It stands to reason that global small caps offer greater geographic diversity.
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 GSFM explains why it’s the right time to include global small caps in a diversified portfolio.
In our last article on global small caps we examined the case for investing in global small caps. To recap, small caps – both domestic and global – provide portfolio diversification, long-term growth opportunities and, as an under-researched sector, the opportunity to invest in the leaders of the future. Smaller companies (and investors) are often the beneficiary of merger and acquisition activity.
Given the impact of the COVID-19 pandemic on market volatility, it’s important to note that periods of underperformance for global small caps coincide with recessionary environments. However, small caps historically go on to experience meaningful outperformance in economic recoveries.
Domestic versus global small caps
Australian investors typically have a large home bias – or in other words, a larger exposure to domestic companies. While there are some excellent opportunities to be found among Australia’s small cap stocks (and funds), there are also good reasons to add an allocation to global small caps to the mix. Let’s compare the pair.
The universe
While it stands to reason that global small caps offer greater geographic diversity, this sector also offers a significantly larger universe, with a greater variance in market cap across the opportunity set. This ranges from much larger to somewhat smaller companies (figure one).
Not only are there 4,000 more global small caps than domestic small caps in the respective universes (based on commonly used benchmark indices), in the global universe it’s important to note that 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’.
Because domestic small caps have a considerably smaller universe, the largest constituent and top ten stocks comprise a greater share of that universe. Interestingly, the median market cap of domestic and global small caps is similar when you account for the currency differences.
Sectors
The other interesting comparison between the domestic and global small cap universes are the sector weightings (figure two). Notably, Australian small caps have a much more substantial weighting toward companies in the Materials sector, while global small caps have a greater weighting to tech and healthcare stocks, two sectors that have benefited from trends arising from the COVID-19 pandemic.
Small caps are generally considered an important diversification tool; however, it is also important to diversify geographically. There are larger markets outside of Australia with substantially larger consumer bases – therefore a small cap in Australia is less likely to have the growth opportunities available to peers in Europe or North America.
It’s a good time for global small caps
There are three reasons that it’s a good time to consider adding an exposure to global small companies to your clients’ portfolios.
- Global small caps outperform over the longer term
- Global small caps outperform during periods of economic recovery
- Global small caps experiencing a valuation discount
Let’s explore each of these in details.
Global small caps outperform over the longer term
For long-term investors, global small caps offer a growth opportunity. The MSCI World Small Cap index has outperformed MSCI World over the long term. Two periods of underperformance highlighted in figure three coincide with recessionary environments.
Over the twenty years measured in figure three, global small caps returned two times that of large caps. This is significant outperformance and highlights the sector’s appeal for long term investors.
As highlighted in figure three, periods of underperformance for global small caps coincide with recessionary environments. However, small caps historically go on to experience meaningful outperformance in economic recoveries (figure four).
For example:
- between 2000 and 2006 global small caps outperformed global large caps by circa 200 percent
- between 2009 and 2014 global small caps outperformed global large caps by circa 35 percent.
Global small caps are experiencing a valuation discount
Because global small caps are a larger, less well researched universe, small caps typically trade at a wide discount to that of global large caps on a price/earnings basis (figure five). Historically, this valuation discount premium is between 1.0-1.2 times; currently, small caps are trading at a discount of 0.8 times.
Interestingly global small caps are trading at a discount compared to global large cap stocks on a range of other metrics, including price to cash flow and EV/EBITA. This latter ratio, enterprise value/EBITDA, is used to determine the value of a company. The enterprise multiple looks at a company the way a potential acquirer would by considering the company’s debt[1].
The present valuation gap between large and small companies, the largest in 10 years, indicates it’s a good time to allocate capital to this sector.
Global small caps versus emerging markets
Emerging markets are often touted as a diversification opportunity for Australian investors. However, global small caps are a solid alternative when examined on a risk/return basis.
As illustrated in figure six, global small caps have experienced significantly higher returns than emerging markets, with only slightly higher volatility. Global small caps also exhibit a significantly better sharpe ratio; this ratio shows the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Finally, for Australian investors, the correlation benefits of global small caps and emerging markets are very similar.
Important attributes of small cap stocks – and managers
Whatever its geographic location, there are several important attributes of small cap stocks. Firstly, companies should have experienced management teams and key stakeholders should be significant shareholders in their own business – the more skin in the game the better. Different to large companies, a couple of people can really make the difference between compounding above average returns or compounding at a negative number.
Secondly, companies should be well capitalised with not too much debt. The key is to look for exposure to high-quality businesses with high rates of return on invested capital that also exhibit considerable secular growth.
Finally, companies should have high ratios of excess cash flow.
When it comes to selecting a global small cap fund, investors have the choice between active management or investing in an index-tracking exchange traded fund (ETF).
GSFM believes active management is the most appropriate for global small caps; the sheer number of mispriced opportunities in the small-cap sector alone makes a strong case for this approach.
An active approach also enables an investment team to manage risk by looking at businesses they understand, trying to evidence long-term track records, identifying strong balance sheets and not overpaying for them.
It is important to have an investment team that is resourced and experienced to exploit the available opportunities. Stock selection is absolutely paramount in the small-cap space because the risk parameters are higher. Not every business is a great business and, as highlighted in figure one, the global small cap universe is large.
Active management also makes it easier to avoid business that aren’t growing or aren’t run by smart, honest and capable people.
Case study: Esty Inc.
Etsy Inc (NASDAQ: ETSY) is a leading e-commerce service provider offering unique and handmade items. It’s a marketplace of 2.3 million micro-merchants that on average sell a few thousand dollars a year worth of goods, and has over 40 million active buyers who have bought at least one item in the last 12 months. Eighty percent of the listings are items sold only on Etsy, making it a destination for unique products.
At the end of October 2020, Etsy was the top stock in the MSCI World Small Cap Index, representing 0.25% of that index. It’s been one of the beneficiaries of the COVID-19 pandemic – with lockdown and people not feeling confident about shopping in stores, Etsy experienced an uptick in sales from new and existing customers. This resulted in increased cash flow and margin growth, which has seen the stock outperform in 2020 (figure seven).
While a large component of the recent growth stems from facemasks and the accelerating trend of brick and mortar store closures, excluding facemask sales, the company is still seeing very strong growth.
Stock markets are inefficient and this creates opportunities for patient, well-informed investors to buy an ownership stake in a company below intrinsic value. This is particularly evident in smaller companies that tend to be under researched by the investment community.
Although global 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. This comes about due to the increased opportunity set and different characteristics within the global small cap universe.
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, the case for investing in global small caps remains solid and, from a timing perspective, is worth examining for appropriate clients.
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