Small & Mid-Cap Equities: Punching above their weight
Martin Steward takes a tour of some world-beating European companies with four leading small-caps managers
When you get down to small-caps it’s all about the businesses on the ground. Country weights in portfolios reveal little about risk profiles. It is surprising how many of Europe’s best smaller companies sell their goods and services worldwide. Some even help the big multinationals sell globally – which is one reason traditional sector categories do not reveal much, either: a small logistics firm on a contract with BASF, GSK or Walmart might be an industrial stock, but its cycle will have more to do with chemicals, pharmaceuticals or (US) consumer staples.
So when you compare performance over three years (during which quality and defensiveness was best) and three months (when risk assets rallied) in the Mercer universe you might conclude that MFS Investment Management runs the most conservative portfolio. Its low beta suggests the same thing – and yet it pairs a slight overweight in Germany with almost twice the benchmark weight in Spain. Threadneedle Investments appears to edge more into risk or pro-cyclicality, but has twice the benchmark weight in Germany but only two-thirds the benchmark weight in Italy.
Is MFS overweight consumer staples and underweight financials? Yes – by 7 and 12 percentage points, respectively. But then again it is also overweight materials and underweight healthcare.
Staples in disguise
“In materials, we would own those that we are more confident can withstand a tough environment,” explains international small-cap equities investment officer Peter Fruzzetti, suggesting diversified chemicals company Croda, food casings manufacturer Devro and flavour and fragrances specialist Symrise. “Any of those could be considered a consumer staples-type business.”
For MFS, ‘staples’ is redefined to include Devro, as well as firms like Christian Hansen and Kerry Group, both involved in manufacturing cultures for dairy products; and Britvic, which makes much of its revenue as a distributor of Pepsi products.
Bunzl, MFS’s top holding, exemplifies the idea that a sector like distribution or logistics can offer staples exposure in an industrials wrapper: in its biggest market, North America, it delivers packaging and cleaning goods to supermarkets. Its top-line growth will never be stellar, but earnings and profits are extremely stable.
“While there aren’t many Proctor & Gambles in small-caps there are many quality manufacturers, distributors and other companies that feed into consumer-facing businesses,” says Fruzzetti.
This idea can be traced in other managers’ key positions: Nordea Investment Management also holds Britvic and Symrise, as well as Viscofan, which competes directly with Devro.
These are valuable exposures when the MSCI benchmark contains only 5% pure consumer staples stocks; and this kind of sectoral line-blurring helps explain why sectors do not determine the other portfolios’ risk profiles any more than they do MFS’s.
Nordea and BNP Paribas Investment Partners (BNPIP) both show betas of around 0.90, and higher volatility than MFS. While Nordea runs portfolio-level underweights in materials and industrials, its top-10 holdings include Rubis, Bertrandt, NORMA, Andritz and Morgan Crucible – a great illustration of how individual stock positions can begin to explain risk exposures more completely than sector weights.
Damien Kohler, head of European small and mid-caps at BNPIP, is the manager who balances common-factor risks most clearly. His biggest active sector weight is a mere 4.5 percentage point underweight in financials – which would be bigger without some offsetting positions in listed real estate. Similarly, the slight underweight in energy would be greater were oil and gas construction firm John Wood Group not its sixth-biggest holding.
Kohler will focus research efforts on sectors he is underweight more than five percentage points: this was the position in energy in summer 2011, which led BNPIP to take a closer look at oil and gas services firm John Wood. The firm had just acquired PSN, whose business should smooth-out some of John Wood’s pro-cyclicality and help bolster an already healthy balance sheet; BNPIP thought that its cash-generating capacity was undervalued. “We have good reasons to own the company but without this specific energy focus that arose because of our underweight we may never have looked at it,” Kohler explains.
There are almost one thousand stocks in the MSCI Europe Small Caps index and many hundreds more off-benchmark. It is natural that portfolio managers focus on specific areas of expertise, but also, as BNPIP shows, that if they have factor tilts to fix, redirecting the research focus is likely to uncover hidden gems.
Given this background, the rest of this article will discuss a range of portfolio companies held by our four featured managers against the context of five common themes: dominant market positions; productivity enhancement; emerging markets; ageing populations and healthcare efficiency; and market consolidation.
Nordea portfolio manager Kalle Huhdanmäki says he is “obsessed” with pricing power.
“Our companies need to be market leaders,” he insists. “That’s especially important when there is very little growth in the economy.”
Nordea’s biggest holding, the French provider of bulk storage at chemicals and oil and gas terminals, Rubis, competes head-to-head with the Netherlands’ Vopak – but hardly anyone else. It is difficult to get the pitches in ports, let alone the permits to operate, and demand is high and growing: both companies enjoy 90%-plus utilisation rates.
