European small-cap funds are good option

Buying shares of the biggest European exporters seemed like a winning strategy earlier this year as the euro weakened.

But as overseas demand failed to live up to its billing, smaller companies have ended up being the much better bet. They've rallied four times as much in 2015, up 8.8 percent. Companies in the Euro Stoxx Small Index benefited from the recovery at home and offered shelter from an emerging-market slowdown, the commodity rout and the Federal Reserve's interest- rate increase.

And there's more to come, according to Pictet Asset Management, whose European small-cap fund has beaten 94 percent of rivals to gain 24 percent this year. Improving consumer and business confidence as well as European Central Bank stimulus means staying local in Europe remains the better option, according to the money manager.

"Profit growth still held on in Europe even as global growth fears intensified," said Guillaume Chagnard, a product specialist on the small-cap equities team of Pictet in London. His firm oversees 134 billion euros ($147 billion). "Smaller companies will benefit from Europe's improving economy, without getting hit as hard by the commodity and oil rout. When you consider that earnings are still far below the 2007 peak, then there's good potential here going into next year."

Investors rushed to buy exporters in the first quarter, after a plunge in the euro ignited speculation that the weaker currency would translate into higher profits. That trade was quickly undone as concerns about the health of the global economy escalated, roiling markets in the second half of the year. But while forecasts for U.S. growth fell for both 2015 and 2016, projections for a European recovery remained largely intact.

At the same time, the region's small-cap stocks fared better than large companies during the August-September rout. That's because members of the Euro Stoxx Small Index get about three-quarters of their sales from Europe, according to data from the 42 of 85 firms that provide the information. That compares with less than half for those on the Euro Stoxx 50 Index.

Recent euro-area data from manufacturing to unemployment and economic confidence have given investors more evidence of a resurgence at home, as has last quarter's earnings season: only 14 percent of Europe's domestically focused companies missed revenue estimates, versus 37 percent for exporters, according to a Barclays Plc note from Nov. 30.

While small caps in Europe have become one of this year's top trades, the potential for further gains is limited, according to Wouter Sturkenboom at Russell Investments. He cites the risk that emerging-market stress will spill over to derail the region's fragile recovery, and says any rout is likely to see this year's winners being sold off first -- and faster.

"Most of Europe's domestically-led outperformance should be behind us," said Sturkenboom, Russell Investments' senior investment strategist in London. "We're now entering a dangerous environment where you have expensive valuations, a disappointing global business cycle and fading momentum in financial markets. It's difficult to look at the world in 2016 and see where any surprise could come from."

Small caps are 29 percent more expensive than large caps in Europe, according to valuation data based on projected earnings. While high multiples mean that investors need to dig deeper to find good buys, the divergence between global growth and Europe's recovery makes those stocks even more compelling, says Lorenzo Carcano, a fund manager at B Metzler Seel Sohn & Co. in Frankfurt.

"The case for owning European small caps in a low-growth environment is even stronger because they have higher growth potential in earnings than large caps," said Carcano, whose 601 million-euro European Smaller Companies fund has beaten 97 percent of its rivals in 2015. "Sometimes you have to be a contrarian. Yes, the strong dollar is good for exporters, but global demand has been disappointing."