Small & Mid-Caps: Small is beautiful
The global small-caps universe is one of great diversity and opportunity. Joseph Mariathasan and Martin Steward speak to some top managers about their portfolios
Is there a case for focusing on global smaller companies as a separate asset class? To answer that question means understanding what the key drivers of return are likely to be and how they compare with large-caps.
The ‘small-cap effect’ is well known, albeit controversial, and certainly provides one justification. But the relative valuations of small and large-caps show pronounced periods when one looks cheap or expensive relative to the other. Richard Watt, managing director, global portfolio management, at New York’s Epoch Investment Partners, notes that small-caps have outperformed recently and that large-caps might therefore be the more attractive proposition in the near term. Nick Hamilton, head of global equity products at Invesco Perpetual, is more optimistic, pointing out that earnings collapsed for global small-caps in the financial crisis (from $11 to 11 cents per share at index level), and have only returned to $7 per share, still 40% off the pre-crisis level.
“Smaller companies have defended their cashflows and earnings recovery has been good,” Hamilton says. “They have above-average cashflows and strong balance sheets [and are therefore] very attractive to competitors.”
Watt argues that on an absolute basis, analysis of the components of equity returns does not suggest that the equity universe as a whole will give very attractive returns compared with the decades of the 1980s and 1990s, and that having exposure to an asset class such as global small-caps that can deliver more risk would make sense. Earnings growth is primarily a function of GDP growth and inflation. But the expansion of P/E ratios over the past few decades has been driven by the lowering of bond yields following the Volcker-led crushing of the inflation of the 1970s. “Interest rates now are at such low levels that they can only go upwards, giving no support to P/E expansion,” Watt notes. “With dividend yields at 2% or so, we are in a world where equity returns will generally be much lower than seen in the 1980s and 1990s.”
It is certainly a fact that small-caps are much less analysed by investment banks than large-caps and, indeed, this trend has increased, if anything. “Over the last 10-15 years, investment banks have become much more like introducing agents for smaller companies rather than selling agents,” says Watt. As a result, the market should show more inefficiencies, giving well resourced fund managers the opportunity to outperform.
What also differentiates small-caps from large is their sheer number and the large dispersion of their returns. As Hamilton points out, the MSCI Global Small Cap index, which includes emerging market companies, represents 4,500 stocks with a total market cap of $4trn (€3trn). This approaches three times the number of developed market large companies (1,650), at just one sixth of the value ($24trn).
If one includes stocks outside the index universe, the small-cap opportunity set becomes larger still. It is, however, not just the number of stocks that provides the opportunity, but the dispersion of returns. William Priest, Epoch’s CEO, in an analysis of relative returns of small, mid and large-cap stocks over a 12-year period, makes the point that while the median absolute return for each segment is almost identical, the 10th and 90th percentiles are very different - with small-caps far ahead in the 90th percentile and far behind at the 10th. This implies that there is far more scope for an active approach to add value and, combined with the relative paucity of research on small companies, this is what justifies seeking high performing small-cap managers.
But of course all these upsides present a serious downside: picking small-cap stocks is a task akin to finding the proverbial needles in a haystack. Adopting a well-designed framework for analysis is key to any successful investment process. This can be purely bottom-up stock selection, as in a firm like New Jersey-based equity specialist Harding Loevner, or combined with top-down macro-economic and thematic analysis to slant portfolios, as in Threadneedle’s approach.
The extent that top-down analysis plays a role is reflected to some extent in the number of stocks a strategy has. Invesco Perpetual has a heavy role for top-down analysis, with allocations split among sub-funds, and has around 340 stocks. Epoch has upwards of 200 stocks in its portfolio. By contrast, Harding Loevner’s pure stockpicking approach results in a portfolio of around 80 stocks. Similarly, Franklin Templeton’s European Small-mid Cap Growth fund, a fundamental bottom-up strategy, is even more concentrated at just 30 stocks.
One popular framework for analysis of small and mid-cap companies (among both top-down and bottom-up practitioners) is the ‘five forces’ outlined by Michael Porter of Harvard Business School in 1979, which seek to identify the small companies most likely to enjoy long-term success. These five forces are: the degree of rivalry within an industry; the threat of product substitution; buyer power; supplier power; and barriers to entry.
