The development of the Euro-zone has led to the development of investment approaches that take a truly pan-European approach, ignoring country weightings in the search for the best opportunities in each sector. Small companies, however, are still more domestically focused and their behaviour tied more to the local index and local economies. Splitting off separate small cap mandates can make great sense and the greater importance of local economies puts a premium on having access to detailed local knowledge compared with large-cap approaches.
The sheer number of small cap companies that are in the universe – probably 5,000 or more listed and 2,500 with capitalisations above €200m and below €2bn gives rise to issues of how much research can be undertaken on small caps by in-house teams. Larger caps are better researched by external analysts, giving rise to different fund management processes required to tackle small cap. According to broker CSFB Holt, large-cap companies with capitalisations greater than $5bn have as much as five times as many analysts covering a stock as those covering companies smaller than $1bn.
Chris Dyer from Goldman Sachs Asset Management (GSAM)points out that “over the last several years we have seen the number of analysts covering these companies fall sharply… currently there are only three analysts covering each company below €1bn in market cap…Contrast that with large-cap companies where there are roughly 16 analysts covering each company above $5bn of market cap.”
In the search for higher alpha, it is the less researched markets, the less transparent and less liquid that are likely to provide the greatest opportunities. Dyer says that “2,500 companies, many of them not well known and not well covered, means pricing inefficiency”. And he points out “therein lies the opportunity”. This also means that it becomes more difficult to rely on in-house teams of researchers within fund managers to cover the market, and places a greater reliance on the use of local brokers within each country.
Adrian Bignell at Invesco-Perpetual argues that “having an in-house research team means that if your analyst makes a recommendation of something you disagree with, it creates tension so you either end up incorporating something you are not keen on in your portfolio, or not selling it quickly enough.” He goes on to add that “local brokers know the markets well and they add a lot of value… why reinvent the wheel?”
GSAM also uses local brokers as a key part of its selection process and according to Dyer, “those brokers know companies that aren’t necessarily on the quantitative screens but may nevertheless be interesting emerging companies”.
The idea that there is a systematic small cap premium has been debated for many years now, and as Garret Quigley from Dimensional Fund Advisors (DFA) argues, “there is some evidence that there is a size premium in Europe, which would be consistent with evidence from other regions around the world. In other words, the smaller the size of company, the higher the return.”
Certainly the historical returns from different size segments in Europe do appear to show a systematic trend of higher returns the smaller the cap segment, with the smallest 5% by market cap showing an annualised return over 2% higher than the largest 70% in the period 1981 to 2004.
However, as David Dudding from Threadneedle Asset Management points out, “ small cap investing is a long-term game. It is a volatile and risky asset class that goes through long periods of outperformance and then underperformance relative to large caps.” It is suitable for long term investors willing to ride out volatility both because “if you believe markets are efficient, then small caps should give better returns to offset that risk” and also if you don’t believe in market efficiency, “then small caps are where you will find the mispriced assets”.
Indeed, DFA’s Philip Nash has the view that “in time clients may make separate allocations to European micro cap in the same way as they have done in the US”, where micro cap is the bottom 5% of the universe with small cap being defined as the bottom 8-10%.
While it is inevitable that a performance benchmark must be used in the form of a suitable index, it is important to recognise their limitations and the dangers of trying to maintain very low tracking errors against an index. There is always a trade-off between investability and coverage and with 5,000 or so companies to choose from, there are no indices that fully cover the market.
The commonly used benchmarks are provided by HSBC, MSCI, S&P Citigroup and more recently FTSE. These differ significantly in their methodology with for example, MSCI adopting a fixed capitalisation range for small cap globally, while others such as S&P Citigroup and FTSE basing stock selection on taking a fixed percentage of each market. As a result, the S&P Citigroup has a higher average capitalisation than the others.
Any index covering only a segment of a market will have artificial turnover set by its construction methodology. This is especially significant in illiquid portfolios of the market where turnover comes at significant cost.
After their strong performance over the last several years, are small caps now looking expensive? DFA’s Quigley found that “investors entered the 2000s with an inherent large -cap bias while in the process of looking for alternative asset classes. I think they have started to look at the smaller parts of the listed market. So I think there is a collective shifting to look at the small cap market”. GSAM’s Dyer argues that while “it is very clear that the small cap asset class as a whole has had three very good years and that has pushed up valuations, at the same time the companies as a whole have been growing quite strongly. Right now we see the small cap market trading on 13.5x 2006 earnings”.
Invesco-Perpetual’s Bignell argues: “Small caps are no longer at a glaring discount but are reasonable in absolute terms. During the past 15 years small caps traded generally in line with large caps but then in the 1990s, large caps took off and became expensive. On absolute basis, at multiples of 15 or 14, they don’t look expensive except to large caps.”
However, Threadneedle’s Dudding warns that “right now, everyone is very excited about small caps because they have been doing so well and there is a risk that we are entering into something of a bubble with the establishment of hedge funds focusing on small caps, etc, so I would be more wary if I were a retail investor and maybe did not have such a long time horizon”.
He saw small caps as historically at “average 10% discount” and they are now “at a premium of 5-7% because so many private equity and hedge funds are investing in them”, although Dyer would argue that this is also a result of the “earnings momentum of smaller companies”. For Dudding, there is “more upside in large caps. I don’t see Europe as undervalued but large caps offer better value, but for a long-term institution, it is fine.”
How important are the economic and political processes within the EU for the smaller company sector? For Invesco-Perpetual’s Bignell, “it doesn’t matter who runs Germany because German companies are reforming. Management are saying to unions, we want an extra fours hours a week with no wage increase and if you don’t accept, we will shift production to Romania.”
