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Small cap wonders

The sovereign crisis is the latest deterrent for investors looking at European small caps, despite the solid returns generated from this area of the market.

Over the past 10 years or more, little activity has been seen in European smaller companies funds in the way of launches or, in the case of investment companies, discounts narrowing.

According to the Association of Investment Companies, the European smaller companies sector had an average discount of -10.75 in 2008, last year it was -14.41 and today it is -14.78. Yet this does not seem to correspond with the performance of these funds.

Lipper figures reveal that while 2008 was a difficult year for European small caps, with listed funds falling on average by 40 per cent, 2010 saw gains of 23-34 per cent. The long-term investment story is also sound, with the lowest European smaller companies investment trust returning 48.06 per cent over the 10 years to February 28, 2011, while the best return was 154.62 per cent.

The open-ended peer group performance mirrors this trend, with Lipper figures showing the best gain in the IMA’s European smaller companies sector at 201.25 per cent over the decade. No loss decade of equity returns here. However, despite the performance case for this area of the market, European small caps, much like the mainstream European fund sectors, have gained little ground in terms of popularity.

The largest portfolio in the IMA’s sector is Threadneedle’s £1.05bn European smaller companies fund but the second-biggest fund, also a Threadneedle offering, is almost half that size at £566m, followed by the £491m Baring Europe select fund.

It is not as if many of these funds have not been around long enough to gain traction. Invesco Perpetual’s European smaller companies fund was launched more than 25 years ago and yet it has just £173.83m in assets. In fact, of the 15 constituents in the IMA sector, only five were launched in the past decade.

It is a similar story in the AIC’s European small cap sector, where new entrants have been beyond sparse. The oldest vehicle in the AIC’s sector was launched in 1972, European assets trust, while the youngest peer group member is Montanaro European smaller companies trust, launched in 1992, according to Financial Express data.

Well, it was the youngest. The performance prospects of European small caps may be failing to spark investor attention but managers are looking to this end of the market to bolster returns.

The long-standing TR European growth trust portfolio, launched in 1990 and managed by Stephen Peak, recently refocused its mandate more on small caps, having drifted to an all-cap stance in recent years. The underlying benchmark for the close-ended fund has switched to the HSBC smaller companies Europe ex UK index and the managers are selling down larger company positions and redeploying capital to growth opportunities further down the market cap scale.

The trust has almost shrunk in assets by half over the past five years, which is why it was decided to revamp the trust’s structure after consultation with shareholders. “These changes are designed to drive performance,” Peak says.

He, along with fellow managers Ollie Beckett and Simon Savill, say the rationale for the revamp was to try and capitalise on what they see as opportunity in an under-researched part of the market, targeting global leaders operating in niche areas.

“Smaller companies investing is not about buying bit players. You can buy globally dominant companies in smaller niches of the market, businesses that have something special and which can show sustainable growth over time,” they said in a recent Henderson webcast.

There is significant diversity, breadth and depth in the European smaller companies universe, according to Savill, who says TR European growth’s market encompasses around 3,000 stocks. Even after the recent run in small caps, Savill says there are still companies on attractive valuations and sound growth prospects.

The F&C managed European assets trust is another close-ended fund detailing a positive picture for the small and mid-cap area of Europe. Paras Anand, who took over running the portfolio in mid-2010, agrees the universe is broad enough to provide opportunities that have been neglected in the recent strong period.

Commenting on the outlook, European assets trust chairman Sir John Ward says: “For investors in small and medium-sized companies, periods where corporate activity is at high levels can be a source of further growth in the market. Although we are early into the year, 2011 is already seeing a continuation of this theme. Companies with healthy balance sheets can take advantage of low borrowing rates to bolt on businesses that can augment and potentially open up new markets. In addition to this, corporate results continue to be good and economic data is generally encouraging.”

Adrian Bignell, manager of Invesco Perpetual’s open-ended European smaller companies fund, also sees reasons to be positive on the sector. While he says performance of European small caps was muted in February, slightly underperforming their large-cap counterparts, he attributes this to the tensions in the Middle East as well as speculation of a possible bailout for Portugal.

Overall, he says the month saw better-than-expected corporate earnings, underscoring the case for investment in this area of the market. “We are optimistic in our outlook for smaller companies, which we believe to be attractively valued, both relative to other regions and compared with history. This, along with equity returns comparing favourably relative to other asset classes, and the fact that M&A activity appears to be picking up, makes us believe the European smaller companies’ asset class is attractive at the present time.”

Bignell and Ward both believe that while the sovereign debt crisis in Europe has hit sentiment, it has also had an upside. Bignell says: “This has presented many opportunities to buy stocks that are on already attractive valuations.”


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