Its eight-biggest position is Viscofan, which owns about three-quarters of the sausage casing market with Devro. Nordea used to hold both stocks before slimming the portfolio down a couple of years ago. The industry consolidated following a price war led by Devro, which was also more aggressive in its acquisitions: the legacy, Huhdanmäki argues, is a portfolio of facilities that do not share the uniformity and efficiency of Viscofan’s production processes.
“This year Devro has given up a bit of market share to Viscofan because they are in the process of installing new production equipment in one of their factories,” says his colleague Jesper Gulstad.
MFS holds both companies, with Devro the slightly bigger position. Fruzzetti likes the industry as a way to capitalize on the move away from animal gut casings, but also sees the growth potential in Devro’s acquisitions and the work it is currently doing to improve production efficiency and design the right casing to challenge Viscofan in Germany. “The last six months have seen them stuggling a bit,” he concedes. “But that’s why I thought there was a little more upside in Devro than its competitors.”
Sausage casing is perhaps an unusual oligopoly. The phenomenon is much more common in healthcare, chemicals and high-tech industrials. Take one of Threadneedle’s holdings, Elekta, which competes with only two other firms in sophisticated radiology machines and software and will soon see one rival, Siemens, pull out of the market. Or from its top-10, Victrex, whose ‘PEEK’-branded polymer corners a range of applications from aerospace to medical technology; and Elementis, a classic example of vertical integration whose unique material to enhance flow characteristics is based upon the mineral hectorite, for which it owns all the significant mines. “It is exposed to shale oil and gas, but also, via paints and chrome, to the US housing recovery,” notes portfolio manager Mark Heslop.
And, on the subject of shale, we might mention another key Threadneedle holding, Schoeller-Bleckmann Oilfield Equipment. Whereas vertical drilling presents few problems when it comes to locating your drill or positioning your drill strings, horizontal drilling certainly does. Schoeller-Bleckmann not only specialises in the precision steelwork required to accommodate drill strings horizontally, it also does so in the non-magentisable steel necessary to house the GPS equipment that keeps track of the drills as they burrow away. Rather like Elementis, Schoeller-Bleckmann is vertically-integrated with VoestAlpine Group, which manufactures its crucial specialised steel.
“I don’t know how they do the things they do,” says Heslop, “but I do know that for a very long time they’ve had a 50% market share and generated 20% EBIT margins.”
Fruzzetti reminds us that monopolies and oligopoplies do not have to be global or based on cutting-edge technology by citing his second-biggest holding, Stagecoach. Two-thirds of its profits come from UK regional bus routes for which it also owns the depots – another example of vertical integration limiting competition. Management has demonstrated its discipline in this area, selling its London routes to Macquarie in 2006 when the bidding process got to aggressive, and buying them back four years later at a considerable discount.
“The lack of competition and excellent management of utilisation results in 15-17% margins versus other UK bus companies struggling to achieve 8-9%,” Fruzzetti observes.
An oligopolist’s market position is fine, but it is much better if that market is growing, whether secularly – via emerging markets exposure or demographic change, for example – or cyclically, by exploiting current themes related to efficiency-enhancement.
Sometimes these longer and short-cycle themes overlap, of course. The demand for lighter, more fuel-efficient cars speaks to our desire to save money and save the planet.
Lighter engines need more robust construction – and the engineered joining technology from NORMA, (Nordea’s seventh-largest holding) is key to achieving that. It enjoys enviable margins because its technology is both highly-valued and yet a tiny proportion of the manufacturing costs of an entire car: Gulstad contrasts the huge costs incurred by one truck maker that had to recall a fleet when clamps produced by a competitor failed.
At the top of Threadneedle’s portfolio we have Spectris, which specialises in testing and measurement instruments that play into industry’s desire to get the most productivity and longest life out of its capital equipment; and Grenkeleasing, which leases capital equipment to medium-sized businesses that are currently reluctant to spend on new machines. Moreover, as de-leveraging banks like GE Capital withdraw from the leasing business it stands to take their market share.
Grenkeleasing is also a kind of outsourcing business, another efficiency-related area whose models are almost infinitely varied.
One of the more compelling is outsourced R&D. From Nordea’s top-three, we could select Bertrandt, whose automotive design business has grown thanks to the proliferation of models that carmakers bring out each time they introduce a new line. Volkswagen will design the basic Golf, but needs Bertrandt’s extra capacity for work on all the additional iterations of that model. It is much more specialised than the average automotive supplier, explains Gulstad, but also very scalable, as basic design ideas from one project can be leveraged across others.
From MFS’s portfolio we could select Croda. Fruzzetti notes that while most large chemical companies sell through distributors, Croda prides itself on its direct relationships with the R&D divisions of giants like Proctor & Gamble and L’Oréal. By keeping in touch with their specific areas of research it stands ready to respond, in its own laboratories, directly to their needs – a quasi-outsourced research model.
