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Jun 28, 2011

European vacation

Investors are cautious of European small-cap companies after a strong run, finds Alex Jolliffe

Jim Campbell, who manages $3 bn-worth of assets with a team at JPMorgan, has cut his exposure to European smaller companies heavily after a strong run by the sector. He and his colleagues manage a range of assets, including the £500 mn ($814 mn) JPMorgan European Smaller Companies Investment Trust, which can borrow to invest and focuses on non-UK stocks.

The managers told shareholders on May 17 that they had reduced their borrowing from close to its maximum at the end of April to zero. Technically, gearing fell from about 117 percent to 100 percent. The higher the gearing, the more sensitive the trust’s share price is to moves in its holdings. The managers can range between being fully geared – 120 percent – to holding 20 percent cash. ‘We feel we had a very good run ,’ explains Campbell. ‘People are wary of the European smaller companies sector.’

Jim CampbellHe believes equity market investors are periodically gripped by manic emotions, which drive them to move in four cycles. The first is despair: the market moves from peak to trough as results disappoint investors’ expectations. He points to research from Goldman Sachs, which shows the worst return came at a despairing time when earnings fell by an annualized average of 7.3 percent.

The second is a season of hope and falling volatility: investors expect a better future and enjoy their highest returns. The third cycle – growth – brings investors a time when earnings grow faster than the P/E multiple: earnings are at their highest and returns are still positive.

Campbell believes investors are currently in this growth stage. Asked about valuations, he says Europe’s small companies are at the upper end of the range, relative to larger groups. He also says, however, that in absolute terms, valuations are cheap when valued in price-to-book terms.

The fourth cycle is optimism: the P/E multiple grows faster than earnings. Returns are strongly positive and volatility increases. The next phase will be despair, which began the cycle.

Experienced hand
During the 22 years Campbell has been investing, he has seen what he calls a revolution in European investor relations. Companies used to release two earnings statements per year; now they put out results every quarter.

Investors once had no detail about operating costs, but all that has changed. German firms used to publish annual reports in English in July; now they come out in March. ‘Investor relations is now generally good,’ says Campbell. ‘The level of disclosure has gone through the roof.’

He and his team invest for the European Smaller Companies Investment Trust in companies with market capitalizations of between £33 mn and £3.1 bn. Their picks have produced a weighted average of £1.5 bn, beating the UK average of £1.2 bn. They select stocks from a possible 1,000 firms, by backing either growth companies with strong operational momentum or value businesses with a catalyst for a rerating.

The team’s biggest sectoral bet is industrial companies, which account for 33.6 percent of the fund. This decision was driven by belief in Europe’s economic recovery – the team’s confidence in these engineering groups is a change from the recent past when the sector was one of the trust’s most extreme underweight positions.

‘I was in Germany last week,’ says Campbell, who, along with his team, visits hundreds of companies every year. ‘The key factor in Germany is that the exporters have been strong beneficiaries of the weaker currency. There is also enormous demand for their industrial goods – Germany is booming as an industrial economy.’

He and Francesco Conte, the other investment manager, argue that Germany’s industrial strength has made Europe’s economic recovery much stronger than economists expected. The European economies’ ability to manufacture the products that the fast-growing emerging economies want – expensive cars, luxury goods, consumer products and state of the art capital goods needed in manufacturing processes, planes, trains and power plants – is impressive, Campbell and Conte say in a report to shareholders.

Major plays
The managers’ biggest stock is Oerlikon, the Swiss industrial group. It performed well in the first quarter after analysts upgraded forecasts following its strong margin recovery in the second half of 2010. The trust also benefited during the opening three months of the year from AMG Advanced Metallurgical, the Dutch producer of specialist metals, which announced a 17 percent year-on-year increase in fourth-quarter sales. AMG aims to develop metallurgical processes to meet the growing demand for materials that reduce carbon dioxide emissions.

Campbell’s team bought some engineering firms because they expected them to benefit from emerging market growth. They invested in Nokian Tyres of Finland because it was the biggest foreign manufacturer of tires in Russia, where demand was booming. They also bought Andritz, the Austrian group that provides plant for pulp and paper, which has benefited from demand in the emerging markets, specifically Brazil.

Emerging markets growth drove Campbell to make trades in other sectors, too. He bought shares in Hugo Boss, the German clothes and luxury goods group that has been opening numerous shops in China. Another play on luxury is Bulgari, the Italian jewelry maker, which rose in the first quarter after a takeover bid by French group LVMH.

The team further believed emerging market interest in food was starting to develop, so it invested in Christian Hansen, a Danish food ingredients and enzymes business.

Campbell’s second-choice sector is financial services, where Swiss banks and Italian asset management groups did well in the first quarter because investors provided net inflows into equities. EFG International, the Swiss private bank and asset manager, is the trust’s third-biggest stock.

Another key portfolio theme is structural growth, which led Campbell to invest in Yoox, the global online luxury retailer for various fashion and design brands. The internet continued to attract him when he placed a bet on Paddy Power, the bookie with a web presence. He also bought Barco, which produces digital cinema projectors, because of the structural growth theme.

Ups and downs
A key attraction of smaller companies in Europe, as in other markets, is that they have had the potential to generate higher returns over the long term. That opportunity goes hand in hand with the risk of greater losses in bad years, however.

An investor who bought £100 worth of shares in the trust 10 years ago would have £284.90 today, helped by booms in financials, construction, engineering and then the financial sector again.

By contrast, a shareholder who invested £100 in the average European investment trust – excluding smaller companies – would have £212.30 after a decade, by mid-May 2011.

That run of superior performance has come in part from the sheer lack of research by analysts, who have tended to neglect European smaller companies, and this has led to valuation anomalies. On average, there are just five sell-side analysts who cover each company with a market capitalization between €140 mn and €500 mn ($202 mn and $723 mn). Some 11 analysts provide research into groups capitalized at €500 mn to €3 bn. Above €3 bn, the number of analysts covering each company rises to 20.

Fund snapshot

Name: JPMorgan European Smaller Companies Investment Trust
Trust managers: Jim Campbell and Francesco Conte
Benchmark: HSBC Smaller European Companies (ex UK) Index
Launch date: 1990
Total assets: £494.1 bn
Top 10 holdings: Oerlikon, Koninklijke Ten Cate, EFG International, Barco, Bucher, AMG Advanced Metallurgical, Azimut, SNS Reaal, Interpump, Altran Technologies

Details correct as of May 31, 201

Source: JPMorgan

This article appeared in the July print edition of IR magazine.