Investor sentiment towards smaller companies in Europe has inevitably been affected by the financial crisis in the region, and deteriorating confidence in the ability of European politicians to act decisively to address the ongoing sovereign debt crisis.
European smaller companies, as measured by the HSBC Smaller Companies European ex UK Index, have declined by 26.8% in Sterling terms over the six months to the end of November, compared to a decline of 19.1% in the wider MSCI Europe ex UK Index over the same period.
Bottom-up fundamental research has been more important than ever in this volatile environment and our focus throughout this period has been on finding companies with robust balance sheets and a history of delivering strong returns on equity to shareholders. This strategy has helped mitigate some of the heavy losses seen in European equity markets and the Baring Europe Select Trust has continued to register strong relative performance in recent months.
Performance summary of the Baring Europe Select Trust
|
|
3mths |
6mths |
1yr |
3yrs* |
|
Baring Europe Select Trust |
-7.1% |
-22.3% |
-10.7% |
16.9% |
|
HSBC Smaller Companies Europe ex UK Index |
-11.9% |
-26.8% |
-12.3% |
15.1% |
|
Arithmetic value added |
4.8% |
4.5% |
1.7% |
1.9% |
Past performance is not a guide to future performance. Source: Barings, as at 30th November 2011. On a NAV per unit basis with net income reinvested, in Sterling terms. *Annualised returns.
An unsupportive macroeconomic backdrop has led us to focus our attention on companies in areas such as Information Technology, Health Care and Consumer Goods - relatively defensive sectors where companies tend to be more insulated from the short-term economic fortunes of Europe. At the start of the summer, expectations for earnings growth in these sectors were less ambitious than elsewhere and our holdings have therefore proved to be relatively resilient throughout the subsequent wide-ranging downgrades to corporate earnings across the continent.
More economically sensitive sectors have been particularly hard hit and our cautious stance towards companies in the Industrials and Materials sectors has been beneficial for relative performance. Given the worsening economic environment in Europe, we felt that earnings forecasts here at the start of the summer were too optimistic and profit margins - which were already at cyclical highs - have come under pressure over the third and fourth quarters of the year.
In terms of our current investment strategy, we continue to look for attractively valued companies with robust balance sheets and sustainable margins, where the market is underestimating the resilience of their business model and not giving sufficient credit to quality management teams.
Notably, the recent falls in markets have outstripped the pace of downward earnings revisions and this has started to expose some compelling value for bottom-up stock pickers. While this does not imply that the recent swathe of downgrades is now over, we believe that European smaller companies currently look very cheap relative to their historical means, with attractive dividend yields and generally strong balance sheets, and no longer require significant profit margin growth to represent good value.
Following the recent weakness in markets, we have become more constructive on the investment case for firms in the Energy, Industrials and Consumer Discretionary sectors, where we had previously been running a large underweight position. Valuations in these sectors have now fallen to such a level that they appear to be discounting all but the bleakest economic scenario and we are increasingly finding attractive opportunities here, particularly in the oil services niche where we believe selected firms should benefit from rising capital expenditure from oil majors.
There has been little change to the geographic allocation of the Trust over the second half of 2011. We remain very cautious on the prospects for southern Europe: markets such as Greece, Portugal and Spain have continued to perform poorly due to their respective debt woes. We have also recently moved to reduce our exposure to Italy as we believe that the new technocratic government is likely to introduce austerity measures which could stifle domestic demand and depress economic activity.
A note, however, should be made on Ireland, where stock selection leads us to be overweight despite the country's sovereign debt issues. Our exposure here is focused on stocks such as Paddy Power and Ryanair, companies which derive a significant amount of their revenue from overseas. The growth in their international businesses has been reflected in share price performance and these stocks have been strong performers relative to the market in recent months.
Nicholas Williams
Head of Small Cap Equities
Investment Manager, Baring Europe Select Trust
Baring Asset Management, London
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