The “small-cap premium” has shown persistence over medium and long-term investment horizons.
Many investors and advisers recognise that a diversified portfolio should include an allocation to equities across the market capitalisation spectrum. This allows investors to capture the “small-cap premium” which has shown persistence over medium and long-term investment horizons. In this article from GSFM’s investment partner, Toronto-based global small cap specialists Cambridge Global Asset Management, the case for investing in global small caps is made.
Popularised by Nobel Prize winners Eugene Fama and Kenneth French, academics have been studying the “small-cap premium” or “size effect” for over 30 years. Why does this premium exist?
Fama and French hypothesised that the higher return premium is observed because small caps have higher systematic risk, while other researchers have put forth other ideas like behavioural biases and liquidity.
Although the small cap premium is positive, it is cyclical and varies over different time periods. This means that it is important to have a long-term time horizon when investing in global small caps in order to capture the return premium and take advantage of the diversification benefits.
Despite these benefits, many investors lack small cap exposure within their portfolios. Given the potential for enhanced returns and diversification benefits, why are investors underweight global small-caps?
Common reasons cited among institutional investors are that investing in small caps is more complicated, costly and resource-intensive. Simply put, there are more companies to cover and less information is readily available. Other reasons include the perceived higher risk of small-cap equities as compared to large caps, and the lack of familiarity with small caps as compared to more widely followed and household names in large caps.
The first section of this article explains why adding an allocation to global small caps can lead to better portfolio outcomes and the second addresses the need for active management within global small caps.
The case for global small caps
“Omitting small caps is in fact a significant active decision which many investors are making unintentionally.”[1]
Although small caps are often perceived as riskier and more volatile than large caps, an allocation to small-cap equities may provide an opportunity for return enhancement and portfolio diversification due to the increased opportunity set and different characteristics within global small caps.
It’s important to note that 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 May 2020, the MSCI World Small Cap Index comprised small cap representation across 23 developed markets and had 4,263 constituents[2]. As illustrated in figure one, the average market cap of companies in the MSCI World Small Cap Index universe is just over US$1.2 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. These include:
Diversification
Figure two compares the sector weightings of two indices – the MSCI World Small Cap Index and MSCI World Index. Each of the indices has different weightings to the GICs sectors, with the largest in each highlighted. The global small cap market provides diversification benefits relative to global large cap markets; the MSCI World Index has 20.12% exposure to information technology stocks, three of which are in the top 10 stocks.
While there are varied opinions about the ongoing growth prospects of technology heavyweights Apple and Microsoft (ranked one and two by market cap), 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 across an 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
The under-researched and under-followed nature of global small caps can create a disconnect between stock prices and fundamentals, which provides active managers with an opportunity for harvesting alpha.
The average number of analyst recommendations per security is almost three times as high for stocks in the MSCI World Index as compared to stocks in the MSCI World Small Cap Index. Small caps present 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 Microsoft, which had an initial IPO on 13 March 1986, raising US$61 million at US$21 per share[3]. At end May 2020, its market cap was US$1,328 billion and today, a $1000 investment at IPO would be worth US$196,330[4].
Global small caps in the current environment
In a recent podcast, Greg Dean, portfolio manager of the Cambridge Global Smaller Companies Fund, discussed global small caps in the context of the COVID-19 pandemic[5]. While it’s natural to expect that volatility impacting equity markets would be magnified at the smaller end of the market, it has instead opened enormous opportunity.
Opportunity one: new entrants to the small cap universe
As global markets tumbled in the first quarter of 2020, a range of quality companies came into the small-mid cap universe as market capitalisation fell. Others, of course, fell into microcap territory and exited the universe. However, it’s those coming into the universe that get Cambridge’s investment team excited.
Although Cambridge refreshes its investment universe on a quarterly basis, this, in Greg Dean’s words, is usually ‘a non-event’. The magnitude of the correction this year, however, saw a whole host of companies that were in the US$5-10 billion market cap range drop to within the US$3-6 billion market cap range, and into the smaller companies’ universe.
Instead of the usual handful of companies, an additional 125 companies that met Cambridge’s regional, sector, size, and revenue growth criteria entered the global small cap universe. At the same time, the quality of the universe improved, opening up a range of significant opportunities.
