bad year for Asset class with funds falling 30.38% on average over 12 months to november
The European Smaller Companies sector has been a roller coaster ride for investors over the past three years.The highly cyclical nature of the underlying asset class has lead to both staggeringly good and bad performance.
When markets are rising and monetary policy is lax, money flows into smaller companies as investors look to cash in on the sector's heady growth potential.
Conversely, falling markets and rising interest rates hit smaller companies hard, as liquidity dries up and investors flee to large caps, which they typically believe to be safer investments.
Confidence in the asset class has been weak since the technology correction and there is still a bit of a stigma attached to smaller companies following the meteoric rise and equally spectacular fall of many technology-related IPOs during the heights of 1999 and early 2000.
This year has again been tough for the sector, with funds contracting by 30.38% on average over the 12 months to the end of November.
Every fund in the sector has posted negative growth in that period as well as double digit losses. The volatile nature of the sector can be summated by discrete analysis of the past two years' performance.
While this year has seen funds fall by almost a third on average, the previous year, December 1999 to November 2000, saw the sector rise by 35.86%.
First State European Smaller Companies is the second best performing fund over the three years to the end of November, up 46.87% compared to a sector average increase of 15.78%.
The fund, managed by Jimmy Burns for more than 10 years, is a concentrated portfolio relying on bottom-up stockpicking to add value.
The portfolio will typically include 35 stocks with a maximum 5% holding in a company at purchase and 7% thereafter.
Although benchmark aware, asset allocation, in terms of sector and geographic exposure, is flexible and more a by-product of the stockpicking process.
However, most holdings are based in France, Germany or Switzerland because of the favourable regulatory environments for smaller companies in those countries, Burns said.
Stockpicking is driven by a combination of experience, contact with local brokers and company meetings. Burns said he will not invest in companies whose management he has yet to meet. He added that meetings with one company often lead to meetings with further companies recommended by their peers.
Fundamental analysis, including close inspection of companies' balance sheets, plays a key role in the investment process.
Burns believes this is one of the key reasons the fund has managed to preserve more of its capital than every fund but one in the sector over the past year. Over the 12 months to the end of November, First State European Smaller Companies is down 21.4%, versus a sector average -30.38%.
Burns said: 'I pay particular attention to the quality of a company. The average net debt to equity of the fund's holdings is 14%. Companies must have cash on their balance sheets for us to invest, which is why the fund has relatively held up this year.'
The focus on market leaders maximises the potential returns, he added. 'If you are looking for the leading company in a sector,' he said, 'either the potential will be realised through rapid earnings per share growth or there is always the chance they will get taken over.'
Dried pet food producer Royal Canin is one such example. The company has received a bid from Mars UK, which is awaiting clearance by the EU.
Earlier in the year, a Burns holding, Dutch bank Kempan, was taken over at a 3% premium, further bolstering the fund's one-year numbers.
The targeting of quality liquid companies also reins in the fund's beta, annualised at 0.82% versus a sector average of 0.99%.
The success of the bottom-up style is also reflected in the fund's high alpha score of 0.82, compared to a sector average of -1.53.
This low beta, high alpha approach is also evident in how the fund performed during the technology boom. Between December 1999 and November 2000, the fund posted growth of 49.81%, compared to a sector average of 35.86%.
Burns preferred to play the technology theme through investing in established, profitable companies that developed a technology division or service, rather than pureplay internet start-ups. This strategy enabled the fund to capture the technology upside while avoiding much of the risk.
The fund currently has a number of interests in sectors not heavily geared into stock market performance, such as healthcare, business services and security companies.
Schroders is the only group to have two funds in the sector: a retail and an institutional portfolio, both managed by Daniele Serruya.
The funds are run along similar lines, typically with a 60% cross-over, although the institutional mandate leads the fund to invest more in the larger small caps.
This difference in approach is reflected in the fund's slightly divergent returns over the three years to the end of November.
Schroders' European Smaller Companies fund is up 6.11% compared to its institutional sister fund, which is up 14.43% compared to a sector average of 15.78%.
The fund's beta scores also reflect the institutional funds more risk averse strategy, annualised at 0.75% compared to the retail fund's 0.94%, which is still below average score.
Serruya adopts a bottom-up approach to stockpicking, along with her four-man team, backed up by 26 pan-European analysts. The main objective is to seek out growth at a reasonable price and those companies that can go on to become tomorrow's blue chips.
While benchmarks are observed, they are not followed religiously and Serruya has the freedom to follow stylistic trends, which are constantly monitored. The funds have a diversified portfolio, with the retail fund currently holding 59 stocks, with no more than 5% invested in any one company.
Besides targeting those areas of the market shielded from the economy, such as hospital logistics, drug wholesale and business services, Serruya is looking out for value plays as well as weeding out a few stocks.
She said: 'At the margin, we have been buying into stocks we feel were unduly punished in the slaughter going down. Against that, we have cut a few positions which we felt were too financially geared for their own good.'
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