He goes on to add that “because the cost base in Europe is so high, especially versus the US, it is clear that European companies have more fat to cut and hence more capacity to help maintain margins in a low-growth environment”. The strength of the euro also has much less relevance to the small company sector which is inherently domestically focused.
“The overall European equity market has both a public and a private component and there is a symbiotic relationship between the two, with the private market competing with the public market for investment opportunities,” points out Paul Waller, an executive director at 3i.
“It also drives public equity returns through bid premia, etc, and acts as a market force that impacts upon share ratings. Additionally, it is an important source of IPO opportunity and a real driver of M&A activity – half of UK MA, according to some recent reports”. He adds that “becoming public is the gold medal for many company owners and managers in the private sector”, while in the public markets the strongly motivated and ruthlessly financially driven character of the private equity sector has, according to Invesco-Perpetual’s Bignell, led to “more heat on management as if they do not run their businesses efficiently, private equity firms will come in and restructure them”.
Waller also sees the private markets increasingly becoming a substitute for public markets, with large buy-out firms raising multi-billion dollar funds aimed at the €200m-€1bn sector in Europe. The increased M&A activity that this has fuelled has also bid up prices in the sector, which has also made it more difficult for smaller companies to make acquisitions to expand, as they compete with the financially stronger conglomerates that comprise the mid-market and large buy-out private equity firms.
GSAM’s Dyer has also found that “if we look at our portfolio over the last, say, two years, we have seen a tremendous number of companies bought out by private equity. We certainly don’t expect that activity to fall away anytime soon because we know these funds continue to have $10bn of assets to deploy”. And as Threadneedle’s Dudding points out, smaller companies often make attractive bid targets because of “their manageable size”, the fact that they “are politically less sensitive” and they have “cheaper valuations”. As a result, the private equity sector is, according to Dudding, “an increasing competitor to all small cap managers”.
The number and diversity of investment opportunities does give rise to a wide variation of investment approaches and if one considers the European private equity sector alongside the quoted markets, the variation in approaches becomes even more stark, with portfolios ranging form the private equity approach of 20 or so stocks with heavy involvement by the management firm in restructuring, to the semi-passive approach of DFA that tries to pick up the ‘structural premia’ in the asset class as a whole with portfolios of 3,000 stocks.
Running a pure index fund does have inherent drawbacks since there is no a priori reason why any particular index methodology should be adhered to slavishly, yet the index construction will produce costly trading with no real investment gain. However, a distinction has to be made between running index funds and having a passive investment process where trading is minimised.
DFA would argue that its process is semi-passive and it has effectively defined its own index. Quigley explains that “we are trying to capture the small segment of the listed market and to the extent that that will overlap with indices, that’s fine. In Europe the MSCI Small Cap universe only goes down so far. We will be deeper.”, while Nash argues that “people instinctively feel that small cap is an inefficient asset class, so their first foray will be to active managers.
“In this there are some parallels with emerging markets where the first assumption has always been to go with active managers.” This is certainly the case for the European small cap market currently where “in the last four or five years we have seen a very positive small cap effect and big investors are allocating to the asset class for the first time”. DFA’s competitive advantage lies in the second phase, according to Nash, when “we often find people coming to us disenchanted with the active managers, people who come to the passive approach as a result of bad experience”.
For an active manager, the key issue is how to identify suitable investment opportunity across a wide range of jurisdictions without incurring excessive costs. As we have seen, the role of the local broker is often critical, but the use of quantitative screens also provides another essential component of many managers’ investment processes.
These range form the full-blown active quantitative processes used effectively by firms such as Axa Rosenberg, to asking the brokers themselves to supply lists of forms ranked according to specified criteria. GSAM, for example, use three quantitative screens, the first being an approach incorporating valuation, profitability, earnings quality, management impact, momentum, and analyst sentiment developed by the Goldman Sachs’ New York-based quantitative team.
The second screen is based on looking at traditional ‘growth at a reasonable price’ focused on company earnings, sales growth and margins; and the third is the CSFB Holt approach of looking at cashflow returns on invested capital.
As Dyer explains: “We have found through experience that certain screens work differently in different market environments. If you relied on growth at a reasonable price screen in 2002-3 it wouldn’t have been particularly effective as growth was hard to come by. The key to the screening is that it is just the beginning of the process. When we use the screens we are just trying to identify which companies are moving up the screens or down the screens in terms of their attractiveness. When we have identified them we will take the next step of actually calling management, meeting them, etc.”
Interestingly, of the roughly 2,500 companies within their opportunity set, the screens only cover just about 1,500 of them. The other 1,000 do not have broker coverage and therefore forecast estimates. The two other ways of sourcing ideas for them, indeed, for any active manager, is first to go out and meet with different companies and second the use of local brokers. Meetings with company managements play a more important role than maybe the case for large companies “Within the small cap space we think management can have a disproportionate impact on the fortunes of the business, both positive and negative. So it is very important to meet and understand their strategy, feel comfortable with them. A lot of these companies still have substantial family ownership,” says Dyer.
The European small cap market has yet to see the diversity of investment approaches encountered in the US small cap environment. DFA’s Quigley points out that “if you take US small cap growth stocks back to 1907 and annualise returns you get 9.5%. For value stocks over the same period the return is 14.5%, 500bp difference per year small cap value over small cap growth. That’s bigger than the equity premium. These are very powerful undercurrents but most of the industry misses it.”
According to Quigley, the European small cap market is still “where the US was in the 1980s, shortly after the stats came out showing the small cap effect. In Europe there has never been similar investigations into the small cap effect, until now, which is why I think we are still in the first wave”. What is clear is that the diversity of approaches by managers will increase, and if you include the incoming hedge funds as well as the longer-established private equity players, the decision for investors should be how to structure their own total exposure to the European small cap universe.