Have Active European Small-Cap Managers lost their skill to generate alpha?

Transcription

1 Article Have Active European Small-Cap Managers lost their skill to generate alpha? Introduction 2 The recent underperformance of Active Managers 2 Explanation #1 The growth of smallcap ETFs? 3 Explanation #2 Increased Broker research coverage? 4 Explanation #3 The distorting influence of aggressive central banks 5 In the long term, quality is the way to go 8 Valuation is the key 9 In the end company fundamentals will prevail 10 Conclusion European small-cap managers as a group have had difficulties outperforming their respective benchmarks in recent years. Especially since 2012, we find that the majority of active managers have generated underperformance. To illustrate, year-to-date almost three quarters of all active European small-cap managers have underperformed. In this piece, we will examine a couple of potential reasons and often heard explanations. Our key take away is that the search for yield since 2012 has inflated the share prices of more risky, lower quality, over-leveraged companies relative to higher quality companies with solid balance sheets. Most active managers are focused on higher quality companies and as a result have underperformed the broader market. We believe this is a temporary effect. We do not believe that active managers have suddenly lost their skill to generate alpha. Company fundamentals prevail over time. This will level the playing field and especially those active European small-cap managers that have remained true to their consistent valuation-aware high-quality approach are well-positioned to be rewarded for that going forward.

2 2 Introduction With a large and diverse universe of smaller companies and with a lack of broker coverage, the European small-cap equity markets seem fertile hunting ground for fundamental bottom-up stock pickers. The European small-cap market consists of many thousands of listed smaller less liquid companies, while sell-side research coverage is decreasing as the broker business model has come under pressure. Many of these European companies have strong and unique business models with a good market share, a global client base, high barriers to entry, strong management and healthy balance sheets. These dynamics create market inefficiencies that can be exploited by active managers. During our manager searches we have identified a total of 100 fundamental small-cap managers with a longer term track record. Analyzing the historical track records of these managers, we find a downward trend in the percentage of managers that have been able to outperform the MSCI Europe Small Cap Index. For example, this year (up to August) more than 75% of all active managers have underperformed. It s also interesting to see that the degree of underperformance seems to be correlated to the number of managers that underperform (i.e. when more managers underperform, the magnitude of the average underperformance also tends to be higher). And it is also interesting to observe the same general trend in US smallcaps (which seems to be driven by the same factor, although we will As part of our fiduciary duty to our clients, the Kempen Capital Management Multi Management Team has been selecting fundamental European small-cap managers successfully for many years. However, in recent years we have seen fundamental active managers that focus on European small-caps underperforming their respective benchmarks. This is opposite to the long term strong and consistent outperformance that we have seen historically with many managers. What is driving this effect? Is this temporary or will this persevere? focus on European small-caps here). In the paragraphs that follow, we will go through a number of often heard explanations, including (i) the growth of ETFs, (ii) Broker research coverage and (iii) the distorting influence of aggressive central bank s policies. We will use our own research as well the research of the managers that we have selected for our Approved List to find an answer to the central question of this piece: Have European Active small-cap Managers lost their skill to generate alpha? u The recent underperformance of Active Managers The definition of European small-caps varies between benchmark provider and per brokerage house. We use the MSCI definition, which is most widely used. MSCI defines small-caps covering all investable securities with a market capitalization below that of the companies in the MSCI Standard Indexes, targeting approximately 14% of each market s free-float adjusted market capitalization. The MSCI Europe Small Cap Index comprises of 916 companies, with an average market cap of 1.1bn, ranging from a minimum of 25m to a maximum of 6.6bn. The median market cap is 660m. Additionally, (according to Factset) approx smaller companies across Europe are listed but are not included in the MSCI benchmark. Many of these companies are too small or illiquid, but at least a couple hundred companies could yet be interesting from a fundamental investment perspec-

