Growing expectations the US economy may experience a soft landing, bodes well for the potential performance of global small companies, after an extended period in which market headlines have been dominated by US megacaps.

Bell Asset Management in late September calculated there was potential for 30% upside in global small and mid-cap equities over the next two years versus negligible upside in the market as a whole. Its calculations are based on the premise that market P/E ratios revert to their 10-year average and that consensus earnings-per-share numbers materialise as expected.

“Now that we are on the path to progressive interest rate cuts in the US, the focus should be on the multiple catalysts that could lead to a period of strong performance of global small and mid cap equities,” says Ned Bell, Chief Investment Officer at Bell Asset Management.

The rationale for including small companies in a portfolio is their greater scope for outperformance compared to larger companies due to their earlier position within the business lifecycle. An analysis by ETF provider VanEck shows global small caps have outperformed bigger companies as well as Australian small caps over the long term.

Beyond the US

Global advisory firm Oxford Economics put forward a similar thesis to others in August: “Based on our latest baseline forecast, our model points to outperformance of nearly 5% year-on year for global small caps over the next 12 months, and more than 8% by end-2025. This compares to a decline of around 20% vis-à-vis the broad market from the peak in Q3 2018,” its analysts wrote.

“As we move into a monetary easing cycle, we also expect corporate deleveraging to bottom out, and anticipate leverage to pick up modestly again, which has typically been consistent with small-cap outperformance. Small caps should also benefit from their low starting valuations.” 

Opportunities in the global small cap market may extend beyond the US, even though it dominates the indices used to gauge their performance. The global small cap universe, as measured by the MSCI World ex Australia Small Cap Index, includes 3,881 companies, of which 37% are outside the US. 

“Within that US exposure, you’re getting a high concentration to companies in industrials but not much exposure to real estate, financials or consumer discretionary – these were the four leading sectors contributing to performance over the last 12 months, meaning investors limiting themselves to the US would have missed out,” says Arian Neiron, VanEck’s Chief Executive Officer and Managing Director, Asia Pacific.

Tapping the market

Advisers can either invest in global small caps directly or via several global small cap funds listed on the ASX. 

The latter use different strategies and hence hold different stocks in their portfolios. Vanguard’s MSCI International Small Companies Index ETF (ASX: VISM) tracks the MSCI World ex-Australia Small Cap Index and at August 31 held its biggest positions in diversified healthcare company Tenet Healthcare, online used car retailer Carvana and cloud computing company Nutanix.

VanEck’s MSCI International Small Companies Quality ETF (ASX: QSML) instead tracks the MSCI World ex Australia Small Cap Quality 150 index and produced a total return of 16.81% in the year to August 31. Its biggest holdings at October 1 included US home builder Toll Brothers, Casey’s General Stores and arc welding manufacturer Lincoln Electrical Holdings. VanEck also offers a currency hedged version of the same fund.

iShares S&P Small-Cap ETF (ASX: IJR) focuses on US stocks only by aiming to match the S&P Small-Cap 600. 

For advisers seeking active investments, Dimensional’s Global Small Company Active ETF was listed on the ASX in August this year. Its biggest positions at 30 September were in companies such as landowner Texas Pacific Land Corp, manufacturing company Flex and Carvana. The fund may use the MSCI World ex Australia Small Cap Index as a reference for performance but does not benchmark itself to it.

Vaughan Nelson’s Global SMID Fund (ASX: VNGS) is another active fund and aims to outperform the MSCI ACWI SMID Cap Index on a rolling five-year basis. Its biggest holdings at August 31 included US chemicals company Element Solutions, Brazilian fintech NU Holdings and Internet Initiative Japan.

Bottom line

Despite the promising outlook, it’s good to remember the small cap universe is a broad church which encompasses companies at different stages of development and in varying states of financial health.

“Many global small caps are growth companies, highly leveraged, with weak balance sheets, and these are best avoided. Small companies with strong fundamentals are best positioned for growth over the next year and beyond. Consider ‘quality’ small companies, which have high return on equity, stable earnings and low financial leverage,” VanEck’s Neiron says. 

Global small caps typically comprise just a small portion of Australian portfolios – but may be entering a period in which their inclusion in asset allocation reaps benefits for investors.

Learn more about how to diversify your clients’ portfolios by trading International Markets with AUSIEX.