: “We’re looking for companies that, through a cycle, can grow in excess of GDP. The economic environment is a minor point – they need to be taking market share, or developing an innovative new product that is disrupting a market. We want companies in control of their own destiny.” That said, he admits that lower interest rates are helpful, particularly for sentiment.

Emo is also looking for growth themes that can transcend economic performance. More recently, the trust has been buying defence companies, including BAE Systems and Dassault Systèmes, believing this is a “game changing” time for European defence spending. The trust is light on consumer discretionary companies, but has been buying companies such as Infineon, which is plugged into the energy transition theme.

M&A boost

Cooke says that a tick up in mergers and acquisitions (M&A) activity is proving useful in driving share price performance. Private equity and other larger companies have started buying smaller companies. “That tells us the smart money thinks there’s value”, Cooke adds. This is also happening among the larger companies held by European Opportunities Trust. One of its top performers has been UK-listed cybersecurity group Darktrace (the trust is differentiated from peers in that it has adopted a pan-European rather than a Europe ex UK mandate), which was taken out by private equity buyers.

However, in the end, it may just be performance and valuation that encourages investors to explore beyond the mega-caps. Cooke says: “Small company valuations have dropped to levels as cheap as we’ve seen. They’ve been steadily de-rating. Investors now pay a lower valuation for small cap than they do for the average company.”

This has had little to do with their operational performance, which has continued to keep pace with that of their larger peers. Cooke says small caps are still not being given the credit they deserve. “The risk reward for them is looking very favourable versus some of the large companies.” Any signs of recovery are ‘anecdotal and single data points’, he says, but he points out that when there was a big drop in the Nasdaq at the start of August, small caps rose. He believes this could be the first sign of a more enduring change.

Marcel Stötzel, co-portfolio manager at Fidelity European Trust, has also been looking at companies that are beneficiaries of falling inflation in an acknowledgement that the environment is changing. This includes capital intensive businesses such as Ryanair, which is benefiting from lower jet fuel and wage costs. French electrical company Legrand is tapped into datacentre growth, which makes it a ‘picks and shovels’ play on AI.

However, it may still take more market confidence to tempt investors out of the intuitively ‘safe’ growth names such as Novo Nordisk and ASML, where valuations may be higher, but the growth trajectory is clear. While there are tentative signs that this is happening already, particularly for smaller companies, investors may need more proof before discounts start to narrow.

[1] https://www.msci.com/www/fact-sheet/msci-europe-index/05836521

[2] https://www.marketwatch.com/investing/stock/asml

[3] https://www.marketwatch.com/investing/stock/novo.b?mod=mw_quote_switch&countrycode=dk

[4] https://www.theaic.co.uk/investment-company-screener#?filtersSelectedValue=%7B%22aICSectorId%22:%7B%22id%22:%22LC00000611%22%7D%7D&page=1&perPage=10&sortField=cumFairNAVReturnM12&sortOrder=asc&universeId=CEWWE$$ALL_5549

[5] https://www.theaic.co.uk/investment-company-screener#?filtersSelectedValue=%7B%22aICSectorId%22:%7B%22id%22:%22LC00000613%22%7D%7D&page=1&perPage=10&sortField=cumFairNAVReturnM12&sortOrder=asc&universeId=CEWWE$$ALL_5549

[6] https://www.imf.org/en/Publications/WEO/Issues/2024/07/16/world-economic-outlook-update-july-2024#Projections