3 3 tive. Most active managers have mandates that allow them to invest outside the benchmark (albeit with constraints with regards to liquidity and a maximum non-benchmark exposure). As such these hundreds of additional non-benchmark companies is also part of the European small-cap universe. % of actively managed European small-cap funds that outperformed the MSCI Europe Small Cap Index over the last 10 years We have identified a total of 100 fundamental European small-cap funds with a track record of at least three years. Many of these managers we have met with over the years. Analyzing the historical track records of these funds in Morningstar, we find a downward trend in the percentage of active small-cap managers that have been able to outperform the MSCI Europe Small Cap Index. For example, this year (up to August) more than 75% of all fundamental active managers have underperformed the MSCI Europe Small Cap index. Source: Morningstar Interestingly, we see the same trend within US small-caps with more and more fundamental managers underperforming, which may indicate a global trend. However we intend to focus on European small-caps specifically in this piece. Why has it suddenly become increasingly difficult for active managers to outperform in the small-cap space? Next, we will go through three often heard explanations, including; 1. Recent growth of small-cap ETFs relative to active managers. 2. Increased broker research coverage. 3. The distorting influence of aggressive central bank s policies u Explanation #1: The growth of small-cap ETFs? Net flows into European small-caps ( ) The recent growth of exchange-traded funds (ETFs) may have had 4,5 influence on the small-cap space and is often used as explanation for the recent underperformance of active managers. Small-cap ETFs have seen healthy asset growth over the last few years and new inflow into small-cap ETF s means indiscriminate buying of the small-cap constituents of the small-cap indices that are being tracked. As European small-caps tend to be less liquid than for instance large caps, these inflows could result in higher share prices, and as such relatively strong performance of the indices being tracked, especially when flows are big and lumpy. The broader European ETF market has been growing relatively strong with almost 20% per year and total AUM reached a new Net inflow active managers (3 yr) 1,2 Net inflow ETF's (3 yr) Source: Morningstar, Deutsche Bank ETF Review 2014

4 4 record high of $396.6bn at the end of However, cash inflows into the European small-cap ETFs subset have remained limited, especially when compared to inflows into active managers strategies. Over the last three years (2011 to 2013), total net inflows into European small-cap ETF s totaled $1.2bn. This brings total AUM in European small-cap ETF s to $4.3bn per the start of 2014 (industry data from Deutsche Bank). As measured over the same period, active European small-cap managers received total net inflows of $4.5bn, which brings total AUM in actively managed small-cap funds to approx. $40bn per the end of This does not include the assets in separately managed accounts that are managed pari passu to the small-cap funds, as this data is proprietary and not available in public databases. We estimate that these assets could easily be equally large as total AUM in the mutual funds listed in Morningstar, as that is the case with the managers on our Approved List. Even excluding those flows, active strategies have received substantially more inflows over the last few years and they clearly manage far more assets in aggregate compared to all ETF s combined. Putting this into perspective versus the combined market cap of the entire listed European small-cap asset class, conservatively esti- ETF and Active managers' market share of total European small-cap market mated to be 840bn (i.e. being the total market cap of the MSCI Europe Small Cap Index), the total assets in ETF s is substantially less than 1%. All in all, the inflows in ETF s in our view are insignificant and simply cannot explain why active managers have underperformed over the last few years. u Explanation #2: Increased Broker research coverage? ETFs Investment Funds Other Most active managers we have talked to over the years told us that Source: Morningstar, KCM they don t rely on external broker research. They rather perform their own proprietary research as that should give them an edge. Obviously most managers do look at broker research to have a feeling where market consensus estimates are. Interestingly, most small-cap managers claim that the quality of broker research has come down over the years. An increasing amount of trades are executed electronically and traditional trade revenues and broker fees have come down over the last few years, especially for smaller companies. The equity brokerage business model therefore has come under pressure and as a result, each sell-side analyst has to cover increasingly more companies. Our managers also refer to a

