Threadneedle European Smaller Companies fund is only portfolio in the sector to achieve a positive return over one year to 4 November
The fallout from the internet bubble is still affecting European smaller companies, with the Threadneedle European Smaller Companies portfolio the only fund to generate a positive return over one year to 4 November.
The fund was one of only two in the 14-strong sector that produced positive growth over three years, the other being Aegon European Smaller Companies, which, as revealed in Investment Week last week, is soon to close.
European smaller companies funds on average posted a loss of 16.72% over one year and of 21.3% over three, a far cry from the period October 1999 to September 2000 in which funds delivered average growth of 91.83%.
Jimmy Burns, manager of the First State European Smaller Companies fund, said the performance created by smaller companies funds in 1999-2000 was primarily the result of the internet bubble.
During this period, he added, a lot of new companies came into the stock market, particularly the German Neuer Markt, many of which had unsound business models.
Burns said: 'During this time, little fundamental analysis took place and valuations got out of line. As a result, when the bull market ended two years ago, many funds were left with stocks they could not get rid of.'
Burns added he was only involved in this to a small extent as his policy is to invest in profitable companies with good track records, which a lot of the tech companies lacked.
Burns said: 'I am a bottom-up stock picker. I look for quality businesses with rock solid balance sheets and sustainable business models, such as a company that can grow its earnings irrespective of the current economic conditions.'
As a result of not getting too heavily involved in the internet boom, Burns' fund has made a loss of just 3.45% over one year to 4 November and is down 12.79% over three years.
It has achieved this with an annualised alpha of 3.98%, compared to the mean of '1.53%. The fund achieved this with a below average beta of 0.84%, compared to the 0.99% sector mean.
The management of European smaller companies does not change very often, Burns said, as most are family-run businesses or controlled by one major shareholder.
As a result, he said, investors are able to use trade records as a guide to how a company will perform over the next three years.
'We look for interesting growth stories, visit companies and check their management track record as a guide to what will happen in the future, taking a three to five-year view,' said Burns. 'We pay attention to valuations but we do not want to overpay for companies.
'In 2000, the market went into March and then fell. The holdings in my portfolio continued to produce good earnings growth and were re-rated upwards.'
Burns typically looks for stocks with earnings growth of 15% to 25%. However in the current current conditions, he will settle for 10% to 15%. To back his judgement, Burns runs a concentrated portfolio of around 40 stocks.
Paul Doyle, head of European smaller companies at Threadneedle and co-manager of the European Smaller Companies fund, said the portfolio is not invested by style, it is opportunistic and the portfolio is tilted to different market conditions.
Over one year to 4 November, it has made a positive return of 1%, compared to the sector fall of 16.72%. Over three years, it has grown 2.29%, compared with the sector fall of 21.3%.
Doyle said: 'The backbone of the portfolio is companies growing their top-line and profits and generating good cashflow through a variety of market conditions.'
The fund invests in strong franchises that are under-researched by the market, said Doyle.
A variety of valuation screens are used and both Doyle and lead manager David Dudding meet a lot of companies.
As smaller companies are less researched than large caps, Doyle said, it is an important part of the process to meet companies as there are several thousand in the universe to invest in, of which the fund holds around 80 to 100.
When meeting companies, Doyle continued, he looks for adequate disclosure and for the managers of the company to have their own shares and options, demonstrating their interest in the business.
'In the past few months we have been looking to increase the beta of the portfolio in a very cautious way,' Doyle said. 'We have been trying to find companies in the tech and cyclical area on good valuations with strong balance sheets and which have no credit risk.'
One such company is the French radio company NRJ, which is on 20 times earnings. Doyle believes it is a cyclical business that will do well when the economy turns up.
He said: 'We are still not sure the recent rally is sustainable. Europe, which is on 15 times earnings at present, needs to see major activity from the ECB through rate cuts, if the rally is to be sustained.'
Francesco Conte, co-manager of the JPMF Europe Smaller Companies fund, got into tech aggressively between 1999 and 2000. However, in the current environment, he has diversified the portfolio into more traditional areas.
The JPMF fund, which Conte manages with Jim Campbell, uses a quantitative screen to look at stocks, with much importance placed on earnings revisions and valuations.
Conte said: 'By placing an importance on these factors, we have a different definition of growth than many other managers. We invest in growth wherever it is perceived as being today, rather than looking at secular growth stories of the past. As such, instead of trying to catch the bottom of tech, we invest in businesses that are doing well now.'
In this environment, Conte's favoured areas are health and engineering. While his fund is unable to invest in the pharmaceutical giants, Conte said, support services, hospitals, dentals and pharmacies are all seeing good numbers and decent growth, as are engineering businesses.
There are now around 150 holdings in the portfolio, a rise from the days of the internet boom, when the fund was running around 110 positions.
Conte said: 'In this environment, it is difficult to make a huge commitment to one sector or business. To get back to running 110 holdings, we need to see more visibility in the market.'
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