LARGE GAINS MEANS BEING SMALL-MINDED

Small has certainly been beautiful for equity investors over the past year. Small and mid-cap stocks have out-performed large caps in all major markets.

European small-cap stocks have been no exception. Over one year to 24 January, the DJ Stoxx Small 200 index returned 17.2 per cent. It gained 19.5 per cent over three years and 5.9 per cent over five. By the end of 2004, the MSCI Europe Small Cap index was up 28.6 per cent since the start of 2003, whereas the MSCI Europe index gained just 14.2 per cent over the same period.

Goldman Sachs Asset Management (GSAM), one of the prime believers in this strategy, says there are a number of reasons why small caps will generally deliver healthy returns in 2005, even if fewer stocks will generate a greater proportion of the performance.

This is because of record company margins and cash flows and favourable underlying economic conditions, including continued economic recovery and a benign interest rate environment.

Another reason is a decline in the number of analysts covering European small-cap companies. GSAM says this means the market is more underresearched and thus potentially more inefficient than before. This should create investment opportunities. The decline in sell-side analysts, says GSAM, is due to investment banks paying close attention to costs.

VOLATILITY, LIQUIDITY

But while recent performance has been impressive, small caps are naturally more volatile than large caps.

Furthermore, liquidity can dry up quickly, making it difficult to sell shares. This volatility is demonstrated in the performance of European small-cap funds. The Parvest Euro Small Cap fund, for example, managed by BNP Paribas, has returned 23.67 per cent over the past year but -27.68 per cent over five. Invesco GT Cont Euro Enterprises has grown 18.18 per cent over one year but fallen 48.02 per cent over five.

‘European small caps will deliver positive returns over the next two years but large caps will generate higher performance’ - David Dudding, Threadneedle

David Dudding, manager of the Threadneedle Eur SC Growth 1 Euro fund, says he is cautious about investing in this sector after the recent rally. The Threadneedle fund is the second best performer over one and three years.

“We believe European small caps will deliver a positive return over the next one or two years but think large caps will generate a higher performance,” says Mr Dudding. “Small caps are trading at similar prices or are more expensive than large caps. Two years ago, European small caps were very cheap but investors did not believe at the time. It is harder to find attractive value now among small caps.”

According to Threadneedle, European stock markets in general, however, offer investors attractive value relative to the US and to bonds. At around 14 times earnings, many fund managers argue Europe is still cheap. This is less than the average 18 times P/E ratio for the S&P500 and 20 for the Nikkei 225 index. Fund managers also highlight the fact that average dividend yield from European stocks is 3.5 pert cent, just below the 3.7 per cent yield available on German government bonds.

There are still concerns about European equities, however, notably about the two largest economies, France and Germany. At the end of November 2004, the Organisation for Economic Co-operation and Development (OECD) cut its forecast for economic growth in 2005 from 2.4 to 1.9 per cent. This would just beat the 1.8 per cent growth in 2004, but falls short of the European Commission’s forecast of 2 per cent for 2005. In 2004, the eurozone grew at half the pace of the rest of the world. Unemployment is around 9 per cent on average across the zone.

THE EURO EFFECT

The strength of the euro has added to the concerns. If the euro were to remain a strong currency, it would detrimentally affect exports. The strength of the euro is of less concern to small-cap managers, however, as these companies tend to have fewer exports than large caps, says Mr Dudding. “There are plenty of European companies which do not have exposure to the US. Germany had a strong currency for 20 to 30 years before the euro was introduced and it did not stop it being a strong exporting country.”

For the first time in many years, labour costs have come down faster in Europe than in the US. This has been helped by the enlargement of the European Union, says Mr Dudding, with companies having realised they need to become more efficient to survive.

Threadneedle takes a bottom-up approach to selecting stocks. This has led to an overweight position in Germany. “Germany and the Netherlands are the cheapest equity markets in Europe but the faster earnings growth is in Germany,” adds Mr Dudding.

Average forecasts for earnings growth for 2005 in Germany is 26 per cent, but the stock market is trading on 12.9 per cent earnings. Mr Dudding says: “This does not add up. Either earnings forecasts are too high or stocks are cheap.”

