Global small caps do some heavy lifting

Australian investors and financial advisers have long understood the benefits of adding Australian small cap funds to a diversified portfolio. Those same benefits apply to global small caps – and on a much larger scale given the huge opportunity set – yet few portfolios have an exposure to this asset class. In this article, Grant Samuel Funds Management (GSFM) examines the sector and the benefits of including global small caps in a diversified portfolio.

In a global context, a small cap is not all that small – the MSCI World Small Cap Index defines a small cap as a stock in the US$100 million – US$5 billion range. Anything smaller is considered a ‘microcap’. At 29 June 2018, the MSCI World Small Cap Index comprised small cap representation across 23 developed markets and had 4,390 constituents^[1]. As illustrated in figure one, the average market cap of companies in the MSCI World Small Cap Index universe is nearly US$1.5 billion.

 

 

Why invest in global small caps?

There are several good reasons to invest in global small caps, and the reasons often cited for investing in Australian smaller companies hold for their global counterparts:

• Diversification – some growth areas, such as health care or information technology, have greater representation in the MSCI World Small Cap Index.
• Smaller companies are often under-researched by stock analysts and therefore potentially mispriced.
• Opportunity for growth – investing in a small cap company in its initial stages of development, staying invested while it expands and grows, can potentially provide substantial returns.
• Smaller companies tend to be more nimble and better able to adjust to change – or indeed disrupt their larger competitors by being agents of change.
• Smaller companies are often the target of merger and acquisition activity, which is generally positive for the company’s share price.
• Management engagement – it’s common for the company’s founder/s to remain on the management team and maintain a significant equity stake, thereby creating alignment between management and shareholders.

Let’s explore these in greater detail.

Diversification

Figure two compares the sector weightings of two indices – the MSCI World Small Cap Index and S&P/ASX200. Each of the indices has different weightings to the GICs sectors, with the largest in each highlighted. Investors in Australian equities often have significant exposure to financials and materials; the global small cap market provides representation across a broader range of sectors, including higher exposure to industrials, consumer discretionary, such as companies in the luxury goods or travel industries, and information technology, including the emerging fintech sector.

The global small cap market also provides diversification benefits relative to global large cap markets. The MSCI World Index has 18.53% exposure to information technology stocks, five of which are in the top 10 stocks and comprise nearly 50% of that weighting. While there are varied opinions about the ongoing growth prospects of technology heavyweights Apple and Microsoft, it’s a relatively safe bet that the next technology superstar will emerge from the small cap universe.

 

 

As well as the diversification that comes from exposure to different stocks and sectors, global small caps also provide the benefits of behaving differently to their large cap peers during the economic cycle.

Small caps tend to react more positively than larger companies at the beginning of a market rebound, although may be more impacted during a bear market. Typically, small caps are more exposed to domestic revenue and therefore more impacted by their local economy and less sensitive to global macroeconomic factors.

Under-researched

With more than 4,000 stocks to choose from, how can a research analyst cover the universe? In short, they can’t, which presents opportunities for astute investment managers to cherry pick the best opportunities and identify those companies that both meet their investment criteria and are best placed to deliver value to investors.

Opportunity for growth

Large companies start as small businesses and grow; it’s far easier for a small company to double in size than a larger company. By identifying the next generation of small companies with a durable competitive advantage, strong market and solid management, investors can benefit. These are the businesses likely to grow faster and eventually graduate into the large cap segment.

Consider Apple Inc., which graduated into the MSCI US Large Cap Index in November 2004; before then, it was a constituent of the MSCI World Small Cap Index. Now it’s the largest company in the MSCI World Index, with a 2.35% weighting and market cap in excess of US$939 billion.

Nimble

Smaller companies tend to respond better to the changing competitive environment. It can be easier to innovate and change business strategy in response to market forces without the bureaucracy that can hamstring larger companies. In this era of disruption, many of the disruptors are smaller companies looking for a competitive edge over their larger peers.

It’s interesting to note that the length of time in the S&P500 is changing dramatically, largely as a result of disruption. A recent longevity forecast^[2] of S&P500 companies suggests the average tenure on the S&P500 list will shrink over the next decade. The research found:

• the 33-year average tenure in 1964 had narrowed to 24 years by 2016
• average tenure is forecast to shrink to 12 years by 2027.

Or, to look at it another way, approximately 50% of current S&P500 companies will be replaced over the next ten years. This will also impact the MSCI World Index and benefit those smaller companies either perpetrating the disruption or equipped to compete with the disruptors.

M&A activity

Good quality smaller companies have long been targeted for merger and acquisition activity; this is sometimes the end game for the small business’s management team.

In the United States, last year’s changes to the tax code have provided a windfall to many corporates, putting them in an advantageous position to buy smaller competitors or complementary businesses.

According to a recent Ernst & Young (EY)^[3] report, the global appetite for M&A remains high and above long-term averages. There are three reasons for this:

1. The two key ingredients for a robust M&A market, corporate earnings and credit availability, remain strong.
2. There have been several quarters of synchronised global growth
3. Optimism around the impact of US tax reform.

Management engagement

Global small cap companies often have a more focused line of business and higher rates of management with significant shareholdings in the business, resulting in greater alignment of interests between the owners and shareholders.

Many stocks in the MSCI World Small Cap Index are household names in their local market and some have a global brand. Names such as Flight Centre and A2 Milk (Australia), domain registrar Go Daddy (US) or Vitasoy (Hong Kong) have both a high domestic and global profile.

Capacity

While Australian small cap funds can reach capacity quite quickly because of the much smaller investment universe, global small cap funds have a much larger universe from which to select stocks and, as a result, rarely face capacity issues.

Risks of global small caps

As with all investments, there are risks associated with investing global small caps. Those risks more pertinent to this sector include:

Liquidity risk, which is the risk that due to abnormal or extreme market conditions it may be difficult to sell an asset quickly without adversely impacting the price received; it can sometimes take longer to trade a small cap stock compared to larger companies.

Small capitalisation risk, the risk that investment in smaller companies may involve greater risk of loss and price fluctuation. Small cap companies may be thinly traded or less liquid and have to be sold at a discount from current market prices.

Larger competitors, which may have better access to credit markets, be in a position to be more competitive or implement more fulsome promotional strategies.

Does the investment thesis stack up?

Figures three and four illustrates the risk and return of global large cap equity versus global small cap equity, represented by the MSCI World Index and MSCI World Small Cap Index indices.

Over the periods ending 29 June 2018, global small cap equity had the highest return, albeit with a slightly higher volatility (as measured by standard deviation) relative to global large cap. In fact, over the time periods in figure three, global small caps outperformed large caps by an average of 2.9% per annum.

 

 

While there are some risks associated with investing in global small caps, there are also a number of benefits. Most of these benefits are akin to those arising from an investment in domestic small caps – but with a much larger universe, with companies that have the potential to tap much larger markets and which have significant growth potential.

[1] MSCI World Small Cap Index Fact Sheet – June 2018
[2] Innosite 2018 Corporate Longevity Briefing
[3] EY, Global Capital Confidence Barometer, 2018

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Grant Samuel Funds Management and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Grant Samuel Funds Management, its related bodies and associates do not give any warranty nor make any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.