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Pros and cons of European smaller companies funds

This article is part of
Guide to European Smaller Companies Funds

Smaller companies can offer greater growth potential, albeit with typically higher volatility than larger companies.

Historically, and over the long term, the returns from European smaller companies have outstripped the returns of larger companies.

However advisers must note that in periods of falling equity markets, smaller companies can sharply under-perform larger companies.

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A further difference compared with bigger firms is that typically there is a wider spread of returns in any single calendar year among smaller companies than the spread of returns achievable from larger companies.

Ultimately, with a proportion being start ups, some smaller companies can achieve strong gains while others may go bust in any one year.

The real gains that can be made in this area, according to Nick Williams, manager of the Baring Europe Select trust, is because the market for small and mid cap companies is inefficiently priced.

Fundamental analysis is the best way to identify under-recognised growth opportunities, he says.

Mr Williams says his strategy is to build a balanced portfolio of mispriced European smaller companies with the potential for positive earnings surprise, typically comprising 80 to 110 securities.

Laurent Inglebert, investment manager at Aberdeen Asset Management, says the benefit of this type of fund for investors is the opportunity to attain exposure to a category of stocks that have a greater exposure to an economic recovery in Europe than their larger peers.

Another important consideration for potential investors in smaller companies to take into account is the fact that the sector is significantly under-researched, he adds.

This research deficiency presents a valuable informational advantage – it may be possible to spot opportunities that others have overlooked, Mr Inglebert says.

He adds another upside for potential investors to consider is the increasing tendency for smaller companies to get acquired.

A combination of factors, including increased credit availability, healthier balance sheets and improved director confidence are likely behind the increase of companies in this bracket being acquisition targets, he notes.

Mr Inglebert says: “There is at least anecdotal evidence that many larger companies are looking to grow by snapping up smaller rivals.”

European smaller companies usually focus on growth as the primary source of returns, agrees Ollie Beckett, manager of Henderson Horizon Pan European Smaller Companies fund.

For smaller European companies funds, Mr Beckett says performance is driven by the identification of those smaller-cap firms that are well positioned for profitable expansion, or which are likely to attract attention from larger companies looking to add specialist expertise, or innovative new products and services via merger and acquisition activity.

But Mr Beckett warns smaller European stocks tend to be less liquid than their larger peers, with fewer shares in the market, and a smaller pool of investors willing to buy or sell.

Mr Beckett says this can make trading more risky, but should a company manage to grow its revenues, it can attract attention from investors – which can lead to potentially dramatic share price gains in a short space of time.