Aberdeen European Smaller Companies - Morningstar's take

Tom Whitelaw, fund analyst at Morningstar, comments: Aberdeen's Pan-European equities team, now headed by James Laing, took on the Aberdeen European Smaller Companies fund in 2002. As with all of Aberdeen's Pan European offerings, they aligned the process with the same unconstrained bottom-up strategy originally devised by Hugh Young in Asia.

It would appear that Laing and his team--who also run the firm's UK-focussed funds--are still getting to grips with the European smaller companies sector. This is in part a function of the team's responsibilities. Laing has a staff of 16 investment managers and analysts at his disposal on the pan-European team, and they are expected to do 1,000 company visits this year. That's a large number, but the bulk of the team's attention is focussed on UK equities, in keeping with the large amount of assets the group runs in UK-only funds. For the rest of Europe, not only does the team have to review new companies, but they must also understand the industries and national markets in which they operate. These can differ significantly to the UK, where most of the team's time is spent. The fact that this fund is focussed on small-caps makes research all the more challenging.

Experience in the sector may also be an issue. Aberdeen's distinctive, research-intensive nature, coupled with the firm's approach of training graduates from the bottom up, means that it cannot simply go out and hire experienced European research analysts or managers the skill set has to be learnt on the job. Prior to taking on this fund, Laing's team didn't have deep European small-cap experience.

The results thus far bear out our concerns. Over five years -- well into the new team's term -- the fund has lost an annualised 2% more than other smaller cap focused funds in its Morningstar Europe ex-UK Small/Mid Cap category with an average market capitalisation of under £1bn.The picture hasn't improved over the shorter term. The fund has lost almost 20% year to date, 2% more than it's HSBC Smaller Companies Europe ex UK benchmark, and 4.5% more than its aforementioned peers.

We like Aberdeen's strategy, which is highly disciplined and is consistently applied across all of its funds. The team is also gaining in experience as it continues to research the pan-European universe. It's also well worth noting that Aberdeen's process--with its focus on quality and value--will lag in markets where the priciest shares or lower quality issues lead the way, and some of the fund's underperformance is thus understandable.

Even so, the fund has had long-enough to prove itself across a variety of market environments, and has yet to do so. The team's structure and limited experience with smaller European stocks remains a concern. We admire many of the other offerings run by this group, but we don't currently believe this is a strong choice.

Strategy

The managers of this fund invest on the premise that share prices over the long term reflect underlying business fundamentals. Consequently, the bottom-up driven unconstrained fund invests only in stocks that successfully pass through its quality screen and meet its stringent valuation criterion. Quality is assessed on the basis of clarity in a company's business strategy and execution resting in the hands of experienced top management. Strength of balance sheet, transparency of earnings, and a commitment to shareholder value are other traits the team looks for. Companies are deemed attractively valued if they appear to be trading cheaply relative to the valuations of similar companies based on ratios such as price to earnings and price to cash flows. This focus on quality and valuation renders the team unwilling to pay too much for growth or chase momentum, and also means they are willing to go against the grain and buy into sectors or companies that are out of favour. The fund is likely to experience pockets of benchmark relative underperformance, as it does not chase momentum or over pay for growth The average holding period for this 45-75 stock portfolio is 3-5 years, resulting in a low 25%-35% annual turnover, helping to reduce dealing costs.

Management

The fund has been run by Aberdeen's Pan European Equities team since 2002. The team was originally headed by Chou Chong, but he stepped down in early 2008 as moved back to Aberdeen's Singapore unit for personal reasons. James Laing now heads the group. Laing joined Aberdeen Asset Management in 2000, having previously worked in the private client division and on several UK investment trusts. We don't expect the change in leadership to have much of an impact on the fund given Laing's tenure on the team and Aberdeen's consistent in-house process.

The team has a relatively flat structure comprising 17 investment managers and analysts. Analysts are hired early in their career arcs and trained comprehensively in the group's approach. This helps in applying the group's investment process consistently across all levels. In general, each member of the team spends at least half their working day on proprietary stocks research, with senior members increasingly involved in portfolio construction. Laing has ultimate veto rights, but these are rarely employed. The team is responsible for running all UK and European equity mandates. At the end of last year total European (ex specialist UK mandates) funds under management was £1.1bn.

One potential concern is the firm's incentive structure which does not directly link manager pay to performance. Although Aberdeen's subjective system is not uncommon in the City, we believe incentive pay that emphasises long-term performance helps more clearly align managers' interests with those of fund owners.

For more information, visit morningstar.co.uk