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

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
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