“It is very easy to find small companies that look like large companies, but these tend not to be good investments,” says Francis Ellison, product specialist at Threadneedle, whose investment process relies heavily on Porter’s framework to identify firms exposed to positive long-term themes, with strong sustainable business models that can be bought below fair value. A good example of this is DiaSorin, the Italian supplier of diagnostic machines (which are loss leaders) and consumables (which enjoy stable demand and high margins), that became the subject of a KKR-buyout rumour earlier this year. Focusing on Porter’s five forces gives a quality and growth bias to Threadneedle’s portfolio. “When times are tough, growth investing tends to outperform value,” as Ellison observes.
Harding Loevner is also a keen exponent of the ‘five forces’. In fact, it assesses companies on four key areas: durable growth of revenues, earnings and cash generation under a variety of business conditions; capable management with a track record of success, a proven regard for shareholders and a clearly-articulated business strategy; financial strength in the shape of strong free cash generation, sound balance sheets and access to credit; and competitive advantage, preferably in industries with favourable competitive structures, resulting in high and rising profit margins. As Robert Cresci, portfolio manager for the firm’s International ACW ex-US small cap product explains, after thorough fundamental analysis Porter’s five forces are used to develop a single Quality Quotient (QQ) rating that serves as a common framework for evaluating the rate, duration, and risks of each company’s prospective earnings growth.
“We need to verify the balance sheet, which means visiting their factories, going to trade shows, and so on, to get a good indication of their products and their competitors,” Cresci explains. “Talking to sales managers and competitors gives us technical understanding of the products and perspective on the industry’s competitive environment and long-term trends.”
Large chunks of the marketplace do not fit into Porter’s framework, of course - banks are an obvious example where big is usually better. As a result, Threadneedle has only a 5.5% weighting in financials versus 20.4% in the index. Harding Loevner is also underweight in financials at 8.6%, but has bought into small regional banks such as Laurentian Bank of Canada, a Quebec-based institution operating across Canada and focusing on small and medium-sized enterprises, as well as a couple of small Asian banks with a similar model.
Away from the ‘five forces’, Epoch combines its top-down analysis with a stock selection methodology based on the idea that the most important metric for identifying good companies is free cashflow - in contrast to the more usual accounting metrics such as earnings or book value.
“Companies can either reinvest free cash flow, which is a measure of growth, or return it to shareholders, which is a measure of value,” Watt explains. “What they should do is determined by their cost of capital.”
There are lots of reasons why companies do not return cash to shareholders, even if the cost of capital would imply that they should. Japanese companies are an obvious example and, not surprisingly, Epoch is underweight Japan and has had a negative view for a long time. Epoch also became concerned about credit risk and leverage in banks in 2007 and remains underweight banks both domestically and internationally as asset quality and capital issues continue to create significant uncertainty. However, it is reducing its underweight in consumer discretionary (at the expense of its overweight in industrials), with a preference for US over Europe, where the impact of austerity measures remains uncertain.
Epoch is biased to non-US healthcare stocks, with a focus on rising demand for healthcare services in emerging economies. It prefers exposure to chemicals and process companies over direct exposure to price driven commodities and, in energy, the preference is for non-US names with exposure to oil, with an underweight in US energy services because of the sector’s exposure to natural gas.
For the Franklin Templeton European Small-Mid Cap Growth fund, retailing is the big overweight. “We became very aggressive in the second half of 2008 in retail,” says portfolio manager Edwin Lugo. “In 2009 we outperformed because we were very aggressive in companies that were distressed. Those that had real problems moved pretty quickly to restructure and set themselves up for growth again in 2012 and 2013.”
Lugo picks out the UK’s Carpetright, which now has virtually no debt on its balance sheet and, as a result, has been able to take market share from Allied Carpets, which had a 15% share but went bankrupt. “Carpetright fell from £6.50 per share to £3.50 per share, and we were buying more and more as it came down and it became a large position in the fund,” he says.
Lugo concedes that deleveraging consumers have created problems for the sector, however. US and UK-listed Signet Jewelers is an example. “We found them attractive because they were generating so much free cash flow. But, of course, one way to do that is to stop expanding with new stores - and, as a result, they’ve been able to go ahead and pay down their debt further,” he says. “So you are right, you see companies that stop expanding, stop paying dividends, collect the cash instead of spending it. But the market has also started to come back for some of these firms - in the case of Signet, jewellery demand has come back. As a result, they’ve cut their expenses and inventories but they’ve also got better margins and cash flows than expected. Signet had such a dramatic move that we sold out in 2009.”