“It might take months to come up with a solution, but Croda knows it has a ready buyer when they return to their clientbase,” Fruzetti explains. “Sometimes it’s not the product or technology that sets a company apart, but its marketing techniques.”
But while Croda bypasses distributors, the ultimate outsourcing play, many other chemicals firms do not. Heslop at Threadneedle picks out Brenntag, which comes into its own when a big player like BASF needs to deliver smaller volumes of material to a range of customers: it has an unrivalled network across every industry that uses chemicals, and it also provides a one-stop-shop for those end-customers sourcing materials from a number of manufacturers.
“Brenntag is crucial for companies like BASF that are trying to break into growing emerging markets because they already have the distribution networks there,” Heslop adds.
This leads us into our first secular theme – emerging markets. It might seem counter-intuitive that a small European company should be the key to a European multinational breaking into those markets, but logistics offers many examples. In Nordea’s portfolio, for example, Switzerland’s DiethelmKellerSiberHegner (DKSH), distributes everything from consumer goods to raw materials across its deep networks in Asia.
Elsewhere in industrials, Andritz, a top-10 stock for both Nordea and Threadneedle, has as its main areas of growth Latin America pulp and paper, and hydropower, which Heslop describes as “very oligopolistic, but also enjoying strong structural global growth”.
Nordea’s top holding, Rubis, is the market leader in petrochemical storage in Morocco and Senegal; its terminals in Turkey are the foundation of major capex to establish a Mediterranan hub to access Middle Eastern oil products. This is barely to scratch the surface of the quality industrial small-caps that are increasingly working to penetrate these growing markets.
Emerging markets is a demographics theme, of course, to some extent the mirror image of the demographics theme in the developed world, ageing populations, which Threadneedle is addressing with its explicitly thematic approach. We have seen stocks that exploit ‘US natural gas’, ‘Austerity winners’ and ‘Productivity enhancement’. Heslop relates Elekta to increasing demand for cancer treatment, but expresses his ‘Ageing population’ theme most explicitly in his third-largest holding, retirement homes provider Medica, and a smaller position in its local competitor, ORPEA.
The French angle is no accident. Care homes are a tricky business involving tight margins, high sunk costs and lots of leverage, as those exposed to the debacle of the UK’s Southern Cross – including BNPIP – found out to their cost in 2010-11. Heslop at Threadneedle points out that, unlike the UK, France’s market is still highly-regulated – there has been a freeze on new authorisations for two years.
“The public sector doesn’t want to encourage the private sector, but it needs it – 80% of the market is public, and government budgets are constrained - and that is a very good place to be if you are one of the private-sector incumbents,” he reasons. “The pipeline of new beds is very visible, as is the incremental margin on those beds, but at the moment they represent a lot of invested capital that is not earning any money – Medica’s ROE today is only 8%. You find it trading at 1-times price-to-book.”
Those constrained government budgets introduce another theme: better value for increasingly burdened healthcare systems. MFS is alone among our four managers with an underweight in healthcare, reflecting Fruzzetti’s concern that much of its revenue comes from cash-strapped governments. The one exception in his top-10 is Sonova, maker of Phonak hearing aids – a play on an ageing population but also the fact that, as he puts it, “90% of its business has nothing to do with reimbursement from governments”.
But austerity should create other healthcare winners. Early intervention improves patients’ prognoses, minimises subsequent treatment and saves money, which is a key reason why Threadneedle holds Italian immuno-diagnostics specialist DiaSorin, and why Nordea does so, too, alongside Germany’s molecular-diagnostics specialist Qiagen.
Until recently, Qiagen would easily have made our list of monopolists – its ‘Digene’-branded test for cervical cancer owned the global market. At MFS, Fruzzetti chooses not to invest out of concern for increasing competition in this area. That danger is recognised at Nordea, but Gulstad counters that Qiagen has been pro-active in shifting its growth focus to personalised medicine, where diagnostics plays a crucial role providing information for the manufacturers of tailored treatments.
“Qiagen were the rulers of the world in human papilloma virus (HPV) technology,” says Huhdanmäki. “But other things are in focus now and that will eventually be recognised in the share price that currently reflects the change in the market around HPV.”
In addition, a good argument can be made for the difficulty of attacking an incumbent position in diagnostics technology because it so often exemplifies the sought-after ‘Nespresso model’ that combines a big-ticket item of capital equipment (the diagnostic machine) with the recurring revenues of consumables (the means of getting tissue samples into the machine). Both Heslop at Threadneedle and Huhdanmäki at Nordea cite this attraction, but the latter also discusses related growth opportunities for companies like Switzerland’s Tecan, which manufactures components for laboratory instruments: “They have a great market because a big part of the business model for the likes of Qiagen and DiaSorin is to place as many diagnostics machines as possible in order to secure the repeat revenues from the consumables.”
