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UK exposure - or lack of it - has been decisive in European small and mid-caps. But Martin Steward finds that managers have also had to contend with a difficult ‘risk-on, risk-off' environment

What is the UK's place in Europe? Don't stop reading. This isn't another dissection of last December's EU Summit. It is, rather, the question that every European small and mid-caps manager must ask itself. The widely-referenced HSBC Smaller European Companies index includes more than twice as many businesses from the UK as it does from Germany, mighty home of the Mittelstand. In terms of market-cap the UK is nearly three times as significant. That's unfortunate, because all of the managers featured in our review find more opportunities outside the UK, where markets remain less well-covered by analysts.

Kempen Capital Management uses the HSBC index to benchmark its Sustainable Small Cap strategy, but explicitly cuts the UK weighting by half to create a more representative reference. The result, today, is a very slight underweight - rather than the 16 percentage points suggested by comparison with the standard index.

Danske Capital's European Equities Small-cap strategy benchmarks against a Morgan Stanley index that weights the UK even bigger - but it has even less UK than Kempen's at a 27 percentage point underweight. "Frankly, I find it difficult to understand why the UK is such a big part of the benchmark," says chief portfolio manager Ivan Larsen.

Similarly, ODDO Asset Management's Avenir Europe strategy is about 23 percentage points underweight the UK. Head of mid-cap equity, Pascal Riégis, articulates why that has been so significant in the slide down the Mercer performance universe between Q2 and Q3 of 2011 (see page 47): "UK exposure has been very positive this year. Take two comparable companies, one based in the UK, one in continental Europe, and the UK firm trades at an 8-10% premium."

In the meantime, European small-cap strategies like Threadneedle's or RCM's (both underweight the UK only around seven percentage points) are outperforming.

So why bet so hard against Britain? Ironically, ODDO's top holding - UK-based Rolls Royce - might offer the clue. Riégis and his co-managers Grégory Deschamps, Sébastien Maillard and Frédéric Doussard, like the aeroplane-engine business model, in general, with its high barriers to entry and recurring maintenance revenues - they also own France's Safran. "We are fortunate in Europe to have two genuine world leaders among the handful of global competitors," he says. And that is the key. The world comes to France and the UK for these products. "The companies we invest in also have an international profile and business model," says Riégis. "But half the UK market is purely domestic - financials, real estate developers, retailers."

Exposure to global markets is a long-term theme that makes a lot of sense. While it can lead into pro-cyclical industrial sectors and experience volatility when global growth slows, it doesn't have to be that way. Alongside Rolls Royce, ODDO his also able to pick out stocks in the defensive med-tech sector on the same international-growth theme, like its fourth-largest holding, Fresenius. Riégis thinks that the potential in its 2008 acquisition of APP Pharmaceuticals has yet to be fully realised; it has opened up a vast new US hospitals market to the German firm, where its bags-within-bags intravenous technology will significantly improve shelf life and reduce hospital costs once it is FDA-approved.

But it's also not just about solid German and Dutch markets. If you want to be contrarian, the international theme can lead you to some intriguing places - like Iberia. Mirroring ODDO's Fresenius play, Danske holds Spanish med-tech blood plasma specialist Grifols, which recently acquired the US firm Talecris Biotherapeutics. "This merger makes Grifols a leading player in this industry," says Larsen. "It's been one of the best performing med-tech stocks during 2011."

In the consumer staples area, Danske also owns Portuguese supermarket chain Jerónimo Martins ("It's not about Portugal but about Poland," says Larsen, alluding to its ownership of the Biedronka brand); Spain's Distribuidora Internacional De Alimentacion (DIA), with growing footprints in Latin America and China; and its compatriot Viscofan, producer of artificial food casings - another company with a truly global footprint, in terms of acquisitions and sales offices from the US to China.

"It's not about the domicile of a company, but about what it's doing and where it is generating revenue," says Larsen. "We don't see ourselves as thematic investors but, of course, you will identify some themes in the stocks you pick - for instance, exposure to emerging markets is interesting."

