Crowded out

One might imagine small-caps markets to be hives of alpha-generating inefficiency and anomaly - and yet Joseph Mariathasan finds that returns in Europe are dominated by beta

The growth of small companies is arguably the lifeblood of capitalism: from today’s small companies come tomorrow’s Googles. Whether European small companies are currently an attractive asset class for institutional investors is not so straightforward.

As Raj Shant, head of European equities at Newton Asset Management, points out, as a group, small companies are much less liquid and more leveraged than large caps. They enjoy smaller margins and return on equity, and are less diversified by product and geography.

Add all that together, and it is no surprise that they are very much more volatile - the MSCI European Small Cap index showed a 53% fall in 2008, with a 50% rise from January to end September 2009. But Shant notes that the relief rally for small cap is self-limiting, a one-off event that relied on a change of perceptions by investors that companies that were thought to be in imminent danger of bankruptcy were going to survive into a post-crash world. This ‘dash to trash’ between March and June saw the top-decile performers outperform the rest of the small-cap market by 100%, while the subsequent rally was more broad-based. From now on, the investment case has to be made on longer-term fundamentals.

The beta story
The small and mid-cap overall market levels are now fairly valued, according to fund managers such as Carl Lee, head of BlackRock’s European specialist equity team. Indeed, investment markets may be discounting a V-shaped recovery while small caps are most vulnerable to a slowdown in growth. Kathleen Dewandeleer at Scottish Widows Investment Partnership has recently seen restocking by smaller Dutch and Belgian companies, but she still wonders what the level of final demand will be once consumers have de-leveraged and sales pick up. Forthcoming quarterly earnings will be fundamental to getting a sense of direction.

Despite this, Philip Dicken, pan-European equities fund manager at Threadneedle, argues that while the economic recovery will be relatively muted, equities are likely to outperform because of the low cost of borrowing and the level of liquidity that has flooded away from the low yields on cash. But as Josepf Schopf, a partner of Lupus Alpha warns, the real danger for European small caps is if the European economy grinds to a halt again in a double-dip recession.

“Small-cap valuations are now discounting sales growth in 2010 that is 3-4% above the rate we’ve seen in 2009,” Schopf observes. “As companies have reduced their cost bases so much, this would produce an earnings growth of 20-25%. But if this does not happen, it could be expensive for investors. Share prices could fall by as much as 25%.” Any pull-back on quantitative easing or signs of rising interest rates would exacerbate this. Furthermore, while large caps with good balance sheets are enjoying the boom in primary corporate bond markets, access to finance is still difficult for small companies that rely on beleaguered banks, despite government attempts to get money moving. It is not surprising that fund managers remain wary of moving from their defensive strategies.
But while small caps have always faced the issue of more difficult access to credit, there are also a couple of positive structural pressures that differentiate small caps - the activity of private equity firms and the so-called small-cap effect.

Leveraged buy-outs
The mid-market private equity universe overlaps with listed small-cap markets, and public-to-private transactions did become prominent just prior to the crash. European small caps virtually always traded at lower valuations to the market as a whole over the 30 years before 2006-07, when everything turned around at the height of the leveraged buy-out (LBO) boom. This implies that private equity activity pushed valuations for the small caps throughout the period.

Further evidence is provided by Sparinvest, which has a strong value-driven approach similar to that adopted by LBO firms. Its analysis of a database of 400,000 European merger and acquisition (M&A) transactions is revealing. A third of the exits from their investments have been due to M&A. Not surprisingly, there was no activity of this kind in 2008, although there has been some in 2009. But during 2005-07 they were unable to find attractively valued small companies. Kasper Billy Jacobsen, portfolio manager, ascribes this to the fact that the activity of private equity firms drove prices too high as they leveraged the balance sheets of their acquisitions to enable them to outbid industrial firms in takeovers. Private equity firms were typically paying 10 times EBITDA while, historically, the database shows M&A transactions typically around seven times.

“I don’t believe most private equity firms add value, generally, through their management skills,” says Jacobsen. “Our philosophy is that management knows what they are doing. The private equity firms were paying too much and their strategy revolved around just leveraging the balance sheets. Investors are better placed to leverage investments than companies.”

Sparinvest sees evidence that it is industrial players that are becoming more active in the M&A marketplace as private equity gets squeezed out because of a lack of access to credit. As a result, small-cap valuations relative to the market as a whole are likely to remain much closer to longer-term averages than they did during the LBO boom.

There are theoretical reasons why trying to capture the beta of the small-cap universe might be a good idea. Many academics have produced strong evidence of the so called ‘small-cap effect’, whereby small caps consistently produce higher long-term returns than large caps. Dimensional Fund Advisers, which was set up to exploit this effect, attributes it to the higher underlying cost of capital for smaller companies. Its approach, according to investment director Garrett Quigley, consists of targeting the smallest 10-12% of each of the currency groups within the developed European markets. This approach of not following an index but, instead, creating a target universe, minimises turnover to less than 10%, most of which is necessitated by companies becoming too big for the fund’s universe - critical to protecting long-term returns in such illiquid markets as small caps.

