Multiple factors drive segment marked by nimbleness
Europe’s small and medium caps can earn relatively high returns, especially when their balance sheets are strong and their business generates plenty of cash.
- Focus on stocks that can achieve 20-40% returns over 1-3 years
- Strong balance sheets are essential
- Relative yields are attractive now
Being selective and diversifying can dramatically reduce the risk of default. We focus on stock picking, not sectors or countries, for a more balanced portfolio. We buy companies that can grow in a difficult business environment and boost total cash returns via increasing dividends and share buybacks. We believe European small-cap equities can offer double-digit earnings growth and even faster growth prospects for the dividend with a current yield of 3-4%.
Sector can offer growth, value, M&A gains
One example is International Personal Finance, a UK company that offers consumer loans in emerging markets. Another is the UK’s Talk Talk Telecom, which focuses on affordable mobile phone products in a market where budget conscious consumers are looking to save money.
For some companies, the overriding focus is on growth, other stocks are pure value investments and then there are merger and acquisition stocks. Logica is an example – it was bought by a Canadian player. A merger or acquisition typically supports valuations. In this market, we believe smaller companies are more likely to be takeover targets than their larger peers. We have seen ample activity in this area: about one deal per month.
Source of attractive yields
Falling corporate bond yields represent a major opportunity for the sector. Understandably, investors would prefer a current 3-4% dividend yield from a company that generates enough cash to cover its dividends twice over and can adapt easily to tough market trends over a 2% yield from a government bond.
We are cautious on the market because of the global macroeconomic environment. We look for companies that can still grow, for instance in emerging markets, or because they have an attractively priced product demanded by budget-conscious consumers. A typical example is WH Smith in the UK. It has taken out less profitable products and focused on improving the product mix. It undertakes a share buyback every year and has a high dividend yield.