Many investment professionals favour diversity but Rob Smith, manager of the Baring German Growth Trust, believes a focus on Germany is better than a wider Europe fund. Not surprising, you might say, as he runs a Germany fund. But then again, Germany is one of the larger parts of Europe ex UK indices, so you get probably get a good chunk of it in a Europe fund, and crucially it is one of the healthier areas of the eurozone.
So what are the arguments in favour of Germany?
"The historic price-earnings ratio of the HDAX index is at a historic low while the earnings for this index are superior to those of MSCI Europe, which you would expect given the problems across the region," says Mr Smith. "German corporates in general are risk averse so many don't have borrowings, while exports as a share of the EU 17 group of nations are up."
He also argues that German corporates are well positioned in terms of their relative cost base. Plus, Germany's share of world exports has also risen since the turn of the Millennium despite an adverse currency environment until two or three years ago, and they are still stronger than Japan and the US.
"Because German corporates had to deal with a strong currency they learned to innovate and produce high quality, while keeping costs down," he says. "Their exposure to the weaker parts of Europe such as Portugal, Italy, Greece and Spain is minimal, which is why their earnings have not suffered a lot. Where there have been set backs this has been made up from other countries around the world, even though some report that business in Italy and Spain is down by around 50 per cent."
It is for these reasons that he believes corporate earnings should continue to rise and why German companies should be valued more highly - the HDAX index trades at a discount to MSCI Europe. "Lower valuations and superior earnings growth are forecast to continue while the rest of Europe is under significant pressure due to debt problems, probably for some time to come."
Mr Smith says his fund's portfolio is even cheaper than its benchmark, the HDAX. He uses the HDAX rather than the better known DAX as it is larger at 110 companies (it includes the MDAX and TecDAX indices as well as the 30 companies in the DAX) so represents over 95 per cent of the German equity market, making it more representative.
Cheapness doesn't come at the expense of quality - while he is pro-growth the fund has a high-quality bias. "I don't want to invest in value traps that go nowhere," he says. "Over the medium to long term this strategy tends to outperform and it also means I have a lower debt-to-equity ratio compared with my benchmark."
Mr Smith and his team seek companies with good growth prospects and balance sheets where the market is underestimating the resilience of their earnings and quality management teams.
How does he achieve both cheapness and quality? "My bias to mid and small caps," he says.
Mr Smith also invests in smaller companies outside the HDAX. "But not at the expense of liquidity," he adds. "I could get near to 80 per cent of my portfolio to cash in a matter of a couple of days."
Stock liquidity is a key portfolio construction parameter.
He finds small- and mid-cap shares particularly attractive at the moment. "These had been under pressure due to volatility but over the last couple of months some have picked up again, while others started six to nine months ago," he says. "This is a good place for stock ideas in most sectors as some of these companies have a really good niche business. But our biggest active position within the fund in terms of sector is information technology as you find some really attractive small-cap niche companies."
Companies he likes include Jenoptik, which makes specialist laser products and has recently been very successful at selling products across a number of markets and industries, for example the US and Middle East, and medical and infrastructure.
Meanwhile, top 10 holdings include larger technology companies such as SAP (7.6 per cent of assets), which delivers software applications for businesses, although the largest holding is healthcare company Bayer at nearly 10 per cent of assets.
Caution
Area he is not so keen on are companies exposed to the automotive sector because there has been a "downward lurch in sales across Europe that is so severe, even though there has been a recovery in the US and the rest of the world, in many cases it is not enough to make up for the big downdraft in Europe".
He also thinks utilities have little or no value. As a result, he recently sold gas and electricity company E.ON.
An exception in the automotive sector is top 10 holding Volkswagen, because the "new model cycle with the launch of the latest Golf vehicle is in its favour", meaning demand is well supported unlike with other manufacturers. But BMW was recently sold and profits reinvested into Deutsche Bank.
"As we look ahead into the third-quarter reporting season, with all the corporate bond and equity issuance that has occurred recently, investment banks should have had a robust quarter, while further deterioration in the auto market brings into question the sustainability of earnings in such a highly-cyclical sector," he says.
But a possible slowdown in emerging markets doesn't concern him, although some fear this could hit European exporters. "It is just that the growth rate is down a bit rather than there is a demand fall," he argues. "I can't think that there's a lot to worry about. Most of my companies say that their percentage of earnings continues to edge up through this soft period."
But he admits that if things deteriorated significantly in China, or there is a global recession as in 2009, this would have a detrimental impact. France is also "worth keeping a close eye on because the French economy could get a lot worse and takes a bigger proportion of German business than southern Europe".
