French small-caps shrug off election fears

As with the worlds of haute couture and prêt-à-porter in fashion, France’s small-cap companies depend vitally on the success of the main Paris bourse.

Yet as the country braces itself for the presidential election, and as US and other international investors start reducing their French holdings, a flight from the small-caps to the larger, more liquid French companies might be expected.

But the opposite has actually been the case.

The small-caps index is up 4.3 per cent so far this year, after a storming 10 per cent rise in 2016. The blue-chip CAC 40 is up just 0.7 per cent this year.

While there is a possibility, albeit remote, that far-right National Front leader Marine Le Pen could win and lead France out of the euro, there is little sign of domestic investors in French equities getting cold feet.

The main market would normally be expected to outperform the small-cap market in times of political turbulence when investor appetite for risk lessens, as happened in 2007-08 during the financial crisis and 2011 when the eurozone was consumed by sovereign debt worries.

But Christoph Riniker, head of equity strategy research at Julius Baer in Zurich, says that as international investors reduce their French holdings the small-caps’ outperformance has been even more pronounced.

“There is a marked correlation between French policy uncertainty and the performance of the French smaller caps versus the large-caps. A rising policy uncertainty causes smaller caps to outperform and vice versa,” he says

He points out that small-caps are “more concentrated with French investors who can handle the political factors and are more relaxed than foreigners”.

Moreover if there is a recovery in the French economy — and jobless numbers and purchasing managers data are both on an improving trend — Mr Riniker says small-caps are better placed to take advantage, with cyclical stocks accounting for 82 per cent of the index compared with 57 per cent for big companies.

There have been some Le Pen-related wobbles — in bond markets. Yields on short-term German bonds hit record lows on Thursday as investors moved to protect themselves against the possibility of a victory for Ms Le Pen.

For the stock market, another factor encouraging a benign analysis is the market’s reaction to the UK’s Brexit vote last June and President Donald Trump’s election last November when fears that equities would plunge proved misplaced.

The two candidates seen as most likely to challenge Ms Le Pen in a second round run-off, conservative François Fillon, and Emmanuel Macron, who is standing as an independent, are both pro-European.

However, Raphael Moreau, co-ordinator of small-cap investment at fund managers Amiral Gestion in Paris, believes that international investors are paying more attention to a possible Le Pen victory than their French counterparts.

“I don’t think people at this stage care about the result of the election. The base case is either Macron or Fillon. Besides, if Le Pen does win, it’s a problem not just for France. It’s a Europe-wide problem”.

French small-cap stocks’ performance has been bolstered by mergers and acquisitions, with 15 companies going private or taken over in 2016 including Grand Marnier, the orange-flavoured cognac liqueur maker.

Monetary policy is also accommodating, with low interest rates making bonds less attractive. Analysts also point out that the domestic focus of such companies means that they are less exposed to international concerns like slowing growth in China.

That’s not to say that small-caps do not have their drawbacks. They typically have 40 per cent in free float, and are often tightly controlled by family shareholders. The lack of liquidity, and the difficulty executing an exit, is a turn-off for some investors.

And their outperformance over the larger French companies on the CAC 40 has been polished by a weaker performance from banks which last year were “seen as a reflation play on the back of the steepening of the yield curve”, says Caroline Gauthier, deputy head of small and mid-cap investments at French fund manager Amundi.

Small-caps tend to outperform at the start of the year as fund managers are more ready to take on risk.

On some measures, small-caps still look undervalued. Mr Moreau of Amiral points out that on a price to book valuation, small-caps are trading at 2004-05 levels. He says that stocks are “ridiculously cheap”.

“Volatility is very low despite the political risk,” adds Ms Gauthier. “We never saw this in the past, and it suggests the markets want to keep this optimism”.