The most compelling reason for investing in European small companies is that they behave quite differently from European large companies. They trade differently and they perform differently. They therefore provide the diversification of risk that pension funds, battered by three years of equity bear markets, are looking for.
This reasoning was behind the recent decision of AP3, Sweden’s third national pension fund, to move E291m from its internally managed European equities portfolio into four externally managed mandates for European small and mid caps. Until last September all of the fund’s European equity portfolios had been invested in large cap equities. “By extending the investment universe to small and mid cap equities, the fund will attain a beneficial diversification of risks,” the fund explained.
Diversification is provided principally by different levels of cyclicality – their behaviour over the business cycle. Joseph Baumeler, small and mid cap specialist at Credit Suisse Asset Management in Geneva says what distinguishes small caps from large caps is their higher cyclicality, the result of their greater financial and operational leverage: “On average small caps move more strongly than large caps in both directions. In general, small caps are strong performers in anticipation of an economic recovery and weak in economic downturns. The changing risk appetite of investors during a stock market cycle also adds to the volatility of small caps over a cycle.”
So if a pension fund can time its entry into the European small caps market correctly, it can significantly improve returns, Baumeler suggests. “The valuation discount to large caps is normally between 5% and 10% and this changes over a stock market cycle. A pension fund therefore can add performance in holding a specialised small cap fund at the right time in a cycle.”
There is also a long-term argument for moving into the management of European small caps, he says. Empirical studies demonstrate a slightly better performance for small caps over the long term: “European small caps are definitely well suited to the long term investment objectives of pension funds,” he says.
However, market timers must get the timing of their entry right, he emphasises. “It is normally a good idea to enter this asset class when stock markets are in deep gloom. This is exactly when everyone shuns any risks.”
These risks are often over-sold, he suggests. “Small caps are considered riskier and volatility is certainly higher for small caps than for large caps, not only for single stocks but for the typical small cap indices. But this volatility is only higher over longer periods – at least one year. In the short term the very broad indices tend to smooth the volatility.”
Illiquidity can be a problem in the short term, however. Small cap stocks are characteristically less liquid than large caps and therefore more difficult to buy and sell. “This is one reason for having a substantially longer time horizon in investing in small caps because going in and out it more costly and often time consuming,” he says.
However, there is still money to be made. In spite of a growing interest in European small caps, the market is still an inefficient one. Baumeler believes there are still plenty of untraded and unresearched companies to focus on. “Dedicated small cap specialists should be able to add more value than large cap managers thanks to the sometimes irrational and weird behaviour of smaller companies. In European small caps, inefficient pricing is the norm and not the exception”
One of the reasons for the market’s inefficiency is its size. European small cap managers have a large universe of companies to choose from – some 3,000 to 5,000 names, depending on one’s test of investability. With a universe this size, benchmarks are of limited use. There is no index that fully covers the universe. The HSBC indices come closest, since the HSBC smaller Europe excluding UK and including UK indices both have more than 1,400 names.
At the other end of the scale is the Dow Jones Stoxx 200 Small which is made up of the 200 components of the Dow Jones Stoxx 600 with the smallest market capitalisation.
Between them is the MSCI European small caps Index with some 800 names in it. This aims to include 40% of the full market capitalisation of the eligible small cap universe within each industry group in each country. Two years ago MSCI raised the eligible companies’ full market capitalisation upper limit from $800m to $1,500m and made the index more investable by free float adjusting the market capitalisation of the index constituents to include only shares that are freely available to foreign investors.

However, European small cap indices provide only the loosest of reference points for active, stock-picking portfolio managers. Nathalie Degans, European small caps manager at Morgan Stanley, says the weightings in her portfolios will bear little relationship to the index they are benchmarked to. The fund aims to outperform the MSCI European small caps Index benchmark by 3% over a full business cycle. However, it does not attempt to replicate the weightings of the benchmark.
“The biggest weighting we have is in a Swiss insurance stock with a weighting of about 1%. This the only one with a full weighting in the index. The next highest is 0 .5% and most of our holdings are at 0.2% and even less. That means that whether or not you own a stock that is in the index is not really going to drive your performance.
“We have always been benchmark-aware as opposed to benchmark-driven, in the sense that we know how the index is constituted from a country, industry and market cap point of view.”
Similarly, performance parameters such as tracking error are of limited use to small cap value investors, she says. “Tracking error is really something we have shied away from because of our investment style, a value style which is not index-driven. It is not our game. Anyway, tracking error doesn’t really work for small caps – how can you have tracking error when your universe is so big?”
