One word sums up the reason for investing in European smaller companies: change. Fundamental changes...
One word sums up the reason for investing in European smaller companies: change. Fundamental changes are taking place in Europe which are creating a more attractive environment for the small company investor.
What evidence exists to support the argument that the environment in Europe is changing? The first indicator is the performance of smaller companies relative to their larger counterparts.
As the chart shows, since the start of 1999 we have seen the first period of sustained outperformance by smaller companies for five years. It is not a coincidence that the turn in relative performance was marked by several well-respected commentators announcing the death of small companies at the same time that most institutional investors had their lowest exposure to the sector for many years.
Topping the tables
Another indicator of the resurgence of smaller companies is the fact that a number of smaller company funds featured at the top of the performance league tables for the first time in years, demonstrating the exceptional returns on investment that have been made in the area over the past year. So, what has prompted this turnaround?
We believe there have been a number of important developments taking place in Europe over the past few years. The breaking down of national barriers, deregulation and the introduction of the euro have driven a remarkable level of corporate restructuring, merger and take-over activity as companies adapt to a changing environment and prepare themselves to compete on a regional or even global basis instead of just nationally. At the same time there has been a change in cultural attitudes in European boardrooms, as the traditional role of banks becomes less important, cross-shareholdings are unwound and independent shareholders make their voices heard.
These changes have been particularly evident amongst the very largest companies in Europe, helping to drive markets in recent years. However, it has become clear that not every large merger is to the benefit of shareholders, particularly in a rising market. It can be difficult to integrate companies which have very different cultures, synergies can take time to arrive, if at all, and the entire process can take many months to meet with the approval of the various regulatory authorities.
It cannot be denied, however, that a radical change in corporate culture is taking place. In the case of Telecom Italia, the management had to rethink plans to exchange shares in the rapidly growing mobile telephone business for shares in the holding company when the shareholders objected bitterly. More often than not, though, management are now successfully aligning their interests with those of shareholders, who are becoming more active and, after all, own the company. In many cases smaller companies are able to introduce change quickly. Their very size means that they are likely to be more nimble, able to take decisions and implement them rapidly without the bureaucracy and tradition which can create difficulties for large companies. If there is corporate activity amongst smaller companies, it can generally be resolved quickly, rarely raising any competition concerns, to the benefit of the shareholders.
Paying for performance
The emergence of performance-related pay for the senior management of smaller companies, often based around stock options, has been a key element in helping to align the interests of management and shareholders, resulting in this emergence of a US-style equity culture in continental Europe. It has become acceptable for management to make very significant amounts of money if the share prices of the companies they are running perform strongly, and this shareholder-friendly innovation is encouraged by the large investment banks which are so influential in bringing new companies to market.
The growth of the venture capital industry and the establishment of new and successful stock markets that make listing new companies easier has been a vital factor in the development of this culture. The star performer here has certainly been Germany's Neuer Markt.
The existence of the Neuer Markt and other exchanges such as the Nouveau Marché in France and the Easdaq has acted as a catalyst for the listing of dozens of new companies. Most of these companies operate in high growth sectors such as technology, healthcare and media. Five years ago, a smaller company investor in Europe would have struggled to identify half a dozen high quality technology companies to invest in. There are now more than two hundred such companies listed on the Neuer Markt alone, giving ample choice for investors.
Rapid growth sectors
The existence of genuine growth companies is something else that is new. Traditionally, smaller companies in continental Europe have offered an attractive combination of good prospects for earnings growth and very reasonable relative valuations. While many smaller company shares remain at a steep discount to their large peers, the most attractive areas of the market have been the rapidly expanding technology and media sectors, where there are real prospects for high earnings growth. Here, share price valuations at least equal and in many cases exceed the levels seen in the more mainstream large companies. However, against that the growth potential from some of these companies is exceptional - it is much easier for a small company to double its earnings than it is for a large one, and these companies can be market leaders in their chosen fields.
The relative ease of achieving a listing for only moderately sized companies, and the potential rewards of doing so for the owners, means that highly successful companies needing capital to fund growth are now much more likely to seek a stock market listing than a parent group with deep pockets, which might previously have been seen as the best solution. Most of these companies come within the smaller company uni
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