Montanaro European Smaller Companies Trust (MTE) aims to achieve capital growth by investing principally in smaller, quoted, Continental European companies (those within the European Union, Norway and Switzerland) but is not restricted from investing in smaller companies quoted on other European stock exchanges. The benchmark index is the MSCI Europe ex UK Small Cap Index in sterling terms.
The original company dates back to 1981, but Montanaro Asset Management Limited (MAML) took on the management of the trust in September 2006 and the European small cap investment approach dates from that time. MAML had £2.2bn of assets under management at the end of 31 July 2019.
In an environment of slowing growth in Europe, Brexit issues, a US/China trade war spiralling into a currency war and negative bond yields/ inverted yield curves, where the cost of borrowing for the short-term is more expensive than the cost of borrowing for the longterm and usually a predictor of recessions, it might be tempting to hide, ‘ostrich-like’, in cash.
MTE offers an alternative solution. Its managers see little reward in trying to game the swings in macroeconomic sentiment. Instead, MTE’s manager’s focus is on picking stocks – identifying growing companies with strong business franchises, high-quality management, earnings and corporate structures.
MAML believes that it has the largest and most experienced team in Europe, specialising in researching and investing in quoted small- and mid-cap companies. It is about to further strengthen the team by hiring an 11th analyst. It is well-positioned to take advantage of the market inefficiencies that falling analyst coverage has created.
MTE has had strong performance relative both to its benchmark and its peer group. The trust held its own against the benchmark until 2018, but accelerated away once concerns started to build about the pace of economic growth in the first quarter of 2018.
Against the peer group, MTE lagged a little in 2014/15 as investors become less risk averse and lower quality stocks performed well. MTE delivered a net asset value (NAV) total return of 315.8% over the 10 years ended 31 July 2019 and 352.7% in share price total return terms. This compares to 237.8% for its MSCI European (ex UK) Smaller Companies Index benchmark and an NAV total return of 282.6% for the next best performing European small cap investment trust, European Assets.
Compared with other trusts in the AIC’s European smaller companies sector, whilst a respectable size, MTE is the smallest of these and it might be hoped that its superior performance will, in time, allow it to expand. This, all things being equal, would also lower its ongoing charge ratio and improve liquidity in its shares. MTE has the lowest yield, reflecting its focus on growing companies. Looking at cumulative performance, MTE remains the best-performing fund in the peer group over all time periods.
Montanaro European Smaller Companies Price 1,030.0p
Price as at 27 August 2019
Investment strategy – undiscovered gems
MTE’s manager seeks to construct a portfolio of about 50 profitable companies. These should have simple business models; defensible, niche, market-leading positions in growing markets; high operating margins and high returns on capital, such as barriers to entry/a sustainable competitive advantage; trade at sensible valuations; and have trustworthy and high-quality management aligned to shareholders and demonstrating sound environmental, social and governance practices.
This is a strategy that works over the long-term, as is evidenced by MTE’s performance, and works well in periods of heightened uncertainty, as investors seek out businesses that are not dependent on cyclical growth. The decline in the quality and availability of external analysis, exacerbated by the MiFID II legislation, has created an environment where it is possible to find undiscovered gems – companies whose quality and growth potential is unrecognised by the market.
One attribute that MTE’s manager looks for is companies whose products or services make up a small but critical part of the end product. The manager believes that these companies have a better-than-average chance of sustaining higher margins.
MTE’s gearing (borrowing) is low when compared to its peers. After cutting it in 2018, the manager has been gradually reintroducing some gearing recently. This reflects a contrarian stance – a contrarian investor makes purchases and sales that are in contrast to the prevailing market sentiment of the time by buying unloved stocks when they are believed to be cheap and selling stocks down when they are in favour – engendered by the valuations of the stocks that they like and a reaction to the all-pervading gloom surrounding Europe and markets.
The managers’ view – weeding out anomalies
The manager (MAML) said that Fortnox and MIPS are both good examples of stocks that have become larger within the portfolio by steadily compounding their sales and earnings. Both started as fairly small positions. In Fortnox’s case, the manager believes the stock has no stockbroking analyst coverage. The manager’s style is to run these ‘winners’, hence why they have become significant positions within the portfolio.
Three companies that no longer feature in MTE’s portfolio are Cerved, ÅF and Krones. Cerved and ÅF were sold for very similar reasons – both made significant acquisitions in a departure from their usual practice. At the end of January, Italian credit analysis/credit management company Cerved announced plans to expand beyond the Italian market by acquiring Eurobank Property Services in Greece and its two subsidiaries. That acquisition was completed in April.
MTE’s manager was concerned that Cerved’s growth was stalling and its plans to expand into other countries might be indicative of a perceived lack of opportunity in its home market. It was also felt that Cerved would not have the same competitive advantage in new markets that it has in Italy.
In December 2018, ÅF and Pöyry announced a merger to form “a leading European engineering and consulting company”. The merger process was completed in February 2019. The manager felt uncomfortable with the scale of the transaction, which was a departure from ÅF’s previous growth strategy.
Krones is a manufacturer of plastic bottles. The attraction for MTE was that it was raising prices and its new chief financial officer was promising to cut its costs – suggesting that its margins and profits would rise. However, the company unexpectedly raised wages and guaranteed the jobs of its German workforce. This seemed incompatible with the promise to cut costs. Its working capital situation deteriorated too. From the manager’s viewpoint, clear cracks were appearing in the investment thesis and consequently the position was sold. Three weeks later, Krones issued a profit warning, saying its margins had halved.
In terms of purchases, Marel is an Icelandic company which supplies machinery to the food processing industry. It is a leading player in Europe, having been consolidating its industry through a combination of organic growth and small bolt-on acquisitions. Another food company, held by other funds managed by MAML, had spoken highly of Marel and helped bring it to MTE’s attention. The manager felt that Marel’s stock price might be depressed, reflecting a lack of liquidity in the stock, given that it was only listed in Iceland. When the company announced a dual listing on the Amsterdam Stock Exchange, MTE took a stake. The expectation is that investors’ awareness and interest in the company will increase. Marel should also now find it easier to raise additional capital when needed.
NCAB is a Swedish company that is not well known, probably because it is only covered by one analyst. NCAB acts a middleman in the printed circuit board (PCB) market and is a good example of the “small, but critical” group of companies in MTE’s portfolio. The manufacturers of PCBs have consolidated, and the industry is dominated by a handful of Chinese companies. Relatively small customers, as opposed to a major OEM – an original equipment manufacturer, such as a car company – have very little leverage. However, NCAB can consolidate purchase orders, helping to level the playing field.
NCAB gives preference to PCB manufacturers that it knows and where it is the leading customer. It works in partnership with these manufacturers, placing its own people in the factory to ensure ESG compliance, quality control and help make the factory more efficient. For the end customer, NCAB can advise on PCB design – weeding out costly mistakes whereby one third of designs need to be re-worked. Therefore, NCAB can add value to both sides.
NCAB’s business is not capital intensive. One attribute that MTE’s manager found intriguing was that NCAB’s most mature markets boast the highest margins. In new markets, it discounts to win business, but once integrated into a supply chain, it is hard to replace and, because PCBs represent only a small part of the cost of the end product, it can earn decent margins. There are still a few PCB manufacturers in Europe. As these go out of business, NCAB is picking up new customers. The company offers an attractive free cash flow yield and dividend yield. The manager is also comforted that NCAB reported flat operating profits in the last downturn.
Further reading: Investment trusts: a beginner’s guide