5 5 trend towards junioralisation of the sell side coverage, as senior analysts tend to join the buy side. We don t have perfect data to support these observations. However, a quick analysis of Bloomberg data shows that the total Average number of broker-analysts per constituent company of the MSCI Europe Small Cap Index number of sell side broker recommendations has increased slightly over the last five years. As the number of companies that are part of the MSCI Europe Small Cap index decreased from 1089 per January 2010 to 936 per the beginning of 2014, we found that on average each small-cap company is being followed by 10 analysts 6 (as opposed to approx. 30 analysts on average in the large cap space). This number increased slightly compared to 2010, but the change in our view is not material. 4 2 Obviously, this is a very crude analysis of the European small-cap brokerage market and we do not claim to have full insight here. However, as we have not seen a material change in broker coverage and as most active managers don t rely on external broker research in the first place, this leads us to believe that this cannot explain why active managers have struggled to generate alpha over the last few years Source: Bloomberg, data from January 2010 to January 2014 u Explanation #3: The distorting influence of aggressive central banks Ever since the 2008 credit crisis, global central banks have been highly accommodative. Although the US Federal Reserve (Fed) is reducing its asset purchases, its large balance sheet has grown to a record size while rates have touched historical lows. In Europe, the European Central Bank (ECB) recently committed to asset purchases as well, while the deposit rates currently are negative and the refinance rate is close to zero. Because of this flood of liquidity and rates being kept at historical lows, yield has become scarce. This has sent investors searching for yield and income wherever they can find it, increasing risk taking behavior. This global search for yield especially benefitted smaller companies that employ a lot of leverage (cheap financing can create short term attractive yield) while companies with more solid balance sheets have thus far lagged behind. Also, less profitable companies that in the period before lagged the broader market suddenly started outperforming. Within the European small-cap market this is best evidenced starting in When ECB president Mario Draghi gave a speech in July 2012, stating that he would do whatever it takes to save the Euro, sentiment suddenly turned around and investors became clearly risk-on. From that point onwards,

6 6 investors started favoring companies with higher leverage over companies with low leverage and more risky lower quality companies started outperforming more stable profitable higher quality companies. The chart shows the impact in practice. The chart is based on calculations of one of the managers on our Approved List (Kempen UK, based in Edinburgh). Companies with strong balance sheets (low net debt to equity ratios) and attractive profitability (measured by high Return on Capital Employed, ROCE 1 ) have underperformed the broader market since July This trend has continued into 2014, although the relative performance of higher quality companies seems to be turning more recently. Historical performance of companies of high quality (ROCE) and with high balance sheet strength (Net Debt/Equity) relatively measured as the 1 st quartile vs the 4 th quartile Draghi's speech The majority of active managers in European small-caps focus on selecting quality companies, which is inarguably an overused and subjective term. Few, if any, managers explicitly state that they implement a strategy that focuses on low-quality or crappy companies. Definitions of quality tend to differ per manager, but a healthy balance sheet, attractive margins, pricing power and stable predictable growth seems to be a common denominator in the quality definition. One however should not confuse low quality and value as these are quite different strategies. Buying high quality assets without paying premium prices is just as much value investing as buying average quality assets at discount prices 2. Strong vs Weak Balance Sheet High vs Low ROCE (Quality) Source: Factset, KCM Within European small-caps, the risk of a company going bankrupt is substantially higher than compared to large caps, as small-caps are simply smaller, and generally have less diversified business models, more volatile cash flows and often more difficult to access financing at attractive terms compared to large caps. Higher quality small-cap companies however have a lower risk of going bankrupt and are able to generate stable and attractive earnings growth through the cycle. Quality companies are better equipped to grow their earnings through the cycle versus the broader market. When companies deliver on earnings, in the long term, investors are rewarded for that. It however obviously depends on valuations, as expected returns for low quality companies in theory should be higher to compensate for risk. Most managers however believe that small-cap markets are not efficient and on the long term they are rewarded relatively more for investing in higher quality companies compared to low quality, as long as they don t overpay for quality. Here we believe to have found the true reason why active managers have underperformed lately. They all focus on investing in quality companies and exactly these companies have signifi- 1 ROCE = Earnings before interest expenses minus income taxes divided by total equity, provisions and net debt. 2 See The quality Dimension of Value Investing by Robert Novy-Marx, working paper 2013 for more details.

