12 Jun 2018
Global equity markets have endured a torrid time in the first few months of 2018. The downturn has reached all regions, as concerns about higher interest rates and a potential trade war between the US and China have escalated. But smaller-cap equities have proven relatively resilient during this turbulent period.
This relatively strong showing underscores the benefits for investors of including a small-cap component in their portfolios. There are three compelling reasons for an allocation to small-caps.
First, as their recent performance illustrates, shares in smaller companies offer considerable scope for diversification because their performance is not highly correlated to that of large-cap indices.
Secondly, small-caps provide potential for superior returns; historically, they have outperformed their larger-cap peers. Over the 20 years to end-April 2018, the MSCI ACWI Small Cap index gained almost 400% in local currency terms; its large-cap equivalent, the MSCI World Index, gained around 190%.1
Finally, the asset class entails far less risk than many assume – indeed, small-cap companies are often less risky investments than their large-cap peers.
Many smaller companies have a more domestic focus than their large-cap peers and so are less sensitive to global ructions and the fluctuations of foreign exchange. Because they typically respond to different drivers from large-cap stocks, small-cap stocks are a valuable source of diversification in a portfolio.
There is also huge potential for diversification within the small-cap universe. The MSCI ACWI Small Cap Index comprises more than 6,000 companies. Compared with their large-cap peers, small-cap stocks tend to exhibit greater dispersion in their returns, which are driven more by stock-specific factors than by macroeconomics and policy shifts. This creates an attractive environment for stock-pickers – and a sizeable opportunity for specialist small-cap investors.
The biggest companies in a given market inevitably dominate investors’ attention. But if you break down broad market indices by company rather than market capitalisation, a very different picture emerges. Although smaller companies account for only the bottom 15% of global market-cap-weighted indices, they make up over 70% of the world’s listed companies.
Most investment analysts, however, focus on the 30% of companies that account for 85% of market capitalisation. As a result, there is an average of 22 analysts per stock in this segment of the market. In contrast, there is an average of six stocks per analyst in the smaller-cap universe. This discrepancy in analyst coverage means that there is greater potential for mis-pricing to occur, creating ample opportunities for those managers with the skills and the resources to exploit them.
Since the inception of the small-cap index in 2000, the asset class has significantly outperformed its larger peers. There will always be periods where larger companies outperform, of course, but we believe that the superior innovation and growth prospects of small-cap stocks will lead to outperformance over the longer term.
One reason investors cite for not investing in smaller companies is that they deem the asset class too high risk for their clients. But small-cap stocks have actually been less volatile than some large-cap indices (European, Asia Pacific and emerging markets) and have produced superior risk-adjusted returns in a global context and across most regions.
That’s not to say that there aren’t risks attached to small-cap investments. But those risks, which tend to be more stock-specific, are different to those entailed by investment in large-cap companies – underscoring the diversification benefits that small-cap investing offers.
Looking ahead, the recent stock market correction indicates that investors have finally woken up to the prospect of higher interest rates and the removal of monetary policy accommodation. This means that stocks are unlikely to be a one-way bet from here, although strong economic data and corporate earnings still provide reasons to be constructive. Nonetheless, with risk reintroduced and central bank support being removed, stock prices will need to be justified by the merits of their future cashflows, rather than by interest rate-driven valuation expansion.
Against this backdrop, we believe that our research-driven, high-conviction approach is the best way to deliver superior long-term results.
1Source: Thomson Reuters DataStream, 30 April 1998 to 30 April 2018.
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