avesco Sustainable Finance:
Opportunities through small caps in turbulent times

ChampionsNews: Since the beginning of 2022, the performance of small companies has followed only one direction: downward. Isn’t investing in small companies a bet against large companies that cannot be won?

Oliver N. Hagedorn: The likelihood of failure is higher, particularly in uncertain times. Therefore, it is understandable for investors to question why they should invest in small companies. In short: historically and statistically, it has been worthwhile.
Let's take a moment to consider the big picture. There have been plenty of catastrophes that have occurred over 94 years. And yes, in all these crises, small caps were always the biggest losers, as investors typically seek refuge in larger companies, or large caps, during times of crisis.
Yet, small caps have been the best performing asset class in six out of ten rolling annual periods. For large companies, this was only the case in two and half out of ten years.
We compared European stocks of small, medium, and large companies (see Fig. 1). Even when looking at a 15-year period, it becomes evident that small caps have been a good choice. Over the last 15 years since the financial crisis of 2008, European small caps have outperformed large caps by an average of 1.4 percent annually.

Regarding volatility, this often plays a significant role in investments in small caps. How do you address this in your investment process?

It's true that small companies carry higher operational risks. They often have a low equity ratio, in conjunction with low free cash flow and a low EBIT margin. With the avesco Sustainable Hidden Champions Equity, Share Class I (DE000A12BKF6) / Share Class R (DE000A1J9FJ5) (SHC Fund), we invest in stocks and stock-like securities of European, usually lesser-known continental and global market leaders (Hidden Champions) with sustainable business models, primarily in the small- and mid-cap sectors, where responsible corporate governance is ensured (see Fig. 2).
Due to their world-leading positions in a niche market and their low visibility, these firms are known as Hidden Champions. The companies within the SHC Fund adopt a holistic approach to sustainability, integrating it uniformly across ecological, economic, social, and corporate governance aspects. The way they are evaluated follows a bespoke sustainability framework devised by avesco. With the sustainability transformation, these markets are growing in size and significance, providing our Hidden Champions the opportunity to evolve into major industry players.

Which key figures do you attach particular importance to when selecting the Hidden Champions for the portfolio of the Sustainable Hidden Champions Equity Fund?

The fund operates on a systematic management approach, where assets are actively identified, analysed, and invested based on a defined investment process. For instance, German firms had an EBIT margin of seven percent in 2022. In our fund, this was 12.15 percent. This indicates that our chosen hidden champions were markedly more profitable than the average German company. Impressively, in 2022, these sustainable hidden champions largely maintained their EBIT margins, as they were able to pass on their higher costs. This demonstrates their pricing power (refer to Fig. 3).

How do you steer your fund through the current turbulent times?

Let's first consider the universally applicable, broader picture: the risk of market timing. Scientific evidence shows that significant market downturns are rare and usually short-lived. Also, the principle of investment duration applies: pragmatically speaking, you should not invest in stocks if the investment horizon is just a few years. For those looking at an investment period of ten years or more, market downturns are manageable. Statistically, the rallies following a crisis are often two to three times as long. During phases of market recovery, the Sustainable Hidden Champions (SHCs) we have selected enjoy a distinct advantage: they have a higher equity ratio than DAX corporations. This means they require less debt financing, making them less dependent on rising or high interest rates. In times of crisis, Hidden Champions offer additional benefits (see Fig. 4).

Conclusion

We regard the agility and adaptability of the small and mid-cap companies within the avesco Sustainable Hidden Champions Equity as positive attributes, even in turbulent times. Hidden Champions often emerge from crises strengthened, actively leveraging them as chances for innovation and growth.

Note:

The questions and answers in this article are based on the webinar "And the crisis greets us daily: Through turbulent times with the SHC fund" with avesco Founder & CEO Oliver N. Hagedorn.