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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
If we call 15% the peak (this is a bit harsh as many banks are still trying to slim down for Basel III at this point) then the largest single sector in Europe is at 2/3rds ROE of the previous level for structural reasons. Another concern that seems to have been forgotten since Draghi changed the course of the eurozone crisis last summer, relates to companies that depend upon the crisis economies. I am a keen advocate of recovery in many of these economies (recent Eurostat data provides strong evidence) and we should see modest growth in the core of Europe next year, although some of these economies, such as Greece and Iceland, will take a decade to regain their peak GDP.
I believe that there is potential for recovery, (many of this year’s downgrades have come from the strength of Europe’s currencies, particularly against the US dollar) but the return to peak argument is not logical in the short term. A further issue is that many investors making the value argument then suggest buying into Europe’s international sectors, such as industrials or luxury goods. The industrials sector contains some very good companies but their return on capital employed (ROCE) indicates they are already at peak and many are priced accordingly.
How do small caps measure up?
Recent investment notes that I have written have often carried a cautionary note. The reason for this is that my central premise, as it has been for a number of years, is that any region that has a hangover from the financial crisis is stuck in a relatively low growth environment, and zero bound rates and quantitative easing (QE) are simply proof of this.
My cautious statements need to be set against the market noise of ‘escape velocity’ and ‘normalisation’. A normal recovery in the US would see no QE, rates rising, non-farm payrolls printing 250k per month and a general self-sustaining feel good factor. We have not reached this level of recovery in the US or Europe, and it is unlikely we will for some time to come. In this environment, I am continuing to look for companies which can sustainably grow their sales above market rates, and their earnings faster.
These companies will attract higher ratings as capital pursues scarce growth opportunities. While exposure to the periphery is low within the portfolios I manage, I do not have a closed mind to a recovery for good quality companies in those markets which may also benefit from a massive cyclical headwind turning into a tailwind. The small and mid caps that I invest in usually have a secular growth story, which explains the large number of technology companies in the portfolio. Healthcare companies that benefit from trends such as aging and obesity are also among my favoured stocks.
The bottom line is that an investment in European smaller companies is not made on pure value grounds. This has not been the case for some years - as an asset class small caps have consistently beaten large caps. Instead, the Ignis European Growth and Ignis European Smaller Companies portfolios contain high quality, self-funded growth companies which will thrive in the economic environment that I expect to continue. There is obviously the chance that there will be a further re-rating towards peak (and away from average) levels as these companies prosper and a return to modest growth gains greater attention. Personally, as a manager of both large and smaller companies funds, I continue to prefer the opportunity in the latter, where growth is more plentiful and better valued.
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