Big returns from small companies

Small can be beautiful. Over the past five years, it has certainly paid to be invested in small and mid cap stocks rather than larger companies in Europe. In the five years to 8 January 2007, the DJ Stoxx Small 200 Eur index returned 96.76 per cent compared to 85.28 per cent by the mid cap index and just 28.87 per cent by the large cap index. A number of managers and commentators have been predicting a revival in the fortunes of large caps. But even over one year to 8 January 2007, small caps still out-performed (29.68 per cent) both mid caps (27.55 per cent) and large caps (15.98 per cent). Risky business European small and mid cap managers are generally optimistic about the outlook for this asset class despite the growth in share prices. Eric Woehrling, manager of the Martin Currie GF PEurMid Cap fund, says there is no shortage of investment opportunities among mid caps. This is partly being driven by liquidity, including M&A activity. Therefore, one risk confronting the asset class, he says, is if liquidity dries up and risk aversion increases. Mr Woehrling, however, says it is a mistake to view mid caps as a homogeneous group of stocks. “When people talk about the performance of mid caps, they are discussing the aggregate but this is obviously not reflective of all mid cap stocks. In 1997, for example, mid caps under-performed large caps by 20 per cent. But in that year, the top performing stock in the whole market was a mid cap company. “We do not have to take a view on the index but just be bullish about the 30 stocks we hold in the portfolio. I live and die by these 30 stocks. I can always find 30 stocks to invest in and there are never fewer than 150 that out-perform the MSCI index in any year. The problem is that people think all mid cap stocks are more expensive than large caps.” He adds that if investors are concerned about the outlook for mid caps generally, there are ways to take defensive positions. Sticking firm Mr Woehrling cites Deutsche Börse as an example. “There is still trading on the exchange even when mid caps under-perform.” The approach has worked since the Martin Currie GF PEurMid Cap fund was launched. Over one year to 8 January 2007, the fund returned 40.17 per cent compared to 27.55 per cent from the index. Yvette Lloyd, product specialist on the Fidelity Funds European SmCos fund, says small and mid caps started to out-perform large caps from January 2000. One reason was “their attractive valuations relative to large caps” following the bear market. The out-performance continued in 2006, says Ms Lloyd, although they under-performed in May when investors became more risk averse. This under-performance was short-lived and Ms Lloyd says mid and small caps continued to “trend upwards, most notably in the final quarter of 2006. “Key reasons include their lower exposure to the US economy when investors are concerned about a slow down and their lack of exposure to the dollar as they tend to be more domestically focused.” This leaves the question of what is the outlook for small and mid caps. Ms Lloyd says small caps are now trading at higher valuations than larger companies. “This is because larger companies have de-rated from peaks reached in 2000 at the height of the Internet bubble. The smaller company discount in terms of valuations to larger companies has now eroded.” Continued growth But Ms Lloyd says there are reasons to be optimistic about small caps. She says smaller company valuations remain only slightly above the historical average. “Earnings growth figures are still supportive of the smaller company asset class although there was some pull back in 2006. Growth still exceeds that of larger companies. M&A activity, particularly from private equity deals, has been driving smaller company performance. “Equity market volatility is still at low levels. This has historically provided an important support for smaller companies. In addition, the corporate default rate remains low, indicating that higher risk, higher return stocks should still be in demand.” Ms Lloyd says the fund currently has historically high weightings in technology, healthcare and consumer services. “The consumer sector of the smaller company market could benefit from continuing growth in European domestic markets, led by improving employment and increasing domestic demand. “Conversely, industrial cyclical companies look expensive on a valuation basis and could be adversely affected by a slowing global economy.” Damien Kohler, manager of the Parvest Europe Mid Cap fund at BNP Paribas Asset Management, also believes mid caps still offer attractive value to investors. “At the end of December, our portfolio had a pricing earnings (P/E) ratio of 16 times and earnings growth of 14 per cent. “The mid cap benchmark had a P/E ratio of 16 times and earnings growth of 12 per cent. In contrast, the large cap index is on 13 times and 7 per cent earnings growth.” Despite the expectation of a slow down in the US economy, Mr Kohler says the fund should be able to find 60 companies enjoying earnings and dividend income growth. “Mid caps will continue to benefit from merger and acquisitions activity.” The fund has reduced its exposure to oil and mining stocks. This is partly because of the fall in commodity prices while a slow down of the US economy would have a further impact. “The oil price is volatile and there are opportunities to raise our weighting at cheap prices.” Mr Kohler is optimistic about financial stocks in Europe, including Investec and Sarasin. He has also been increasing the fund’s weighting to healthcare and support services companies.

