Insights
Report

The case for Global SMID

Nicole Mardell
Senior Global Equities Analyst
August 2017
Nicole Mardell
Senior Global Equities Analyst

17 years experience

Research Coverage

Primary: Global SMID Generalist and is co-lead on the Consumer Discretionary and Consumer Staples

The case for Global SMID

August 2017

At a time when global equity strategies are maturing and the search for returns are ever more prevalent after a relatively strong extended period of positive returns, there are two arguments that can be made for making a discrete investment allocation to global small- and mid-cap (SMID) companies.

The first argument considers Global SMID from an asset allocation perspective. If you believe that growth in sales and earnings are a scarce fundamental commodity that ultimately dictates a company’s share price performance over time, together with stock price inefficiencies of the asset class, then an allocation to Global SMID may add value going forward. Not only does Global SMID hold superior risk-adjusted return characteristics to broad global benchmarks, it also offer a strong growth option without a lot of the shortcomings of other global growth asset classes and its underfollowing by sell-side analysts provides the active investment manager with a greater opportunity to produce a differentiated view to help generate alpha. 

The second argument considers Global SMID as a style diversifier. In an environment where style diversification is becoming less effective, and where Global portfolios are becoming more subject to unintended consequences, diversifying by size, and not style, is becoming an increasingly important driver behind maximising risk-adjusted returns.

1.    Global SMID as an Asset Allocator

Since 2000, an allocation to Global SMID would have added 3.3% per annum over and above the MSCI ACWI Index(1). Additionally the asset class has performed particularly well in recent periods, especially when compared to Emerging markets, one of the more popular Global ‘growth’ asset classes(2), as evidenced in Chart 1 and Table 1 below.

 

Chart 1: MSCI Index Performance

 Source: eVestment Alliance 

  Source: eVestment Alliance. Quarterly returns in A$, annualised. As at 30 December 2016. 

 

Global SMID holds superior risk-adjusted return characteristics to broad global benchmarks

Since 2000, Global SMID has exhibited the lowest level of risk out of the Growth asset classes, and with risk-adjusted returns second behind Small cap. Table 3 below further shows Global SMID provided for better risk-adjusted returns versus Emerging markets and significantly better versus Global World indices, that it outperformed MSCI ACWI 68% of the time and held the lowest tracking error amongst Global growth asset classes.

 

Source: eVestment Alliance. Quarterly data in A$. As at 30 December 2016

Performance metrics are calculated against MSCI ACWI. 

 

Global SMID offers a strong growth option

Historically, as an asset class, Global SMID has provided growth shown to outstrip that found in other common global equity buckets such as Global Large caps[3] and Emerging Market equities. Table 2 below shows this has been true for fundamentals such as sales and earnings in particular, and where both SMID and Small caps have led dividend growth.  

 

Source: Bloomberg, USD, Index level data  

*Starting Calandar Year MSCI SMID Index data is 2009

**Earnings defined as diluted earnings from continued operations 

 

It is entirely reasonable to observe SMID cap, and Small cap, return on capital (ROC) at the lower end of the group, leverage slightly higher and free cash flow weaker, as they are typically in their ‘growth’ phases where the focus is on growing capital expenditures and investing in their franchises. As such, returns as measured by ROC in table above, can take time to grow. 

Interesting to further point out over the last 8 years, that despite actual ROCs not being overly impressive, all Global indices have shown an improvement, with the exception of Emerging markets, and that the greatest improvement generated has come from SMID.  

This points to the fact that Global SMID, as a global asset class, is less directly exposed to more macro issues (such as weak economics and weak commodity prices) and heightened political risks within key Emerging markets that can sometimes influence poor capital allocation decisions made by management teams of associated companies. Markets such as Brazil, Russia and China, that tend to be driven by one or two Energy and Resource focused ‘heavy-weights’, also come with their own political ties. For example (1) Petrobras, an integrated energy company and Brazil’s top publicly traded company by revenues and which is controlled by the Brazilian government [4]; (2) Gazprom, another oil and gas company, one of Russia’s largest company and one of the world’s largest publicly listed gas producer, is majority-owned by the Russian government and accounts for approximately 25% of Russia’s tax revenues with its various stakes in local financial institutions, electricity assets and telecom networks[5]; and (3) over 150 state-owned enterprises (SOEs) in China[6] which in themselves have an abundance of financial resources and power to effectively act like independent ‘empires’ or oligopolies influencing political and economic decisions of the country.

