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Europe, Europe Small Caps

Why European Small Caps Performed Strongly in 2013

by Christopher Gannatti, Associate Director of Research on February 6, 2014

European equities have been in focus since approximately the second half of 2013 and into early 2014. After the global financial crisis of 2008–09, it was easy to find reasons to express negative viewpoints about Europe. However, as is so often the case in equity markets, the crisis occurred, valuations adjusted downward, and then performance started to turn around.

When Did Performance Start to Turn Around?

Whether one looks at the performance of the S&P Europe 350 Index (large-cap European equities) or the MSCI Europe Small Cap Index (small-cap European equities), the notable shift in performance from downward/flat to an upward trend occurred in June of 2012.1 It’s interesting to us that the performance shift occurred approximately one year prior to the European equity markets coming into serious focus for investors.

Being Economically Sensitive

Some of the best times, historically speaking, to consider different equity markets have been points of inflection—when the characteristics of a market shift in such a way as to bring new information to light and function as a catalyst for investors to change their thinking. In the second half of 2013, discussions about Europe’s economic growth prospects improved. This occurred at the same time as economic growth expectations in emerging markets were largely adjusted downward. People started having more confidence in Europe not only because its growth prospects were improving but also because, judged against the other regional allocation options, Europe was improving its stature and started looking better as a potential allocation option.

Positioning oneself to take the greatest potential advantage of this shift involves two elements, in our view:

Small Caps: In regional equity markets around the world, small-cap companies are often the most nimble. As economic growth expectations improve, they are the fastest in adjusting their business models to take advantage of the new situation. They also tend to have a greater share of their revenue streams coming from their local markets than do large-cap, global exporters.

Industrials & Consumer Discretionary: These are some of the sectors within small-cap stocks that are the most highly leveraged to changing economic growth prospects. Consumer Discretionary firms can quickly respond to the uptick in consumption of discretionary items as consumers feel better about their future economic prospects. Industrials can increase their capital spending initiatives as they prepare for the increased demand for their outputs from their customer bases.

The WisdomTree Europe SmallCap Dividend Index Was Strongly Exposed to These Elements

Between June 29, 2012, and December 31, 2013, the WisdomTree Europe SmallCap Dividend Index (WTESC) had an average exposure of greater than 40% to these two sectors (Consumer Discretionary and Industrials). WTESC also has its annual rebalance in June of each year to refocus on the small-cap segment of the dividend-paying equity market in Europe.

Did Exposure Translate to Performance?

Below, due to the availability of data, we note the performance of WTESC against the performance of the S&P Europe 350 Index, an index designed to measure the performance of large-cap European companies.
 
WTESC Captured the Trend of Improving Equity Performance in Europe (6/29/2012–12/31/2013)

Average Annual Returns (as of 12/31/2013)

Outperformance by More Than 45%: WTESC outperformed the S&P Europe 350 by more than 45% cumulatively from the June 2012 inflection point of Europe’s market, with a total return of over 80% over the 18-month period.

Industrials & Consumer Discretionary Explain One-Third of Differential: WTESC’s attribution relative to the S&P Europe 350 was helped in 9 out of 10 sectors, the exception being Financials (which had strong performance in both large caps and small caps but were under-weight in WTESC). Of the greater than 45% performance advantage, nearly one-third was explained by two sectors—Consumer Discretionary and Industrials—which both had some of the strongest returns in the small-cap category compared to the large-cap category but also received more than twice the cumulative weight in small caps than in large caps.

Cyclical Recovery Drivers: The next two sectors most responsible for WTESC’s outperformance continue along the theme of a cyclically driven recovery. Information Technology is a sector that is sensitive to economic trends, and it received almost 4x the weight in small caps than in large caps, and these stocks had much better returns than European large caps in general. Also, Consumer Staples, a more defensive and less cyclical sector, is under-weight in small caps compared to large caps, and that under-weight contributed to WTESC’s outperformance.

Completion with Economic Sensitivity

When investors think about Europe and making an allocation, many times their first thoughts are for the more well-known large-cap companies. While these have certainly performed well, we believe that investors who are excited about Europe’s improving economic prospects should complement their positions with exposures to European small caps. These strategies may have the potential to capture the economic sensitivity driving the allocation decision in the first place.
 
1Source: Bloomberg. Period: 6/29/2012 to 12/31/2013.

Important Risks Related to this Article

Investments focused in Europe are increasing the impact of events and developments associated with the region, which can adversely affect performance. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility.

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