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Taking the lift to top-level returns

Dave Duddings Threadneedle European Smaller Companies fund has a glowing performance record. Despite a slump in skyscraper projects, its two biggest stocks are in the elevator business.

A conversation with Threadneedles Dave Dudding is an elevating affair. He runs one of the best European investment funds, rated AAA by Standard & Poors. And he likes elevators.

The Threadneedle European Smaller Companies fund has garnered 540m under management and is first quartile over one year, three years, five years and 10. Dudding, who started managing assets in the fund in 2001, is responsible for most of these performance figures.

He describes his investment style as idiosyncratic. In other words, it seems Threadneedle lets him get on with it, free from the index restraints that plague fund managers in investment houses that mostly run life and pensions money.
He doesnt talk about active bets or overweights and underweights. All our positions are active positions.

Investors who put their money into a small cap fund generally accept that it is a risky product, he says.

But while this is a go-anywhere fund my universe is Iceland to Turkey its not gung-ho. The biggest position Dudding takes in any one stock is 3% of the portfolio, and he limits it to 2% at first purchase. Turnover is relatively high, but he holds lots of the names for years.

He is not a fan of micro-cap stocks. He prefers more mature businesses, and in some ways you could describe this fund as mid cap rather than small cap. Were not in the top 225 stocks. But that means there are plenty of stocks we could buy, if we wished, that have a free float of billions of euros.

The typical stock in the fund has a market cap of about 1 billion (870m), although a few are at about the 100m mark.

So how do you start choosing stocks when your market takes in anywhere from the Canary Islands to Russia?

What I try to do is find companies with strong pricing power, market share and competitive advantage, he says.

We avoid, on the whole, cyclical stocks, and I dont tend to like commodity stocks either, as its so hard to add value.

Avoiding cyclicals tends to mean the fund performs better in downturns but may not participate fully in upturns. We have recently trailed because the companies with the worst balance sheets are the ones that have been going up most during the recent rally. But he is relaxed about the fact that the fund is showing fourth-quartile positions over the year to date. My aim is to get rich slow, he says.

Dudding finds his best ideas when meeting companies but not about the company hes actually meeting. I go to a lot of company meetings. But I find you get the best ideas when they start talking to us about other companies in their market. It is the best unbiased source of advice.

Pinning him down on sector weightings is difficult because they clearly emerge from individual stock positions rather than top-down views. But he says a large part of his outperformance in the earlier part of this decade came from a realisation that German industrials were ludicrously cheap.

My first full year, 2002, was a bad year for European equities, but the fund did well, he says. In the following year I bought a lot of German industrials and held them for some time. Valuations were rock bottom, but other investors just didnt want to know.

More recently he has benefited from positions in medical and healthcare stocks, although he acknowledges that a lack of exposure to financials has hurt performance in recent months. Smaller companies in Europe did better during 2008 than large cap. But there are not many banks in the small cap universe.

So what does he have in his portfolio? His two largest positions are in the elevator business. He holds Kone, a Finnish manufacturer in what is a highly consolidated global industry with only five sizeable players.

But surely, as skyscraper projects from Dubai to Chongqing are cancelled, arent companies such as Kone going to be left without orders?

Yes, says Dudding, but it doesnt really matter. He says that some elevator manufacturers sell lifts at, or even below, cost price. The real money is in the servicing contracts. Maintenance income is 55% of Kones turnover, its very stable and as the market is so consolidated worldwide, there is not too much pricing risk. Companies such as Otis have been around for 100 years, and theres still a lot of international growth potential.

Kones share price has risen from 14 at the end of last year to 22 last week.

His second largest holding, LEM Holding of Switzerland, is also in elevators. It makes small electronic devices for energy consumption measurement that are used in lifts, but also in many other products. Dudding expects LEM, whose share price has doubled since it hit a SFr110 (64) low in December, to be a big beneficiary of the rise of electric cars.

Small cap funds tend to have a bias towards technology, but thats not Duddings approach. He asks if you would describe Rightmove, the property portal, as a technology company? Its not, really, but it has benefited from technological development. What Dudding wants to see in a tech company is the ability to dominate a market.

Theres a French equivalent to Rightmove. I dont own it at the moment, but Id describe it as a natural monopoly rather than a technology company.

More recently he has acquired a holding in Swissquote, an online broking company that is taking market share from its financially embarrassed rivals UBS and Credit Suisse. Dudding likens it to Hargreaves Lansdown. Its a cheap and easy, low-cost way of dealing that has the potential to grow rapidly in the Swiss domestic market.

The strengthening of sterling against the euro may deter some from allocating to this market, as any gains may be wiped out by a rise in the pound. Dudding will not be drawn on the euro Its a mugs game predicting currency movements and does not manage the fund with a currency reference.

What he does predict is that, although Europe still has significant economic problems and the recent rally probably has little further to run, on a five-year view, investors are absolutely fine.


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