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Damien McIntyre

Small-cap benefits outweigh risks

By Damien McIntyre
4 minute read

With small caps (as shown by the MSCI World Small Cap index) outperforming the broader equity market (represented by MSCI World) over the long-term, it is clear that an allocation to global small caps should be an important part of portfolio diversification.

In fact small caps have returned twice that of large caps over the past 20 years. Considering that periods of underperformance for small-cap stocks generally coincide with recessionary environments, and that they historically tend to go on to outperform during an economic recovery, it is clear that now is not the time to be leaving them out of the portfolio contribution process.

One reason some investors avoid small-cap stocks is because of the perception that small-cap investing is linked to increased volatility. But this does not have to be the case. 

By focusing on a concentrated portfolio of high-quality companies there is the opportunity to insulate investors from the unnecessary volatility seen with many small to mid-cap growth funds. 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.

Importantly, Australian investors need the flexibility to invest anywhere in the world – the small-cap opportunities in Australia alone are just too limited. But for those who are worried about liquidity in small-cap stocks, and what this means for redemptions, it’s important to note that the global definition of “small cap” is very different to that which would be understood by Australian investors. 

In a global context, a small cap is, quite simply, not all that small. The MSCI World Small Cap Index defines a small cap as a stock in the US$100 million to US$5 billion range. Anything smaller is considered a “microcap”. In fact, the average market cap of companies in the MSCI World Small Cap Index universe is just over US$1.2 billion.

Instead of size, a more important attribute of small-cap stocks at a global level is the opportunity to invest in companies that are undervalued or not well understood by the market.

It is well known and understood that stock markets are inefficient, and it is this inefficiency that creates opportunities for active investors. Patient, well-informed investors can buy an ownership stake in a company below intrinsic value. This is particularly evident in smaller companies that tend to be under-followed by the investment community.

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.

For instance, the average number of analyst recommendations per security is almost three times as high for stocks in the MSCI World Index compared to stocks in the MSCI World Small Cap Index. 

Small caps present opportunities for astute investment managers to cherrypick the best opportunities and identify those companies that both meet their investment criteria and are best placed to deliver value to investors.

Nevertheless, 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 are 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.

The key to successful small-cap investment for managers such as Toronto-based global small-cap specialists Cambridge Global Asset Management, is to focus on finding companies with a high return on invested capital and operating margins, low balance sheet leverage, a sustainable competitive advantage, strong capital allocation and a management team closely aligned with shareholders. 

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.

Quite simply, the case for small caps is a strong one. Small caps are a larger, less well researched, universe – and overall small caps trade at a wider discount than that of large caps on a PE basis.

Damien McIntyre, chief executive, GSFM