Where are the opportunities for active investors to add value when investing in smaller companies? And how does this differ from their peers investing in larger companies? In the penultimate wire of our small-cap series, we dive into the expanding small-cap universe, address the rising role of passive investing and how active investors can exploit the full range of return premiums on offer. In the final installment of the four part series, Michelle Lopez, Deputy Head of Australian Equities, will give her thoughts on the inefficiencies and opportunities for investors on the ASX.
Larger universe + fewer analysts = greater opportunity for active managers
There are fewer investment banking analysts per company for smaller companies than large. This is due to the combination of a larger number of companies and their lower market capitalisation. Lower capitalisation means lower share turnover, which translates into lower revenue for the investment bankers. The US market represents nearly half of the MSCI AC World Smaller Companies Index. Here there are 23 analysts covering large-cap companies on average compared to seven for small caps.
MIFID II regulations are reshaping the broking industry. One year after the new regulations took effect, a Numis study of the UK smaller companies market looked at their effect on analyst coverage. They found that total research coverage had declined by about eight percent.
An earlier Numis study found that broker recommendations on small-cap stocks added value. Relative returns were positive when there had been a strong consensus buy. (There was one exception, stocks with just one recommendation). By contrast, this was not the case for large-cap stocks.
The stocks of smaller companies also have a wider range of investment outcomes, from best to worst performer. Of the stocks in the MSCI AC World Smaller Companies index, 26% generated positive returns of over 50% in 2017. This compares to 17% for the MSCI AC World Index. Just 0.5% of the Smaller Companies Index (70 stocks) saw negative returns of greater than 50%, compared to 0.02% (or just five stocks) of large and mid-cap stocks. This reflects a wider range of fundamental outcomes. Smaller companies have more scope to grow. But they also include a higher proportion of loss-makers: 16% for the MSCI AC World Smaller Companies Index versus 7% for MSCI AC World Index in 2017.
The small-cap research that is available is often much shallower. This information gap opens up opportunities to find compelling investment ideas that others have yet to discover.
Rising role of ‘passive’ investors
Three trends are combining to leave an increasing portion of the equity market under the management of passive or quantitative investors.
First, the shift in assets from active to passive management has been a pervasive theme among large-cap portfolios. However, it is less significant for smaller companies, albeit it is growing from a low base. The fee differential between passive and actively managed equity funds is less stark for smaller companies. Fidelity recently made headline news by offering two zero-fee funds to US investors. A UK investor in Vanguard’s FTSE 100 Index Unit Trust will pay ongoing charges of just 0.06%. By contrast, the Vanguard Global Small-Cap Index Fund has ongoing charges of 0.38% for UK investors.
Second, smart beta products are growing in popularity, with investment decisions driven by quantitative models. Assets under management for these products, in mutual funds and ETFs, surpassed US$1 trillion in 2017, according to Morningstar. Many products include a tilt to smaller companies (or size factor, alongside value, quality, momentum and low volatility strategies).
The cost of gathering and processing data has fallen. The number of investment professionals with quantitative skills has risen. These quants can rapidly turn the latest academic research into investment practice. However, anomalies that can be exploited by fundamental analysis persist among smaller companies. This is, in part, due to higher trading costs and limited scope to implement short positions.
Third, there has been a growing role for macro managers. They typically buy and sell index products to implement their trading views. They often ignore smaller companies altogether. If they do invest in smaller companies – long or short - it is typically to take a view on the relative merits of smaller companies versus large.
Together, these trends mean managers who do not analyse individual companies play a growing role in the market. This may increase the scope for stock-pickers to add value through fundamental analysis.
Institutional investors often overlook smaller companies
Few institutional investors break out smaller companies from the wider equity category.
Harry Nimmo, the main author of this series, has a strong track record of investing in smaller companies – one that stretches over more than two decades. Yet Requests for Proposals (RFPs) have been extremely rare. Many institutional investors follow the advice of investment consultants. Consultants help their clients design and validate their long-term investment strategy. This important and influential group of advisors has systematically over looked the opportunities within the large investment universe of smaller companies.
A style analysis of a typical actively managed equity portfolio would show an overweight to smaller companies. A typical fund is underweight the very largest companies in an index. And, where permitted, these funds own a handful of (the largest) smaller companies. This factor exposure discouraged adding a dedicated exposure to smaller companies.
Investors who ignore smaller companies based on style analysis overlook the stock picking opportunities within a very large portion of the overall equity market.
Wide range of risks = wide range of opportunities
The small-cap universe is large, placing a premium on manager resources. Extracting value from a large universe of global stocks requires a disciplined investment process. Some form of quantitative screening is a necessary first step in assessing over 6,000 companies. This is true whether investors base their subsequent decisions on judgement, quantitative analysis or a combination of the two.
The small-cap premium is not the only style premium available to investors in smaller companies. Value, quality, momentum and low-volatility strategies have also delivered long-term premiums, but also with significant periods of underperformance. For example, value has lagged even on a decade-long view.
Investors also need to be aware of country, industry and currency risks. This is true whether they actively target these risks or they are a by-product of their stock selection process.
The dominant risk – and opportunity – in a smaller companies portfolio is stock-specific risk. A quantitative screen can highlight where to look for these opportunities. But fundamental analysis provides investors with a deeper understanding.
Portfolio managers who meet with company management teams can assess those aspects of investment that are hard to quantify, such as corporate strategy. Investors need judgement to understand environmental, social and governance (ESG) risks. ESG analysis is not only a necessary step in understanding risk. It also allows investors to encourage companies to change their behaviour. And it provides scope for investors to profit from changes to ESG ratings.
Smaller companies are too big a portion of the global investment universe to ignore. They offer the potential for a return premium for long-term investors. They bring diversification benefits through exposure to different risks. And the combination of a large universe and fewer analysts provides scope for active managers to add value above the index return.
‘Junior’ stock markets have lower barriers to entry to encourage new firms and new industries to develop. Historically this has translated into higher risk and lower returns for investors in these markets. But as these markets mature, they offer opportunities for selective investors to find high quality opportunities.
Smaller companies are different from their larger peers on many levels. Understanding the differences allows investors to achieve a better balance of risk and return.
Academic literature offers encouragement to stock pickers. The lack of analyst coverage and higher trading costs means that well-known anomalies persist in the universe of smaller stocks.
Investors should not buy smaller companies simply because they are small. Yes, smaller companies are expected to outperform their larger peers over the long term. But this return premium simply reflects the higher risks involved.
But nor should investors ignore smaller companies simply because they are small. Investing in smaller companies opens up the opportunity to find compelling investment ideas that others have yet to discover.
How does this effect the ASX?
In our final wire of the four part series, Michelle Lopez, Deputy Head of Australian Equities, will give her thoughts on the domestic landscape, some of the inefficiencies on the ASX and two companies that she is finding particularly attractive at the moment. To be the first to read her thoughts, follow her here.
most interesting commentary on the analysts adding value in small caps! great article thanks