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GGlobal small-cap stocks have long been a rich hunting ground for stock-picking investors, attracted by the potential for capital appreciation with smaller companies.

While some investors always find small caps appealing, there are sound reasons for all investors to consider this asset class at the present time. These are threefold: technical changes to the MSCI Barra indices means that the allocation to small caps in the MSCI World index has significantly risen; on a number of measures, the asset class is ready for reappraisal; and, finally, current market conditions may translate into an attractive entry point into the asset class.

In the last year, the credit crunch, rising inflation and the slowdown in developed economies has hit equity prices and this has led to a position where small caps are now undervalued.

Perhaps the trigger for reassessing global small caps is the change to the methodology used for the MSCI Barra indices that has increased the proportion of the MSCI equity universe covered by the MSCI World Small Cap index from 4.1-12 per cent. This is due to moving from a sampled approach to exhaustive coverage and it means that anyone holding a neutral index weighting in small caps is now more than 50 per cent underweight. This change means that the number of stocks in the MSCI World Small Cap universe has more than doubled, from 2054 stocks to 4449 stocks. At the same time, the market cap upper limit has risen from $1.5-4bn (£0.85-2.26bn) for all countries covered, apart from Canada and Japan, where the new ceiling is $2.5bn. These changes give a broader market coverage of small caps in comparison to the previous methodology, which was biased to the lower end of the asset class.

In the light of these index changes, it is timely to examine the characteristics of the global small-cap asset class over the last 10 years, as analysis shows some interesting developments regarding risk-adjusted returns, valuations, balance sheet strength and liquidity.

Return profiles

For instance, as at 30 June 2008, global small caps had better risk-adjusted returns over the last 10 years than global large caps, US large caps and international large caps.

This shows the risk/return profile of global small caps has improved. And on a price-to-book valuation basis, global small caps are now one of the most attractive asset classes, with a price-to-book ratio of 1.6, compared with 2.1 for world large cap and 2.4 for US large cap, for example.

In Europe and the US, small-cap valuations in relation to larger-cap stocks picked up in 2007, but have since corrected sharply, presenting a buying opportunity that is likely to lead to renewed interest in global small caps. In Japan, small caps have moved from being overvalued to trading below the historic average. The move from a long period of deflation to a more normal inflationary environment could be a catalyst for a re-rating of the depressed small-cap asset class. The Japanese small-cap market has priced in a particularly negative scenario, with large falls from mid-2007 to June 2008 resulting in 50 per cent of the asset class having a dividend yield greater than the Japanese bond yield. As well as the improved risk/return profile and attractive absolute and relative value of the asset class as a whole, many individual small-cap stocks are attractive from an investment perspective.

Over the last six years, many companies have benefited from a strong economic environment, both at a local level and globally. Many global small caps have spent cash wisely, investing in future growth while de-leveraging their balance sheets. As a result, debt levels are at historic lows, making small caps less vulnerable to tighter lending criteria or the effects of financial leverage as economic growth slows.

Small caps generally show better earnings growth than large caps and this gap has widened for global small-cap companies since 2006. Strong top-line growth has played a role and acquisitions and small market share gains can be very meaningful for small caps.

The best small-cap companies have high-quality franchises and are dominant players in their sectors. Examples include Nokian Tyres from Finland, and Shimano, the Japanese firm that is the world leader in bicycle components.

Another positive attribute is the improved liquidity profile shown by global small caps over the last 10 years. Here, the revised methodology for the MSCI Small Caps focuses on investability through the systematic application of liquidity screens, minimum free-float requirements in absolute US dollar terms and minimum free-float percentages per security. These features will help ensure that the global small-cap stocks are tradeable and liquid.

Active managers

The small-cap asset class also repays the efforts of active managers who specialise in it. It covers a wider range of sub-industries with more companies in each sub-industry category, on average, than the global large-cap universe. This means that large-cap managers might only invest in a representative sample of small-cap stocks or may vary their small-cap allocation on an opportunistic basis. Both these strategies may reduce the potential for diversification and return benefits.

Analyst coverage of small-cap stocks remains relatively sparse too, contributing to pricing inefficiencies. Ninety-five per cent of all global large-cap stocks have at least one sell-side analyst estimate, whereas one in six global small caps has no coverage. On average, global large caps receive triple the analyst coverage of global small caps.

These statistics and the nature of the small-cap market, as well as its increase in size under the MSCI index reorganisation, show the importance of having experienced, active managers when investing in the asset class.

Such managers can understand and exploit the dynamics of its broad universe, identifying pricing inefficiencies and managing portfolio risk through diversification.

In conclusion, now may be a good time for investors to increase their exposure to the global small-cap asset class, following the increase in its weighting within the MSCI equity universe. The risk/return profile of global small caps has improved and they offer compelling long-term value.

Nathalie Degans is managing director of global small-cap value strategies at Morgan Stanley Investment Management