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Don’t Neglect Small-Cap Equities!

Don’t Neglect Small-Cap Equities!

In this article, we talk about small-cap equities and their value proposition in your portfolio at this current juncture.

Most equity portfolios should have significant exposure to the larger-capitalised equity space, but small-cap stocks may have alluded the attention of global investors from time to time as they have typically received less coverage and attention. There are however, various benefits by complementing large-cap equity exposure with small-cap stocks in one's portfolio. In this article, we talk about small-cap equities and their value proposition in your portfolio at this current juncture.

Do Not Overlook Small-Caps!

Equity markets as a whole performed decently in 2016 as pointed out in our Top Markets 2016 article, despite the initial rough beginning and a tumultuous time of unexpected developments throughout the year. However, the performance of the smaller-capitalised companies differed from their larger-capitalised counterparts, and in fact, have outperformed over the past few years. Chart 1 below compares the MSCI AC World Index against the MSCI ACWI Small Cap Index (representative of the global small-cap equity universe), and the latter have been outperforming the former by 176 basis points since January 2012 (in USD terms as of 20 January 2017). On a total return basis, the global small-cap index has generated 95.15% in SGD terms over the past 5 years (a 14.14% annualised return).

Chart 1: Performance of Large-Cap & Small-Cap Equity Indexes Since January 2012

Small-cap stocks are essentially equity securities of publicly-listed companies with smaller market capitalisations (typically between 300 million to 2 billion). They tend to have a higher return profile as compared to a typical large-cap stock, as these companies start from a lower base and have greater room to grow their market share and expand operations. They may have the ability to grow earnings at a quicker pace than their large-cap counterparts during times of strong economic growth as well, which translates into potentially higher share price gains. Many successful corporations that we know today were once humble, smaller-capitalised companies. Commensurately on the flipside, they are also inherently riskier as they may possess the following characteristics: uncertain rate of growth and high business risks (due to younger histories), smaller market shares, lesser ways and access to financing and higher costs of financing relative to larger companies that have more stable business models. Additionally, they are also riskier as they could be more vulnerable during unfavourable macroeconomic environments or when market conditions deteriorate for the worse.

Why Small-Cap Equities?

Higher Potential For Returns With An Expanded Opportunity Set

It is a known fact based upon much empirical research that small-cap stocks have lesser analyst coverage than their large-cap counterparts among the sell-side and brokerage houses. For example, the well-known Development Bank of Singapore (DBS) has more than 20 sell-side analysts tracking its stock and issuing recommendations as of 20 January 2017, while restauranteur Jumbo Group, with a market capitalisation of close to SGD 490 million, has only 3 official coverages.

Chart 2 below shows the average number of sell-side analyst recommendations per stock constituent of a few well-known equity market indexes. Whether it is America's S&P 500 Index, Britain's FTSE 100 Index or Japan's TOPIX, one can observe that there are more stock recommendations for large-cap constituents as compared to their small-cap counterparts, in this case, the Russell 2000 Index, the FTSE Small Capitalisation Index and the TOPIX Small Index.

Chart 2: Average Analyst Recommendations For Various Equity Index's Constituents

Lesser coverage also means less attention garnered, which means that there is a higher level of inefficiency existing among small-cap stocks as compared to the inefficiencies existing in the large-cap equity space with regards to pricing. With higher levels of inefficiency, there are higher chances and opportunities of mispricing and undervaluation, wetting the appetite of an active, skilled and savvy stock-picker. With a broadened investment universe or expanded opportunity set, one has more chances for outsized returns, which translates to higher return potential.

Additionally, the small-cap equity space tends to see higher levels of acquisition activity, which also means that smaller-capitalised companies see greater and quicker expansions in their valuation multiples than their large-cap counterparts. Valuation multiple expansion is one return component other than earnings growth and dividend yields, and with the small-cap space, an investor could get that more often by riding on acquisition activity. In fact, some well-known investors had considerable success pursuing an investment strategy of seeking out micro-capitalised and smaller-capitalised companies that display a high potential of becoming acquisition targets. By purchasing small-cap equity funds, you are well poised to leverage off the professional expertise of active investment managers potentially picking those winners for you!

Leverage On Domestic Growth Opportunities!

Since smaller companies tend to grow their businesses and market shares via an organic process of first focusing on the domestic market before branching to foreign markets, investing in small-cap equities is a way to leverage on domestic growth within various countries and their markets. Several countries across the Asia ex Japan region tend to have large consumer bases, with GDP partially driven by their domestic economies (like Indonesia, Thailand and India), thus, investing in their various small-cap equity markets would enable one to capture opportunities from their respective domestic drivers.

Additionally, larger-capitalised companies, and in particular public multi-national corporations, tend to have global operations and highly-integrated supply chains across many countries (just think of Amazon and Apple) than their smaller-capitalised peers. Due to their large scale operations across varied geographies, these large companies may be vulnerable to a rise in geopolitical tensions as well as a rise in protectionism. If trade wars start due to politicians giving in to populism, some of these large multi-national companies could also see their businesses' inputs and outputs affected by an increase in tariffs between countries. On the other hand, small-cap equities, with their domestic focus, may not be as vulnerable should politicians roll out protectionist policies across the developed and emerging world.