Overall the picture painted by SMID caps is one of strong growth with a solid and appropriate return structure for the stage they typically sit within the business/industry life cycle. Specifically SMID caps:

  • Are in the sweet spot of their business life cycle - Once companies move past the start-up phase they enter the SMID cap stage – the sweet spot – where their business model has been proven, they have achieved some product and customer diversification, are on their way to building a strong franchise with an improving balance sheet and cash flows to support them, yet still with plenty of growth opportunities available to capture and exploit.  This can lead to consistently above average revenue and earnings growth, and over time a strong return profile.

 

 

 

  • Face minimal issues with the law of large numbers - Many large caps can find it difficult to sustain good growth rates due to their sheer size, making it tough to create new products or services that move the needle in terms of revenue or earnings, and where incremental R&D spending for these large caps often has a diminishing effect on profitability and returns. Large caps have often already expanded into all corners of the globe and therefore have less opportunity to penetrate new markets through geographic diversification. SMID caps do not face these same issues and usually have plenty of organic growth opportunities available to them. 

 

Global SMID is without shortcomings of other global growth asset classes

Specifically when compared to Global Small caps, Global SMID caps: 

  • Offer better liquidity - Better trading liquidity (buyers) can help to reduce transaction costs and lower risks associated with investing in companies with poor liquidity either due to size or market exposure. This is an important consideration, especially during bear markets, where the ability to sell a small cap position if required may be nearly impossible; notwithstanding the overall longer waiting period for selling in normal market conditions.   
  • Offer better diversification, where at the company level it can sometimes be similar to large caps but on a smaller scale. Small caps tend to sell a limited number of products and/or services into a small number of geographies/regions. Global SMID caps generally have more diversified revenue streams, creating more stability while still benefitting from ample growth opportunities. Somewhat reflected in Global SMID’s historically higher ROC versus Small caps and comparable ROC to Large caps (Table 2).
  • Command stronger balance sheets, often generate better cashflow and have better access to capital markets during times of ‘stress’ which can help them hold up better in market downturns (Table 4).
  • Not a forced seller due to market cap - Investment Managers of small caps often have to sell an investment once it reaches a certain market cap level. This sell decision could come at a time when the company still has plenty of growth opportunities ahead. By having exposure to Global SMID caps, an active manager is able to hold the position for longer and capture more of the potential upside. Whilst a SMID cap manager may still be forced to sell when the company enters the large cap space, at least they may have been able to benefit from more of the market cap growth over time. 

Further advantages of Global SMID as an asset class:

  • Offer superior outperformance in different environments where small caps are often the strongest performing asset class in strong up markets and large caps typically hold up better in down markets, SMID caps often perform well in both types of markets (see Table 4 below). Actually SMID performed the strongest within the Global growth asset classes in down markets, which perhaps help support the case for SMID to be seen as a possible lower risk ‘growth’ option. Whilst small caps may present the strongest upside capture and returns, this comes with the risk of less favourable liquidity characteristics and arguably being at the relatively riskier early stage of their business life cycle.

 

Source: eVestment Alliance. Quarterly returns in A$. As at December 2016

Performance metrics are calculated against MSCI ACWI. 

 

  • More micro focused – the type of risk taken within a SMID company is less volatile or more controllable given it is potentially more micro-driven versus that within Emerging markets, where company growth and stock market performance can be more dependent, if not sometimes entirely reliant, upon macro and political issues.
  • Are underfollowed by sell-side analysts, when compared to large caps. This can help create stock price inefficiencies and a greater opportunity for active investment managers to produce a differentiated view to consensus and greater ability to generate alpha. For the purpose of illustration, assume a market cap cut off at A$31bn, under which is regarded as SMID cap down to A$1bn, at which point and below is Small cap.  Table 5 highlights there are 4-5x the amount of overall recommendations and estimates on Large caps’ sales and earnings vs SMID caps despite just over two-thirds of the Global Market consisting of companies with market caps in the SMID cap range.

 

Source: Bloomberg, April 2017

 

  • Can be M&A targets, given their attractiveness for larger companies looking for growth. Investing in companies that become take-out targets can be an excellent way to generate alpha as many large companies tend to overpay in their desperate search for growth.

 

2.    Global SMID as a Style Diversifier

Active and passive exposures for global equity portfolios are looking increasingly similar and are arguably going through, what we at BAM are referring to a ‘portfolio eclipse’. A result of this is a build-up of stock specific risk causing asset owners to end up holding a handful of stocks, mostly and unintentionally large caps, that are seemingly driven by momentum as a dominant factor. Additionally, this effect can lead to a disconnect between valuation and fundamentals, where the diversification benefits of an active / passive split dissipates and downside protection is compromised.

 

Global SMID offers diversification by size not style

Arguably the true diversification ‘test’ with any portfolio comes during periods of major weakness. Table 6 below compares the traditional style buckets of Value and Growth to how the three key market cap groups i.e. