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Equity Perspectives

For all the volatility of recent years, a growing number of investors with long-term horizons have gravitated toward international small caps for both diversification and uncorrelated returns. 

Portfolio allocation models and methodologies are constantly evolving to respond to changing variables, such as newly emerged or dissipated risk factors, skewed risk/return profiles of once-predictable assets, or even shifting investment objectives. A simple example can be seen over the past few decades as U.S. investors discovered myriad new opportunities to invest in a broad universe of public companies overseas, which, subsequently, helped offset home-biased risks and equity return correlations. While much of that international equity exposure favored larger-sized companies, many investors have since found their relentless search for alpha1 would be incomplete if they did not allocate a certain portion of their portfolios to international small caps. Driving their interest has been a combination of outperformance, attractive valuation, impressive cash flow, and a large opportunity set compared with other major equity asset classes.

Of course, the overall size of non-U.S. small cap equity allocations remains a small fraction of what has flowed into U.S. small cap strategies, even though the total market cap of the S&P Developed Ex-U.S. SmallCap® Index2 was nearly $4.4 trillion versus $1.95 trillion for the Russell 2000® Index,3 as of November 29, 2013. But considering the surge in innovation and economic growth outside the United States, one can argue with conviction that growing interest in international small caps is just getting started, which in turn may narrow the valuation gap with their U.S. counterparts. (More on that later.)

As a Russell Investments research report put it, “International small cap is a promising asset class, [and is] just beginning to be considered for inclusion in a broadened global equity portfolio. While developed large and mid cap companies likely will continue to constitute the bulk of international allocations, in the next decade investors are expected to slowly integrate non-U.S. small cap as they move toward fully realized global equity portfolios. In particular, the historical lower correlation4 between U.S. and non-U.S. small cap stocks would seem to make possible diversification benefits particularly attractive.”5

Reinforcing this view, InterSec Research reports that $12 billion in institutional assets flowed into actively managed international small caps between 2010 and 2012. Such products “continue to draw assets through both new allocations and replacement searches, and add value over the longer term,” InterSec said.6 In tracking more than $1.6 trillion in U.S. tax-exempt assets across 11 asset classes, InterSec found that international small caps generated the second-best excess return for the three years ended December 2012. Still, international small caps remain an overlooked opportunity compared with the rapid asset growth in international large cap strategies before 2008, not to mention the amount of money that moved to emerging markets strategies instead. But interest in international small caps is definitely on the increase.

The key points underpinning such a strategy are as follows:

Performance
While international small caps may entail greater volatility, the asset class has demonstrated long-term outperformance relative to over the 20-year period ended October 31, 2013, relative to international large caps and emerging markets. (See Chart 1.) According to Zephyr Style Advisor, the S&P’s Developed ex-U.S. SmallCap Index eclipsed international large caps, as represented by the MSCI EAFE Index, by a substantial margin, with comparable risk, between November 1, 1993, and October 31, 2013. (So did the MSCI EAFE Small Cap Index, from its inception January 1, 2001, to October 31, 2013.) (See Table 1.) Those two international small cap indexes also carried lower risk than emerging markets, as represented by the MSCI Emerging Markets Index. They also have a somewhat lower correlation to U.S. small and large cap benchmarks. (See Table 2.)

Chart 1. International Small Caps Have Demonstrated Long-Term Outperformance
Growth of $100 from January 1, 1993, to October 31, 2013

Source: Russell and Zephyr.