Rory Hammerson, manager of the Kempen strategy, warns that emerging market demand taps can be turned off painfully sharply - but concedes that it has been a key source of incremental revenue growth for companies in unloved domiciles. Just outside its top 10 holdings sits CAF, the Basque rail and tram system specialist whose revenue streams are currently split 50/50 between domestic and overseas markets. Hammerson thinks it is turning Spain's problems to its advantage.

"They are using the spare production capacity to ramp up their ability to prove to the export market that they can deliver a very competitively-priced, quality product," he argues. "As a result they've been winning big contracts from Turkey to New Zealand. They now have a three-year sales order backlog, and a substantial proportion of that comes with service contracts that will generate recurring revenue."

While one wouldn't want to stress the contrarian side of all this - Danske has nearly 37% in industrials and 35% in Germany and the Netherlands, Kempen has 31% in industrials and 30% in Germany and Switzerland - it is important to recognise that ‘industrials' at the small and mid-cap level does not necessarily imply super-high beta in the way that it might among large-caps.

"One large position for us is Vopak, which rents out storage space on long-term contracts in harbours around the world," says Larsen. "It may be a utility - but it's certainly not a traditional, highly pro-cyclical industrial."

If the anti-UK skew goes some way to explaining why these three strategies have slipped down the rankings through 2011, it is the way they think about defensiveness, pro-cyclicality and ‘quality' that may help us understand why Kempen and ODDO share more consistency across all of the time horizons and Danske has been hit hardest over the past 12 months.

On the face of it, the Kempen and Danske strategies appear to share a lot in common. Hammerson says that the Kempen portfolio only invests in two types of stock - at least 60% of the portfolio must be ‘quality' (that is, delivering a high return on capital), while the rest is in ‘special situations' (companies going through management change, restructuring, or some sort of industry-wide regulatory change). Its top holding, Austriamicrosystems, an integrated circuit designer motoring in the slipstream of Apple's blockbuster gadgets, is in the latter camp; it not only recently acquired Texas Advanced Optoelectronic Solutions (which supplies sensors for smartphones and tablets), but also tackled a longstanding problem by switching to an outsourcing model for production.

Similarly, Danske's strategy rests on three legs: quality, value and delta. Quality is a strong market position and pricing power in an industry with rising prices, healthy balance sheets and good management. "Risk is not benchmark-relative for us, risk is investing in a poor-quality company," says Larsen. He presents his portfolio's concentration and stock-specific risk as Exhibit A (it has never held more than 36 stocks).

Delta is akin to Kempen's ‘special situation': structural change to an industry or a company that will affect competitiveness. Larsen picks out Signet, which addressed its creaking balance sheet and managed to capture US market share as competitors struggled; Croda International, which has turned the underperforming Uniqema into a prized asset since its acquisition from ICI in 2006; and Viscofan, which managed to build by acquisition as competitors collapsed thanks to over-supply in the food casings industry. More generally, he points to numerous industrials - like Jungheinrich, the Hamburg-based forklift truck manufacturer - that have used the recession to work hard on cost-flexibility and improving economies of scale.

These examples help explain how quality can be acquired at value: change is happening and markets are often discounting that risk. Jerónimo Martins was bought when markets went sour on Eastern Europe in 2009, for example. The pro-cyclial Beter Bed in the Netherlands was added to the portfolio after the sell-off in August 2011. But this also shows how value - with all of its volatility - makes up an important part of the strategy. Furthermore, delta and value share an equal weight with quality: "I will not buy the world's best-quality company if I cannot identify any significant, longer-term change, or if it is not reasonably-priced," says Larsen.

This would be quite different from the strategy at Kempen where ‘quality' has always accounted for at least 80% of the portfolio, and today sits at 82.5%. It is also worth noting that there is arguably another layer of quality in the form of Kempen's integrated ESG overlay.

Given that background, it is instructive to compare two positions in very similar consumer discretionary sub-sectors: Kempen's holding in the UK soft-furnishing retailer Dunelm Group, and Danske's in the German DIY chain, Praktiker. Dunelm was up 11% from the beginning of July through to mid-December, sailing through the horrors of Q3 2011.

