CPD: Global SMID – a compelling growth story

Know the facts about SMIDs, the risks and how an allocation to this sector can add value to client portfolios.

Investing in Australia’s small to mid-cap stocks has long been a compelling strategy for investors seeking capital growth over the longer term. While larger, well-established companies typically offer more stability, small and mid-cap stocks offer the potential for outsized growth.

While domestic small and mid-cap stocks do provide important diversified benefits and the opportunity to boost the total return of an investment portfolio, those same benefits apply to global small and mid-caps (SMIDs) – and on a significantly larger scale given the much larger opportunity set. However, comparatively fewer investor portfolios have an exposure to this compelling asset class.

When positioned correctly in a globally diversified portfolio, small to mid-cap growth stocks can generate substantial wealth due to their capacity for rapid revenue expansion, innovation and market share gains. Although large caps have dominated the headlines in 2024, the likes of Apple, Nvidia and Google began life as small or mid-cap companies.

Small and mid-cap characteristics

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’.

Using the MSCI ACWI SMID Cap Index to illustrate the investment potential of the SMID sector, there are 7,669 constituents across small and mid-cap companies across 23 developed markets and 24 emerging markets countries^[1]. As illustrated in figure one, the average market cap of companies in the MSCI ACWI SMID Cap Index universe is a little over US$2.85 billion.

It is important for investors to understand that small and mid-cap stocks will generally have different characteristics relative to their large cap peers, as outlined in figure two.

As with any investible universe, the reality is that only a small number of today’s SMID stocks will eventually emerge as leaders within their fields. Many opportunities in the SMID universe are in the early stages of the growth lifecycle – the key is identifying those companies at the beginning of an S-curve.

The S-curve tracks how a company or industry grows over its lifecycle. There comes a point in a lifecycle when growth inflects, driven by a structural change. It is the tailwind created by the structural change that allows a company to deliver and create wealth.

Investors need to identify both the next round of structural changes and the companies that will benefit from them. Importantly, this needs to be as close to the start of the S-curve as possible, and not at the end. Investing in small and medium-sized companies can often deliver early S-curve potential in the growth stories of the future: innovative health, e-commerce, climate change and digital enterprise, to name just a few (figure three).

The benefits of investing in global SMID stocks

There are several good reasons to invest in global SMID stocks, 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 ACWI SMID Cap Index.

Because there are so many of them, SMID companies are often under-researched by stock analysts and therefore potentially mispriced.

Opportunity for growth – investing in a SMID company in its early stages of development, staying invested while it expands and grows, can potentially provide substantial returns.

SMID companies tend to be more nimble and better able to adjust to change – or indeed disrupt their larger competitors by being agents of change.

SMID companies are often the target of merger and acquisition activity, which is generally positive for the company’s share price.

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 or structural change 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 four compares the sector weightings of two indices – the MSCI ACWI SMID 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 SMID 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 industries supporting the fast growing Artificial Intelligence sector.

An exposure to global SMID also provides diversification benefits relative to global large cap markets. The MSCI World Index has 25 percent exposure to information technology stocks, four of which are in the top 10 stocks and comprise 14.6 percent of the total index^[2].

While there are varied opinions about the ongoing growth prospects of technology heavyweights such as Apple, Microsoft and Nvidia (the top three stocks in the MSCI World Index), it’s a relatively safe bet that the next technology superstar will emerge from the SMID universe.

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

SMIDs 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, SMID stocks 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 7,000 stocks to choose from, research analysts cannot possibly cover the entire universe. 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 smaller businesses and grow; it’s far easier for a small or medium sized 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 SMIDs may tap into growing consumer markets in developing economies, further fuelling their growth trajectory.

By identifying the next generation of small and medium sized 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 4.85% weighting and market cap in excess of US$3.3 trillion^[3].

Nimble

Small and medium sized 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^[4] 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 percent 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

Small and medium sized companies are often well-positioned to tap into demographic shifts, changing consumer preferences and importantly, structural trends. 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 SMIDs often serve niche markets or specific segments within larger industries. Consider Kokusai Electric, Besi or ASM (figure five) that provide specialist products and services to Nvidia. 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 SMID companies have long been targeted for merger and acquisition activity; this is sometimes the end game for a smaller company’s management team.

Management engagement

Global SMID 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.

Capacity

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

Why is it a good time to consider global SMIDs?

SMID specialist Munro Partners sees a compelling opportunity in the current market. Many promising small and-mid-cap growth companies experienced significant declines in 2022 when their share price dropped – in many cases 50 percent or more – due to interest rates normalising from historically low levels.

Smaller capitalisation companies are trading at the largest discount to larger capitalisation peers in over two decades. Munro believes there are many undiscovered opportunities to invest in emerging growth companies with structural tailwinds behind their earnings growth and attractive valuations.

This is important because, over the long term, earnings growth drives stock prices. Consensus estimates often misprice growth, and the sustainability of earnings growth, when it is backed by a structural change in the world. There are currently many opportunities to invest in small and mid-cap companies that have strong earnings growth potential, many of which are trading at attractive valuations even relative to their own history (figure six).

In many cases, there is a disconnect between the earnings growth of many small and mid-cap companies and the trajectory of their share prices, i.e. not following that earnings growth. This can present a compelling opportunity to invest in emerging growth companies.

The importance of active management

Recent market volatility has highlighted the importance of investing in quality companies, particularly those poised to take advantage of a structural trend and at, or near, the beginning of the S-curve.

Investing in a SMID fund that has an active management approach brings advantages for investors because investment teams can select opportunities from a broad universe and take active positions across countries, sectors and companies. And, because coverage from sell-side brokers and analysts is generally less comprehensive for small and mid-cap stocks compared to their large cap peers, active managers can benefit from an informational advantage by undertaking their own research and analysis.

Conversely, a passive exposure to this sector will include allcomers, irrespective of balance sheet strength, debt levels or earnings growth potential. As the dispersion in returns between those companies that do and don’t perform well in the SMID sector can be large, active management helps focus on those companies best positioned to take advantage of opportunities in our rapidly changing world.

Investing in global SMIDs can be a valuable addition to a diversified investment portfolio. While investment risks always exist, there are numerous benefits an allocation to global SMIDs can offer investors. Through diversification, growth potential, innovation and access to a less efficient part of the market, an allocation to global SMIDs 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 importantly, to benefit from the structural trends shaping our world.

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References:
[1] MSCI ACWI SMID Cap Index Fact Sheet, 30 September 2024
[2] MSCI World Index Fact Sheet, 30 September 2024
[3] At 30 September 2024
[4] Innosite 2021 Corporate Longevity Forecast, May 2021

The information included in this article is provided for informational purposes only and is general advice only. It does not take into account an investor’s own objectives. The information contained in this article reflects, as of the date of publication, the current opinion of Munro Partners 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. Neither Munro Partners, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.