With a much larger universe of companies to pick from, and almost infinite possibilities for diversification, it’s no surprise that small-cap investors are able to receive better risk-adjusted returns than investors in large caps, according to Trevor Gurwich, vice president and senior portfolio manager for American Century Investments.
“That’s the reason why you want to invest in small caps,” he said. “I think it’s a very important thing to have in everybody’s portfolio. The question is just how much.”
The answer to this question depends, of course, on every investor’s risk tolerance.
Small companies are typically more agile, less subject to onerous regulations, and grow faster. In addition, they are often the target of acquisition by larger companies, which frequently pay premium prices to benefit from the smaller company’s technology, processes, or expertise.
“These are often companies driven by very motivated entrepreneurs, people who have raised significant amount of capital and want to put that capital to work, and they are making changes that are often undetected by the market,” Gurwich said.
It’s no secret that small companies have outperformed large ones over the long term, as the below chart shows, with the MSCI World Small Cap up by 288.43 per cent over 10 years, compared with a 228.42 per cent return for its large cap counterpart.
Performance of indices over 10yrs
Source: FE Analytics
Within the vast universe of small-cap stocks, there are always companies that are growing, contracting, or stagnating, Gurwich said. In other words, there are always opportunities in this space for the discerning investor.
Small caps are a highly dynamic asset class, he said. “Ninety-five per cent of all IPOs take place in our space, and 90 per cent of all M&A deals also happen in our space”.
This constant movement means that you can enter companies at a discount and exit at a premium, he said.
Greater inefficiencies can also be found in the small-cap space, a reflection of the small number of analysts covering companies and the low frequency of their coverage.
“The average small cap in the MSCI AC World index is covered by about six analysts, while the average large cap has about 17 to 20 analysts covering it. And if you look at a company like Facebook or Google, you might have 70 or 80 analysts,” Gurwich said.
The more analysts you have, the more efficient is the outcome of the investment story, the American Century manager said. Indeed, the fewer the analysts, the greater the likelihood of earnings revisions and earnings surprises.
“Almost 13 per cent of our universe has zero coverage, whereas only 1.5 per cent of the large caps doesn’t have coverage,” he said, highlighting the fact that markets are often unaware of what’s going on with these companies.
The manager said this is a large gap that investors can exploit, highlighting the greater dispersion of returns among small-cap names compared with the large-cap stocks.
When it comes to investing in the area, the portfolio manager’s two-pronged philosophy is, one, that earnings drive stock prices; and, two, that the market is inefficient at identifying inflection points.
“When you invest in a company as it starts to inflect, you benefit from both earnings growth and the P/E [price-to-earnings] re-rating opportunity,” Gurwich said.
He believes that one thing needed to be successful in the small-cap world is to have a process that captures a lot of the changes that are happening over time. Keeping an ear to the ground, so to speak.
While markets are focused on a potential US-China trade war, Gurwich noted, small-caps are often more domestic plays limiting exposure to more international themes.
“One of the things that are slightly more favourable for small caps is the fact that there is a greater domestic exposure in small cap names,” he explained, allowing investors to cherry-pick the companies where they can allocate capital most effectively for exposure to growth.
Investing in small caps on a global scale, as opposed to focusing on a specific country or region, also offers a much larger universe and, consequently, much better risk-adjusted returns.
“Every year, a different region tends to outperform or underperform. As a global manager, you can allocate more capital to the regions that are showing better earnings and showing better performance.”
This geographical diversification is important as UK small-cap investors will know, as Brexit uncertainty has stymied that part of the market, as the below chart shows.
Performance of indices since EU referendum
Source: FE Analytics
Referring to UK investors, Gurwich said “One should not put all one’s eggs in one Brexit.” He added that broader geographical diversification could provide a great way of de-risking any potential outcome that might happen regarding a UK investor.
“Your growth and opportunities should not be limited to your back garden,” the manager noted.
Indeed, he highlighted that growth in the next 10 to 20 years will not necessarily come from the UK or Europe. “It will be a combination of growth that’s happening around the world.”
As such, Gurwich’s team at American Century searches for opportunities around the globe, including in emerging markets, where they’re looking for stocks that have been hit badly by the trade wars.
He said they’re also looking in Europe, noting that Europe and China are bigger trading partners than the US and China.
“We think that eventually, with the low interest rate, the accommodative monetary policy, and if we do get to a trade resolution, China would grow, the emerging markets would grow and that would help pull Europe along with China and the emerging markets,” he explained.
The US, on the other hand, is a deep and broad market where it is more about finding opportunities in different sectors.
In terms of sectors, Gurwich and his team are looking for companies “that are more the industrial, cyclical type”. These businesses typically are involved in making machinery, which plugs into the robotics and automation trends of recent years.
However, such companies have been put on hold because businesses in China have stopped ordering as they try to figure out what they’re going to sell their final products for with the threat of tariffs looming.
While acknowledging that the uncertainty and the negative sentiment represent huge risks, Gurwich has found consolation in the current situation.
“The one thing that is different today from previous trade wars or previous conflicts – such as those in the 1930s – is that countries have new tools to combat slower economies,” he said.
For example, the raft of policy measures Beijing is taking is likely to boost market optimism in China.
“While stocks in China have been sold off on fear of trade wars, with the government stimulus, one can anticipate growth,” he explained.
The investment team has been pursuing a variety of themes, including sport in China, where “there’s a long-term trend emerging in sports, driven by a demographic trend in a country getting richer and exercising more”. He has taken a position in Li-Ning, a maker of athletic shoes and other sporting goods.
He said a surge in patriotism is prompting more and more consumers to choose local Chinese products.
E-commerce is another theme the fund manager is looking at across regions as it continues to take share from traditional commerce and there are multiple ways to play that theme around the world.
One holding is Shanghai-based Baozun, a leading brand e-commerce solutions provider, that helps foreign companies – such as Microsoft, Pepsi, Fiat, Coach, Honda, and Mitsubishi – introduce themselves to Chinese consumers in a market that can appear bewildering to newcomers.
GDS, a leading provider of high-performance data infrastructure and services in key markets across China, is another lucrative investment.
“These are the babies that are being thrown out with the bathwater,” said Gurwich, adding that the themes here will continue to prevail whether there’s a trade war or not.