"From a top-down point of view you'd think, ‘UK retail? No thank you'," as Hammerson says, reflecting on Dunelm. "But it's a fantastically-run company - family management own 60% - and it's snapping up market share, not only from the independents but some of the bigger names, too. In tough times there are always opportunities for management who know their market really well."

By contrast, Praktiker lost almost 90% through 2011. After running a wildly popular ‘20%-off-everything' sales drive, the firm decided to abandon this recession-busting strategy in an attempt to rebuild margins. Unfortunately, it only succeeded in driving away custom; revenues collapsed and CEO Wolfgang Werner resigned, to be replaced by turnaround specialist Thomas Fox.

The most galling thing for Danske is that its overarching theme in consumer stocks is value for money - it informs several positions, from German opticians Fielmann to Fourlis, which wields the IKEA brand in Greece and some parts of Eastern Europe. And yet it had been among the Praktiker shareholders lobbying for better margins: "If you have turnover of €3bn but no earnings, then getting an EBITDA of just 1-2% can have a huge effect," Larsen observes. "We had too much faith in management, to be honest."

The episode indicates how Danske's more aggressive take on the ‘special situations' tactic can turn ‘value' into ‘value trap', even though its style is far from pure-value (as its excellent relative performance through 2007-08 and its lagging of the market in 2009 clearly show).

So where does ODDO fit into this? Among the three, its returns are more like Kempen's than Danske's in their consistency across all horizons, and yet it has fallen the furthest in the rankings between Q2 and Q3 2011.

The first thing to note is that ODDO's strategy is more mid-cap than the other two. Although it benchmarks against the HSBC Smaller Companies index, its average market cap is three times as big, at around €5bn. The Kempen portfolio is also slightly larger than the benchmark, at €1.8bn - Hammerson speculates that this might be related to its fairly demanding ESG engagement process. Danske's average market cap sits just below the benchmark's, and he cannot add new funds to any stock that goes above €5bn.

"You can find those genius ideas in small-caps that no-one knows about and which can generate 200-300% returns over a few years," says Riégis. "Or you can attach more importance to not losing money - and I'm obsessed with not losing money."

Bottom-up, the philosophy has the same longer-term, quality tilts that Kempen and Danske claim for theirs - above-average return on capital, and free cash flow generation throughout the cycle that enables self-financed growth. But in addition to the size differential, ODDO's strategy is the only one of the three to have an explicit and significant top-down constraint: it must remain neutral against the HSBC index's split of what Riégis calls cyclical and defensive sectors. That means the portfolio must always have close to 75% in pro-cyclical sectors.

The surprise is that this does not result in a structurally high-beta strategy, and the reason seems to be that the quality requirements, combined with the mid-cap bias, counteract the pro-cyclical tilt. Cyclicals have to be able to generate profits and free cash flow even at the bottom of their industry cycle and, in general, that excludes financials and pure-play materials. Those exclusions need to be corrected with overweights in alternative cyclicals - which tend to be relatively defensive industrials, technology companies, and businesses in the materials science or services industries, like DSM, Brenntag and Rolls Royce.

Over a three-year horizon, this has generated a beta of just 0.79 alongside a tracking error of 8.02% - a clear low-volatility strategy that has delivered almost exactly the return of the benchmark and, therefore, a high Sharpe ratio, high alpha, but low-information ratio. Over one year, however, beta has jumped to 0.90, tracking error has collapsed to 6.3% and the alpha has evaporated. The careful stockpicking that usually counterbalances the pro-cyclical sector tilt has, in 2011, been washed out by a big rotation into anything defensive - and particularly into the ‘crude quality' of regulated cash flows.

There is little doubt that the main factor in recent performance in European small and mid-caps has been UK exposure. But beneath that, we can also see that marginal stockpicking alpha has been virtually non-existent in a ‘risk-on, risk-off' environment that has rewarded defensive sub-sector positioning and that, at stock-specific level, the difference has been made at the extremes, by the home runs (Dunelm) and the own-goals (Praktiker).
 

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