7 7 cantly underperformed the broader market since July Like most active managers, the managers on our Approved List are valuation aware, which effectively means they do not wish to overpay for quality (i.e. they don t buy the quality companies priced for perfection) and some managers also mix a bit of value or special situations into the strategy to a certain extent. To sum up, because of the loose monetary policy of central banks, a search for yield has started since July 2012 and investors have started taking more risk. As active managers generally have a lower risk approach and invest in high quality companies, they have lagged the broader market which has profited from the re-rating of lower quality companies. Montanaro Asset Management, one of the small-cap managers that has been on our Approved List since September 2009 also has been suffering from its focus on quality companies during the last two years. Montanaro looks for profitable companies with high operating margins, good management, niche businesses in growth markets with healthy balance sheets. They are able to find approx. 200 of those companies in the European small-cap market. Of these companies, they have constructed an equally weighted index to be able to track the performance of these quality companies over time versus the broader market. This index functions as a measurable proxy for high-quality European small-cap companies. Simultaneously, Montanaro also created an index of the 200 companies scoring lowest on their quality criteria). In the chart Montanaro shows the relative performance of both indices since Draghi s speech in Montanaro European Small-Cap Quality Indices (EUR indices, rebased) High Quality (Top 200 quality companies) Low Quality (Bottom 200 companies) +91% Low quality outperf. by +55% since June '12 +37% Source: Montanaro Asset Management, Bloomberg, data to 31 July 2014 The chart clearly shows the underperformance of low quality companies since July 2012 with the spread between low and high quality tightening since May of this year. This is exactly the same trend that KCM UK found based on their proprietary research, even though both managers use a slightly different definition of quality. Many other managers identified the same trend recently 3. Despite relative underperformance, quality companies did not generate negative returns over the last two years. Om the contrary, the absolute performance of quality has on average been a substantial +37% as can be seen in Montanaro s chart. The problem is that low quality almost doubled in share price (+91%) over the same period. Just looking at the returns over the last few years however leaves a very important part out of the equation, which is risk. Higher quality companies generally are less risky; they 3 Based on findings of a European small-cap manager Search performed by the Multi Management Team in 2014, which included meetings with dozens of active managers.

8 8 have a lower beta, lower volatility and a lower maximum drawdown compared to the broader market. Vice versa, when investing in lower quality companies, the risk of permanent loss of capital is significantly higher. Depending on the quality definition we see different returns over time, however the general trend is that, when quality underperforms, the absolute performance in practice tends to be positive (i.e. one still earns money, just not as much as one could have made). The most extreme example being 2009, where the far majority of active managers underperformed the MSCI Europe Small Cap, the absolute performance of all managers was on average +48%. Vice versa, in down markets, like 2011 and 2008, we see most active managers outperforming, again due to the same focus on quality. The power of compounding should then lead to attractive returns on the long term. u In the long term, quality is the way to go KCM UK has divided the European Smaller Companies market into four quartiles, high versus low ROCE companies (the 25% most profitable companies are in the first quartile, the next 25% companies second, etc) and measured both 1 year rolling returns and 3-year rolling returns of each group of companies. In the graph below, the accumulated relative share price performance of each quartile of ROCE companies is charted. We left out the vertical axis to focus on relative returns. The graph shows that the first quartile outperforms both the universe and the other quartiles over the long run. Top quartile ROCE companies outperformed the universe 56/75 of the periods tested (75%). KCM found the same trend on a 1-year rolling basis, which shows that corporate profitability is a strong indicator for long term share price outperformance. Historical performance of European small-caps, divided by quartile based on ROCE (high vs. low) Montanaro also looked at the longer term performance of quality companies, and they came to the same conclusion. Over the last 15 years, quality has outperformed the broader small-cap market. However, there have been three periods where quality companies where out of favor, which clearly shows when simply looking at Montanaro s long term relative performance versus the MSCI Europe Small Cap index (see graph on next page). The first period of quality underperformance was in 2003, when the small-cap market started rallying strongly after the low point of the deflated internet bubble. After 12 months, the trend reversed and the Q1 Q2 Q3 Q4 Universe Source: Factset, KCM UK

