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Mind the GARP in Nordic Stocks

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Stockholm (HedgeNordic) – Due to their inherently small domestic markets, Nordic companies have been compelled to set their sights on the global stage from an early stage in their development. This has created fertile ground for a multitude of smaller companies capable of sustained growth beyond the limitations of local borders. With approximately 90 percent of all listed companies in the Nordics falling into the category of small or micro-cap companies, this region offers an attractive playing field for active stock pickers, such as Nordic fund managers Jan Brännback and Janne Lähdesmäki from Schroders.

“Historically, the Nordic region has been the region with one of the strongest, if not the strongest, operational growth, both on the top- and bottom-line, at the small-cap index level,” points out Brännback, who co-manages Schroders Nordic Smaller Companies and Schroders Nordic Micro Cap since their launch in March of 2022. “Nordic small and micro-cap companies have enjoyed higher growth of revenues and earnings, with a significant portion translating into free cash flows, compared to large caps in the region and other markets, and also compared to European small-cap indices.”

“Historically, the Nordic region has been the region with one of the strongest, if not the strongest, operational growth, both on the top- and bottom-line, at the small-cap index level.”

“These attractive fundamental characteristics of the market represent the key attraction for us as stock-picking managers,” emphasizes Brännback. The Nordic markets have also grown significantly in breadth in recent years, with about 1,650 listed companies across the region compared to fewer than 700 a decade earlier, with nine out of ten companies falling in the small and micro-cap category. Nevertheless, this extensive selection comprises a mix of both robust and fragile businesses.

“The selection is wide, but you obviously get a mixed pool of both good and bad businesses,” argues Lähdesmäki. “There are companies that will not survive and do not have a sustainable business model,” elaborates Brännback. This underscores the importance of active stock picking. “History, however, shows that on a net basis, the winners have thrived and the Nordic equity markets have been superior both operationally and from a return perspective.”

“The selection is wide, but you obviously get a mixed pool of both good and bad businesses.”

There are many quality businesses in the large-cap space as well, but offer fewer opportunities for mispricing. “You have 20 analysts covering larger companies on a daily or weekly basis, compared to hundreds and hundreds of listed small Nordic companies with no sell-side coverage,” says Brännback. “The likelihood to find a mispriced asset there is much higher than in the large-cap, where it’s overbrokered, overanalyzed, and also driven significantly by passive money.”

The GARP Approach

Jan Brännback and Janne Lähdesmäki use the investment philosophy of seeking quality growth at a reasonable price – quality GARP – to find winners in the universe of Nordic small- and micro-cap stocks. Quality assumes significant importance in the case of small businesses, which are generally more niche and don’t have as many legs to stand in terms of diversification.

“We look for quality growth,” says Brännback. “We look for growth in the top line and capital-efficient growth, reflected by the quality metric of high return on invested capital,” he elaborates. “Our ideal companies, once at scale, should generate good cash flows to reinvest into their businesses so that they can compound the growth on the top line by expanding the offering or entering new markets.”

“Return on capital employed is the hallmark of a well-run company.”

“Return on capital employed is the hallmark of a well-run company,” stresses Brännback. In the micro-cap space, the team is ready to invest in businesses with a healthy growth profile and a high gross margin before the high returns on capital start being reflected in financial statements. “In such cases, we look for gross margin, which is a good measure of the value added by the product or service these companies offer.” Additionally, a higher gross margin shortens the path to profitability by improving fixed cost absorption.

Return on capital employed and gross margins are important indicators of quality in numerical terms. These indicators, however, reflect the companies’ strong intellectual property (IP), and pricing power, among other economic moats protecting their businesses against macroeconomic challenges and competition. “We try to focus on companies that have unique products, often protected by IP and challenging to replicate,” explains Lähdesmäki. The team also avoids investment in companies with generic products, which often face fierce competition and price pressure. “Being smaller isn’t very helpful if you are fighting with the prices,” says Lähdesmäki. The Schroders team also considers qualitative factors. “We keep track of delivery on what the company’s management team says, on strategy delivery.”

Mind the GARP

Although small-cap stocks have historically outperformed larger ones due to higher growth potential, small-cap stocks are typically more vulnerable to rising interest rates, liquidity issues, slowing economic growth, and broader market uncertainty. The small-cap market has vastly underperformed the broader large-cap market since Schroders launched the two funds in early 2022. This trend is not limited to the Nordics but extends to the United States and Europe as a whole.

“We are bottom-up investors and are not focusing on the macro side, but we are affected by the macro.”

“Operationally, the smaller cap companies have not been having a tougher time compared to larger companies, but the underperformance of small-cap stocks in the Nordics has been rather a function of asset allocation out of this segment and lack of liquidity,” explains Jan Brännback. “We are bottom-up investors and are not focusing on the macro side, but we are affected by the macro,” he argues. “It is clear that this higher yield environment has been a trap for small-cap investors,” he continues. “It has been more pronounced here in the Nordics, where the smaller the company, the worse the performance.”

Investors with a long-term mindset, however, are rewarded for the higher growth associated with smaller-sized companies along with the risk premium linked to lower liquidity and higher operational risk. “That is why the long-term returns have been higher for smaller-cap stocks,” says Brännback. 

“I cannot recall a time when the difference in valuation has been this deep.”

The median growth rate for the micro-cap segment in the Nordics is in the low teens, about three or four times that of large-cap companies. At the same time, valuations have significantly decreased on an index level, with Nordic small-cap stocks trading at a 25 percent discount to large caps. In the micro-cap space, if comparing profitable micro caps versus large caps on a like-for-like basis, the discount on a price-to-earnings multiple is over 40 percent. “I cannot recall a time when the difference in valuation has been this deep,” concludes Brännback.

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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