‘We are looking for companies that provide services for the environment and infrastructure such as the outsourcing of waste management’ - Beryl Bouvier di Nota, Société Générale Asset Management

Beryl Bouvier di Nota, manager of the SGAM Fund Eq Euroland M-Cap fund, argues that the macro economic environment is still positive for small and mid cap stocks. “Small and mid caps were priced on a premium to large caps last year but they out-performed large caps by 15 per cent,” says Ms Bouvier di Nota. “We are positive about small and mid caps because of the high earnings per share expectations in 2007 and 2008.” She says earnings per share growth expectations for mid caps are 15 per cent in 2007 and it is 25 per cent for small caps. In contrast, earnings per share expectations are 10 per cent for large caps. Staying positive Other positive developments, says Ms Bouvier di Nota, are the positive economic growth in Europe, including a recovery in Germany, and continuing mergers and acquisitions activity. A potential risks are companies selling to the US because the weakening dollar makes their products relatively more expensive, says Ms Bouvier di Nota. But, she adds, many companies have production in the US to serve local demand. Ms Bouvier di Nota says she focuses on stock picking to generate returns but the fund also takes a thematic approach to constructing the portfolio. “The thematic approaches are validated by fundamental and financial analysis as stock selection is a key driver of performance.” One theme in the fund at the moment, says Ms Bouvier di Nota, is the environment and energy. “We are looking for companies that provide services for the environment and infrastructure such as the outsourcing of waste management.” An example of a waste management stock is Seche Environement. Another theme in the fund are companies who have moved production to Eastern European to benefit from lower costs and thus to enhance profits. “Pfleiderer is a E1.3bn German company that provides wood panelling, such as in Poland and Russia. Selection factors “In Eastern Europe, its products cost E12 compared to E60 in Germany. Production in Eastern Europe should provide a profit margin of 30 per cent. In Germany, the EBITDA (earnings before interest, taxes, depreciation and amortisation) margin is 14 per cent. The company has expanded to the US where its EBITDA margins should reach 25 per cent.” Among the factors Ms Bouvier di Nota considers when selecting stocks are cash flow, market environment, quality of management, return on equity and capital and its valuation. She also evaluates the possibility of the company expanding and making acquisitions. The portfolio holds between 60 and 80 stocks and the fund can take “strong positions” away from the benchmark. Ms Bouvier di Nota says the fund does not take any particular investment style, such as growth or value. This can mean that at times when the market environment favours funds with distinct investment styles, the SGAM Fund Eq Euroland M-Cap fund may under-perform some of its peers. Mr Kohler at BNP Paribas says he benefits from having a team of six investment professionals. Each member of the team has responsibility for the management of a portfolio. These portfolios are allocated on a country basis. The fund uses an initial quantitative programme as a screening tool. “We also gain investment ideas from meetings with company management and talking to the large cap investment teams,” says Mr Kohler. He says there are two main factors the team looks for when deciding whether to invest in companies. “We evaluate the companies’ growth prospects and whether they can deliver this growth and the valuation of the stock. “We will not invest if a company is expensive even if it has strong growth prospects. If we believe we can make at least a 20 per cent return from a stock, we invest.” Mr Kohler adds that he focuses on ensuring the fund does not take too much risk in countries and sectors. The fund has a potential universe of 700 stocks. Mr Kohler says the fund can invest in stocks that are large caps in their home stock markets but are mid caps on a pan European basis. “We hold British Airways and International Power in the portfolio, for example,” says Mr Kohler. “But we are likely to have to sell International Power in a few months as it will become a large cap stock.” Among the factors which Martin Currie’s Mr Woehrling looks for when selecting stocks are included fast growth and companies experiencing positive change. “If there is positive change and growing earnings per share but no rise in the share price then we have to look at why this is the case. It may be because of prejudice against the sector by investors.” Recoveries He points to the oil sector as an example of how sectors can recover. “The situation changed when the oil price started rising and there were not sufficient reserves around the world. The share price of oil services companies went through the roof.” Mr Woehrling says its quantitative screening tool throws up stock ideas. Julius Baer is an example of a stock it acquired. “Julius Baer was a sleepy fund manager and private client manager. It acquired private banks from UBS and GAM’s hedge fund business in a reverse take over. They took over the management of Julius Baer, which had a positive change and led to synergies and cost reductions.” Managers are optimistic about the outlook for small and mid caps despite the strong returns of the last few years. Returns are unlikely, however, to keep pace with those of the recent past and therefore stock picking skills will probably become even more important.

‘The consumer sector of the smaller company market could benefit from continuing growth in European domestic markets’ - Yvette Lloyd, Fidelity Funds