Perhaps the biggest drawback to European small cap benchmarks, however, is that they are notoriously difficult to beat. Most European small cap managers have under performed the MSCI European small cap index this year, which has risen by over 30%, compared with a 3% rise in the MSCI Europe, which includes large caps.
One reason is that the indices contains tax-driven holdings that hardly trade. When the markets fall, their price remains the same so they artificially sustain the index. Another reason is their illiquidity. Consequently, indices that include a leavening of mid caps tend to be more liquid and therefore enable managers to take bigger bets. Hence the attraction for some managers of the Schroder Salomon small and mid cap index. Its more liquid stocks make it easier to track.
The MSCI European Small Cap, which has outperformed the Schroder Salomon index by 10% since the beginning of the year, has been difficult for fund managers to match. William Sharp, portfolio manager in the European small caps team at AXA Investment Managers in Paris, says AXA funds have underperformed the benchmark by between 1% and 2% this year. “We are managing against the MSCI benchmark so we have to beat this benchmark. But the benchmark is not fair. Unlike big caps benchmarks you cannot hold everything that’s in the small cap benchmark. So each time we are in investing in a company we are taking a big bet against the benchmark.”
The periodic re-balancing of the benchmark makes it even harder to beat the index. As managers say, you lose all the winners and you win all the losers. “When the markets were down at the beginning of the year, we had new stocks in the benchmark, a lot of techno stocks and stock that used to be big caps fallen angels like Elan, Alstom and Swiss Life,” says Sharp. “They were put into the benchmark at a very low price and suddenly they re-bounded.
“The rebalancing was not easy for us, particularly because this stock entered the index with a high weighting – for example Elan and Swiss Life were each 1% of the benchmark. We took some risky bets at the beginning of the year but we couldn’t be on every company that was having serious balance sheet problems, so we missed some of the recovery stories.”
AXA faced particular problems because it buys the same stock for each of its funds. “We are trying to manage all our European small cap funds the same way. That means that when we buy a stock we are buying it for each fund. So at the end of the day it’s a big stake we’re taking.”
When markets become difficult, a European small caps manager who is managing against a benchmark must therefore increase the number of holdings in an attempt to reduce the additional risk. “Last year we increased our holdings to about 120 because we wanted to track the benchmark more closely and to lower the risk because the market was very difficult and it was very risky to make big bets,” says Sharp. “Now with an easier market we are trying to lower the number of holdings. A good number would be 80 with holdings between 1% and 2%.”
There is something of a consensus that an ideal European small caps portfolio would be around 100 holdings with weightings of no more than 2% per holding. Some managers will reduce the risk of bets that become too large by ‘top-slicing’ a position when it exceeds 2% of the portfolio.
Degans of Morgan Stanley suggests that “between 90 and 110 stocks with a 0.5% average position is a happy number. When you own only 40 stocks with a an average weighting of 3% to 4% that’s too risky. When something goes wrong with one of your stocks the impact is much higher. Small caps simply don’t have enough meat on them to help them withstand the bad shocks.”
Away from the benchmark, the basis for portfolio construction will be the chosen investment style – value, growth or a mixture of both. Some European small cap managers have pitched their style strongly in one particular camp
Andy Brough, who co-manages the Schroder ISF Smaller Companies fund, says he is looking above all for growth and the potential for growth:
“So far as we are concerned it is a question of investing in a product or unique service where the demand exceeds the supply, which implies a rapid growth in the early stages. We pay particular attention to the quality of the management and we look for a positive cash flow and levels of leveraged debt. We also want to be sure that the companies we invest in have irreproachable accounting.
For Brough the attraction of companies will vary according to their sector and industry. Whether he rates a company as cheap or expensive will depend on its activity, its competitors and its position in the economic cycle. Whether he is interested in the company at all will depend whether he categorises it as a potential winner or loser.
“We have divided the investment universe into three categories – A, B and C. We prefer ‘A’ companies because we think they should experience definite growth in spite of the economic conditions and because competition is either insignificant or non-existent. The demand for their product or service is important because it indicates that they can hold and even increase their profit margins. We invest first and foremost in ‘A’ companies.
“Category ‘B’ companies are generally more mature businesses which do not qualify as growth companies to the same extent. However, a large number of this type of company perform well when economic conditions are favourable to them. When prices are low, it is an area where interesting opportunities can be found. So we could be interested in ‘B’ companies
“Finally there are the category ‘C’ companies. These face serious competition, and in the long term they are often the losers. They have no place in a growth portfolio.”
As with US small cap managers, the value approach also has a strong support from European small cap managers, who will sift through undervalued companies like prospectors panning for gold. “That’s what we spend our day doing, looking for companies that have been overlooked by the market or that the market has wrongly assessed,” says Degans of Morgan Stanley.
