Global small and medium-sized companies: the facts, the risks and how an allocation to this sector can add value to client portfolios.
Financial advisers have long understood the benefits of adding an Australian small cap exposure to a client’s diversified portfolio. Those same benefits apply to global small caps – and on a significantly larger scale given the much larger opportunity set. However, few investor portfolios have an exposure to global small and medium sized companies.
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 the end of October 2023, the MSCI World Small Cap Index comprised small cap representation across 23 developed markets and had 4,291 constituents[1]. As illustrated in figure one, the average market cap of companies in the MSCI World Small Cap Index universe is a little under US$1.5 billion.
Smaller companies often have distinct advantages and characteristics that can offer unique benefits to investors.
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.
- Because there are so many of them, smaller companies are often under-researched by stock analysts and therefore potentially mispriced.
- Opportunity for growth – investing in a small cap company in its early 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 each of these factors in greater detail.
Diversification
By spreading investments across different companies, industries, and regions, investors can reduce their overall risk exposure. This is especially important in today’s interconnected world, where economic events in one part of the world can have far-reaching effects.
Because Australian investors typically have a ‘home bias’ in their investment behaviour, diversification is important. 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 22.23% exposure to information technology stocks, three of which are in the top 10 stocks and comprise just over 50% of that weighting (at 11.52%).
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 including currency fluctuations, geopolitical tensions and global economic turbulence.
Under-researched
With more than 4,000 stocks to choose from, how can a research analyst possibly cover the entire universe? In short, they can’t; this 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; a company in its early stages of development has room for expansion. Smaller companies may be targeting niche markets or benefiting from emerging trends that larger, more established companies might not be as agile in capitalising upon. Additionally, global small caps may tap into growing consumer markets in developing economies, further fuelling their growth trajectory.
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 5.09% weighting and market cap in excess of US$2.7 trillion[2].
Nimble
Smaller companies tend to respond better to the changing competitive environment and are known for their ability to innovate and adapt quickly to changing market conditions. It can be easier to innovate and change business strategy in response to market forces without the bureaucracy that can hamstring larger companies. This characteristic can be especially beneficial in dynamic industries or during periods of economic disruption; and, 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[3] of S&P500 companies suggests the 30- to 35-year average tenure of S&P 500 companies in the late 1970s is forecast to shrink to 15-20 years this decade.
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.
Demographic trends
Smaller companies are often well-positioned to tap into demographic shifts and changing consumer preferences. For example, companies focused on technology, healthcare, sustainable energy and e-commerce are likely to benefit from evolving consumer behaviours and societal trends.
Access to niche markets
Global smaller companies often serve niche markets or specific segments within larger industries. These specialised market segments can often provide insulation from broader economic downturns and create a loyal customer base, whether business to business or business to consumer, that values the unique products or services provided by these companies.
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.
Based on analysis by Ernst & Young[4], the global appetite for M&A remains strong as corporates seek to acquire innovative startups and tech-enabled competitors to get even closer to their customers and enhance the digital channels that have proved vital for leading companies in the (Covid-19) lockdown recession. This bodes well for smaller companies.
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 Harvey Norman (Australia), Marks & Spencer (UK) or Harley Davidson (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, may be in a position to be more competitive or implement more fulsome promotional strategies.
Investing in global smaller companies can be a valuable constituent of a diversified investment portfolio. While there are some risks associated with investing in this asset class, there are also a number of benefits. By offering diversification, growth potential, innovation and access to a less efficient part of the market, smaller companies provide investors with a compelling opportunity to enhance their portfolio’s risk-return profile. 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.
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