The Lure of European Small-Caps


Riding the recent wave of small-cap outperformance, the $75.7 million AIM European Small Company Fund/A (ESMAX) has delivered impressive returns. For the year through June, it soared 56.1%, vs. a 47.1% climb by its benchmark, the MSCI Europe Small Cap Index. By comparison, the regional market/developed fund peer group gained 29.6% over that period.

For the three years through June, AIM European Small Company gained 23.7% annualized, vs. a 14.5% rise by the index, and a 3.4% gain by its peers. Portfolio managers Jason Holzer and Borge Endresen are firmly in the growth camp -- they insist on stocks with double-digit annual growth with the potential for continued strong earnings increases.

The fund is somewhat less volatile than its peer group, as illustrated by its

standard deviation of 17.7%, compared with 18.4% for its peers. However, the 2% expense ratio slightly exceeds the peer group average of 1.93%. Based on risk and return characteristics during the last three years, S&P gives the fund its highest overall rank of 5 Stars.

Holzer has managed the fund since its inception in August, 2000. Endresen joined the management team in 2002, after working as a fund senior analyst from its beginning. Palash R. Ghosh of Standard & Poor's Fund Advisor recently spoke with Holzer and Endresen about their strategy. Edited excerpts follow:

Q: What kind of stocks do you invest in?

Holzer: We are purely bottom-up investors, seeking small-cap European companies with above-average annual growth rates -- typically in double-digits -- and catalysts for further earnings growth. We also like firms with quality management teams and strong cash flows.

Q: Small-cap stocks have been outperforming large-caps in Europe, especially in 2003. Why has this happened? Do you expect this outperformance to continue?

Holzer: In Europe, as in the U.S., there was an indexing craze during the late 1990s, particularly for large-cap stocks. This mania for large-caps was accentuated in Europe due to the introduction of the euro, which allowed fund managers to purchase stocks outside their home countries.

Initially, they gravitated towards large-cap names. Since then, small-cap equities in Europe have undergone a valuation catch-up. In 2001, European small-cap stocks were trading at a 50% discount to European large-caps. Today, that discount is about 10%. By contrast, small-caps in the U.S. are now trading at a premium relative to large-caps.

Endresen: To illustrate the potential upside for European small-cap stocks, our fund's average forward p-e is only 12, and its average earnings growth rate is about 20%.

Holzer: We also believe the earnings estimates for our companies have been understated, since many of our stocks have no or little brokerage following. Despite the recent price gains, we believe small-caps in Europe remain attractive. However, we don't expect small-caps to continue to outperform large-caps.

Q: How large is your pool of possible investments?

Holzer: Our universe of European companies with market caps between $50 million and $3 billion is quite large -- about 3,500. But with our focused-growth criteria, we actively analyze only about 200 to 250 stocks.

Q: What are your top holdings?

Holzer: As of June 30, our 10 largest positions were Option International, a Belgian wireless technology firm, 2.3%; Puma Rudolf Dassler Sport (PMMAY), the German sports apparel manufacturer, 2.3%; Savills, a British property agent, 2.1%; Meda, a Swedish specialty pharmaceuticals company, 1.7%; Anglo Irish Bank (AGIBY), 1.6%; Sportingbet, a British interactive sports betting and casino service, 1.6%; Aktiv Kapital, a Norwegian debt collector, 1.6%; Bijou Brigitte Modische Accessoires, a German fashion jewelry and accessories firm, 1.5%; Eiffage, a French construction company, 1.4%; and Hunter Douglas (HDUGF), a Dutch window-covering maker, 1.4%.

We currently have about 100 stocks in the portfolio and typically hold 80 to 120 names. We like to keep a diversified and liquid portfolio as risk-control measures.

Q: Can you discuss one of your top holdings?

Holzer: Puma is up almost 10-fold since our initial purchase in 2002. We have great confidence in this company, as it has delivered growth that exceeded all analysts' forecasts. Despite its superb price appreciation, the stock remains attractively valued, trading at only 12 times earnings.

Endresen: Puma has excelled even though the athletic footwear market has been sluggish. Puma's market share in the U.S. remains almost negligible compared with Nike (NKE), so there is much room for growth.

Q: What are your top sectors?

Holzer: As of June 30: consumer discretionary, 35.6%; industrials, 23.6%; financials, 14.3%; information technology, 10.9%; and consumer staples, 6.7%. Thus, the fund has nearly 60% of its assets in either consumer-discretionary or industrial stocks -- this reflects the composition of the European small-cap landscape more than a strong conviction on these particular industries. These sectors account for about 50% of the MSCI Small Cap Europe Index.

Endresen: We're underweight in sectors like tech where we don't see sustainable earnings growth. We're slightly underweight in financials and health care.

Q: What's your current country allocation?

Holzer: As of June 30: Britain, 28%; France, 11.7%; Netherlands, 9.1%; Germany, 8.5%; Switzerland, 6.4%; Norway, 6.2%; Ireland, 5.8%; Sweden, 3.8%; Spain, 2.3%; and Belgium, 2.3%.

Q: Do you only invest in Western Europe or would you also invest in Eastern Europe?

Holzer: The Eastern European markets are quite thin and illiquid. When we invested in the East, the market tended to be mostly blue-chip names, which are typically outside of the small-cap realm.

Endresen: For this fund, we invest primarily in Western European stocks.

Q: You have outperformed your benchmark, the MSCI Europe Small Cap Index, for both the one-year and three-year periods through June 30. What do you attribute this to?

Holzer: Our outperformance has been driven by individual stock selection, since we make no bets on particular countries nor sectors.

Q: On a top-down basis, what makes Western Europe a good place to invest?

Holzer: Inflation is low, interest rates are low (with further rate cuts possible), and consumers have a higher savings rate and lower debt than Americans.

Q: Does the strength of the euro play any role in your stock picking? Or are small-caps immune to currency fluctuations, since smaller companies probably don't export very much?

Endresen: Most of our companies are locally oriented, so the strength of the euro is not much of an issue. However, a strong euro gives consumers in these countries more purchasing power, which can help a company's earnings.

Q: What are your sell criteria?

Holzer: Typically, we sell due to an earnings disappointment, a significant earnings downgrade, fundamentals deterioration, or excessive valuations. We typically don't get rid of a holding if its market cap becomes too large to be small-cap. By prospectus, we can hold up to 20% of our assets outside of small-cap names.

Q: What's your outlook for European small-cap stocks for the rest of 2004 and next year?

Endresen: Our fund rose almost 64% last year, which I don't expect to match this year. But we are confident that our fund and European small-caps will outpace the U.S. equity markets for the next couple of years due largely to the valuation discounts on the continent.


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