Paisley: Indeed, small caps can be volatile over the short-term. It’s a common misperception that they are a lot riskier than larger companies. If we look at the risk-adjusted returns of smaller companies, investors are being more than adequately compensated in the long-run for that additional short-term volatility.
Smaller company equities, although encompassing 14% of the weighted average market capital globally, generated a nearly fivefold increase in returns over the 16 years since 2000, compared to just more than doubled returns for larger company equities.
It’s important to take a long-term view in small caps investing. Our style focus is very much on growth, quality and momentum. We look for high quality names and sustainable, multi-year growth stories rather than short-term restructuring plays, and avoid speculative businesses which are much riskier. Momentum is quite persistent for small caps and can last for many years.
Q: How to find value in European smaller companies?
Paisley: Finding stocks that are under the radar of equity analysts is the key. Small-caps are typically under-researched and so are more likely to be mispriced by the market. The target is to get the non-consensus view of these companies.
Typically we get much better access to smaller companies’ senior management team. Unlike many larger companies, some small-caps have high growth potential and the flexibility to become future niche players. The key is to look for material change that is happening on the company level. This may include a new product, new market potential or any regulatory and technological changes.
Q: How do you compare smaller companies in Europe to other regions?
Paisley: What we see in developed Europe are the benefits of a strong regulatory backdrop with higher standards of corporate governance, accounting and auditing than the emerging markets. There are thousands of global growth companies in Europe and investors are getting diversified exposure to international market opportunities.
The recovery in the European economy is now gaining good traction and we are seeing asset allocators moving money into Europe from other regions like the US where valuations are higher. In addition to this cyclical reason for a higher asset allocation to smaller companies we also believe there is a strong structural growth story as asset allocators use low cost approaches for core assets and augment this with high alphas satellite pots of money such as smaller companies.
Q: Do you see further political risk in Europe and how does it impact your strategy?
Paisley: Following the French presidential elections this year, investors are now focusing more on the economic performance of Europe. There are a couple more political events to watch for in the coming months. In Germany, we do feel that Angela Merkel is in a good position to be re-elected. That said, we focus on bottom-up stock fundamentals rather than macro influences when identifying investment ideas in European small caps. The performance of these companies is less influenced by political events and more driven by what is going on at the company level.
Andrew Paisley is manager of Standard Life Investments European Smaller Companies Fund