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Ignis' Ormiston: Euro small caps outlook rosy but approach with caution
by Ian Ormiston on Oct 14, 2013 at 13:19
Although many of the ideas put forward in the book Small is Beautiful by E. F. Schumacher (1973) look rather dated, the concept of small decentralised organisations has stood the test of time.
Smaller companies are often viewed as the poor relations of their large cap peers, but I would argue that the right kind of smaller company has many inherent advantages which we forget at our peril. The orthodox view throughout much of the 20th century was that economies of scale and specialisation of labour would reap such massive advantages that the large would become increasingly advantaged to the detriment of the small.
While this is true in some regard, access to finance can be challenging and some industries are natural monopolies, there are some inherent advantages to being small.
Nimble and entrepreneurial
A fundamental advantage enjoyed by smaller companies is that they are naturally more nimble and suffused with an entrepreneurial spirit, which is one of the key points made by Schumacher. In continental Europe, private companies usually come to market to enable founders to diversify their wealth, to solve succession issues, or to fund further growth. In the UK, a listing is seen as more of an exit route. European management teams are more focused on building bigger businesses for the long term and this delivers the subsequent rewards to shareholders.
Another advantage of the small company that is often overlooked is that innovation tends to be highest in this sector. New drugs, new technologies or new approaches to business often emerge in smaller companies. In Europe, the breadth of strong nations gives investors’ exposure to more ‘clusters’ of these types of companies. Examples include Swiss pharmaceuticals, German solar, French secure transactions, Danish phonics and Swedish engineers. ‘Clusters’ as defined by economist Michael Porter, are groups of companies in the same field which drive improved productivity – and improved productivity goes hand in hand with improved performance.
Do the valuations stack up?
Valuation is not really a base case for investing in European smaller companies. As an active investment manager and stock picker, I am more interested in growth opportunities, balance sheet strength and the self-funding nature of growth, which is something that is now totally different from the pre-financial crisis era.
Valuations are some way below peak levels in both small and large cap areas. But on average valuations, small caps are only slightly cheap on most measures and large caps have superficially better metrics. A key question to be answered is whether there is a convincing argument to support a preference for small caps over their larger peers? In answering this, it is important to initially examine sector composition. The large cap category continues to be dominated by massive sectors with high leverage and little or no growth, such as the banking, utility and telecom giants. These sectors are much less important in the world of small caps.
In addition to sector composition, a further reason for a small cap preference is illustrated by the oft repeated life cycle diagram . The smaller companies that are most attractive and are typical constituents within my portfolios are typically in the sweet spot for growth. Sales should be increasing sustainably and operating leverage allowing margins to expand giving faster profit growth.
A rosy picture but caution is required
Equity market bulls like to point to the fact that in spite of the substantial rally that we have enjoyed in equity markets, if we compare the price with 10 year average earnings then there is still plenty of value in markets. The major problem with that analysis is that some sectors are now less profitable structurally.
Banks are the best example of this as they have to carry a lot more capital (equity) which will permanently cap return on equity (ROE).
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