9 9 market started trading back on fundamentals again. High quality companies continued to perform relatively well throughout the credit crisis of 2008, but underperformed during the relief rally afterwards. High quality however caught up again in 2010 and did well during the following years. It is only in the recent rally beginning July 2012, that we again have seen high quality companies lagging the broader market again. Since July 2012, we are experiencing the third period of quality underperformance of the last 15 years. This time the period where quality companies have underperformed seems to be lasting a bit longer than usual, which (as we explained above) in our view is due to unprecedented and orchestrated central banks activity triggering a risk-on rally. Obviously we cannot predict when quality will get back into favor, but we do already see some signs of normalization whilst our managers are already claiming that the trend has reversed. In our view the jury is still out, but we believe that long term mean reversion is likely. Historical relative performance of Montanaro European Smaller Companies Fund vs MSCI Europe Small Cap Index (TR, Net, EUR) Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 u Valuation is Key Most European small-cap managers we have talked to recently are telling us that lower quality companies seem to be getting expensive, whilst quality companies are relatively cheap right now compared to historic levels. It seems that because of the loose monetary policy of central banks, the risk premium for distress risk has come down since We believe this is not rational. Quality indicators like low leverage and high ROCE have not changed fundamentally and re-pricing mostly seems to be driven by the search for yield. Quality companies do tend to trade on a premium to the broader market, however this premium varies over time and currently the premium to pay for quality tends to be lower than the long term average. We believe in the long term it is worth paying a premium for companies that deliver on earnings, as long as the premium is not too large as that will impact the potential for future price appreciation. The managers on our Approved List have a disciplined investment approach with a focus on valuations which helps to make sure that they do not overpay for high quality. To illustrate, Kempen UK for instance invests in both high quality companies as well as special situations (companies that are undergoing some material change to the business or the company s outlook e.g. change in management, acquisitions/disposals, or significant change in legislation). The split between quality and special situations varies over time and results from the bottom up,

10 10 simply based on where they can find the most attractively valued opportunities. Interestingly, the allocation to high quality companies in the portfolio has been steadily increasing over the last months as the team is finding more and more attractively valued high quality investment opportunities. The portfolio currently consists mostly of high quality companies and they intend to hold on to that positioning for the foreseeable future. Montanaro has a more constant allocation to high quality companies only, but also is valuation aware. Of the 200 companies that score highest on their quality criteria, out of the total European small-cap universe, they actively select only those companies for the portfolio that are least expensive, while they tend to take profit when a company in the portfolio starts trading for perfection, making the potential downside larger than the expected upside. u In the end company fundamentals will prevail With so many companies trading at valuations that fail to correctly reflect the striking differences among them, we believe that active managers should see the current environment as a major opportunity in the small-cap space. The key, in our view, is to have patience, avoid short-term speculative choices in favor of a longterm approach focused on underlying fundamentals. Lower quality, overly leveraged companies are more likely to fail. Fastgrowing, differentiated, well-run, businesses with attractive free cash flows and earnings are more likely to succeed. Even if such differences are not reflected in short term stock price performance, eventually we believe this will be recognized by the market. The information in this document is not intended as professional investment advice or a recommendation to make certain investments. Kempen Capital Management N.V. (KCM) is licensed as management company of various investment funds and has a license for providing investment services including asset management. As such, KCM is regulated by the Netherlands Authority for the Financial Markets (Autoriteit Financiële Markten). KCM has its statutory seat in Amsterdam and is registered in the Trade Register of the Amsterdam Chamber of Commerce under no