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New life in the new breed

Improved performance by smaller companies may be the start of a fundamental change in the markets, writes Jonathan Sharpe of Gartmore
After several years of underperformance, European smaller companies are finally showing signs of life. They have outperformed large companies by more than 8% so far this year, helped by a strong performance from the more economically sensitive cyclical areas of the market and the emergence of a new breed of small, high growth technology and media companies.
The key question for investors is whether we are experiencing a short-term correction in the long-term secular decline of small companies in Europe, or whether this is in fact the start of a new long-term positive trend.
We believe firmly that we are in the early stages of a fundamental change in the smaller company markets, and that an investment in this area now gives the opportunity to gain exposure to some of the fastest growing and most dynamic companies in Europe. We argue that the key to maximising returns from the smaller company area is to have a disciplined and structured approach to stock selection, with a focus on the growth sectors of the market. This can give investors some confidence of achieving satisfactory returns from a dedicated smaller company fund even when the sector is out of favour, as it was during 1997 and 1998.
A particular feature of the smaller companies market is the broad range of companies which need to be analysed across diverse countries and sectors. It can be a significant challenge for smaller company investors to keep track of all the potential investment opportunities available and to find a common set of analytical tools to judge their relative merits. There are over 5,000 listed companies in continental Europe with a market capitalisation of less than e1.5bn. This is growing rapidly, with over 70 new issues in Germany alone so far this year.
Using a common set of analytical tools is important in assessing such a broad range of companies. One common approach is to assess first the industry in which a company operates, and then the franchise of the company within that industry. This helps to identify common themes in a sector of the market. Many small companies in industrial or manufacturing sectors are finding life increasingly difficult in the modern economy, for example, and application of these tools suggests that this could be due to a deterioration in the franchise of the company.
An example of this trend is the car parts industry. These are many high quality small suppliers of car parts in Europe. These companies are dominated by their customers, the car manufacturers in Europe, who put continual pressure on their suppliers to reduce price and increase service. Small companies operating in this area often do not have the financial resources or the competitive advantage to grow their businesses. The result, in many cases, has been lacklustre share price performance.
Within the smaller companies market we believe the prospects are brightest for companies operating in attractive growth industries, where smaller operators can achieve leading market positions on a European or global basis. The media and technology sectors are good examples of industries where young companies can achieve this. German media companies such as EM TV and Kinowelt are benefiting from strong demand for programming, driven by a proliferation of new television channels. Both of these companies, along with several others, have rapidly built strong market positions in the German media market. Forward-thinking management have stolen a march over larger competitors by moving quickly to secure highly attractive contracts and acquisitions. As a result, EM TV, for example, has been one of the best performing stocks in the whole of Europe over the last year, rising by more than 500% in that period.
The technology sector has also been a fertile hunting ground for the smaller company investor. Investors struggled to find many world class technology companies in Europe five years ago, particularly at the lower end of the market capitalisation scale. The last 12 months have seen an explosion of new companies coming to the market in this area.
Once again, Germany has been the most successful breeding ground of new companies, producing world leaders such as Intershop, Brokat and Utimaco. The common factor in the success of these small companies has been the ability of management to build a leading position in a new, rapidly growing market.
Although Germany has stolen the limelight in terms of numbers, there are signs that companies from other countries are emerging in these growth sectors. Meta4, one of the first software companies to come out of Spain, is seeking to establish itself as a leader in web-enabled knowledge management applications. Sweden has a tradition of producing high quality smaller companies, with stocks such as Icon Medialab and Modern Times Group blazing a trail in the internet and media fields.
One common feature of many of the success stories of the last 12 months is the fact that the companies are new to the stock market. Germany’s new market for high growth companies, the Neuer Markt, has provided opportunity for many companies to gain access to capital. Strong demand from retail investors and, increasingly, institutions, has pushed valuations of the most successful companies to high levels, reflecting in some cases the sky high prices of internet stocks listed on the US NASDAQ Index. The smaller company investor needs to undergo a shift in mindset to analyse the current situation. In the long run, however, success will come from basing investment decisions on fundamental analysis, confidence in management and disciplined risk control.
The final element which the smaller company investor has to cope with is the inefficiency of smaller company markets. This manifests itself in two ways. First, the European smaller company markets tend to be illiquid, making it difficult for institutions to put significant amounts of money to work. Investors must tailor their strategy to cope with this lack of liquidity. One approach is to use a long-term horizon, seeking to buy into stocks early, before the crowd, and to sell early, when there is sufficient interest from to other investors to liquidate positions. The second way in which the market’s inefficiency manifests itself is through the poor information availability about many companies. This actually works in investors’ favour, giving value to original, fundamental research. It is this research which should form the basis of investment decisions, enabling the smaller company specialist to achieve a competitive advantage.
We believe the prospects for European smaller company markets are excellent. We expect to see the continued emergence of a new breed of growth company in Europe. The indications are that we have merely seen the tip of the iceberg in terms of new issues. Germany will continue to lead the way, but companies from other countries will increasingly attract investors’ attention. We believe firmly that investors should have exposure to smaller markets, or risk missing out on some of the most attractive growth opportunities in Europe.
Jonathan Sharpe is head of European smaller companies at Gartmore in London

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