This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Ian Ormiston, manager of the Ignis European Growth Fund and Ignis European Smaller Companies Fund provides his views on the European markets.
Although many of the ideas put forward in the book Small is Beautiful look rather dated, the concept of small decentralised organisations has stood the test of time. Smaller companies are often viewed as the poor relations of their large cap peers, but I would argue that the right kind of smaller company has many inherent advantages which we forget at our peril. The orthodox view throughout much of the 20th century was that economies of scale and specialisation of labour would reap such massive advantages that the large would become increasingly advantaged to the detriment of the small. While this is true in some regard, with access to finance challenging and some industries being natural monopolies, there are some inherent advantages to being small.
A fundamental advantage enjoyed by smaller companies is that they are naturally more nimble and suffused with an entrepreneurial spirit, which is one of the key points made by Schumacher. In Continental Europe, private companies usually come to market to enable founders to diversify their wealth, to solve succession issues, or to fund further growth. In the UK, a listing is seen as more of an exit route. European management teams are more focused on building bigger businesses for the long term and this delivers the subsequent rewards to shareholders.
Another advantage of the small company that is often overlooked is that innovation tends to be highest in this sector. New drugs, new technologies or new approaches to business often emerge in smaller companies. In Europe, the breadth of strong nations gives investors’ exposure to more ‘clusters’ of these types of companies. Examples include Swiss pharmaceuticals, German solar, French secure transactions, Danish phonics and Swedish engineers.
‘Clusters’ as defined by economist Michael Porter, are groups of companies in the same field which drive improved productivity – and improved productivity goes hand in hand with improved performance.
Valuation is not really a base case for investing in European smaller companies. As an active investment manager and stock picker, I am more interested in growth opportunities, balance sheet strength and the selffunding nature of growth, which is something that is now totally different from the pre-financial crisis era.
Valuations are some way below peak levels in both small and large cap areas. But on average valuations, small caps are only slightly cheap on most measures and large caps have superficially better metrics. A key question to be answered is whether there is a convincing argument to support a preference for small caps over their larger peers? In answering this, it is important to initially examine sector composition. The large cap category continues to be dominated by massive sectors with high leverage and little or no growth, such as the banking, utility and telecom giants. These sectors are much less important in the world of small caps. In addition to sector composition, a further reason for a small cap preference is illustrated by the oft repeated life cycle diagram below. The smaller companies that are most attractive and are typical constituents within my portfolios are typically in the sweet spot for growth. Sales should be increasing sustainably and operating leverage allowing margins to expand giving faster profit growth.
Equity market bulls like to point to the fact that in spite of the substantial rally that we have enjoyed in equity markets if we compare the price with ten year average earnings then there is still plenty of value in markets.
The major problem with that analysis is that some sectors are now less profitable structurally.
Banks are the best example of this as they have to carry a lot more capital (equity) which will permanently cap return on equity (ROE).
If we call 15% the peak (this is a bit harsh as many banks are still trying to slim down for Basel III at this point) then the largest single sector in Europe is at 2/3rds ROE of the previous level for structural reasons. Another concern that seems to have been forgotten since Draghi changed the course of the eurozone crisis last summer, relates to companies that depend upon the crisis economies. I am a keen advocate of recovery in many of these economies (recent Eurostat data provides strong evidence) and we should see modest growth in the core of Europe next year. Some of these economies, such as Greece and Iceland will take a decade to regain their peak GDP.
I believe that there is potential for recovery, (many of this year’s downgrades have come from the strength of Europe’s currencies, particularly against the US dollar) but the return to peak argument is not logical in the short term. A further issue is that many investors making the value argument then suggest buying into Europe’s international sectors, such as industrials or luxury goods. The industrials sector contains some very good companies but their return on capital employed (ROCE) indicates they are already at peak and many are priced accordingly.
Recent investment notes that I have written have often carried a cautionary note. The reason for this is that my central premise, as it has been for a number of years, is that any region that has a hangover from the financial crisis is stuck in a relatively low growth environment, and zero bound rates and quantitative easing (QE) are simply proof of this. My cautious statements need to be set against the market noise of ‘escape velocity’ and ‘normalisation’. A normal recovery in the US would see no QE, rates rising, non-farm payrolls printing 250,000 per month and a general self-sustaining feel good factor. We have not reached this level of recovery in the US or Europe, and it is unlikely we will for some time to come. In this environment, I am continuing to look for companies which can sustainably grow their sales above market rates, and their earnings faster. These companies will attract higher ratings as capital pursues scarce growth opportunities. While exposure to the periphery is low within the portfolios I manage, I do not have a closed mind to a recovery for good quality companies in those markets which may also benefit from a massive cyclical headwind turning into a tailwind. The small and mid-caps that I invest in usually have a secular growth story, which explains the large number of technology companies in the portfolio.
Healthcare companies that benefit from trends such as ageing and obesity are also among my favoured stocks.
The bottom line is that an investment in European smaller companies is not made on pure value grounds. This has not been the case for some years – as an asset class small caps have consistently beaten large caps. Instead, the Ignis European Growth and Ignis European Smaller Companies portfolios contain high quality, self-funded growth companies which will thrive in the economic environment that I expect to continue. There is obviously the chance that there will be a further re-rating towards peak (and away from average) levels as these companies prosper and a return to modest growth gains greater attention. Personally, as a manager of both large and smaller companies funds, I continue to prefer the opportunity in the latter, where growth is more plentiful and better valued.
