Montanaro European Smaller Companies Trust: earning its crust

From seemingly endless political drama to the old-fashioned nature of its key industries, the European equity market has done little to electrify the investment space over the past decade. Yet the region has quietly had moments of brilliance. Notwithstanding its lack of the glamour, the FTSE Europe ex UK index has far outpaced all other major regional equity indices bar the S&P 500 over the past five years. Perhaps, more importantly, Europe seems to offer a good hunting ground for dedicated stockpickers in both good times and bad, with a handful of active managers generating strong returns over the years.

Add to this a focus on the small-cap market, where company coverage is low and inefficiencies abound, and you have a recipe for success. That has at least been the case for Montanaro European Smaller Companies Trust (MTE). The fund has had a stellar 2021 so far, with robust performance driving a year-to-date share price total return just shy of 30 per cent as of 26 November. Combined with a particularly strong 2020 and other previous gains, the trust is currently one of the best performing funds available in the UK in the five years to that date.

The investment team bets on the fact that smaller companies tend to outperform bigger peers. The trust benefits from the large choice available in Europe, with thousands of small-cap names to pick from. The manager also exploits the lack of research in small caps and associated market inefficiencies. An in-house team of eleven sector specialists use their own knowledge and a set of proprietary screens to generate ideas. The edge that this level of resources provides has arguably grown since the 2018 introduction of the Mifid II regulation, something that put a squeeze on the distribution of broker research in the small-cap space.

Like many successful active funds, Montanaro European Smaller Companies has a relatively straightforward mantra that it follows closely. The team will exclusively back “quality growth” names: these must be profitable, have good and experienced management, deliver sustainably high returns on capital employed, enjoy high and ideally growing profit margins, and provide goods and services that are in demand and should remain so. The team also likes companies that can “deliver self-funded organic growth and remain focused on their core areas of expertise, rather than businesses that spend a lot of time on acquisitions”.

Like some other successful stockpickers, the trust’s investment managers attempt to maintain a disciplined focus on valuation while also keeping portfolio turnover low. Notably, the team also has a long track record of embedding environmental, social and governance (ESG) factors into company analysis, with an ESG checklist used to rank different businesses. The trust lists the portfolio’s carbon, waste and water intensity in its monthly updates.

In a world where different asset managers are now clamouring to present themselves as ESG aficionados, funds like these with an established process and a convincing track record could do a good job of attracting loyal new investors and riding the sustainability wave.

Thick and thin

So far, so good. But what sets this fund apart from some of its peers is a sense of resilience and consistency. It has generated strong returns for several years in both net asset value (NAV) and share price terms, but the last year has arguably been a particularly reassuring one for investors. If the cyclical rally that set in from November 2020 and burned brightly for a few months initially appeared to be a test for advocates of the quality investing style, this trust has shown its resilience. The shares, like the portfolio NAV, have certainly had a few dips but have largely been on the rise.

As with other successful active European equity funds, a look at Montanaro European Smaller Companies Trust’s holdings shows that innovative businesses can still be found in what appears to be a sleepy part of the world. The fund’s biggest position at the end of October was in NCAB (STOCK:NCAB), a supplier of printed circuit boards, representing 5.3 per cent of assets. Other major positions include Fortnox (SWED:FNOX), a Swedish provider of cloud-based applications for accounting, invoicing and payroll administration, and Sartorius Stedim Biotech (GE:SRT). Its top 10 positions made up around a third of the portfolio.

Another focus for the team is on diversification. This shows in the most recent factsheet. The fund had 57 different holdings at the end of October, with allocations spread out across sectors and geographies. Its biggest recent sector allocation was to information technology, making up 31 per cent of the portfolio, followed by a 22 per cent weighting to healthcare and 20 per cent in industrials. The two countries best represented in the portfolio were Sweden and Germany. However, it should be noted that the team is focused on stock selection rather than sector plays or macroeconomic concerns.

One problem with the trust may be that its success is already priced in by the market. The trust’s shares traded on a 2.9 premium to NAV on 29 November, putting it out of sync with the discounts on European small-cap peers European Assets (EAT), JPMorgan European Discovery (JEDT) and TR European Growth (TRG) and similar pricing on most of the all-cap European equity trusts.

Perhaps, more importantly, the Montanaro shares look expensive relative to their own recent history: its average premium in the 12 months to 29 November comes to 0.3 per cent, making it look expensive by one metric discussed in this week's funds feature. Investors buying in at a higher price than normal may well worry about the portfolio falling out of favour or Covid-induced volatility spelling trouble for returns. Shareholders may naturally question whether the sheer strength of recent performance can be maintained. Equally, some might wonder if any further volatility can temper the recent premium or even move the shares back to a discount.

While prices might look slightly challenging and difficulties could lie ahead, it is worth stressing that this is a holding for the long term. As the investment team put it in a commentary earlier this year discussing the prospect of another resurgence for cyclical assets: “We will keep our heads down and carry on investing in the same way as always – with our 'quality growth', buy and hold hats firmly on.” On a longer view the performance has certainly held up: the trust has had an annualised share price total return of 19.9 per cent over the past decade.

With the Covid-19 situation still looking far from resolved and market rotations blindsiding investors in the past year, funds with consistent and dependable processes continue to prove their value. With its deep resources, a focus on quality and valuation discipline, Montanaro European Smaller Companies Trust is a proven outperformer for the long term.