Investment Process: In search of an edge
Investors have to work hard to gain an information edge to successfully exploit small-cap markets
• The huge size of the global small-cap universe presents a challenge for investors
• Strong relationships with local brokers often help in this market
• Small-cap strategies are often used as a training ground for large-cap managers
• There are three broad approaches to small-cap investment: quantitative, relying on regional managers and global management
Few would disagree with the argument that if inefficiencies exist anywhere in the listed equity markets it is among smaller companies where they are likely to be greatest. Active small-cap managers can exploit information inefficiencies in the marketplace by knowing companies really well through meeting management, undertaking site visits, speaking to suppliers and competitors and so on, and can end up knowing a lot more about a company than the rest of the market.
That is not the situation in large caps where it is difficult to get an information edge since there are so many analysts following a company that market prices quickly reflect any new information.
If that is the case, it is a quandary why small-cap investing, particularly in Europe, is seen as a niche area.
One answer may be that it is not a good business proposition for fund managers. “Small boutique managers focusing on small caps may have just €200m-300m before closing to new business so they won’t make a fortune from fund management,” says Nick Samuels, head of equity manager research at Redington, a UK investment consultancy.
In continental Europe, Redington finds about 80-90 retail and institutional small-cap managers but there are probably about 100 or so funds in the UK. In the US, where US small cap is seen as an established asset class in its own right, there are some 750 managers.
The problem for fund managers is that the global small-cap universe is enormous. In just the developed markets, there may be anywhere between 20,000 and 25,000 stocks with a market capitalisation of less than $5bn (€4.3bn), although only a small fraction of these are investable to any degree.
That still leaves a large number. For instance, Mark Rogers, head of research at Montanaro Asset Management, estimates the number of investable stocks in Western Europe at about 2,500 compared with a total of about 6,000 quoted companies. The average market cap for this investable universe in Europe is about $1bn, which would take 1,000 of them to match the market cap of Apple, but that is up from the figure of $100m during the 1980s.
“We don’t recommend global small cap at all because it is a bit of an oxymoron,” says Samuels. To manage global small-cap strategies, he argues, means having an enormous team with people on the ground across the globe. Large companies with large research teams should, in theory at least, be able to leverage their research costs. But if the day job of an analyst is large cap, they may not wish to spend much time looking at small caps so success may be dependent on the incentives on offer.
“We don’t recommend global small cap at all because it is a bit of an oxymoron”
Samuels also points out another problem with enormous teams – information leakage. It is hard to maintain a consistent view across a large team. “Otherwise all the firms with massive teams would be the best performing fund managers and they never are,” he says.
The challenges lie not just in the information angle but also on the trading side. Strong relationships with local brokers are often seen as essential to be able to source key stocks. But to develop them on a global basis clearly presents enormous challenges.
More than a training ground
The other difficulty with small-cap management, particularly in Europe, is that strategies become a training ground for large caps. Junior portfolio managers that do well managing small-cap funds tend to be shifted onto the flagship large-cap funds. So good managers move on, which is not so good for investors as they see a high manager turnover.
There are potentially three ways of tackling the challenges of active research-driven global small-cap investment. The most comprehensive is probably through quantitative approaches. “If someone demanded a global small-cap fund, that is where we would go,” says Samuels. Quant strategies can assess 30,000 stocks at the same time. While the quality of the data might deteriorate the further down the market-cap spectrum you go, Samuels argues that even if the number of factors that are usable in the small-cap space are fewer, they do work pretty well. Trading is still a problem but the funds would be more diversified, so each trade would be smaller.
Another approach is to focus on regional managers, and investors could build up a global exposure through a set of specialists. Even here, the heterogeneous nature of the European marketplace – with Germany, for example, behaving differently from the UK – presents challenges. The UK has the largest market of small-cap stocks, followed by Germany and then Switzerland.
In Germany, there are fewer listed small-cap companies relative to GDP than in the UK. This is because historically the middle-sized ‘Mittelstand’ firms were supported by the state and financed by banks rather than through listed equity, says Marcus Ratz, a partner at Lupus Alpha. France is under-represented in the small cap-space because the state traditionally supported large companies, while Sweden has a high number of good small caps and is over-represented in terms of its GDP.
To tackle this diversity, Lupus Alpha has a team of nine small-cap managers. Each has an overview of up to 150 companies. The strategies themselves typically have 60-80 stocks in total, and while portfolio companies may be rated three to six times a year, others on the watch list may be seen only every one or two years. “We undertake bottom-up research and because there are a lot of domestically driven companies in the small-cap space,” says Ratz, “we feel that a country approach is most appropriate, whereas in large caps, global sector specialisation would be better”.
So is it possible for a single firm to tackle global small caps using an active process? Montanaro accepts it is the case, albeit with certain important caveats. It launched its first global small-cap fund, the Montanaro Better World fund.
Two specific factors have enabled the firm to make this move. First, the fund has a narrow focus – as the Better World name suggests, the fund follows a narrow, specific positive-impact strategy as well as utilising the firm’s proprietary investment approach. This enables the universe of possibilities to be narrowed down dramatically by filtering through company fundamentals, ESG and impact factors. As a result, hundreds of companies in any sector can be whittled down to a handful that may look interesting enough to warrant more detailed analysis.
Second, Rogers says managing any global product requires two activities – gathering information, and analysing and processing the information using a structured methodology. If information gathering is seen as the more important task, then regional offices are required. If, as is the case with Montanaro, the philosophy and investment process are more important, then the team can be located centrally and travel to visit companies.
Montanaro organises its investment team of 11 along global sector rather than country lines. This enabled it to move from a European-only focus to a global focus by incorporating the US and Asia/Pacific relatively seamlessly, since the analysts already knew their sectors well. “Each analyst would typically just look at 20-30 companies for detailed coverage, so moving to a global sector typically just added one or two stocks, six at most,” says Rogers.
For investors, it may be a challenge to find good global small-cap managers but it should still be possible to get coverage of small caps on a global basis.