Table 1. International Small Caps Have Also Carried Lower Risk Than Emerging Markets and Comparable Risk to International Large Caps

Source: Zephyr StyleADVISOR. Data range 11/01/1993–10/31/2013. MSCI EAFE Small Cap inception 01/01/2001. Past performance is not a reliable indicator or guaranteee of future results. For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. An invest or will not experience similar results. The average annual return (AAR) is the arithmetic mean of a series of rates of return. Cumulative return refers to the amount of money an investment has earned for an investor over a certain period of time. Standard deviation is a widely used statistical measure of risk. Simply put, the higher the standard deviation, the more the portfolio’s returns vary from the portfolio’s average return, which means greater volatility. A Sharpe ratio measures the amount of returns for each unit of volatility that is generated by a portfolio (higher returns and lower volatility means more returns per unit of volatility). This allows investors to analyze how much return they’re receiving from a portfolio in exchange for the level of risk they’re a ssuming.

Table 2. Correlation of International Small Caps to Other Asset Classes
Correlations, January 1, 2000–November 30, 2013

Source: Russell and Zephyr.


Chart 2 illustrates how $100 invested in international small caps (as represented by the Russell Global ex-U.S. Small Cap Index10) has surpassed the Russell 1000®,11 the Russell 2000, the Russell 3000®,12 and the Russell Global ex-U.S. Large Cap13 indexes since November 2001, which some analysts consider the beginning of a “lost decade.” Returns on U.S. equities as measured by the Russell 1000 and Russell 3000, for example, were essentially flat for most of that period. In each case, international small caps outperformed, and the differential widened during the most recent economic recovery. Of course, the performance during other time periods will be different, and there is no guarantee that the asset class will perform similarly in the future.

 

Chart 2. How $100 Invested in International Small Caps Has Eclipsed Four Major Russell Indexes
Growth of $100 from November 30, 2001, to November 30, 2013

Source: Russell Investments. For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment. Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect deduction of fees or expenses, and are not available for direct investment.

Part of the small cap outperformance story can be attributed to historical evidence showing that whenever bear markets have reached a positive inflection point, small cap equities have rebounded strongly as the economy recovered.

According to an October 2013 UBS research report, the major driver of outperformance for small caps (and mid caps, for that matter) was their strong earnings and sales growth. As UBS analyst Bosco Ojeda put it, “Small and mid cap companies can grow more quickly than their large cap counterparts, potentially benefitting from less bureaucracy, fewer layers of management, and, generally, a more entrepreneurial spirit that can help speed decision-making resulting in better top-line growth rates. This offsets problems such as lack of scale, which favors large caps.” 

Another driver of outperformance is the fact that small caps are often the target of mergers and acquisitions as large cap companies target smaller rivals to increase their market opportunity and enhance their competitive positions, Ojeda added.

Attractive Valuations
International small cap stocks appear generally inexpensive compared with U.S./Canada small caps. (See Table 3.) In Europe, for example, sovereign debt worries have obscured the relative attractiveness of both established companies selling at depressed multiples and well-managed niche players with strong global growth prospects. International small caps have been cheap against their own history on most metrics (ex-Latin America), according to J.P. Morgan analyst Eduardo Lecubarri. Last spring, for example, Lecubarri highlighted the attractiveness of international small caps (under $5 billion) when compared with international large caps, particularly in Europe and Asia ex-Japan. Lecubarri also said small caps still benefit from positive fundamentals as well as attractive yields and technical factors.18

Table 3. International Small Cap Stocks Look Cheap versus United States/Canada
Global valuation data ex-financials (last reported unless otherwise indicated)14

Source: U.S. Energy Information Administration. Data as of 12/31/2013.

Strong and Improving Free Cash Flows
Another reason we get excited about international small caps is the number of companies that are generating impressive free cash flow yields19 thanks to the combination of greater capital spending discipline, robust fundamentals, and strong margins. In many cases, those free cash flow yields are significantly higher than their average cost of capital, and their dividend yields far surpass those of U.S. small caps—all of which helps explain why we believe the current interest in international small caps is more sustainable than it was during past cycles.

A Diverse Opportunity Set
There are approximately 2,100 companies with market capitalizations of less than $5 billion and average daily trading volume of more than $1 million outside the United States, according to Bloomberg. In developed markets, some international small caps may have a unique niche supplying global giants, which in turn drives a robust free cash flow trajectory, while others are benefiting from significant penetration of rapidly growing emerging markets. In fast-growing emerging markets, some international small caps may dominate their respective industries and pay healthy dividends. In both cases, the fact that so many international small caps have relatively little analyst coverage presents a significant opportunity for active, bottom-up investment strategies, particularly in those periods when volatility picks up and liquidity becomes difficult in certain countries.

Powerful Demographics Fuel Opportunity
A burgeoning middle class is projected to fuel tremendous demand for the products and services of well-managed industry leaders whose average market cap is smaller than those in developed nations, particularly in the Asia-Pacific region. (See Table 4.) According to Ernst & Young, another three billion people could join this demographic by the year 2030, most of them in Asia.20 The implications for increased spending are staggering. As the Organization for Economic Co-operation and Development (OECD) put it in a 2010 report, the middle class in Asia-Pacific spent just under $5 trillion in 2009; by 2030, that figure could rise to almost $33 trillion, which would amount to an impressive compound annual growth rate of 9.4%.21

Table 4. The Middle Class Is Expected to Soar by 2030
Numbers (in millions) and share (%) of the global middle class

Source: “The Emerging Middle Class in Developing Countries,” Organization for Economic Co-operation and Development (OECD), January 2010.
 

The Bottom Line
While global large cap markets have become more highly correlated in the past 10 years as information inefficiencies have been reduced, also consider a December 2011 Russell Investments report showing that global small cap markets have consistently offered opportunities to diversify global equity portfolios.22

From July 2001 to June 2010—the so-called lost decade—the Russell 3000 Index was essentially flat. During this time, the Russell Global ex-U.S. Small Cap Index was up 166%. As a result, a global portfolio that included a small cap allocation during that period would have been rewarded for the added risk.

“Excluding small caps represents an ‘active’ decision to ignore up to 14% of the [investable] universe and amounts to a negative view on the small cap [risk] premium23 over larger ones,” said a March 2012 MSCI report.24 We believe such a decision would also ignore international companies whose significant growth potential may not be fully appreciated by the market. Many of the perceived risks typically associated with the asset class are also some of the same opportunities we believe would contribute to its continued success. Some examples include exposure to emerging markets; the typically more cyclical growth profiles and greater mergers and acquisitions (M&A) probabilities of smaller companies; and the fact that the stocks within this universe are far less researched by sell-side analysts. (See Chart 3.) No matter how quickly international small caps evolve as an asset class, think of them as an essential component of a truly global portfolio. In the beginning, they benchmarked their strategies against the MSCI EAFE Index, excluding emerging markets. With the rapid expansion of the global economy, they broadened their approach to include emerging markets. Over time, many investors shifted their equity allocations to a truly global approach, divided among the United States, developed markets, and emerging markets. While the U.S. portion of the portfolio included both large and small caps, investors typically focused the international portion only on large caps, overlooking considerable opportunities at the other end of the capitalization spectrum. International small caps should complete their worldview.
 

Chart 3. The Majority of International Small Caps Are Not Covered by Multiple Analysts; That, in Turn, Has the Potential to Drive Considerable OpportunitySource: Bloomberg. Data as of 11/25/2013.Source: Bloomberg. Data as of 11/25/2013.

