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By Blake Pontius, William Blair and Company
Edited by Mark Devcich, Head of Research/Portfolio Manager at Pie Funds, New Zealand
Investing in smaller companies can reveal many undiscovered opportunities. Pursuing these on a global scale appeals to investors seeking to move beyond their home markets. We highlight some of the key benefits of having global small-company (small cap) investments.
Equity asset allocations have become more global in recent years as investors have begun to explore outside their home country. Global-equity exposure has become more popular in Europe, and has also gained traction in the US after years of moderate demand.
Typically, when investing globally, emphasis is given to big multinational corporations and the relatively attractive small cap opportunities can be overlooked. While the trend towards more globalized investments is positive, investors should be mindful of having a large cap (large companies) bias in their portfolio.
Including small cap funds helps to offset this bias, but the traditional approach of regionalized small cap exposure is less than ideal. The addition of a dedicated global small cap fund has the potential to improve investors’ returns while reducing risk. This outcome allows investors to better achieve their objectives.
The global small cap universe has grown significantly in the last 10 years, from approximately 6,400 companies to over 12,000 currently. As illustrated in Figure 1, this growth has been almost exclusively outside of the US, with significant expansion in other developed markets and emerging markets such as Brazil and China.
Figure 1 also shows that the growth in the number of small companies in the emerging markets has nearly quadrupled since 2002. This growth has been assisted by stabilised economies and developing stock markets. The growth in the number of small companies means investors have opportunities to find undervalued companies from amongst a large pool of smaller organisations.
What is a Small Cap?
A small cap is simply a smaller company listed on a stock exchange. Listed companies can also be further broken down into micro, mid, large and mega caps. Classifying a company as a small cap or large cap is a way of grouping all of the listed companies to suit investment styles. It’s generally accepted that a small cap is a company with a market capitalisation of under one billion US dollars. The irony being that a billion-dollar firm is pretty large by most people’s standards! As a good rule of thumb, usually 90 per cent of all listed companies are small caps.
A portfolio mix of companies operating in high-growth emerging markets and more stable developed economies can be created. Figure 2 illustrates that a diversified portfolio of global small cap investments delivers a superior return to investing in any one market, such as the US or Europe, while achieving less volatility (measured by standard deviation).
A global portfolio provides the opportunity for a fund manager to compare a potential investment opportunity with others around the world, regardless of where the investment is located. This gives investment managers the freedom to identify who they believe to be the best companies globally in each sector.
For example, in reviewing consumer sector opportunities, a global fund manager has the ability to effectively compare speciality retail and apparel companies based in the US, Germany and China – relative to both local competitors and global peers.
By further way of example, if the global fund manager believes that the US Industrials market has better opportunities than Japan, then they can allocate a larger portion of their portfolio to the US market. However, if the manager was restricted to investing in Japan they would not be able to take advantage of the opportunities outside that market.
In summary, small cap investing has always been an exciting area ripe with undiscovered opportunities. The pursuit of these opportunities using a global approach should appeal to investors seeking to move beyond their traditional home markets.