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Hidden champions: small companies with big potential

Ken Nicholson, the Mirabaud expert on European small and mid-caps, raises the veil on an under-appreciated side of the economy: smaller companies, innovative and low-profile, internationally active and leaders in their market niches, well capable of prospering in the shadow of large multinationals.

What can European small & mid cap companies offer that's special when it comes to planning an investment strategy?

Identifying companies capable of creating value across the economic cycle is, without doubt, the best way of generating long-term returns for investors.   In Europe, the small & mid cap universe is made up of over 1,000 companies. It is precisely their small market cap that makes them less exposed to macroeconomic events and indicators, and market volatility. This makes them an investment that can offer more stable underlying returns and which, in a period of greater correlation between asset classes, continues to offer the advantages of diversification and upside potential.     

Within this broad market, do you have any preferences?

I feel a genuine passion for the hidden champions, as German academic Herman Simon refers to them in his book of the same name. We define small companies as those with a market cap below EUR 4 billion. The hidden champions are characterised by their excellent performance and leadership in small but highly profitable niche markets with little competition.  We don't only invest in hidden champions, but these companies interest us a great deal for the stable growth and compound returns they offer. We are not looking for firms that are going to double in value in a year, but rather those that are very stable and will generate returns of 10-15%. 

What are the main characteristics of these hidden champions?

They often are family businesses but in many cases rely on professional managers, as the business is handed down over generations and the current owners may not have the same management skills of their parents or grandparents.  Although in some cases, the families play an active role in management. 

Another factor that links them is that they tend to have a substantial track record, which is very valuable. I remember meeting Danish company, Rockwool, that makes products for the construction sector and they told me that before the financial crisis they were being pressurised to increase their debt at a time when many investors believed that without sufficient leveraging, your balance sheet was not  "efficient".   The company resisted this pressure because, from what they told me, they had had debts in the past and it was not a pleasant experience.  I asked them what they meant by this and they told me that in the 1950s they took a loan from a German bank and the consequences were quite serious for the firm.

When I'm asked about economic instability in Europe, I always mention these types of companies, that have managed to survive for many years, throughout several crises, that have learnt from their mistakes and that have managed to maintain an annual return thanks to prioritising innovation, continual improvement, commitment to customer service and a focus on international expansion.

Which main niche markets do these hidden champions operate in?

The most interesting thing about the hidden champions is not so much their exposure to a specific sector, but the fact that they share the same mentality when managing the business.  At the moment, for example, there are many particularly interesting companies in the industrial machinery and medical technology sectors, but there are also good ideas in many other industries.  This fact is particularly relevant, as it enables us to have a highly diversified portfolio, with equity stakes in different sectors.   

And how is it distributed geographically?

In his book, Simon says that around 80% of today's hidden champions are found in Europe. So, we could say that Europe specialises in this type of company, with a particularly high number to be found in Germany, especially among the Mittelstand but also in some parts of Italy and in the Nordic countries. There are also good opportunities in Spain and France. There are some countries, like the UK, where there is a high concentration of large companies, making hidden champions less common, but, in general, it is clear that Europe is fertile ground for these firms.  

But only a very few fund managers follow small and mid-cap stocks...

Exactly. In my opinion, this lack of interest in small & medium-sized companies generates a lot of inefficiencies in the global offer to investors. Within the Mirabaud team that specialises in European small and mid-cap companies we dedicate a lot of resources and effort in finding "hidden champions" and I can assure you that it is not something we achieve by sitting, waiting patiently in our offices for them to appear.    

We are always on the move making on average about 400 management visits a year.   Already for this year we have more than 24 research trips planned all around Europe, with several company visits included in every one of them.   And that number is sure to increase. We sometimes joke among ourselves, that if they coined the phrase "industrial tourism", we would be a clear benchmark.    

What parameters does your team use to include a company in your portfolios?

Many investors are interested in short-term opportunities and in identifying the next disruptive trend or technology.   We prefer to focus on companies with more modest growth but with plenty of stability.  Our priority is to achieve long-term returns for investors. 

Our biggest problem when it comes to spotting hidden champions within the wide range of small & mid cap European companies is to identify them, since many are unlisted private companies. We look for them and when we find them, we then apply a series of criteria including looking at their liquidity risk and other core business risks. After that, we decide whether to invest or not.

Bibliography

Hidden Champions of the 21st century : Success Strategies of Unknown World Market Leaders

Invented by German academic Professor Hermann Simon, the idea of hidden champions is spelled out in his major work Hidden Champions of the Twenty-First Century: The Success Strategies of Unknown World Market Leaders, in which he looks not just at the criteria for defining this type of company, but also the lessons that can be drawn from their experience.

Hermann Simon, Springer, New York, 2009