European equities
21 Jun 2016

Size matters

Why European smaller companies? Investors are typically attracted to smaller companies as an asset class on account of the fact that the earnings growth produced, over time, is superior to that of their large cap counterparts.

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Why European smaller companies?

Investors are typically attracted to smaller companies as an asset class on account of the fact that the earnings growth produced, over time, is superior to that of their large cap counterparts. The chart below aptly demonstrates this. Indexed to 100 in 2001, smaller companies have outperformed by over 125% in the period 2001 to 2015.

Source: MSCI Europe ex UK Small Cap vs MSCI Europe ex UK. OMGI as at 31/12/2015.

Add to this the fact that smaller company managers usually beat the benchmark index, and my track record demonstrates that I usually beat the peer group (see overleaf), investors should be presented with a reasonably compelling case.

Why Europe?

A more important question for many investors is why Europe? Dogged by anaemic growth, a fragile banking system, negative interest rates, politics, and the occasional drama in Greece over bailout terms, investor nerves remain fragile.

Concerns, centring on the macroeconomic environment, politics and the stock market more generally are addressed below:

The macroeconomic environment. Europe slowed discernibly in the second  half of 2015 into 2016, predominantly because of global headwinds. Domestic demand, by contrast, has remained on track, driven by robust employment growth across the eurozone region. Since then we have seen increased monetary stimulus by the European Central Bank (ECB) in the form of corporate bond buying and several non-ECB central banks have cut their policy rates. This should help nudge growth back to an annualised rate of between 1.5% and 1.75% in the second half of the year. So, we believe, the eurozone is a relatively calm port in the global economic storm, and growing close to its productive potential (the long-term underlying measure of how an economy can grow).

Politics. Politics will always cause noise. The recent German state elections, whereby Angela Merkel’s Christian Democrat Party fared badly, principally on account of her ‘open doors’ approach to the migration crisis, is a timely reminder of how quickly the political status quo can change.

In the run up to the UK’s EU referendum vote, investors could see increased volatility, especially in the event of an ‘out’ vote as markets struggle to reach necessary conclusions. The strong rise in the rate of sterling relative to the euro on the back  of the Ipsos MORI poll (18 May 2016) suggests that the UK is more likely to vote ‘remain’, so dampening the disquiet about EU institutions for now at least.

Stock market. Reporting was largely in line with expectations at the full year stage (year ending December 2015). The first quarter (for the three months ending March 2016) was moderately positive for the market and even more positive for the fund. Lowly-set turn of the year expectations were relatively easy to beat. We should see mid-single digit sales growth from our small companies this year and low teens earnings growth. For that, investors are paying a forward price/earnings multiple of around 14x and are receiving a dividend yield of 3.4%[1].

Small cap fund forward price/ earnings multiple relative to the benchmark since the Old Mutual Europe ex UK Smaller Company Fund inception

Source: Bloomberg, as at May 2016.

Fund positioning

Our portfolio remains biased towards

pro-cyclical stocks, domestically orientated stocks (81% of sales from the companies in the portfolio are generated from within Europe) and relatively financially strong at 1.5x net debt/EBITDA compared to 1.7x for the benchmark. (Most of that debt is clustered in asset-backed companies).

Performance. The fund is in the top quartile of its peer group year-to-date and well ahead of its benchmark, the

Euromoney Europe Small Cap ex UK index. Cumulative fund performance over the five years to April 2016 93% versus 50% for the peer group average[2].

As we move away from a momentum driven market to a more uncertain one our focus on stock specific catalysts should continue to deliver.

Cumulative five year performance track record for Ian Ormiston versus the median peer group*

*Please note: Ian had a career break from July 2014 – November 2014, in which time the performance in this period follows the average manager.

1 Source: Bloomberg as at end April 2016.

2 Source: Citywire, period  01/04/2011 01/04/2016


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