The four best small caps in Europe

A professional investor tells MoneyWeek where he'd put his money now. This week: Andy Lynch, manager of Schroder Europe Smaller Companies Fund.

After a fantastic run over the last year or so, many have been questioning whether European small companies can rise any further. But this is the wrong question to ask. With such a huge variety of stocks to choose from (the HSBC index includes well over 1,000 companies, for example), it's still easy to find good stocks that have the potential to perform well: if you pick the right company, you'll get good returns over the next 12 months or more, regardless of whether smaller companies as an asset class under or outperform.

The challenge is, of course, to select the right stocks. I try to do this by looking for companies that are growing their top line, generating good, organic cash flow and returns above the cost of capital and that pay good dividends. I also like to see a company doing something quite unique, which gives them pricing power and helps them succeed even in a tough environment. On the whole, I am avoiding tech stocks - there are many companies with excellent products and strong fundamentals around, but in general I feel valuations are just too high. That said, there are one or two selective opportunities in the sector. One is Option, a Belgian company that supplies mobile data cards for wireless connections and is the exclusive supplier to Vodafone. Option is growing fast, yet its shares are still available at a reasonable price. With margins improving and potential there for much more top-line growth, we think it has good prospects.

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Another Belgian company is Kinepolis, a micro-cap valued at around e160 million. The company owns and operates cinemas in Belgium, Luxembourg, France and Spain. It is trading well and generating good cash flow from its cinemas - it announced in July that first-half ticket sales rose year on year by 5% to 12.1 million sales. It also has freehold ownership of its cinema complexes, something not fully represented on its balance sheet. These fixed assets could be sold off; this should benefit shareholders in the long term.

Hellenic Exchanges runs the Athens stock exchange and clearing house. They have a significant proportion of their market value as surplus cash, which they could return to shareholders. The appointment of a new chief executive gives us hope that this will happen. Equally, the privatisation plans of the Greek government will increase liquidity on the Greek market, which will bring both listing fees and more turnover. The high levels of fixed costs in the business mean that extra revenues turn very quickly into extra profits, making this cheap business look very compelling.

Many investors are now focusing on eastern Europe and, in particular, the countries that joined the European Union in May this year. While it is true that these economies are growing at much faster rates than, say, France and Germany, on the whole returns do not sufficiently outweigh the risks associated with currency and corporate governance. One way of gaining exposure without taking on these risks, however, is to invest in western European companies that operate in these emerging European economies. With that in mind, a company I like is YIT, a Finnish construction firm that operates in the Nordic countries, the Baltic region and Russia. The company is well managed, pays a nice dividend and is benefiting from rising construction and house building work in the Moscow and St Petersburg areas.