1Alpha refers to the return of a portfolio that is attributable to the efforts of an active manager. In many cases, alpha may be negative.
2The S&P Developed Ex-U.S. SmallCap® Index captures the bottom 15% of companies domiciled in the developed markets excluding the United States within the S&P Global BMI with a float-adjusted market capitalization of at least US$100 million and a value traded of at least US$50 million for the past 12 months at the time of the annual reconstitution. Stocks are excluded if their market capitalization falls below US$75 million or if the value traded is less than US$35 million at the time of reconstitution.
3The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
4Correlation is a statistical measure of how two securities move in relation to each other. A security with a correlation coefficient of +1 implies that as one security moves up, the other security will move in lockstep, in the same direction. A security with a correlation of .90, to cite one example, implies that that as one security moves up, the other security will move in the same direction 90% of the time.
5Mat Lystra, “International Small Cap: Defining a Promising Asset Class,” Russell Research, December 2011.
6“2011 Year-End Investment Industry Research Report of the U.S. Tax-Exempt Cross-Border Marketplace,” InterSec Research, January 2012.
7The MSCI EAFE Small Cap indexes target 40% of the eligible small cap universe within each industry group, within each country. MSCI defines the small cap universe as all listed securities that have a market capitalization in the range of $200 million to $1.5 billion.
8The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market-capitalization index that is designed to measure the equity market performance of developed markets, excluding the United States and Canada. The MSCI EAFE Index consists of the following 21 developed-market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.
9The MSCI Emerging Markets Index is a free float-adjusted market-capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Greece, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
10The Russell Global ex-U.S. Small Cap Index measures performance of the small cap segment of the global equity market, excluding companies assigned to the United States, and reconstituted annually to accurately reflect the changes in the market over time.
11The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.
12The Russell 3000® Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market.
13The Russell Global ex-U.S. Large Cap Index measures performance of the large cap segment of the global equity market, excluding companies assigned to the United States, and reconstituted annually to accurately reflect the changes in the market over time.
14All the numbers in the global ex-U.S. portion of this table are based on equal-weighted averages of stocks (excluding financials where appropriate) from J.P. Morgan’s databases, excluding the top and bottom 5% of outliers for each metric. Small caps here include all stocks listed in a region with market caps between $100 million and $5 billion (as of the beginning of the year for historical numbers), while large caps comprise all stocks listed in the region with market caps greater than $5 billion.
15The price-to-earnings (P/E) ratio, also known as the multiple, reflects how much a stock costs relative to its earnings. It is calculated by dividing the current stock price (the P) by the current earnings (the E). Forward-looking numbers in P/E Yr+1 are from IBES estimates at the relevant point in time.
16A price-to-book (P/B) ratio helps determine whether a stock is undervalued or overvalued. It is calculated by dividing a stock’s price per share by its book value per share.
17Dividend yield is the percentage of income earned by the investor. The yield is calculated by dividing the amount of dividends per share by the current market price per share of stock. For example, if the stock market’s price is $20 a share and the annual dividend is $1.00 per share, the dividend yield is 5%.
18Eduardo Lecubarri, “The Global SMid View,” J.P. Morgan Global Equity Research, April 12, 2013.
19Free cash flow is defined as net income plus amortization and depreciation minus capital expenditures and dividends. Free cash flow yield equals free cash flow per share divided by the current market price per share.
20“Innovating for the Next Three Billion,” Ernst & Young, November 2011. The report was based on two studies conducted in September 2011: an online survey of 547 C-suite executives, board directors, and senior managers in rapid-growth markets, and in-depth interviews with senior executives and thought leaders. The survey focused on developed-market companies with rapid-growth market operations and rapid-growth market companies in Brazil, Russia, India, China, Mexico, Turkey, Indonesia, and South Korea. Half the companies surveyed have more than US$1 billion in revenue, and 70% reported EBITDA growth in excess of 5% in 2011, Ernst & Young said.
21Homi Kharas, “The Emerging Middle Class in Developing Countries,” Working Paper No. 285, OECD Development Centre, January 2010.
22Lystra, op. cit.
23Risk premium is generally defined as the return in excess of the risk-free rate of return that an investment is expected to yield. A stock’s risk premium is a form of compensation for investors who tolerate the extra risk—compared with that of a risk-free asset—in a given investment.
24Jennifer Bender, Remy Briand, Giacomo Fachinotti, and Sivananth Ramachandran, “Small Caps—No Small Oversight: Institutional Investors and Global Small Cap Equities,” MSCI, March 2012. 

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