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Metzler duo: how automation affects European small caps

Metzler duo: how automation affects European small caps

As host to the ECB’s headquarters, Frankfurt draws plenty of investor attention, but this institutional heavyweight is not the only financial highlight in the city. The location is also home to the top-performing fund managers of Europe’s leading small-cap equity funds.

Stefan Meyer and Lorenzo Carcano work at Metzler, one of the oldest private banks in the world, which traces its origins to a cloth trading firm founded in 1674.

Carcano, who hails from the Lake Como region of Italy, has been working at the bank for 21 years and co-runs the Metzler European Smaller Companies fund, which boasts a 10-year track record and has expanded its assets from €40 million to €575 million over the decade.

Meyer started co-managing the fund shortly after joining the firm in 2006 and together with Carcano also oversees the Metzler European Small and Micro Cap fund.

The fund managers see themselves as pure stock-pickers and prioritise bets on strong business models over opportunistic plays on the macro outlook. They also favour a long-term approach, as Carcano says: ‘Slow and steady wins the race.’

‘If you have good market positioning with a good business model, you have pricing power, which means profitability and rising earnings. As a result you don’t end up with a portfolio which requires strong leverage or re-rating,’ Meyer says.

Focus on automation

One big theme that fund managers follow is automation and in particular the ‘Internet of Things’. One company that fits this category is u-blox, a Swiss producer of GPS modules and chips. Carcano says the firm is well-managed and has a high share of recurring software revenue.

The fund managers don’t have a specific allocation to automation, but many businesses in the portfolio have a solid digital strategy.

‘Some names, of course, are benefiting from the right digitalisation strategy more than others, for example Fineco Bank in Italy. This is a very successful online bank which integrates a strong asset gathering business. This company doesn’t have thousands of branches and has a state-of-the-art IT platform, which we deem as being the right strategy,’ Carcano says.

Another example of this exposure to the digitalisation trend is Asetek, a Norwegian producer of cooling solutions.

The company produces mini fans with liquid around them that can be put on top of the chip to cool it down. This kind of equipment offers a big return on investment, Carcano says, as it reduces a lot of the energy cost.

‘If we put some numbers into perspective, 2% of global energy consumption is just cooling of data centres. You can minimise this output because you have a company like Asetek that offers a very innovative product.’

Meyer says a faster and more efficient manufacturing process will be a competitive advantage for many names in the future, while smart sensors will affect not only industrial production but even how the energy grid is managed.

‘Over the last 10-15 years the market was more concerned with consumer products: at first we had PCs, then internet in the 80s and 90s, shortly followed by smart phones. But now we have a shift towards the manufacturing industry, which is going to affect how we make products, for example emerging virtual factories with virtual prototypes that are able to develop digital twins.’

Off the beaten track

Meyer says the short-term focus of the industry is one of the biggest challenges. In his view outperformance is a long-term affair and depends on an investor’s ability to identify long-term themes or business models ahead of peers.

One example of a company the managers spotted early is UK-retailer ASOS. Meyer says few investors recognised its potential six years ago.

‘In 2011 Asos was sold off by almost half as investors thought its UK-focused business model was maturing. We stepped in at this stage, as we saw the potential for a convincing international expansion. At the end of the day the stock went up very strongly. We sold our last position in this stock last year as the valuation is becoming quite ambitious now.’

Despite being based in Germany and having easier access to local companies, the fund managers don’t have a home bias.

Generally Carcano and Meyer prioritise single stocks and don’t concentrate on specific countries in their allocation.

‘Germany has a very interesting environment where you have many attractive business models. However, some of those have become very pricey, for example Grenke Leasing or Rational. Those are fantastic business models, but they are rather expensive, and that is why we don’t have them in the portfolio,’ Carcano says.

The current cash position in the Metzler European Small and Micro Cap fund is relatively high at 7.6%. However, the fund managers say this is down to profit-taking rather than a lack of opportunities.

Carcano says some of the names in the fund have returned 60-80% year-to-date and the portfolio would become too concentrated if you let those positions increase unchecked.

‘If the company returned 80% in four months’ time and you initially had 3% exposure in the fund, you would end up with 6% of exposure. We usually take profits because we want to have a balanced portfolio instead of holding one huge position that is enjoying a very strong momentum.’

The volume of the Metzler European Small and Micro cap fund is also relatively small, at just €41 million versus €296 million in the Metzler European Smaller Companies fund.

The fund managers don’t expect the latter’s volume to shoot up to €300 million, otherwise it will exceed its capacity and they might need to soft- or hard-close it as a result.

‘We are trying to focus less and less on those clients who only use small-cap exposure as a tactical way to increase beta in their portfolio. We aim to attract investors who share our view that smaller companies are one of the smartest investments you can have over the long run: here you have more earnings growth and more inefficiency, hence structurally more performance and alpha potential,’ Carcano says.

Ahead of the curve

Meyer and Carcano have been able to keep pace with markets so far, although they describe the current environment as ‘crazy’.

‘Our message for years has been “buy the dip”. Unfortunately, since the crisis investors have been acting in exactly the opposite way: they sell whenever there is a correction and buy whenever market is up too much.’

Meyer says the outlook for European equities is positive, especially as political uncertainty has faded. However, there is a lot of complacency in the market and if a correction comes, it could take investors by surprise.

‘We saw the markets going up in one straight line since Trump was elected, which was not expected. Stock valuations have come up and the implied volatility of the market is at the lowest levels since decades,’ he says.

Meyer says at the moment PMIs and leading indicators are at elevated levels, while more cyclical sectors are reporting good numbers in terms of earnings momentum and top-line growth.

‘Everything looks good but the catch here is that we won’t see strong improvement anymore. The latest upturn in the market means we have priced in leading indicators nicely but over the next two quarters we won’t go much above 58%.’

He says that if valuations stay around 50%, PMIs will be coming down slightly and it remains to be seen how market sentiment will develop.

However, he says that since the financial crisis a lot of cyclical companies have spent years restructuring and focusing on cost and cash flows, which is a positive development.

‘If you look at investment styles and themes in the market, the name of the game since the financial crisis has been defensive growth. Basically everything that is stable and offers a bit of growth has been re-rating a lot.’

In the meantime Meyer doesn’t see any signs of European equity entering the bubble territory.

‘I have recently read we are approaching bubble levels and was laughing about it because current valuations are not comparable with those in the 2000s.’

The duo are confident that their bottom-up approach is resilient but they constantly monitor markets for relevant trends.

‘Ten years ago we were talking a lot about basic resources companies and oil stocks, while right now we are talking about digitalisation, Internet of Things and robotics,’ Meyer says.

‘As a fund manager you should never become lazy in this regard, you need to be open and learn new things all the time and be ready to question existing thinking schemes.’

This article originally appeared in the June 2017 edition of Citywire Switzerland magazine.

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