Finding Large Opportunities in Small-Cap Stocks

While the world’s expectations for US earnings growth have weakened into nearly single digits, Europe is finally seeing some positive developments after years of headwinds. At the same time, European valuations are about 40% cheaper than those in the US on the basis of the Schiller price-to-earnings ratio.1 As we survey the brightening landscape in Europe, looking for companies that meet our criteria for earnings, quality and valuations (EQV), an especially interesting area for us is in the small-cap market.

Investing off the beaten path

We tend to like somewhat esoteric companies as well as companies on the smaller end of the small-cap universe, including micro caps. Why? These companies typically have very few analysts covering them and very few institutional shareholders, so we are often able to find more attractive opportunities off the beaten path.

An example of this can be found in Romania. Romania is a frontier market, which means its economy is in the third tier of development behind developed markets and emerging markets. But what Romania has is one of the highest growth rates in in Europe, as well as many positive reforms in the areas of tackling corruption, liberalization, and privatization. Moreover, with a price-to-earnings (P/E) ratio of 9.5x projected for the next 12 months,1 Romania is one of the cheapest markets in Europe and emerging Europe.

A recent addition to Invesco European Small Company Fund and International Small Company Fund was Romgaz (1.00% and 1.50% of Invesco European Small Company Fund and Invesco International Small Company Fund as of March 31, 2015).

Romgaz is the dominant natural gas supplier in Romania. It has a strong balance sheet, with more than 20% of its market capitalization in net cash.1 It is attractively valued, with a free cash flow yield of more than 12% and a P/E ratio under 8x, not including the cash on its balance sheet.1 And, it has an attractive dividend payout ratio of 85%.1

Another positive for the company, in our view, is price liberalization of natural gas. Per an agreement between Romania, the European Commission and the International Monetary Fund, natural gas prices will be gradually aligned with EU averages over the coming years. We believe that over time, this will provide Romgaz with a meaningful source of growth above and beyond the country’s normal natural gas consumption, which tends to follow gross domestic product growth.

I believe Romgaz is an interesting opportunity and a good example of how we’re not afraid to go off the beaten path when the EQV characteristics are right for us.

Taking a long-term view of small-cap markets

While we have great flexibility in the markets we’ll consider, we remain disciplined in the questions we ask before making an investment in a company:

  • Is its earnings growth sustainable?
  • Is the company generating attractive returns and financially strong?
  • Is the stock attractively valued?

Our preference for companies with strong balance sheets has been a challenge in the recent zero, or even negative, interest rate environment in Europe — an environment that has helped companies with higher leverage. However, we take a long-term view of investing, versus the short-term view that many take in the small-cap market. Our time horizon is five years, and we believe that the tactical and strategic flexibility afforded by strong balance sheets will be a long-term strength for our holdings.

Learn more about Invesco European Small Company Fund and International Small Company Fund.

1 Source: Bloomberg L.P. as of March 31, 2015

A company’s price-to-earnings (P/E) ratio compares its current share price to its earnings per share. The Shiller P/E ratio, also known as the cyclically adjusted P/E ratio, is calculated using real per-share earnings over a 10-year period.

Free cash flow yield is a method of calculating a company’s value. It is calculated by dividing a company’s free cash flow by its enterprise value.

Dividend payout ratio is a company’s yearly dividend per share divided by its earnings per share.

Important information about Invesco European Small Company Fund and International Small Company Fund:

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks.

An investment in a derivative could lose more than the cash amount invested.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

The Funds are subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in each Fund.

Important information about Invesco European Small Company Fund:

The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

Important information:

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

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