European small and mid caps-Stock picks Q4 2007-Q1 2008 - Fourlis

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Mid cap European small and mid caps 17 October 2007 abc Estimated ex-ante US equity risk premium, % 5 4 3 2 1 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 US Implied ERP Av erage +1 St. Dev -1 St. Dev Source: HSBC, Thomson Financial Datastream At the regional and sectoral levels, conviction has been in short supply over the course of 2007, as we thought it might be. This is a reflection of several issues – M&A and infrastructure appeal, for example – that cut across conventional cyclical attributes. If anything, this lack of intra-market conviction has become even more pronounced as a result of the ABS and liquidity crises. Nonetheless, on a 3- 6 month view, we have cut our cyclical positions and added to a mixture of technology and growthoriented sectors and regions, with the weak dollar making some degree of shift back into the US more favourable. We have trimmed our Overweight positions in Europe and emerging markets accordingly, though Europe remains our favourite among the larger blocs. One of those cross-market themes that we thought might make themselves felt in 2007 is size and, indeed, so far, this has been the case. Larger-cap companies are beginning to claw back some of the last few years’ underperformance. The turnaround is now clearly visible in price relative charts in the US and Europe and has been for some time in Japan. US and Europe trailing PE/economic value added (EVA) index (ROE/COE) 30 25 20 15 10 5 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 PE/EVA Source: HSBC, Thomson Financial Datastream 4
Mid cap European small and mid caps 17 October 2007 abc We expect large caps to continue to outperform. Larger companies tend to be less dependent on the vagaries of the business cycle, partly by virtue of their greater international diversification. They have stronger balance sheets and are likely to be relatively sheltered from any residual liquidity pressures. When M&A revives, we suspect its focus will shift upscale – partly because private equity may become a little less prominent and partly because many of the potential targets in the small/mid-cap space have already been snapped up and/or have become too expensive. Recently, large caps have been trading more cheaply than small and mid-cap companies, both in terms of PEs and dividend yields. And not all large caps look equally attractive. Most utilities, for example, are large simply by virtue of their physical assets and their earnings are non-cyclical. However, for us, their earnings are too defensive, their balance sheets are not the strongest and there has already been a wave of consolidation in the sector, so we see less consolidation to look forward to. There are many small technology companies, for example, that we would buy ahead of larger utilities. Other things being equal, though, we think investors will continue to ‘think big’ over the course of the rest of 2007 and into 2008. As with other intra-market themes, however, we do not expect size to prove overwhelmingly important: we simply expect smaller-cap indices to rise less markedly than their large-cap peers. Some of the post-2000 outperformance by mid and small caps has reflected a structural decision by many money managers to increase their exposure to what they see as relatively under-researched and, hence (arguably), less efficiently priced segments of the global market. Smaller caps – together with emerging markets, their regional equivalents, perhaps – have benefited accordingly. This shift is unlikely to be reversed any time soon, in our opinion. Price relatives: small & mid cap indices versus large caps 200 160 120 80 40 97 98 99 00 01 02 03 04 05 06 07 UK US Germany Japan PE relatives: small & mid cap indices versus large caps 180 160 140 120 100 80 60 40 97 98 99 00 01 02 03 04 05 06 07 UK US Germany Japan Source: HSBC, Thomson Financial Datastream Source: HSBC, Thomson Financial Datastream 5
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European small and mid caps-Stock picks Q4 2007-Q1 2008 - Fourlis

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