At such times, the Cambridge team takes Warren Buffett’s words to heart: “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble”.
Case study: Financials
A good example of a market leader that’s become part of the small cap universe through the correction is Hargreaves Lansdown, a UK-based company that provides investment platforms for investors. These platforms encompass robo-advice, share trading and savings vehicles.
Hargreaves went public in 2007 and since then has grown sales at a 13% compound annual rate organically. A year ago it had a market cap of GBP 10 billion, which by market close 26 June 2020 had fallen substantially to sit at GPB 7 billion.
Hargreaves Lansdown has a 65%+ operating margin and significant tailwind behind the sector. Because investors can DIY for 90 basis points, the company has been systematically taking share from the advised channel and legacy pension products. Since the Cambridge team had undertaken an in-depth analysis of the sector while examining smaller competitors (AJ Bell, a long-time holding), it was quick to recognise an opportunity in its competitor, Hargreaves Lansdown, which was introduced into the small cap universe (from large cap) because of the company’s reduced valuation.
Opportunity two: It’s not bad news for all companies
While the quarterly earnings season is monitored, in normal circumstances the Cambridge team is not too focused on quarterly earnings – after all, it’s not much of an investment thesis if it hinges on a single quarter. However, this year is different. While there have been corrections and financial crises in the past, a health crisis precipitating a financial crisis is new.
While patterns of market volatility may be homogenous, the pandemic is not affecting all companies in the same way. There has been a huge divergence in potential earnings outcomes; as a result, this earnings season is more important than those that have gone before. While some companies have cancelled dividends and issued downward revisions on earnings guidance, others have thrived in the unusual environment and have issued upwards revisions of expected earnings. Not surprisingly, a number of such companies are in the healthcare sector, which makes up 13.09 percent of the MSCI World Small Cap Index.
Case study: Ambu
Cambridge has followed Ambu for nearly 6 years, adding it to its global small cap strategies in November 2019.
Since 1937, Ambu’s philosophy has been to make life easier for doctors and to develop innovative products that can save lives. One of its early products was the breathing bag, used in hospitals worldwide.
Ten years ago, Ambu innovated to develop single use bronchoscopes, used to examine human airways. Previously, bronchoscopes were cleaned and reused. Hospitals generally had to buy several expensive scopes to ensure equipment was always available, to allow time for appropriate sterilisation and allow for any equipment failure.
Ambu developed the single use scope; it had to be robust and flexible, sterile, and with a reasonable camera on the end to connect to a monitor…and be available at a reasonable cost. This has been a highly successful product innovation for Ambu, which has dominant market share. A new CEO in 2019 brought forward the company’s 10 year plan to develop single use scopes for all forms of endoscopy, including gastroscopy, colonoscopy, urology and ears, nose and throat.
A stringent focus on infection prevention has been driving the successful penetration of markets; COVID-19 has brought to light just how important infection management is, boosting demand and increasing sales and earnings expectations. Infection control is likely to accelerate adoption across the other products Ambu is bringing to market.
Finally, a note on active management and global small caps. The greater opportunity set within global small caps provides active managers with a larger pool of potential investments to choose from. The MSCI World Small Cap Index has almost three times as many constituents (4,263) as compared to the MSCI World Index (1,637)[6].
Another factor that favours active management is that there are a number of challenges with passive replication in the small cap space:
- Full replication is challenging given the large number of stocks, liquidity concerns and potential transaction costs.
- Even a tracking portfolio would still need a large number of securities, raising some of the same challenges as full replication.
One solution would be to use optimisation techniques coupled with an appropriate risk model to reduce tracking error but even then, the tracking error may still be higher than desired during certain market conditions.
Dispersion of returns – the magnitude of movements by individual stocks – has traditionally been higher for small caps, making it important to pick winners and avoid the losers. The wider range of outcomes offers superior opportunities for active management; this concept is critical when considering how active managers can add value.
Inefficiencies and the large opportunity set mean that deep due diligence and analysis is required in this space, making a strong case for active management and bottom-up stock picking in this asset class. In all, despite a volatile market environment, the case for investing in small caps remains solid.
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