There is controversy as to how real the small-cap effect is. Newton’s Shant is no great believer. “My own view is that a lot of the studies do not take account of survivorship bias,” he suggests. (Quigley points to studies, including one from the London Business School, that do take account of this bias). Shant adds: “On a risk-adjusted basis, you would be better off in large caps. However, I would concede that the small-cap universe is a good place to add alpha.”

The alpha story
Dimensional Fund Advisers’ 1,000-stock, highly diversified portfolio differs entirely from strategies used by specialist active small-cap managers with portfolios that might have 50 stocks or less, and for whom an index may be irrelevant beyond pure performance measurement. BlackRock’s Lee sees the two extremes as the difference between market timing and stock selection.

Active funds inevitably give a mixture of the two, with Lee perceiving market timing as more important when the VIX index of implied volatility is high. But how many stocks an active manager should have is more controversial. BlackRock’s active portfolios have 250 stocks from an investable universe of 2,500. Lee goes so far as to argue that many managers hold fewer than 100 stocks only because they do not have the resources to analyse enough companies to give more diversified portfolios. Andrew Lynch, European small-cap manager at Schroders, points out that small-cap managers will always find it difficult to hug indices from the likes of MSCI and HSBC which include over 1,000 often very illiquid names. He argues that the discipline of active investment in small caps is very different from large caps, forcing managers to adopt focused strategies.

Moreover, the sheer number of companies enables specialist small-cap management teams to focus on niche strategies that might be subject to different pressures from the marketplace as a whole. “We are looking for stocks operating in a niche with barriers to entry, and hence able to compete against larger companies and generate cash to become long-term winners,” says Philip Dicken, pan-European equities fund manager at Threadneedle.

Many firms seeking to generate alpha have portfolios with fewer than 100 stocks, with Threadneedle having 80-100. Lupus Alpha focuses on 60-80 companies where access to credit is not an issue, and even with reduced earnings have good free cashflow. As Schopf explains: “Most foresaw that bank lending would be a problem and reduced stock and accelerated payments from clients. Others also issued more equity, whilst some of the larger companies have been active in the bond markets.”

Sparinvest’s strategy is also focused on finding quality companies in a 65-100 stock portfolio independent of the gyrations of the marketplace. “We act more like the corporate finance department of a bank and we focus more on the absolute value of a company rather than the upside potential that may never be realised,” explains Jacobsen. This deep value approach gives rise to very conservative valuations, with the firm only looking to purchase companies at a 40% discount to their own calculation of intrinsic value. Net debt to equity has to be less than 50%, including items such as pension liabilities, while other items, such as goodwill, are deducted from the equity. Sparinvest’s strategy has led to a third of its 200 or so exits from investments during the past 12 years arising from M&A, while the rest came from selling investments that reached intrinsic value.

Given all the potential anomalies that could be exploited within the European marketplace, how has the fund management industry responded and how successful has it been? Altis Asset Management undertakes regular analysis of this issue based on the Morningstar universe of 130 mutual funds and the results, according to director Oscar Vermeulen, are somewhat frustrating: “In this year’s ‘junk rally’ the quality stocks underperformed,” he notes. “Most European small-cap managers underperformed massively, with a few exceptions, as they have a structural tilt towards quality companies. You can excuse managers for that, as a rally of ‘trash’ might not be the environment you want your manager to do well in.”

No manager could have been expected to outperform both on the downside and on the upside during the gyrations seen in the past couple of years. More worryingly, however, Altis manager Stefan Warntjes says that while outperforming the MSCI European Small-Cap index is feasible and outperforming the MSCI European Small-Cap Growth index is almost trivial, practically no one outperforms the MSCI Small-Cap Value index over the long term (7-10 years). Those that outperform the regular MSCI European Small-Cap index do so by having a ‘quality bias’, he argues, suggesting that what looks like stockpicking alpha is often just the value effect. He sees 2001 as providing a good example:

“Everyone beat the Small-Cap Growth index, a fair share of managers beat the regular MSCI Small-Cap index, but no one beat the Value index until value underperformed growth.”

In the US, things seem to be different, claims Warntjes. “There, you find fantastic small-cap boutiques that really beat the market with a value-based approach based on picking stocks,” he says. By contrast, he finds it disappointing that European managers, often owned by banks, allow small-cap funds to be run by teams and individuals that change frequently. “In Europe there are just a few dedicated small-cap specialists in boutique fund management firms.”

Perhaps the time is ripe for the competitive environment of European small-cap fund managers to change. One sector that Lee’s team at BlackRock says is undervalued is Europe’s asset management industry itself. Lee also argues that it is an exciting time to be a small-cap manager, with the anomalies that are in the marketplace. Perhaps as the fund management industry restructures itself more successful European small-cap teams within large organisations should try to emulate their US peers, creating value-oriented independent boutiques that can take advantage of the diversity within the asset class to create alpha, even if the potential for beta for the market as a whole is subdued.

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