Further to our recent article espousing some of the reasons why Europe is not a complete no go area for investment, it seemed timely to explain the thinking behind the inclusion of European Smaller Companies funds in our portfolios at a time when markets are again showing concern over the situation in Greece.
Our preferred European Smaller Companies fund does not invest based on the market as a whole or on market sentiment, it invests based on strict stock selection criteria. The manager looks for companies that have pricing power, ie the ability to protect margins and so continue to invest in the business and grow over time. He looks for companies that can do this whatever the domestic economic environment, but also looks for companies that can benefit from expanding into ever more globalised markets. The key comment though I think refers to "whatever the domestic economic environment". Every company in every country has at least half an eye on their domestic situation, but the right companies have planned to grow beyond the realms of their geographical boundaries and are able to compete successfully on a much wider scale, which doesn't negate concerns over the Eurozone, but does at least reduce the impact.
Looking at the economics for European small cap stocks, they are currently trading at slightly higher valuations than large cap stocks as a result of their strong recent performance. This would not normally signal a great time to buy, but excluding financials, the manager still believes that small cap earnings growth will beat that of large cap stocks for the calendar year.
To make all the economics become real, the manager has highlighted a couple of stock examples which he believes sum up why his strategy will continue to work despite wider market conditions:
A German chain of opticians, who currently have around 50% market share in terms of volumes. As the company grows, their pricing power increases and they are able to keep down the prices of glasses and contact lenses for the consumer, which increases the number of consumers who use their stores. This cycle has allowed the company to grow for a number of years and there are no signs to suggest that this cycle will stop any time soon.
A French pharmaceutical group who have a niche position in the market for producing drugs and medication for pets and farm animals. The company is one of few groups to focus solely on animal medication rather than see it as a sideline to the production of human drugs. This places the company in a relatively unique position, because they are able to exploit long term growth potential; as meat becomes an increasingly significant part of people's diets in developing countries, growth in the numbers of animals raised for consumption increases, which in turn drives rising demand for animal medications. In addition consumer spending on pets is a relatively defensive source of ongoing revenues and the company is able to exploit the weakness in the Euro by exporting its goods abroad to emerging markets.
Overall, the message is that our chosen manager will continue to focus on active stock selection based on long term growth stories rather than on short term market timing. The latter approach would inevitably be more affected by volatility in the Eurozone than an approach based on company fundamentals should be.
Hopefully this article highlights some of the reasons why we invest in the sector and why we believe that our selected manager has the right approach, particularly in today's climate.
Tags: Eurozone, volatility