Continental drift: it's a market phenomenon

Small companies in Europe are becoming an increasingly attractive investment option, but be careful which you choose.

Europe offers a wealth of investment opportunities for those who are selective. While there is much debate among fund managers about which countries offer the best opportunities, most agree that careful stock selection is essential.

Until recently, investing in continental Europe was not a fashionable option. But as Europe emerges from recession, many companies have started to restructure and place more emphasis on shareholder value.

Share prices in the UK and US are at record levels (starting to look overpriced, some professionals would say), suggesting that now might be a good time for investors to look at unit trusts and investment trusts investing in Europe.

There are more than 120 European unit trust funds run by around 86 investment houses. And there are more than 20 investment trust funds run by about the same number of investment managers. The portfolios of the funds vary enormously, as does their performance.

Continental Europe has taken longer to emerge from the world recession than the UK or the US, but its recovery looks healthy, says Daniele Serruya, European small companies fund manager at Schroders.

"We are starting to see a recovery in Europe and the capacity of the economies to grow without inflation is great," she says. "Growth without inflation is an ideal recipe for good equity markets." Lower interest rates have meant lower costs and higher earnings figures, both of which have made companies more attractive and pushed up share prices.

Restructuring and cost control have become key issues. Many large European companies have been criticised for being too diverse and having too many layers of management. In order to become more efficient and profitable, these companies have had to sell off non-core activities and slim down workforces.

This has not been an easy course for many firms - particularly those with close links with governments and political parties - which are keen to avoid job losses. The result has been that many firms have been flabby. And with high labour costs and strong European currencies, many companies have found it hard to compete globally.

"The biggest need for restructuring has been in countries such as Germany and France," says Philip Mottram, a director at Abtrust. "Germany has started to tackle the problem and is now one of the most attractive areas for investment in Europe."

Ms Serruya agrees: "The change in management attitudes, and the increasing focus on shareholder value, has been particularly evident in recent times in Germany."

Many large French companies have been criticised for outdated labour practices and not taking shareholders' interests into consideration. There has been even less restructuring of companies in France, and it is generally regarded as being about a year behind Germany in this respect.

Ms Serruya disagrees, arguing that many French companies are restructuring but just not making the headlines. These companies offer good value and their share prices are undervalued, she says.

Scandinavia and the Netherlands are popular with many fund managers. There has been more restructuring in these countries than elsewhere in Europe, and companies are often more open with shareholders. In general, the core areas of Europe are attracting most capital from UK fund managers while Spain, Portugal and Greece are attracting little attention.

The main attractions are small and medium-sized companies, which are now growing at a faster rate than many blue-chip firms. In the first half of the Nineties, smaller companies underperformed blue-chip firms, but since the start of this year there has been a turnaround in fortunes.

European blue-chip companies have increased in value by 7 per cent this year while smaller companies are up by 8 per cent, says Jim Campbell, investment manager at Fleming Investment Management. The benefits of lower interest rates are feeding through to companies so that average earnings growth is at 17 per cent for small companies and 15 per cent for blue chips.

This is encouraging fund managers to start buying into smaller companies. "Following a long spell of underperformance," says Mr Campbell, "small companies seem to have turned the corner. In the first six months of this year we have seen a trend of blue-chip managers moving further down the market capitalisation scale to exploit the growth and value which is offered in many smaller companies."

Many small and medium-sized firms have found it easier to restructure than larger firms as there is less government control. These companies often have more dynamic styles of management than large companies and seem keener to offer shareholder value.

Many small European companies are world leaders in their field but are undervalued because they are European, says Rory Powe, head of European equities at Invesco.

"Europe is perceived to be unfashionable because of the economic situation and the lack of excitement over European Monetary Union," he says. "So there are many companies which are global players, but because they are European they are not enjoying the high valuations their US counterparts are enjoying."

Several European companies dominate their global niche markets, particularly in the healthcare, business computer software, luxury goods and leisure markets. Many of these have not yet been identified by fund managers who have been too busy concentrating on the more established markets.

"European small and medium-sized companies are not as well researched or well known as they should be because this is a less mature market than the US and UK," he points out.

Fund managers vary over which countries offer the best opportunities, but all agree that choosing the right companies is more important than choosing a particular area - although some countries are attracting more attention than others.

Many French firms are seen as dynamic and offering good value. While large companies often receive a lot of state funding and so have less incentive to restructure, this is not true of smaller companies. Many small French companies are coming to the market in search of more capital and have more entrepreneurial and innovative management styles than many more traditional European companies.

Scandinavia is popular with most small company fund managers. It has many high-growth firms, restructuring of companies is often more advanced and management style more geared towards pleasing shareholders than in other parts of Europe.

Invesco's smaller caps fund is weighted in favour of Scandinavia, Holland and Italy. Mr Powe says: "The enterprise culture is probably stronger and technology leadership is more evident in these countries."

Fleming has also found lots of value in the Italian market, says Mr Campbell - "lots of small restructuring growth stories ... and some particularly interesting companies."

But Schroder is less keen on the Mediterranean countries, says Ms Serruya. "We tend to favour hardcore Europe as opposed to soft currency areas. In the run-up to EMU we feel we are safer in these countries than in Italy and Spain where there are concerns that they will not reach the Maastricht requirements in time."

While funds vary over their weightings in different European countries, all argue that it is the individual companies themselves that they are most interested in. As Richard Pease, a director at Jupiter Asset Management, says: "You've got to be very selective. But with the right companies, Europe's a profitable place to invest" n