Exposure to global smaller companies can capture diversification by market capitalisation, but also by developed and emerging market exposure, writes Nick Hamilton

It has been a volatile few months for global equity markets and smaller companies have not escaped. Risk appetite returned in October as market expectations of progress on the euro debt crisis deal increased and macro-economic data beat expectations, particularly in the US, where the initial estimate of a 2.5% increase in Q3 GDP eased fears that the world's largest economy would fall into recession.

Global smaller companies rallied sharply over the month and outperformed larger companies. The MSCI World Small Cap index rose 7.9% over the month, against an increase of 6.5% for the MSCI World index, while the MSCI Emerging Markets index outperformed both, returning 9.3%. We have to expect that volatility will loom large for some time while global markets come to terms with the toxic combination of indebtedness and low economic growth in a number of peripheral European markets.

During short-term periods, smaller companies tend to be a more volatile asset class.  They are less insulated from economic downturns than larger companies, and their earnings can fall more sharply when growth falters. The economic sensitivity of smaller companies is largely because of the higher degree of cyclical and industrial exposure within the small company universe. However, what we see in smaller companies is that demand is very idiosyncratic (stock-specific) and there are often more localised factors that determine the demand environment for these companies. The last decade has witnessed a rise in profitability for companies across equity markets, some of which is accounted for by labour productivity factors (such as outsourcing) and expanding global markets. Smaller companies have themselves experienced this and as Empirical Research Partners points out, profitability has recovered to previous levels.

Profits will undoubtedly come under pressure and the correction in equity markets reflects that reality today. However, because of the earnings recovery potential, smaller companies will usually be out of the blocks first when economies stabilise and shift from recession to recovery. According to recent work by Empirical Research Partners, smaller companies, like large companies, have experienced a decade when free cash-flow margins have risen impressively, despite smaller companies being more capital intensive.

Since 2008, capital spending has been on an upward trajectory and very strong post-capital spending profits have driven free cash flow to the high levels we see today. This has enabled companies to invest and yet still return capital to shareholders in the form of dividend increases or a reduction in the share count through buybacks, which is encouraging.

Equity return premium potential
The current market dynamics offer just a short-term perspective. But if we take the world's largest equity market (the US) as a proxy for global markets due to its longer recorded history, then the evidence of smaller company outperformance on average over longer periods is significant. A 2010 asset class study by BP Choi and S Mukherji that looked at returns from 1926 to 2007 concluded that smaller company outperformance is, on average, around 1.7% per annum, in real terms. Smaller companies had, on average, the highest return of the asset classes examined in the study (government bonds - intermediate and long-term, corporate bonds, large-cap and small-cap equities) and, moreover, their volatility had been no greater than that of larger companies as the holding period moved out to 10 years. For the same amount of long-term risk, you can potentially receive a significant return premium.

Emerging market domestic demand
Traditional approaches to global smaller company investing have historically favoured developed markets, and while we should not discount the significant opportunities that these markets can offer, taking a broader approach to incorporate investments in emerging markets can potentially enhance diversification and returns.

Emerging markets play an important role in the global economy. At the end of 2010, emerging markets had accounted for 48% of global output (in terms of purchasing power parity), according to IMF figures. As their equity markets develop, their share of global capitalisation is expected to continue to increase.

For many investors, emerging market exposure initially came via large-cap-focused emerging country funds. Yet, extending beyond large-cap companies in these markets offers a credible way to gain exposure to the opportunities arising due to the growing middle class in a number of emerging market economies where consumer spending is on the increase. Smaller companies tend to have a greater domestic bias compared with larger companies and are therefore more likely, we believe, to benefit from robust domestic economies where the consumer growth story remains intact.

While there are over 9,000 companies in the world's main global indices, including developed and emerging markets, only around 1,600 are defined as large-cap. This means that the vast majority of listed shares are those of medium-sized and smaller companies. We believe that there are compelling reasons for investing into this huge global market. The inherent dynamism in these companies is supported by management whose interests tend to be closely aligned with those of shareholders.

The management of smaller companies tend to hold a significant amount of their own shares, so have a real incentive to succeed. Importantly, the incentive to succeed isn't driven by profits alone but also by an entrepreneurial spirit. Studies have shown that managerial ownership improves company performance. Empirical research - such as that published in the Jornal of Financial Economics in 1988 by R Morck, A Shleifer and R Vishny - points to an improvement in corporate performance when managerial ownership rises from zero to 5%. Performance continues to rise as managerial ownership grows to an inflection point of 25%.

A common misconception is that smaller companies are inherently less profitable. However, we believe that what is commonly misunderstood is that many smaller companies have very strong economics. However, the addressable end market is limited by size. For example, a small specialist auto parts manufacturer might control the global supply of a component product but if that product has a relatively small market value, the size of the business is, by definition, limited. However, if that company controls the supply of the product, then profit margins can be above that for the industry. Size often says little about the profitability or economics of a business.

We also like the ability of smaller companies to identify growth opportunities and to execute business more quickly than larger companies. In a recent comment, Hewlett Packard's CEO admitted that the size of his company was effectively limiting its ability to respond to product cycles in the global economy. Large companies become complex and dynamism is often forsaken for process which may limit growth opportunities.

Finally, it is becoming apparent that large global companies, which today are sitting on large cash hoards, are looking to acquire innovation and growth through acquisition and that is a positive for those smaller companies which are likely to become targets as we move through this economic cycle.

To summarise, exposure to global smaller companies across both developed and emerging markets can offer diversification benefits and the potential for strong long-term returns. We believe that global smaller company investing favours a long-term, fundamental stock-picking approach; and that it can offer an attractive long-term investment opportunity.

Nick Hamilton is head of global equity products at Invesco Perpetual