It may be the world’s biggest businesses that attract the headlines, but smaller companies are giving them a run for their money.
So, what are the advantages of investing in global smaller companies that are enticing investors to choose them as part of their equity allocation?
Investment returns are obviously key. One of the main attractions of investing in global smaller companies is that they tend to be a consistently outperforming asset class. That is because most smaller companies are in the earlier stages of their development, so they typically have higher growth potential than their larger peers. This helps drive superior price performance over long periods, as illustrated in the chart.
This is not a flash in the pan. Several academic studies have demonstrated a consistent small-cap effect over many decades and in most countries around the world. The potential to maintain their record looks promising: economic indicators are improving with PMI figures rising in China, the Eurozone, Japan and the UK. Furthermore, markets are on an upwards trend, which creates a positive environment for global small caps to thrive.
Another significant attraction of global smaller companies is the diversification benefits they offer, helping investors improve the risk and return profile of their portfolios.
There are 6,000 companies in the MSCI AC World Small Cap Index, but they fall outside the usual benchmark for global equity funds, the MSCI AC World Index. As a result, they are often ignored and under-researched. This is a mistake as despite being just the bottom 15 per cent of world market cap, they represent 70 per cent of the world’s listed companies and contain many high-quality, established businesses that are often market leaders in their field.
But what about risk? It is fair to say there is a common perception that smaller businesses are not quite as safe an investment prospect as bigger, global names. However, they are not as risky as you might think, especially when you focus on the higher quality ones.
It is true that the small-cap asset class overall is slightly more volatile, but this is mostly due to the greater proportion of lower quality, often loss-making, businesses than we would find in the large-cap universe. If you avoid these and focus on high-quality smaller companies, you reduce the volatility substantially. Moreover, a focus on quality also improves your returns, which is contrary to the idea that the only way to improve returns is to take on more risk. In my experience, it is lower risk smaller companies that deliver the highest returns and what long-term investors should concentrate on.
How do we define a high-quality smaller company? Factors they can be identified by include their strong balance sheets, high margins, low debt, capable and seasoned management teams, profitable growth, impressive records, high standards of corporate governance and solid returns on capital.
They tend to have a more resilient earnings stream and suffer less when the market goes down, providing a degree of stability for investors’ portfolios. They are also often characterised by tremendous innovation, which drives higher earnings growth. It is also a good sign if the founder of the company is still actively involved in running the business: arguably no one has a bigger stake in the company achieving its goals.