This return to the subject of oligopolies and competition brings us to our final, and perhaps most important, small-caps dynamic: market consolidation. Investors allocate to smaller companies for their growth potential. Sometimes this means the growth of their end-markets, but growth in market share is often more specifically characteristic of smaller firms, as they out-compete and then acquire their peers.
This is how Devro and Viscofan came to dominate what had been a fiercely competitive sausage-casings market, and in low-growth heavy industrial markets being an active consolidator is often regarded as crucial to improve pricing power and operating leverage to outperform high fixed costs: this is certainly the argument that Kohler at BNPIP makes for acquisition programmes at both IMTECH and DCC, for example.
Companies can be selected from our featured portfolios that exemplify a variety of acquisition strategies. Rubis from the Nordea holdings is busy picking up fuel and gas distribution businesses from oil majors shifting focus away from the downstream: they not only get them cheap, but also take control of the value chain for their core chemical-storage business, boosting overall margins with vertical integration.
By contrast Brenntag boasts a mere 7% of the chemical distribution market but is still three-times bigger than its nearest competitor and the leading consolidator in this very fragmented industry. “As regulations get tighter, a lot of the mom-and-pop shops are shutting down because they can’t afford to meet the requirements anymore,” Heslop explains.
The pressures of regulation are telling in another fragmented industry – pharmaceutical, food and environmental testing – in which Heslop’s seventh-biggest holding, Eurofins Scientific, is the lead consolidator. These acquisition programmes do not simply remove competitors. “Often you will have very localised, inefficient, unprofitable labs where Eurofins is able to create enormous efficiency gains,” says Heslop.
At Nordea, Huhdanmäki and Gulstad identify the same dynamic for NORMA, but also point to its recent acquisition of Switzerland’s Connectors Verbindungstechnik as a first step to expand its motor vehicles franchise into medical engineering. Huhdanmäki is “very happy” with this opportunity to apply MORMA’s established skills to a business that will smooth-out its pro-cyclicality. Elsewhere in Nordea’s portfolio, one might point to something similar at Rubis, or Bertrandt’s extension of its car-design R&D into the aerospace sector.
But while these moves can reduce business-cycle risk, bad acquisitions remain notorious value destroyers, especially if markets are not enjoying any organic growth. Kohler at BNPIP acknowledges that recent poor performance by his eighth-biggest holding, IMTECH, is at least partly to do with investors’ scepticism towards its acquisition strategy in the stagnating industrial construction sector – away from which Kohler’s top holding, Bilfinger, has been diversifying.
But that is also one of the reasons why there is so much alpha available in small-caps, and why portfolio managers place such emphasis on confidence in company management. For the BNPIP strategy in particular, a section of the portfolio dedicated to turnaround cases leads to more of a focus on new CEOs and management teams. One reason it holds UK gaming stock Ladbrokes over the more dominant William Hill is the turnaround being led by Richard Glynn, appointed CEO in 2010, which has already delivered a management restructure and reinstatement of the dividend. Kohler singles out Colin Day, whom he has followed during his time as finance officer at Aegis and Reckitt Benckiser and who became CEO of BNPIP’s top-three holding, Filtrona, in 2011.
“He was always focused on growth, cash flow generation, working capital, tax rates – every item was important,” he says. “When you have a CEO like that, and then you add on top the M&A, you know you have a good candidate for a stock that will make a difference.”
Even so, things do not always work out: Kohler bought Clariant in 2009 shortly after Hariolf Kottmann became CEO, and bought-into the plan to smooth-out some of its pro-cyclicality with the 2011 acquisition of Sud-Chemie. He has since cut the position following underperformance.
Kohler is careful to emphasise that company visits – the people part of his strategy – have to build on solid quantitative foundations. It is a sentiment echoed by Fruzzetti, our top-performing manager. He notes that Bunzl is now on its second generation of management and that he not only respects the new guard, but followed Anthony Habgood to Whitbread and has also owned Filtrona, the plastics manufacturer that Bunzl spun-out back in 2005.
“But you have to be careful when you listen to management, and especially about first impressions, because some of these guys are great salespeople,” he observes. “It’s perhaps only when you have known management for a decade, as I have with Bunzl, that you can begin to feel truly comfortable.”
This is what can make small-caps so rewarding: investors genuinely have to grow with their companies. That is why portfolio managers tend to specialise, and why even those gathered at the top of performance tables hold very different stocks. This short tour of some of those companies should have shown that, while it is possible to identify common themes, implementation of those themes is diverse. For the same reasons, while European small-caps undoubtedly deliver a big dose of systematic risk relative to large-caps, they also represent one of the world’s great hives of alpha.