Opportunities abound for the small cap players come the Euro, say Arjen Jongma and Arnoud Wolff at Robeco Institutional Asset Management

The euro is forcing all companies to reassess how they manage their business. In the discussion about the euro, the focus has been on large caps. This is understandable since many new investors select large companies with well established track records. Moreover, new products and new funds, like equity guarantee products or euro funds, tend to focus solely on large caps. This contributes to the substantial difference in performance between large cap and small/mid cap stocks. M&A activity and capital restructuring has further supported the large cap share price performance. 'European large cap stocks leave small caps behind' was a Wall Street Journal headline in February of this year. This is remarkable, because based on extensive academic research, there is compelling evidence that, in the long run, small companies do better than large ones.

Investing in small/mid cap companies has traditionally been interesting for reasons of risk diversification and enhanced returns. Small/mid caps are clearly a different asset class with a slightly higher risk profile, but also higher earnings growth at lower multiples. What specific arguments for small/ mid caps can be made with the appearance of one single currency, the euro? One important aspect is the fact that devaluation will no longer be a policy option used to compensate for lost competitive ad-vantage. This argument offers better op-portunities for the more euro focusing small/mid caps than for the large global players. In addition, an accelerated process of deregulation and harmonisation of legislation across national borders will result in diminishing nationally protected industries.

As a consequence above average earnings growth can be expected for small/mid caps, and superior earnings growth is one of the key drivers for their expected outperformance in the near future. Within the small/mid cap universe of companies the niche players are the beneficiaries of the new level playing field. Large caps are forced to compete with each other in the Euro(pean) zone. The consequence of greater transparency of pricing will force all companies to more closely focus on their cost base, resulting in increased outsourcing of non-core activities, for example. This provides opportunities for niche players. They can develop specific competitive advantages within their sector. Examples are biotechnology and medical technology within the healthcare sector, or specialty chemicals and industrial components within the basic materials sector. Within the service sector medium sized companies have already shown excellent relative performance over the past five years.

Investing in small/mid cap stocks will be a different ball game in the Euroland of the future. Large cap asset managers are faced with some 350 relevant stocks. General trends and sector dynamics can be applied to most companies within the same sector. Pan-European sector selection with a flavour of country influence suffices to generate an effective and efficient management of large cap funds.

Small/mid caps are still more driven by local or nat-ional circumstances. A blend of local knowledge and Pan-European sector specifics is necessary in selecting outstanding small/mid cap stocks. The European small/mid cap team of the Robeco Group is therefore country-oriented for their small/mid caps (with local presence in The Netherlands, France and Switzerland), but they are also integrated within the large cap sector teams.

Part of the selection of small/mid cap stocks is done by identifying niche growth areas within specific (sub)sectors in Europe and linking these to the knowledge of specific countries. An example is the medical technology sector where most niche players can be found in Switzerland, a country that is known for its excellence in the healthcare industry. Other examples are the outsourcing industry in the UK, luxury goods in Italy, specialty machinery in Germany and technology in Scandinavia.

However, this is not sufficient to cover all interesting stocks within Europe, because there are several thousands of them. Stock selection in the small/mid cap area also requires investment in information technology and a commitment to research in order to handle this multitude of stocks. The asset manager needs to be able to screen the stocks on the basis of the performance drivers, to manage the funds on a daily basis and to incorporate client wishes including risk control. It is clear that the adequacy of the database, especially for the under-researched small/mid cap stocks is crucially important to the performance of these tasks. We have developed our own proprietary database for European stocks, which includes several thousand small/mid cap companies.

For a successful screening of the stocks we have developed a proprietary multi-factor screening model that runs on its database with European stocks. With this screening mechanism some 10% of the thousands of stocks from this universe show up as attractive. This eases the task of the manager, be-cause he/she can concentrate on the selection within this group of attractive stocks.

Small/mid cap stocks offer an interesting alternative to large caps. In recent months small/mid caps have already outperformed large caps. When investors recognise the positive impact the euro will have on the earnings of medium sized niche players, this outperformance is likely to continue. Valuations of large caps are already stretched, while valuations of small/mid caps are still attractive. Expected earnings are running ahead of those of large caps and there is significant potential for selected stocks such as outsourcers, software providers and medical technology.

WithinRobeco small/mid cap stocks continue to be selected from a country perspective, but knowledge of sector developments certainly play a role in the final selection. Furthermore, modern IT techniques and screening models enhance the stock selection process on a pan-European scale. This results in superior stock selection within an attractive alternative asset class: European small/mid caps.

Arjen Jongma and Arnoud Wolff are portfolio managers in Rotterdam at Robeco Institutional Asset Management. Jaap van Duijn, chief investment officer, and Angelien Kemna, overall head of the equity group also contributed to this article