The fund is overweight in construction and engineering stocks as this is where the manager sees most value. He holds between 80 and 100 stocks in his fund. His investment style is growth at reasonable value. He looks for reasonable valuations, earnings growth of faster than the market and strong cash flows.

A quite different approach is adopted by the Axa Rosenberg EurExUK S Cap fund. It is ranked 11th in the sector over one year but over five years, the fund is ranked first with a return of 28.57 per cent. The fund takes a quantitative and systematic approach to selecting stocks by using computer models.

Dr Morag Lenman, portfolio manager, Europe at Axa Rosenberg, says: “One reason we take this approach is because it enables us to cover a greater universe of stocks than other small-cap managers. We use models to selectstocks. A valuation model is used to identify undervalued stocks with growth potential. This is done by aggregating all assets at a company.

“We also analyse and compare it with earnings forecasts. We look at valuation models every night and have no macro economic input. Valuations of companies are compared against their peer group rather than on an absolute basis. These models enable us to analyse a lot more companies than other asset managers. This is an advantage in a part of the market that is not well researched compared with large caps.”

Axa Rosenberg does not take country or sector weightings, but selects what it considers to be attractive stocks on a valuation basis. This leads to a portfolio of around 190 stocks, which Dr Lenman says is significantly more than the average small-cap fund. Such diversification also lowers volatility, she adds. The fund has had a high information ratio and low tracking error since launch relative to other small-cap funds, according to the manager.

Dr Lenman says the P/E ratio of the fund has changed little over the past two years, despite the rally in small caps. “The P/E has stayed around 11 times. While the share prices of small caps have risen so have their earnings.”

‘There will be rallies in technology shares but there will not be the growth people expect’ - Raik Hoffmann, DWS

Raik Hoffmann, manager of the DWS Euroland Neue Markte fund, says it can be argued that there is little room for general out-performance given the recent rally in small caps. But he adds the fact that small and mid-cap stocks have approached the valuations of large caps should not necessarily be a deterrent for investors. “The only reason small caps have traditionally traded at a discount to large stocks is because they have generally had less liquidity and investors expect some sort of a risk premium.

“In the current environment of low interest rates and volatility, it is expected that stock markets will move sideways or slightly upwards. Investors will thus pay a premium to get higher growth from small caps than the general market.”

Mr Hoffmann adds that the advantage of small caps is the fact they often have a focused business model and are easier to analyse because they only have one or two areas of operations. “Multinational companies can be difficult to evaluate as they have so many different parts around the world.”

He admits, however, that after the strong equity growth of last year, there will be more selective out-performance from small caps in 2005. Mr Hoffmann cites Groupe Bourbon as an example of a stock he invests in. “It is a French conglomerate but it is focusing on its oil services business. It has sold sugar and retailing businesses so it can put the resources into the oil services business.”

GROWTH ORIENTATION

The DWS fund originally focused on technology stocks. But Mr Hoffmann says that at the start of 2003, the fund mandate was altered to allow it to invest in growth companies generally. “There will be rallies in technology shares but there will not be the growth people expect.”

Gary Potter, co-manager of the Credit Suisse Portfolio Services, which selects funds manufactured by other groups, says the valuation gap between small and large caps “has certainly closed”. But he adds that there is potential for positive returns going forward given the likelihood of corporate activity.

“There has been restructuring of balance sheets at European companies,” says Mr Potter. “Cash flow is strong at the corporate level and therefore there is likely to be mergers and acquisitions involving small and mid-cap companies.”

While valuations may be less attractive than a year ago, Mr Potter says this does not mean they should be excluded from investors’ portfolios. “Small caps have greater scope to grow their earnings than larger companies. It is much harder for a large-cap company to increase earnings by 10 per cent than a small company.

“Whether volatility and liquidity will be an issue in small caps depends on the time horizon of the investor. Obviously, the longer a client can invest the less these issues matter. Diversification across small and mid caps is important in reducing risk in a portfolio or fund.”

While Mr Potter agrees that European stockmarkets are cheaper than the US, he points out that the latter has faster economic growth. But he adds that another attraction of small and mid caps is the fact they are less affected by the strength of the euro than large caps.

‘Using computer models enables us to cover a greater universe of stocks than other small-cap managers’ - Morag Lenman, Axa Rosenberg