Dec 2 2013

The global smaller company picture

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In almost all geographic regions, smaller companies have strongly outperformed their large-cap equivalents in the past five years.

This is even the case in countries where there has, to date, been little semblance of a recovery, such as across much of continental Europe. Do managers now need to look further afield for value? Or can global smaller companies still deliver?

The IMA UK Smaller Companies sector is the top-performing of all sectors in the past five years. But hot on its heels are the North American and European smaller companies sectors, where funds have delivered an average of 135.7 per cent and 125.8 per cent respectively. In these two cases, the smaller-cap sector is 43.2 per cent and 51.2 per cent ahead of their more generalist equivalents.

While global smaller companies funds do not have a separate IMA sector, the majority of the top-performing funds in the IMA Global Sector have a mid- and small-cap bias. For example, top over five years is the Invesco Perpetual Global Smaller Companies fund, which is up 153.9 per cent. The Schroder and McInroy and Wood Global Smaller company specialist funds are also in the top-10 over the period.

The question for investors might reasonably be whether the good times are over for global smaller companies. Part of the problem is that global smaller companies have not performed as expected.

In general, smaller companies are thought to be more domestic in focus and therefore should be more sensitive to the economic climate. Yet this hasn’t proved to be the case – they have outperformed at a time when economic activity was weak across the board. Admittedly, this was from an extremely over-sold position after the credit crisis, but managers now have to wrestle with the dilemma that they have performed in a bad climate and now the climate should suit them better, but they are more expensive.

Catherine Stanley, manager of the F&C Global Smaller Cap Equity fund, says that although smaller companies have outperformed by a similar amount across individual countries, the drivers have been quite different.

Some have been buoyed by corporate earnings recovery, such as US smaller companies, whereas others have been driven by a recovery in valuations from a significantly oversold position, such as smaller companies in continental Europe. She adds that the global smaller companies universe is vast – running into thousands – and therefore it has been relatively easy to, “avoid areas we don’t like and find those with self-help and improvement”.

Nick Mustoe, manager of the Invesco Perpetual Global Smaller Companies fund, also says that there are structural reasons for the long-term outperformance of smaller companies, it is not simply about economic growth.

From here, global smaller companies managers are tending to favour later cycle economies. Ms Stanley, for example, is overweight Europe and the UK, while being underweight the US. “This is driven by bottom-up stockpicking. The US is expensive and small-cap valuations are more stretched. It remains difficult to find value there,” she adds.

Mr Mustoe is also overweight continental Europe believing that data is now clearly pointing towards a recovery. He says: “Valuations in cyclical areas such as consumer discretionary stocks or housebuilders have moved ahead of predicted growth and investors have to be careful what they are paying for...but we have had a good weighting in Europe for some time. It simply got too undervalued and now there is a more stable backdrop European valuations should normalise relative to other areas.”

Ms Stanley says that European smaller company earnings have seen no recovery. There have been signs of stability, but no cyclical upgrades. “All that has been seen is a recovery from a very over-sold position. If we get an economic recovery in Europe, that should push onwards,” she adds. In the UK, she says, there is a lot of IPO activity and secondary fundraising.

Across the board she is investing in more cyclical areas. She is also finding interesting ideas in consumer durables. Industrial companies, in contrast, have rallied and it is difficult to find value there.

Mr Mustoe has also been taking increasing exposure to Asia and other emerging markets on valuation grounds. He believes recent negative sentiment towards China has knocked prices of Asian smaller companies unfairly, which have continued to lag the broader market. He has taken this as a buying opportunity. He has also been increasing exposure to Latin America.

Ultimately, Ms Stanley believes that smaller companies are still likely to outperform because of the expanding global economy. However, she says that the absolute strength of global smaller companies may moderate. Mr Mustoe believes that investors need to be careful on valuations, but there are still pockets of undervaluation among global smaller companies.

Cherry Reynard is a freelance journalist