10 reasons to consider European smaller companies
Ian Ormiston, manager of the Ignis European Smaller Companies Fund, gives 10 reasons to consider European smaller companies: "UK smaller company funds have long been the default choice for UK investors seeking exposure to dynamic and fast growing firms. But factors increasingly point towards Continental Europe as a better environment in which to invest in companies with outstanding growth potential."Below, Ian has listed 10 reasons why investors should consider looking further afield when reviewing their exposure to smaller companies.
1. European smaller companies outperform larger companies over the long term
European smaller companies have enjoyed a 10-year re-rating relative to their larger counterparts and over the same period, have delivered higher sterling returns than both large and small cap stocks in the UK.
2. A deeper investment pool and larger average company size
Continental Europe offers a deeper and broader pool of smaller companies than the UK. These companies tend to be bigger and more mature than their UK counterparts, which means they can provide higher risk-adjusted returns.
Number of stocks with a market capitalisation below €1.5bn. Source: Bloomberg 02/05/2009
3. More diverse investment opportunities
The UK is a relatively small single economy and market within Europe. Western Europe (ex UK) itself is as diverse as the US, but it is only down at the smaller companies level that regional differences become apparent and create a wide range of opportunities.
Country spread of market capitalisation in HSBC Smaller Europe ex UK
Source: Datastream 02/06/2009
4. The euro effect
Before the euro's introduction in 1998, many small European companies (like their UK counterparts) enjoyed years of relatively risk-free domestic growth but subsequently stumbled when attempting to expand abroad. With an increasingly recognisable eurozone economy those risks are now considerably lower and opportunities for growth are therefore considerably higher.
5. Smaller companies typically outperform in a recovery phase
Smaller companies are the best positioned for a recovery. In the US market, where the data is most consistent, in nine out of the last 10 recoveries since 1941 smaller companies have outperformed larger companies by an average of 19.5%.
Source: JP Morgan 24/03/2009
6. Management interests more aligned with investors' needs
In Continental Europe private companies usually come to market to enable founders to diversify their wealth, to solve succession issues or to fund further growth. In contrast a listing in the UK is perceived as more of an exit route. European management teams are more focused on building bigger businesses for the long term - with the associated rewards this brings for shareholders.
7. Earnings, growth - and a 2.8% dividend
Growth in sales and earnings are the key reasons for considering this market segment but, while yield is very much a secondary consideration for small caps, the relative maturity and family ownership structure of Continental European smaller companies mean that dividends are often important. Indeed the European small cap market currently offers a yield of 2.8%, which is well above historical levels.
Source: HSBC European Smaller Companies ex UK index as of 22/06/2009. Calculations conducted using UBS PAS.
8. Relative maturity
A company's development can be split into three phases. The first phase, when a company is becoming established, is characterised by high risk and the potential for losses. In the second phase the company has overcome the initial hurdles and is enjoying rapid sales and profits growth. The final stage is often marred by slowing sales growth and more uncertain profitability.
Smaller companies in the Continental European market typically exhibit characteristics of the second phase:
9. Innovation and entrepreneurialism
New drugs, new technologies or new approaches to business often emerge in smaller companies. In Europe, the breadth of strong nations gives investors exposure to more ‘clusters' of these types of companies. For example Switzerland has a thriving pharmaceutical industry, Germany is a leader in the solar power sector while Sweden is known for its engineering prowess. These ‘clusters', as defined by economist Michael Porter, are groups of companies in the same field which drive improved productivity and performance.
10. Consistent outperformance
The Ignis European Smaller Companies Fund has outperformed in 75% of months since its inception, generating healthy performance in both bull and bear market conditions. The fund only invests in companies with strong balance sheets, good cash generation and straightforward business models. It does not invest in illiquid, expensive or turnaround stories.
Source: Lipper, bid to bid, net income reinvested. Ignis European Smaller Companies Fund was launched on 1/11/07
Ian Ormiston says:
"The average smaller company is relatively young and dynamic and is likely to be far more entrepreneurial than the average larger company, in which much of the workforce is less motivated by the success of the company as a whole. Put these factors into a market which is bigger, more diverse and better performing than the UK's, and you have the ingredients for some very attractive returns, particularly coming into a recovery phase. There is nothing wrong with investing in UK smaller companies but if you are interested in benefitting from the performance of this market segment, why not diversify into Europe?"