Why Quality matters for global small caps

From

Aidan Farrell

Investors searching for broader sources of return and diversification have been revisiting global small-cap stocks notes Eaton Vance, a global investment manager.

Aidan Farrell, Director of Global Small Cap Equity, Eaton Vance Advisers International Ltd. says: “In our view, this is one of the largest, most diverse and least researched segments of the equity market, offering fertile territory for alpha generation.

“We believe that a focus on companies with high or improving quality attributes can make a meaningful difference when investing in the global small-cap equity sector.”

Here are some thoughts on what matters to this sector.

Why focus on quality?

Our aim is to manage small-cap portfolios that are well-positioned for both capital preservation and capital appreciation. That’s why we’re committed to investing in companies we deem to be of high or improving quality, based on our proprietary research process. In fact, quality is the cornerstone of our investment philosophy.

What is quality?

The quality characteristics we seek when evaluating companies for investment include:

  • Well-entrenched franchises
  • Durable and scalable business models
  • Beneficiaries of structural growth and change
  • Strong management teams
  • Healthy balance sheets

In our experience, companies with these attributes tend to have the ability to maintain or grow market share during economic expansions and contractions, while also exhibiting better downside protection – a combination that we believe is critical for achieving better risk-adjusted returns throughout the business cycle.

Considering valuation and time

Once we identify a quality small company, the next step in our decision-making process considers current valuation and time. Are the company’s prospects already priced in? Would any other factors keep us from adding that position to the portfolio now? As we see it, time is essentially the discipline of exercising patience on entry points and holding periods, which relates to the long-term nature of our investing mindset.

Quality, valuation and time are vital to our investment approach. If we’re satisfied that all three inputs are aligned, then we would add the stock to the portfolio at an appropriate risk position size. However, any company of sufficient quality without the necessary valuation and time conditions would continue to be monitored closely for a more suitable entry point.

Evidence that quality and valuation outperform

We have evidence to support our focus on quality and valuation. Over the 19-year historical period from 1999 to 2018, we divided the MSCI World Small Cap Index constituents into quintiles based on fundamental factors – with stocks sorted high to low using return on invested capital (ROIC) and return on equity (ROE) as the quality indicators, and free cash flow yield (FCFY) as the valuation indicator.

Stock Level Alpha

Please see disclosures*

Stocks scoring in the first and second quintiles for quality and valuation – in this case, less expensive stocks – outperform the index, while the lowest quality and most expensive stocks in the fifth quintile significantly underperform. The annualized active returns demonstrate the magnitude of outperformance or underperformance that the ROIC, ROE and FCFY factors contribute across each performance quintile.

From our perspective, these results provide compelling evidence that stocks with more attractive quality and valuation metrics have delivered superior performance throughout the cycle and over the longer term.

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* Alpha measures risk-adjusted performance, showing excess – or active – return delivered at the same risk level as the benchmark. It is not possible to directly invest in an index. Index returns do not reflect the effect of any management fees, transaction costs, or expenses. It is not possible to invest directly in an index. Past performance is no guarantee of future results. Investing involves risk including the risk of loss. The value of equity securities may increase or decrease in response to economic and financial events (whether real, expected or perceived) in the U.S. and global markets. Smaller companies are generally subject to greater price fluctuations, limited liquidity, higher transaction costs and higher investment risk than larger, more established companies.

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