Marco Ricci's Europa fund is ranked second in Europe ex UK sector with returns of 37.6% offer to bid over 3 years
Positive on growth in European smaller companies, Marco Ricci, manager of Deutsche Asset Management's Europa fund, is holding a 0% cash weighting in the portfolio for the first time in two years.
Ricci has managed the fund since joining Deutsche in 1997 and, over three years to 13 June, it has returned 37.6% on an offer to bid basis, compared to a sector average of 9.8%. This places the fund second out of 88 funds in the Europe excluding UK sector over that time period.
Europa is essentially a small-cap fund in a large-cap sector but avoids being officially classified in the European smaller companies sector by virtue of investing in the smallest 25% of listed companies in Europe.
Standard & Poor's officially ranks European smaller companies funds as those that invest in the bottom 10% of European companies, as rated by market cap.
The portfolio is therefore exposed to different market forces than its peer group, rendering it highly volatile relative to its sector.
The adverse market conditions besetting both smaller companies and growth stocks in general has hit the fund's performance over the past year. Over the 12 months to 13 June, the fund has returned -32.9% on an offer to bid basis, compared to a sector average of -21.5%, and has consequently slipped to fourth quartile, ranked 97 out of 100 funds.
Over the past three months to 13 June, the fund has returned -4.6% on a bid to bid basis, compared to a sector average of -1.9%, giving it a ranking of 99 out of 105 funds.
Ricci believes the markets have almost reached a bottom, however, and expects the fund to rally in the near term, when the outlook for smaller companies and growth stocks in general starts to pick up.
How would you describe your investment process?
The key process is stock-picking. When we select companies, we perform in-depth fundamental analysis with a focus on long-term cash flow returns on the invested capital.
I am part of a team of three small-cap fund managers. We work both in London and Frankfurt and are fully integrated.
We take advantage of the input from the 13 global sector research teams.
We spend a lot of time with companies, in London or at their premises, and I personally travel on average three or four days a month.
How do you pick which companies to invest in?
The key for me is stock selection through fundamental analysis.
We believe that, over the long run, a company with faster than average growth in earnings and cash flows will outperform the others.
My experience has taught me that stock market performance comes from those small companies which become large.
We look for companies with the right business models, the right products and the right services that we think will be the blue chips of the future. We do this with detailed business analysis along the lines of: Why do clients choose your product or service? Why are you better than your competitors? Why will you stay ahead of them?
We test management's knowledge on their businesses and their ability to think forward, to steer the company in the right short-term moves in order to achieve their long-term vision.
The importance of strategy for a company is quite high in small caps. What does the company have to do to become bigger and are they good at mergers and acquisitions?
It is all part of the analysis. I want to invest in companies that will still be around in five years and will be a lot larger in that time than they are now.
Growth investing often seems to be sector led. How do you identify these themes in the market?
There are regular waves of hyper-excitement on certain market sectors, for example biotech in the UK in 1996, media in Europe in 1998 then technology and the internet in 1999-2000. Similar cycles have been happening for a long time.
I see two ways to benefit from stock market waves as an investor.
Firstly, I stick to my investment style, to look at companies one by one.
This should result in the fund being overweight in those sectors where earnings and cash flows are growing faster than average, and these sectors should later outperform.
Secondly, I try not to be too contrarian if a market theme or a trend appears which is distorting valuations for a short period.
For example, if IT and technology stocks are being overbought, I will underperform unless I own some. Then I direct my research effort in that direction and keep an open mind on what drives stock market valuations for that sector at that point in time.
Telecoms are a great example of how risky it is to buy a sector. It is a fantastic sector where demand in all areas is growing. The downside is that the spend on infrastructure and competition means they are making no money.
Two thirds of the companies may go bankrupt but it still is a great sector because the demand is there.
The bottom line remains looking at companies' fundamentals but in the context of what other investors are doing and what the direction the market as a whole is taking.
How would you explain the volatility of your fund relative to your peer group?
The volatility of Europa comes from the underlying volatility of small stocks. Small-caps' profits very often surprise on the downside as well as the upside.
The subsequent stock price movements are amplified by the lower liquidity of small stocks. As a result, the fund is likely to remain more volatile than the average unit trusts in the category.
What constraints are placed on how you run the fund?
The fund mandate is to invest in the bottom 25% of European markets. The cut-off point is companies with a market cap of about E4.5bn. We generally buy stocks with a market cap of less than E3bn but we hold on to them if they become larger and keep outperforming.
We have very efficient and strict controls on how far fund managers can take single stock positions, sector and country deviation from the benchmark. However, these are used purely as an ex-post analysis for risk control purposes.
The fund remains purely built from the bottom up. Every stock has to be part of an approved universe, which practically means it has to be quoted in an approved stock market with minimum market cap and free float requirements.
How would you describe your sell discipline?
Every company has to justify its presence in the portfolio every day. Every time we analyse and meet a better company than one in the fund we sell one to buy the other. We can only have so many companies in the fund and we currently have 70-75 stocks.
In case of profit warnings, we generally sell the position and replace the stock with another that we already know and identify as a potential investment.
The average holding period of a stock is between two and two and a half years. By technical definition, the turnover of the fund is about 100%, which is standard and, if you look at the number of stocks, this is may be a third of the portfolio.
How is the fund currently positioned?
Today, the fund has pretty much a traditional sector breakdown ' a mixture of industrial, services, consumer goods and financial companies.
We believe the activity of the company is less important than how much profits and cash it generates and how fast it is growing.
Which companies do you like at the moment?
One very good example would be Marschollek Lautenschlaeger und Partner, a German financial services company. This is actually a large cap and is a perfect example of a 'small-cap done good.' The fund gained the best performance between summer 1999 and early 2000, when large-cap investors began to buy into this company.
A similar example is Altran Technologies, which now has a E5bn market cap and is actually accelerating its growth rates as it achieves critical mass in the consulting industry.
Another attractive smaller company is Autogrill. Formerly a state-owned company running motorway restaurants, over the past five years it has transformed itself into one of the largest owners of food restaurants worldwide.
It is leveraging on its own brands in Italy and Europe, plus it owns specialised franchises.
For example, it is rolling out the Burger King chain in Italy and has exclusive concessions to run restaurant franchises in many US airports.
Is the outlook for European smaller companies improving?
For the first time in two years, we have no cash in the fund. As we analyse and meet companies, their outlook is a lot better now than it was six months ago.
However, if you look at the price charts, the answer would probably be the exact opposite. Many stocks are clearly following a downward trend. Many small companies are still doing quite badly but I believe we are nearing a turning point because the outlook is slowly improving.
Small caps as an asset class are more volatile than large caps. In the past, small caps have outperformed large caps in very short, but very sharp, bursts. Because of that, the best time to invest in a small-cap fund is probably now.
The one or two year performance numbers look relatively poor but the underlying fundamentals suggest a sudden change for the better is possible.
FUND MANAGER: Marco Ricci
l Ricci joined Deutsche Asset Management's European equity team in 1997 as a small cap specialist.
l He was previously a security analyst with Schroders Securities and an investment analyst for Fidelity International.
l Ricci graduated in finance from the UniversitÃ Bocconi of Milan and has an MBA from Wharton Business School.
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