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In a world obsessed with the safe havens of multi-national mega-cap cash machines, Joseph Mariathasan revisits the case for smaller companies

Smaller companies tend to outperform in the early stages of a recovery – and finally we may be seeing this in the US today. Sure enough, small-cap indices outperformed large-caps during 2012.

But with historically low bond yields, institutional investors have been looking at constructing low-volatility equity portfolios that can produce attractive dividend yields as alternatives to those bonds – this invariably means seeking out low-beta, multi-national, multi-product mega-caps that distribute a big share of profits immediately rather than re-investing them for growth.

That would seem the opposite of smaller companies, which tend to be more domestically-focused, more tightly home-domiciled, more volatile, and more likely to still be in their growth and investment phase. Moreover, with public sectors struggling to raise revenues, large multi-nationals have the advantage of having the ability to avoid various forms of ‘fiscal grab’ by their home governments. Can smaller companies compete for capital in the current clamour for safety by institutional investors?

A key determinant for making any investment decision is relative valuation. But relative valuations of small versus large-caps need to be handled with care, argues Andrew Neville, portfolio manager at Allianz Global Investors, because large-caps as a group are disproportionately influenced by multi-national mega-caps. Neville divides the market into mega-caps, large-caps and mid and small-caps.

“Mega-caps have been de-rated over the past 15 years,” he notes. “Large-caps have held their valuations but if you look at BP, Glaxo and so on, they have been de-rated every cycle and because they form such a large part of the benchmarks, they drag the benchmarks down. Mid-caps may look expensive at 12-times earnings, but large-caps are also on 12-times. [It’s the mega caps that] are on nine-times earnings. They’ve been de-rated for two reasons: firstly they give you low growth, albeit it stable with good dividends; and secondly, they are too large to be taken over through leveraged buyouts, so they don’t have that debt/equity arbitrage.”

Against this background, while small-caps currently look expensive versus larger companies, Neville thinks that they are fairly valued, “pretty much in line with their long-term average”.

Young Chin, CIO for equity and alternatives at Pyramis Global Advisors, agrees. “In terms of relative valuation, I think we are in a period where there is a demonstration of some rebound taking place whilst still at relatively lower valuations from historical norms,” he says.

A boost to those valuations could come through increased M&A activity. Hamilton points out that large European companies have cash on their balance sheets equivalent to 65% of total small-cap market capitalisation. “In a tough world, where a company’s ability to grow organically is challenged and where high-quality companies can borrow very cheaply, we would think that a pick-up in market confidence will lead to a pretty strong rise in M&A,” he suggests.

But it is not tactical valuation that really makes the case for small-caps. Indeed, their relative illiquidity suggests that they should be viewed as a contender for strategic investment. So what are the strategic advantages? Nick Hamilton, head of global equity products at Invesco, lists four.

The first is simple: the ‘small-cap effect’ has been much discussed in academia and suggests that small-caps are a source of systematically higher returns than those from the broader market. Second, small-cap management tends to be more entrepreneurial: individuals who have been with a company from the beginning tend to have a collective ambition for it to succeed, which Invesco see as a compelling force; moreover, those individuals often hold a significant proportion of the shares in their own companies. Third, there is ample opportunity for active management in a universe of thousands of stocks with much less sell-side analyst coverage than large-caps. And finally, related to that, there seem to be clear and attractive diversification benefits within small-caps, but also from adding small-caps to a broad portfolio.

“We believe that the important role that smaller companies can play in a portfolio is significantly underestimated and the risks of investing in the asset class are generally overstated,” says Nick Hamilton, head of global equity products at Invesco. “People overstate the impact of volatility. If you are only focussed on a short term time period, you should not be in equities at all.”

Robert Feldman and Lance McInerney, portfolio managers at Pyramis, argue that these diversification benefits have become more important as the trend toward globalisation has increased correlations between national stock markets at the large-cap level. They see small-cap stocks being less affected by global investment trends as they are driven more by idiosyncratic local market factors. Indeed, they go so far as to argue that global small-caps provide significant or better diversification than emerging market stocks (as defined by the MSCI Emerging Market index,).

Certainly local small cap markets can behave differently from each other. “When investors want to adopt a defensive position in Japanese equities, they move to small-caps, which is certainly not something you see elsewhere,” says Feldman. “Their large-cap companies are all exporters, hence if the world slows down, the large Japanese manufacturers start to struggle.”

Similarly, Neville at Allianz Global Investors points to small US technology companies with a cloud computing focus; there is nothing like that in Europe, but there are companies experiencing high growth in online retailing. There can also be opportunities in markets that may not be so obvious.

“We are moving more into Southern Europe,” he reveals. “We are becoming a lot more comfortable and we see that the risks are being quantified. We are buying more companies in Spain and Italy, particularly those that may quoted there, but which have sales predominantly elsewhere, or which can move their asset base very quickly. If their governments attempt a quick tax grab, the companies could just move their staff to France, for example.”

Given these advantages and this diverse opportunity, it should be no surprise that attitudes to small-cap investment are changing. Pyramis has seen a sharp increase in global small-caps over the past few years, due in part to a search for diversification and in part to the launch of the MSCI Global Investable Market indices (MSCI GIMI) in May 2008, which implemented a more robust small-cap index within MSCI’s popular global indices. This has been important: investors all-too-often look at the large-cap indices and assume that they are ‘getting the whole market’. Better indices help them both to throw off this assumption and create benchmarks to implement another approach.

Hamilton at Invesco finds that some big institutional consultants are now talking to Invesco about small-cap mandates: “I say that if you are not going to invest, then you should do so consciously – not by default,” he says. “For long-term investors, the risk is really too much exposure to large-caps and the danger of large-cap getting dethroned.”

Institutional investors have three options when considering the addition of global small-cap equities: maintain the status quo; add dedicated global small cap mandates; or extend existing mandates by, for example, shifting from the MSCI World Standard index to the World IMI, which adds about 4,400 names to the benchmark.

While the last option may sound attractive, existing investment managers may lack the expertise to take advantage of the potential of all these extra smaller companies.
Large-cap managers might be tempted to invest in only a representative sample of the small-cap universe, or to vary the small-cap allocation opportunistically, both of which can reduce diversification and return. The argument for specialist active managers is strong – perhaps stronger than for any other equity universe. The opportunity set is huge and the idiosyncratic risk highly significant. If an investor takes the active decision to add smaller companies to its portfolio, it seems clear that it should also consider leaving the passive benchmarks behind.

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