LONDON Small companies are emerging as the new star performers in Europe as investors seek strong earners, whose shares are less dependent on the macroeconomic environment than traditional large firms struggling with limp global growth.
While the EuroSTOXX 50 index of euro zone blue chips is down 0.7 percent in 2012 .STOXX50E, the STOXX Europe Small 200 .SCXP and its mid-cap equivalent .MCXP are both firmly in the black, up 9.3 and 8.6 percent, respectively - potentially heading for only the second year in a quarter of a century when small firms have surged while the large languish.
"Stock picking is going to be fundamental going forward. You are in a slow growth world, where economic outlooks are going to be very divergent so it's going to be very important to invest in the minority of companies which can grow," said Richard Plackett, who runs BlackRock's 1.4 billion sterling ($2.2 billion) UK Special Situations Fund.
Plackett said he had increased the share of small and medium-cap firms (SMIDs), in the fund to around 65 percent from under 60 percent a year ago.
"Crucially, in terms of stock picking we feel that we can add more value by looking at small and mid-caps that are immature and changing quickly rather than large caps that are mature and changing slowly," Plackett said.
Reflecting investor interest, the FTSE index of UK small caps .FTSC saw its highest quarterly trade volumes in six years in the first quarter, according to Thomson Reuters data.
Savvy - or lucky - stock pickers could have doubled their money this year by investing in, for example, Ophir Energy (OPHR.L), which has found gas in Tanzania, or Cable & Wireless, whose takeover by Vodafone (VOD.L) has been approved by EU regulators.
Merger and acquisition prospects are a major potential driver of returns for the smaller companies, and with firms sitting on large piles of cash, activity - which has been muted by the financial crisis - is expected to pick up.
As much as 88 percent of all M&A in Europe targets small and medium-sized companies, in terms of market capitalization, with the average premium paid over the last 20 years at 28 percent, according to Thomson Reuters data.
European M&A volumes fell 7 percent in the first half, year-on-year, compared with a 44 percent fall in the United States. The second half has already seen a few deals, including Japanese advertising giant Dentsu (4324.T) securing mid-cap UK-listed marketing group Aegis AEGS.L for 3.2 billion pounds ($5 billion).
Aegis shares jumped 46 percent when the deal was announced, to catch up with the purchase price.
Research from Citi shows that over the long run about 60 percent of the share price move in SMIDs can be attributed to stock specific factors - including M&A - and only 40 percent to macroeconomic factors, while for the blue chips the balance is 20-80.
"This means that as a stock picker just getting the stock specifics of a large company right is not enough, you have to also get the macro right as well. On the other hand, for small-caps, macro isn't as important as it is for large-caps," said Lambros Papadopoulos, strategist at Citi.
The macro has proved particularly tricky recently and looks set to remain so, with the euro zone still in crisis, Spain possibly needing a bailout, global economic health looking fragile and U.S. presidential elections and budget cut plans adding further uncertainty over coming months.
On the flip side, for the smaller companies the greater focus on stock specific factors means they are better placed to benefit if they deliver solid earnings.
"Earnings momentum strategies could work better for SMIDs, because one of the most important driver for SMIDs stocks is earnings growth," said Citi's Papadopoulos.
"The strategy of buying stocks with positive earnings momentum - ahead of the rest of the market - is working well for the last five months and it has also started to work earlier for SMIDs than for large caps."
STOXX Europe Small 200 offers a long-term earnings growth rate of 10.7 percent against 6.1 for the EuroSTOXX 50, according to Thomson Reuters DataStream.
Consensus estimates point to broadly flat earnings for blue chips this year against growth of around 10-15 percent for small and mid-caps, although Papadopoulos reckons this gap will close.
For the second quarter, the bigger European companies have so far reported an average 4.7 percent year-on-year drop in earnings, against a 23.5 percent rise for small and micro companies, according to Thomson Reuters StarMine.
"Individual companies ... have this scope to grow where most others don't ... (So) some institutions are beginning to move away just from a narrow focus on liquidity and benchmarks into a slightly more bottom-up stock selection process," said Gervais Williams, fund manager at MAM.
"Generally, market volumes are falling quite badly and at the bottom end of the market there have been periods when we've seen much greater volumes of trade than we've seen in the last two years." ($1 = 0.6463 British pounds)
(Writing By Toni Vorobyova, editing by Nigel Stephenson)