In the US equity market, a normalisation of monetary policy by the Federal Reserve (via rate hikes) as well as an expected expansion in fiscal policy by the incoming Trump administration provides active investors many varying and differentiated opportunities, particularly in the small-cap space. By gaining exposure to small-cap equities there, investors can participate in areas that directly and indirectly benefit from the incoming administration's specific reforms and policies targeted within the domestic US economy.

Build Your Own Global 'Small-Cap Fund' At FSMOne!

At FSMOne, we have an entire plethora of funds for investors to choose from, including funds that invest in small-cap stocks. One may simply use our ‘Fund Selector’ module to select and filter the funds invested in this equity segment.

The products available vary in their geographic focus, allowing one to invest in smaller and middle-capitalised companies leveraged on the domestic economies of the US, Europe, Asia and Japan. Knowing this, one can simply assemble one's own global 'small-cap fund', consisting of different small-cap equity funds invested in the various geographic regions in order to invest in many small-cap stocks worldwide! For example, you could allocate your capital proportionately among various small-cap equity funds, enabling you to eventually obtain global small cap equity exposure.

You could either proportionate them equally or choose to weight them based on the various regions' relative contribution to global GDP. Thus, you could have 25% of your allocated capital in a US small-cap equity fund, 25% in an European small-cap equity fund, 40% in an Asia Pacific excluding Japan small-cap equity fund and the remaining 10% in an equity fund invested in Japanese small-caps.

Chart 3: A Sample Allocation Plan For Your Global Small-Cap Portfolio

Chart 4: Performance of Sample Small-Cap Portfolio Since 2012

As shown in Chart 4 above, a hypothetical portfolio of 4 small-cap equity funds weighted by the allocation shown in Chart 3 would have delivered an annualised return of 16.24% since the start of 2012 (as of 20 January 2017).

For the US equity market (which feature many small-cap stocks), we have Blackrock US Small and Midcap Opp A2 USD which invests in both the small and mid-cap segments and capturing various opportunities there. We also have Parvest Eq USA Mid Cap Classic Dis USD from BNP Paribas IP that focuses on the US midcap equity market. Additionally, we also have the Legg Mason Royce US Sm Cap Opp A USD managed by small-cap specialist Royce & Associates, with the strategy focusing on the US small and micro-cap segment, a rather niche area in the global investible markets. Investors can benefit from the various opportunities via an actively-managed strategy in this current market environment.

For European small-cap equities, we have 4 different funds for you: NATIXIS IF Europe Smaller Cos R/A EU, Threadneedle (Lux) Pan Euro Sm Cap Opp AE EUR, United European Small/Mid Cap Fund and Parvest Eq Europe Small Cap Classic Cap EUR (our recommended product for the space). Additionally, we also have the Amundi Funds Eq Euroland Small Cap A2U-C USD, which focuses on small-cap stocks on the continent excluding UK companies (Euroland). This provides an avenue for investors who wish to obtain small-cap equity exposure on the European continent to leverage on Europe’s domestic recovery.

For the Asia region, the HGIF Asia Ex-Jap Eq Sm Cos SGD AD is our recommended product for investors to acquire small-cap equity exposure in Asia. The managers utilise a rigorous bottom-up fundamental approach to pick suitable candidates, taking advantage of the relative inefficiency in the Asian small-cap universe. The managers also maintain a fairly-diversified approach in managing the portfolio, making this fund ideal as a complement to existing Asian large-cap exposure. Additionally, we also have two HKEX-listed exchange-traded funds (ETFs) that allow investors to access small-cap stocks in mainland China: CSOP SZSE ChiNext ETF (83147) and Harvest CSI Smallcap 500 Index ETF (83150).

For Japanese small-cap funds, we have four different strategies to choose from: BNY Mellon Japan Sm Cap Eq Focus Acc SGD-H, Henderson Hzn Japanese Smaller Comp A2 USD-H, Parvest Eq Jap Small Cap Classic H USD, United Japan Small and Mid Cap SGD.

Alternatively, you could just focus on a specific region with just one or two small-cap equity funds. As highlighted in our 2017 outlook, we are more favourable on the Asia ex Japan region at this juncture, and one could invest in an Asian small-cap equity fund to capture growth opportunities!

Investors are to bear in mind that due to the characteristics and level of risks inherent among small-cap stocks, their share prices will tend to exhibit a higher level of volatility as compared to their large-cap counterparts. Using our analogy of a soccer team, small-cap equities are your ‘forwards’ in your portfolio, giving you the extra return kicker but the team do not function effectively without your defenders and midfielders. Therefore, we advocate that allocations to small-cap equities should not be a core holding in one’s portfolio, making it more suitable as a supplementary allocation.

Contact our affable and helpful Investment Advisory team if you want to find out more!

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