“This is an inefficient market. There are lots of names and they are generally poorly covered. On the sell side you’ll have fewer analysts assigned to them than in large caps. Sometimes you’ll have only local brokers covering them. That creates opportunities because you are able to find companies that are poorly followed.”
However, in the past 18 months, the equivalent of a gold rush has occurred as large cap managers, anxious to justify active management fees, have begun to prospect for value among mid and small caps. “The market has become somewhat more efficient, so it’s harder to find an undiscovered jewel. They can till be found, but you have to turn over a lot of stones.”
Asset allocation by country and sector counts for less with small caps than it does with large caps. In particular, country allocation, as part of a top-down strategy, is considered tricky, and managers will often simply match their country weightings to the benchmark weightings.
Similarly, sectoral allocation has limited use, and sectoral weighting is largely the unplanned result of bottom up stock-picking rather than any top-down strategy. Sharp at AXA IM says this is inevitable. “Stock-picking can give you sectoral overweighting even if you don’t want it. If you have three or four strong ideas in one sector you will end up with overweighting on a sector basis.”
However, some European small cap managers have adopted what could be called a sectoral overlay, enhancing their bottom up stock-picking with some top down sectoral strategy.
Nils Francke, head of the European small cap team at Pictet Asset Management in Geneva, says the sectoral approach found in the large cap investing normally does not work in the small cap universe. However, it can be used to help active stockpicking. If analysts can identify something in the large cap companies that will ‘trigger’ developments in small cap companies, they can stay ahead of the competition.
“What we are trying to do in our small cap universe is monitor the universe – including big caps. One of the things we monitor is the operating environment and sentiment in big caps. What we want to do is be able to invest into something in small caps the moment that we have identified a trigger for performance. That trigger of performance can often come from a statement by a big cap company about its view of the future of the sector.”

Francke says this helps stock pickers to distinguish attractively priced small companies with the potential to perform from companies that have nothing but their price to recommend them. “We spend 70% to 80% of our time on stock-picking, but we spend the other 20% to 30% on portfolio construction or ‘raising our head’. We believe that this is time worth while spent, because by raising our head and doing a little bit of portfolio construction work we can maximise the performance of our stock picks.
The Pictet team has classified four kinds of European small cap stocks:
o Emerging growth: companies which might not have a strong track record but are poised to enter a period of significant growth and are unlikely to be followed by other investors;
o Established growth: companies with a consistently high rate of earnings growth and visible future prospects;
o Defensive growth: companies often belonging to mature sectors but which are undergoing a transformation leading to a temporary earnings acceleration;
o Cyclical growth: companies experiencing temporary earnings acceleration , mostly driven by macro-economic trends.
The opportunity ‘triggers’ for the different classifications of growth companies will be different, says Francke. For the emerging and established growth company classifications the trigger will depend on the answer to the question “what kind of price for what kind of growth?”.
For the two classifications which could be described as “value” – defensive growth and cyclical growth, the triggers are different. In the defensive growth company the trigger will be at the company level, such as management change or corporate restructuring. At the cyclical growth company the trigger will be at a macro-economic level, such as movements in the price of oil or gold.
“A defensive growth company could also be a typical value stock because it probably trades at low price to book. But we only want to buy it when there is a trigger that says we should,” he says. “The main objective is not simply to buy cheap companies but to identify the top 100 investment opportunities in the small cap universe within a systematic approach to stock selection and identify companies which are experiencing an acceleration of relative profit growth not recognised by the market.”
One area of stock selection where European small caps have been at a disadvantage compared with large caps is in their compliance with socially responsible investment (SRI). While most large cap companies are now SRI compliant, smaller companies have not faced the same pressure to adopt SRI policies.
Yet small companies are interested in compliance, according to Neil Dunn Neil Dunn, managing director of Kempen Capital Management (UK), an Edinburgh-based investment management team which has concentrated almost exclusively on European small caps since 1994.
“There is tremendous interest in SRI and small companies are very keen to demonstrate that they are responsibly managed,” he says. At the same time pension funds are asking why small caps cannot be screened for SRI compliance in the same way as large caps. “The whole subject of SRI is gaining interest with companies, pension funds, consultants and trustees. But until now, it has only been large caps that have been rated for sustainability.
Kempen Capital has now teamed up with SNS Asset Management to launch the Kempen/ SNS Smaller Europe SRI Index. Initially, the index will be made up of 69 companies from 14 countries, but this number is expected to increase over the next year as more companies become eligible for inclusion in the index.
The aim of the index is to encourage smaller companies to adopt socially responsible policies. If it achieves this aim it is likely to enhance the attractions of European small caps as an asset class by removing one of the remaining objections.