e-fundresearch: Which fundamental factors are currently most crucial for the European Small-Mid Cap sector?
Ed Lugo: Small caps for the first quarter of 2009 have actually underperformed large caps. In terms of the month of April, small caps have completely turned around. Small cap stocks based on the HSBC index, European index, they are up 23% versus the rest of the market that wasn’t up at nearly as much. So small caps have turned around and it could be, the question is whether or not that will continue, and that’s a difficult question to answer. It all depends on how far the recovery will go going forward.
The forecast for the small and mid cap space in Europe for us it’s difficult to tell. There is no way we know when the bottom is or how long the recovery is going to last because we are bottom-up investors, we don’t spend any time trying to predict the economy. However, from a valuation perspective, we are seeing that the market is really incorporating some kind of a recovery and going forward, it looks like what matters now for the small and mid-cap space to continue to improve at the pace it has is for the improvement in policy across Europe. In terms of why small cap or why small cap versus large cap? Small and mid-cap stocks typically offer an extra boost to the general portfolio. In a way that across Europe, small and mid-cap stocks are stocks that typically always offer alpha, if it’s a fund that’s managed by a disciplined manager, what I mean by that, a lot of these small and mid-cap stocks are overlooked and undervalued and that’s where we get the alpha from. You won’t find that in a large cap portfolio, so that’s where the advantage is in the small and mid-cap space.
e-fundresearch: Which over- and underweight positions are currently implemented in the fund?
Ed Lugo: From a bottom-up valuation perspective, typically we have been finding, for example, in the fourth quarter of 2008, we became very aggressive with retailing, we started getting involved in real estate companies in the fourth quarter, one example is Rightmove Plc. Rightmove is an online service of the residential market, essentially if you are in the UK and you want to buy a home, you get online, Rightmove is no.1, most people go to Rightmove. I even do have agent subscribing to Rightmove so they can get their properties on there. So pretty simple business model, but a company that we like, strong competitive advantage, being No. 1 in the field, strong cash flow generation, and finally trading at a very attractive price that we saw in the fourth quarter of 2008. So, those are the types of ideas and themes that are coming through in the portfolio.
Another example, is Signet, Signet is also in the UK. Signet is a company that, they are No.1 and No.2 in jewelry in the UK with H. Samuels and Ernest Jones. In the U.S., they are also No.1 with Kay Jewelers and Jared jewelers. Now, why jewelry in this time of the market? Well, we all know jewelry purchases are certainly on a downturn, but what’s happening is that the market is mispricing these companies, for example, Signet, what makes it special is, it’s also a great operator, it’s a company that generates tremendous amount of cash and in addition it was trading at very distressed valuations, that was the same with Carpetright, both are retailers and we were able to pick them up and become very aggressive with them in the second half of 2008.
e-fundresearch: How do you assess the performance of the fund YTD, over the last 12 months and over the last three years vs. the benchmark.
Ed Lugo: Over the last 12 months and also year-to-date, both time periods have worked very well for us, in the Global Small-Mid Cap Fund. For instance, for all of 2008, what really helped us out is what we have embedded in our process. Our process should work through the entire cycle, but it certainly works well when we are focusing on companies that have cash on the balance sheet that are trading at attractive valuations, certainly our companies, most of our companies are net cash in the net portfolio. As a result, these companies don’t have to run to the bank to get cash, therefore, most of these companies did well. Also, we are very strict in discipline and what price we are going to pay, so we never overpaid for the companies in the portfolio, so that certainly helped our performance in 2008. Also year-to-date, because we found opportunities in retailing and real estate that really pushed our performance in 2009, we are talking about from the beginning of 2009 to the end of April.
On the European Small-Mid Cap Fund, performance was similar because it’s the same process in each of the funds, so we did benefit again from the process where we do focus on companies with strong balance sheets, we also benefited from the fact that we purchased these companies that could valuation throughout Europe. What’s interesting in Europe, small caps have actually performed quite dramatically in Europe, in the first four months of 2009 and we were able to participate in the bulk of that in that rally in the beginning of 2009.
e-fundresearch: Which impact will the overall macroeconomic developments have on the asset class?
Ed Lugo: What factors are the two most important really for European small mid caps for this turnaround and the two factors really:
1. It’s certainly what’s going in terms of the U.S., in terms of the recovery, the stimulus packages going through, that Geithner put through along with President Obama.
2. The other factor is certainly, really a stabilization of the banking system, crucial in Europe, the question is how fast is some of the European governments going to react to stimulus packages. I believe those are the two key factors going forward.
e-fundresearch: Any other commments which are important to assess the performance as well as the risk-reward characteristics of the fund.
Ed Lugo: Small and mid-caps are attractive all the time, especially in terms of our fund, some people say, you know, should we buy large caps or when are our small caps going to outperform large caps, the answer is no one really knows. The answer really is, is to have both in the portfolio. Small cap stocks today have gone from ridiculous levels, up to distressed levels and up to bargain levels, so they are still attractive on their own in terms of valuation. We don’t use any top-down, it is all bottom-up investing.
Edwin Lugo runs the Global Small Mid-Cap team out of New York. That includes the two funds talked about above, which is the Global Small Mid-Cap Fund and the European Small-Mid Cap Fund.
