Split over small caps

European fund managers have disagreed over the merits of investing in smaller companies within the region, following a significant rally in the sub-sector since March.

Nick Williams, manager of the Barings Europe Select fund, said the conditions that produced a trend towards megacap investing in the 1970s were "definitely not prevalent at the moment".

Larger companies were better able to survive the 1970s because their size enabled them to weather the inflated costs of the period, he said.

But Jeff Taylor, manager of the Invesco Perpetual European Equity fund, said he had stocked his top 10 holdings with diversified large caps on visible earnings to counteract uncertain corporate forecasts.

In particular, he said he had taken profits in cyclicals, which are traditionally a large component of smaller companies indices, in favour of defensives.

Mr Taylor had originally moved more heavily into cyclicals during the first quarter on cheap valuations.

He said: "Although the bulk of my portfolio was defensive, a number of cyclicals had become ridiculously cheap, even under an Armageddon scenario. However, I didn't want to chase every bit of yield I could get."

But he added that, despite managers' optimism for the future, companies had given him gloomy assessments of the present.

He said this discrepancy in sentiment mirrored 2002, when economic optimism grew towards the middle of the year, but fell back towards the end of it.

He added cyclicals were not compensating investors for the greater volatility of their dividends by generating a higher dividend yield. Defensives, therefore, looked more attractive from an income perspective, he said.

But Mr Williams said in certain cyclical areas and in smaller companies in general, cuts in earnings forecasts had been too sharp.

"Our basic point of view is people have ignored smaller companies on the grounds of risk," he said. "In some cases, that will be true. You're not going to find the cyclicals are very comfortable at the moment."

But he said the sell side had cut earnings estimates too aggressively, particularly in areas experiencing secular growth trends such as Internet penetration.

"Some of the very aggressive downgrades that were put through by the sell side have had to be revised slightly, even for the very cyclical, highly economically sensitive companies," he said.

"In the German market, we're seeing year-on-year growth in car registrations. There is still demand for some components to go into cars."