There is a reason why the so-called “Deutsche Mittelstand" is a household name almost all around the world. A good 3.5 million German companies - and therefore more than 99% of the total - belong to the small and medium-sized company category. The lesser-known gems among them, the so-called hidden champions, combine many positive characteristics. Rarely, however, are they accessible to broad groups of investors. Alexander Lippert, Portfolio Manager for the MainFirst Germany Fund and the MainFirst Top European Ideas Fund, explains why it is worth looking out for the few small and medium-sized companies that can be invested in via the stock exchange.
Small but powerful
There are many exciting small and mid-cap companies in every European country. Germany in particular offers a tremendous number of outstanding companies from the so-called "deutschen Mittelstand" (German small and medium-sized enterprises). These are often leading niche players in their respective industries. A long-term orientation coupled with various competitive advantages in their niche allow them to be highly profitable. The general economic situation in Germany is extremely good compared to other European countries that suffered due to the coronavirus crisis. Short-term support of the labour market by a very generous government has helped the economy to quickly overcome the precarious situation, as well as prepare for a quick recovery afterwards.
Fast and flexible during the crisis
During the coronavirus pandemic, in particular, the companies in our portfolio showed how quickly they were able to adjust their cost base. Many of our hidden champions were even structural winners of this crisis. Thanks in no small part to solid balance sheet ratios, they were often even able to gain market share. This adaptability is the mark of exceptional business models and excellent management. In this way, small to mid-cap companies are well-positioned for the future. The long-term well-being of the company, including shareholders, employees and other stakeholders, contributes to greater consistency, not only in corporate governance but also value creation. With little optimisation of balance sheet structures, spending on future growth via research & development or expansion investments can be financed even in difficult times. Inorganic growth sprees, such as those practised by some large corporations, could jeopardise exactly this. As is often the case in crises, the strong get stronger - but so do those who are faster!
Information deficits
In general, investing in small caps is much more difficult and expensive than investing in blue-chip companies. The challenges of investing in the former include a lack of publicly available information. Given the lack of attention paid to these stocks, there is scant information and even less expert opinion available on how the future of such a company might look. Moreover, there is a lack of intermediaries, such as analysts or journalists. As a rule, they are tasked with explaining what is going on in the companies in a variety of ways. A lack of information from these intermediaries leads to delayed processing of news, which in turn is slow to circulate among investors.
This is precisely where we as a team can make a difference, holding hundreds of dialogues with board members and other company representatives, as well as analysts, every year. In this way, we were able to conduct numerous onsite face-to-face discussions and form our own impression of the current developments and assess the people involved.
Taking advantage of inefficiencies
As companies from the second tier of the stock market, in particular, receive less attention and investor interest, this results in less liquid markets. Therefore, small caps are not suitable for every type of investor. Liquidity is often very low and transaction costs are usually high, due to wider bid-ask spreads. There are simply fewer buyers and sellers for these stocks. This leads to higher volatility when larger transactions in the share coincide with comparatively low liquidity. Such temporary price fluctuations can also be used by patient and informed investors. Here, our own team of traders is constantly on the lookout for liquidity events as they arise.
Less competition
The very existence of market inefficiencies is reason enough for investors take a look at the opportunities arising in small caps. Nevertheless, large institutional investors in particular find it difficult to gain a foothold in the rather small market for altogether more illiquid small caps. For many of these investors, small caps are simply too small to invest in without influencing the market or taking on too much idiosyncratic risk. At the same time, there are still opportunities in the niche for a medium-sized active asset manager like MainFirst. Today's mainstream index or ETF providers also struggle to adequately cover this area with their products and accurately replicate the performance of this market segment. A potential small cap investor has to put a lot of effort into identifying outstanding companies in this underestimated segment of the equity market, for which there is little information available. For while there is news every minute about media-famous corporations like Tesla or Apple, small caps are often tight-lipped and reserved. And so, the big players attract the attention of many millions of investors around the clock, while some promising small caps fly under the radar for a long time.
Opportunities for everyone
One of the greatest opportunities of investing in small caps comes from their superior growth potential compared to often mature, saturated, and bureaucratically-organised large corporations. Investing in a high-growth company in a highly profitable niche with little competition can be extremely lucrative in the long run. Those who find these pearls before others can profit twice over. This is because a reliable expansion of the profit base is usually accompanied by a significant expansion of the multiple paid for it in the market. The higher appreciation of a company's earnings prospects is therefore a tremendous source of additional return. Given all these characteristics, small caps offer great opportunities not only for interested and ambitious retail investors, but also for specialised investors like our team with our two funds.
This is because we are constantly on the lookout for the winners of tomorrow. Ideally, we want to find precisely those companies whose success will enable them to become index members in a few years' time and who will introduce and present themselves to new groups of investors along the way. This is another reason why we maintain close contact with the top management of the companies in which our funds are invested. Only someone who has a good understanding of a company's business model and its prospects for success will ultimately have the discipline to weather market irrationalities.
Selection instead of accumulation
A very high active share, i.e. a deviation from the index composition, as well as a consciously chosen concentration in our funds enable dynamic participation in the growth potential of German and other European small and mid-cap stocks. The MainFirst Germany Fund invests specifically in companies in the size range of the German SDAX and smaller, while many competitors concentrate on the segments and sizes above, such as the MDAX and DAX. The fund consciously does not follow a benchmark in its portfolio composition. Stock selection is primarily bottom-up driven. In the selection, preference is given to the "German Mittelstand" with family-run companies and high-growth market leaders in their niches. In addition, the fund is classified as Article 8 and is has been recognised with the FNG label (rated “sustainable”) by the Forum Nachhaltige Geldanlagen, a renowned sustainable investment forum that operates in German-speaking countries.
Author: Alexander Lippert, Portfolio Manager for the MainFirst Top European Ideas Fund & the MainFirst Germany Fund
