European Small Companies: Structural growth in a low-growth world

Author: Andrew Paisley, head of Smaller Companies, abrdn

It has been three tough years for European investors in small companies that have a bias towards quality and growth. The sub-sector has lagged larger companies and the small cap market in general. It has also underperformed value stocks.

Several factors drove adverse market sentiment, with the speed and magnitude of rate hikes being the main ones. Market participants punished longer duration assets for any hint that rates would remain "higher for longer". Consequently, quality and growth stocks faced sell-offs. But this dynamic has changed. Developed economies are slowing. Inflation is largely under control and most central banks have reached the end of their rate tightening cycles. Therefore, the next moves will be downward, although the timing and magnitude remain uncertain. Historically, small and mid-cap companies outperform large companies when central banks start cutting rates. Admittedly, this chart relates to the US, but we believe there is sufficient analysis relating to other small cap geographies to make similar assumptions about performance.

Small-caps outperform after a rate cut

We expect quality and growth to fare well in a slowdown. Investors should start to distinguish between companies with strong balance sheets and weaker companies that need to refinance at higher rates or turn to shareholders for additional capital. Quality small caps with operational momentum, defensible competitive advantages and access to capital should do well. This includes companies that can grow independently of the external environment, through structural factors and management initiatives. Finally, valuations are at attractive levels, in historical terms, particularly for quality growth stocks.
We believe these factors should mean that quality and growth are back on the menu. The key, however, is to find the stocks with the potential to deliver results in their respective fields.

How does abrdn translate this into practice?

Rational, a leading kitchen supply company, has built a reputation for high quality products and a commitment to customer satisfaction. With a range of innovative, efficient and reliable kitchen appliances, Rational supplies professional kitchens around the world. Their dedication to research and development has resulted in cutting-edge solutions that improve kitchen workflow and energy efficiency. Combine flexible pricing with a leading presence in a niche market and it is clear why Rational could be an attractive long-term growth opportunity.

We believe that companies that help promote and deliver more sustainable production and consumption will have a bright future. Take Borregaard, for example. It uses innovative technologies to transform wood and other biomass into advanced, environmentally friendly chemicals. Its various products are used in agriculture, construction and pharmaceuticals. More than 90% of its revenues come from its alternatives to petroleum products. There are also structural factors driving future growth, including favourable regulations and continued demand for sustainable products. We believe that this combination of quality, growth and environmental responsibility makes Borregaard a leader in the bio-based chemicals sector.

Automation has revolutionised warehouses around the world. But given the complexity involved, security is paramount. Troax is one of the world's leading manufacturers of security solutions. The company specialises in high-quality mesh panel systems for machine guarding, warehouse compartmentalisation and property protection. They are used in a variety of industries, including automotive, manufacturing and logistics.

Troax's dedication to product development, combined with its ability to respond to the needs of niche markets, is a growth factor that can position it for further expansion. One interesting area is active safety. This involves warehouse workers equipped with sensors that warn forklifts of their proximity, causing the vehicles to slow down and avoid collisions. Although still in its early stages, this example demonstrates Troax's dedication to innovation.

Conclusion

Could the time be ripe for small-cap, high-quality growth stocks? We are optimistic. In the face of a recession, many investors will look for those companies that can offer sustainable returns. They may also be tempted by historically low valuations. As always, we advocate a fundamental, bottom-up approach to stock selection. It is through the application of this process that companies such as Troax, Borregaard and Rationale come to the fore.