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How to make a continental quilt

European smaller companies are an attractive asset class to own because of the much higher growth rates achieved by some smaller companies compared with their bigger rivals. This is my biased view as a fund manager in this asset class but a view which I am happy to back with my own savings. The marketing messages you keep hearing about undiscovered smaller companies offering higher rewards to stockpickers are true.

But if you had bought into a European smaller companies fund five years ago, you might only have reached your book cost during the second half of 2004, which is not that impressive. The collapse of the technology sector plus economic recession in Europe were bad news for many small companies and stock prices suffered.

So is anything different now? Not really. The potential rewards from owning strongly-growing companies are still there, as is the risk that times get will tougher again, but I think the rewards are greater than the risk.

It is possible that some companies in areas such as natural resources are overvalued but I would argue that there will always be bubbles of some kind as the market tends to be very momentum-driven. There are enough stocks at attractive valua- tions in sectors such as industrials, services and financials to make me relaxed on this point. Also, recent takeover bids have generally been at significant premiums to the market price.

The bear market was unusual in its length and severity so the good run which small caps have had since partly reflects the very low point they reached. The current valuation level of smaller companies is not over the top if we are now in a more stable phase than the boom/bust of 1999/2002.

There are various concerns currently about world econ- omic growth, such as the impact of high commodity prices, especially on developing economies such as China and India. European smaller companies will not escape the fallout from a slowdown but we have not seen evidence that the trend of improving economic growth in Europe has been reversed and we are sliding back into recession. Outside sectors such as transport and packaging, we have not seen many profit warnings caused by higher raw material costs. Due to better demand, companies have been able to increase prices where necessary.

The political situation in Europe is becoming more supportive to the corporate sector as governments are being forced to cut corporate tax rates and reduce social welfare costs to become more competitive, particularly with Eastern European countries which have lower tax rates.

The fall of the euro against the dollar this year has increased the competitiveness of European companies while interest rates remain at 2 per cent, giving historically cheap financing costs.

Personal savings ratios in Europe remain well above levels in the US, UK and Japan, which reflects slower growth by European economies. It also shows that while the governments might be struggling to keep their promises on public spending, the balance sheets of private individuals are fairly healthy.

If economic growth leads to lower unemployment in countries such as France and Germany, I would expect consumer spending to show more growth. This would be supportive of companies active in more domestically-orientated sectors, which tend to be the smaller ones.

After a run of very strong performance, it is tempting to say enough is enough, but I am happy to invest in companies which I believe can outgrow the rest over a longer period, not just a few years.

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