The fund also owns Jumbo, the number-two toy retailer in Greece after Carrefour. Jumbo also does household goods and seasonal items. Indeed, Jumbo accounts for the entirety of the fund’s overweight position in Greece (4% of the portfolio). The manager, who turned a small store into the leading discount retailer in the country running 31 stores, owns 30% of the company. During the financial crisis sales increased as consumers ran to discounters, and the stock jumped from €5 to €8. “Then it came crashing back down during the Greek debt crisis - and we added even more,” says Lugo. “We have a five-year view and are willing to wait for Greece to turn around, and we think that Jumbo could be worth north of €10 per share.”
With emerging markets driving global growth, it is not surprising that a key element for any successful strategy has to be determining an approach to gain exposure to emerging consumers. How this is done varies dramatically between managers and reflects the inherent trade-offs between gaining direct exposure to emerging market consumers through investing in local stocks, and the governance and transparency issues that these stocks can bring with them.
Franklin Templeton, for example, has no direct exposure to Central and Eastern Europe in its strategy, despite a licence to invest up to 10% of the portfolio in emerging markets. “We do look there,” explains Lugo. “But here’s the problem with emerging markets. We are looking for companies with strong balance sheets, strong competitive advantages, trading at attractive prices. But we also run a very concentrated fund of 30 or so holdings, which means that we need to know our companies really well. Now, once we go east of Austria, disclosure becomes poorer, we don’t feel we can trust management teams or numbers - and the bottom line is that if we are not comfortable with it we don’t own it.”
Lugo’s team has spoken to CEOs in these regions, and it has looked closely at firms like Netia in Poland, for example, with its high free cash-flow generation, but in that case the team was not keen on the fact that telecoms’ two lines of business - fixed line and mobile - are “running down or reaching maturity in these markets”.
Threadneedle is also cautious about direct investment, with almost no direct exposure to the emerging markets of Europe in its European small-cap strategy. Instead, it seeks developed market companies which might have strongly growing businesses in the region. “A company such as Nokian Renkaat, which is a Finnish winter tyre manufacturer with large Russian sales, gives us emerging market exposure with all the advantages of Western European corporate governance and disclosures,” Ellison reasons.
Epoch is also wary of direct exposure to emerging markets but for a different reason: “Valuations look stretched generally,” says Watt. Instead, it has exposure to companies that have a large presence in emerging markets and show high growth - Tupperware Brands Corporation is a good example. Epoch has never had more than 15% directly invested in emerging market, with amounts in the region of typically 5-15% focused on Brazil and a few small Asian countries.
By contrast, Invesco Perpetual, with its strong top-down approach, has around 28% in emerging markets (its 26% North America exposure compares with 54% in the benchmark). “You should never start from an index weighting,” cautions Hamilton. “The shift of the role of indices from performance comparison to portfolio construction has been the death of active equity management.”
The firm has seven sub-portfolios covering the UK, Europe ex-UK, Asia ex-Japan, Japan, US, and emerging markets ex-Asia split into Latin America and EMEA. Asset allocation decisions are made by the CIO and fund managers at a monthly meeting that allocates weightings across each region. Each manager runs his own portfolio, building on the work of a common research team that adopts a fundamental value-biased core approach to stock selection, with no quantitative screens used. “We have exposure to many more emerging markets countries that are not in the index,” says Hamilton. “The real beauty of small-caps is not just the innovation that you see in the developed markets, but that a lot of the flows into emerging markets go to ETFs that are invested in the larger companies, the state-owned enterprises and so on. It’s only by going underneath that you really get exposed to the retail sectors that show the high growth.”
Emerging market smaller companies can look very different from those in the developed markets. “In Europe, the average age of our companies is 69 years, with the oldest being Kas Bank in the Netherlands established in 1806,” says Harding Loevner’s Cresci “In contrast, in Asia, the founders are often still running the business.” Harding Loevner can have up to 25% in emerging market stocks and currently has over 19%, with healthcare provider Fleury in Brazil being a good example.
One aspect of investment in smaller companies in emerging markets is that economies can be buoyed up by macro-economic factors that provide a fertile backdrop for smaller companies to flourish, even if macro-economic factors do not play a part in a fund manager’s process. Brazil is a good case in point. As Watt points out, there has been a large increase in real personal income with the growth of a middle class and Brazil has thriving commodities trade with China. But Epoch believes that a game changer is the recent discovery of the Tupi oilfield. This could hold as much as 15 billion barrels, which would double Brazil’s known oil reserves. That kind of discovery can produce a wealth of opportunities for smaller companies to flourish by providing services to the oilfield operators.
As the sheer diversity of approaches, portfolios and positions attests, investing in small-caps offers a wealth of opportunity for active value. Compared with large-cap investing, finding the right manager with the process that suits your needs is absolutely crucial.