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Strength through diversity By Fiona Hamilton
Smaller companies in most regions have been hugely rewarding over the last five years. This is partly because they began the period exceptionally unloved, so had even greater recovery potential than their larger brethren, and partly Each year there have been predictions that they must be due for at best a dull period, but each year they have continued to outperform. However, it is salutary to note how badly smaller companies fared last year in Japan. Stockmarket confidence was punctured by a share trading scandal, and economic growth did not live up to earlier expectations. European smaller companies have done particularly well, and the current year has seen a continuation of the trend. The HSBC European Smaller Companies index was up nearly 10% in the three months to the end of March, whereas the mainstream FTSE Europe ex UK index was just 4% ahead. With the European smaller companies index having almost tripled since March 2002, the fifteen funds specialising in the sector have not needed to be particularly clever to produce dazzling returns - which is just as well because most of them failed to match the index over five years, although around half are ahead over the last twelve months. The only two which did outperform over the longer period were the Threadneedle European Smaller Companies and the JPM Europe Smaller Companies fund. Threadneedle European Smaller Companies has been managed since 2002 by David Dudding. A brainy 36 year old, his success has helped grow its assets to over £900 million, and it also paved the way for the 2005 launch of the Threadneedle Pan European Smaller Companies. Managed by Philip Dicken, who has been a great help to Dudding since he joined Threadneedle in 2004, it differs from the older fund by including the UK in its remit, and has been one of the top ten unitised funds in any sector over the last year. Dudding says European smaller companies remain exciting to invest in because there is such a wide choice of companies in a diversity of countries. Many are poorly researched, which greatly enhances the possibility of finding undiscovered gems. Because they are smaller, they can grow faster, but they are not necessarily inconsequential, as they may be world leaders in their niche. This is true, for example, as regards some German engineering companies, which are benefiting from soaring exports to the Far East and Eastern Europe. Dudding favours companies with strong management, a high and defensible market share and a business he can understand. "The key to whether smaller companies continue to outperform larger companies is the banks," says Dudding. "The banks are a big part of the larger company universe and they look very cheap, so smaller companies may find it hard to keep up in the short term if banks do well. But they still represent a great long-term investment." The JPM Europe Smaller Companies fund is run by the well-established pair of Jim Campbell and Francesco Conti. With around 280 holdings, it is exceptionally well diversified and looks to keep gently ahead of its benchmark regardless of the economic climate, rather than running risks in an attempt to shoot the lights out. It has lagged a bit over the last 12 months because other managers have been more aggressively invested, but should be less vulnerable in a setback. Campbell believes European smaller companies have deserved their strong run. They are now more fully valued, he reckons, but average growth remains usefully higher than that of larger companies, and some companies are coming through with spectacular results. As long as that continues, the outlook is good. Having been increasingly undervalued during the 1990s, he thinks smaller companies could now overshoot in the other direction and attract even more of a premium rating. So far as stockmarkets in general are concerned, he finds it encouraging that a lot of investors remain cautious, and there is lots of cash waiting to be invested. Elsewhere, the Henderson European Smaller Companies fund has picked up since Simon Savill took charge in 2003. It has a concentrated portfolio of very carefully picked companies, and like the other two funds it has benefited from the strength of German and Austrian construction and engineering companies - in which it remains overweight. A good inflow of funds meant it had a useful cash cushion during the February setback. "European smaller companies are more highly valued, so I have to work harder to find good investment opportunities, but there are still some out there," Savill says. "From a market perspective, things have gone up very strongly, and nothing goes up forever, so I would not be surprised by a short-term correction. But that should throw up some good buying opportunities."
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