The movement towards globalisation of world markets appears more pronounced than ever. In recent m...
The movement towards globalisation of world markets appears more pronounced than ever. In recent months, individuals have watched their investments plummet in value as concerns over the global economic slowdown have taken their toll on all major markets.
These prolonged falls in the major indices have naturally led investors to question the 'big is beautiful' mentality and look for alternative homes for their money.
Many investors and their advisers have traditionally shied away from smaller companies, placing such investments at the higher end of the risk spectrum. They cling instead to the comfort factor of investing in recognised big-name stocks. And it is true that smaller companies come with specific risks attached. Importantly, however, they may also provide some shelter from the volatility arising from global issues Ã in particular the knock-on effect of the US downturn that has hit the large blue-chips so hard in recent months.
This is one reason why investors are already beginning to shift their attentions towards continental Europe, and for good reason. While all major markets are likely to continue to suffer from the downturn in the American economy, Euroland should prove more resilient than most.
The significance of any US recession is less marked in Europe than in other regions. The bulk of the current growth in European GDP is intra-European Ã indeed, the UK ranks as far more significant in trading terms for continental Europe than the US. In addition, more people live and work in Euroland than in America.
Furthermore, the outlook for the Euroland economy as a whole remains relatively positive. Recent economic data shows that consumer spending in Europe remains fairly robust. Most forecasts are for positive growth in Europe in 2001. The relative strength of markets in Euroland may be even more pronounced if the anticipated reduction in European interest rates materialises over the months ahead.
Given these positive factors, the arguments for investing in Europe appears robust. But why opt for European smaller caps in particular?
Among the more obvious reasons is the oft-quoted advantage that small companies Ã starting as they do from a lower initial base in terms of market capitalisation Ã provide considerably more scope to grow than their multinational counterparts. Put another way, it is much easier for a £100m company to double in size than it is for a £20bn company.
Another important point is that smaller companies, by their very nature, tend to operate solely within their own domestic markets. As such, they are largely shielded from 'contagion' Ã the knock-on effects of recession elsewhere in the world. A combination of these and other factors have already combined to make Europe one of the best performing areas for small company funds in recent years. According to Standard & Poor's, the average European smaller companies fund return has exceeded 100% over three and five years. And while all European markets have fallen in recent months, European smaller companies are down by less than their larger counterparts. The HSBC Smaller ex-UK index fell by around 6% in the first quarter of 2001, substantially better than the FT Europe ex-UK, which tumbled by 13%.
Of course, investment in any asset class comes with potential downsides, and smaller companies are no exception. Smaller companies tend to have shorter track records than their blue chip counterparts Ã they are generally less well known and the activities in which they engage are sometimes obscure.
Another perceived drawback to smaller company investment is the limited liquidity of smaller company stocks. Investors tend to be concerned about the damaging impact a large seller could exert on the share price. This is often true Ã but the reverse, of course, is equally true. A small company's value may rise sharply if a stock becomes popular. Consequently, the stock picking ability of the fund manager has an especially significant role to play.
There are obvious currency implications, too. If interest rates remain high in the UK and sterling is strong against the euro, the best potential returns are from investments in the domestic market. A fall in the value of the euro would dilute the benefits of any growth achieved by a Euroland-based investment when the value is converted back to sterling.
So, these caveats aside, what is the current outlook for the overall sector? As far as the macroeconomic background is concerned, most of the news flow from Europe continues to be positive. The labour market continues to be buoyant Ã in contrast to the downsizing that has already begun on the other side of the Atlantic. Corporate and personal tax changes should also have a beneficial effect. The advantages of these will be particularly evident in Germany, where an amendment to the company taxation regime is expected to lead to increased activity in mergers and acquisitions. Other changes to personal taxation across the region should provide a boost to the European economy in the form of increased consumer spending. This in turn should provide a fillip for consumer-related stocks.
There remains, of course, wide divergence between different sectors and geographic areas. In particular, the fall in value of technology stocks has hit much of the smaller companies sector hard. Germany's NeuerMarkt, which is heavily biased towards technology, has taken a pummelling in recent months, and there appears limited room for optimism going forward. This negative sentiment has fed through to other German smaller companies, whether technology related or not, and these have also lost value.
The Nouveau MarchŽ in France, while more diverse than its German counterpart, has also been hit by the poor performance of its new economy constituents.
In this environment, markets with a less overt technology bias are likely to offer a smoother ride. On current form, Europe's better-performing economies include Ireland (which has benefited from the general strength of its economy) and Switzerland, where the technology bias is less volatile. Another market offering good prospects is Spain, which has several construction companies and cyclical stocks within its constituents. These companies have shrugged off the problems affecting other sectors, and are likely to benefit most from any short-term reductions in interest rates.
Individual sectors worth noting include medical technology stocks, which have delivered impressive growth in recent months. Cyclical and value stocks have also come back into favour and fared well. By contrast, companies with exposure to other technology sectors and biotech stocks have done badly. Among the hardest hit have been those smaller companies yet to produce profits, as well as those dependent on the likes of Nokia and Ericsson. Predictably, these have suffered substantial falls in value.
One last, more general, observation, is the wide divergence in performance among funds investing in this sector. The key to successful investment in smaller companies remains a consistent approach.
Successful investors in the smaller companies sector will apply several standard criteria in their stock selection. The best performing companies will invariably be high growth stocks, typically niche players. These companies will normally be among the leaders in their field and will have the power to set prices, as well as being able to demonstrate a sound structure for developing the business. They are likely to be involved in growth industries, particularly those where new entrants will have difficulty breaking through. And if they are to succeed in the longer term, the companies need to have strong management structures and a clear outlook on where the business is heading.
Finally, the most attractive companies are those that are profitable and have an established flow of earnings. And this normally means that internet and biotech companies are excluded. This has been one of the hardest lessons for many investors over the past year. Many funds have unwittingly ended up becoming a ready source of venture capital, with all the risks that entails. The dangers of taking this approach are clear to see.
Alastair Duffy is portfolio manager on the European team at Aegon Asset Management
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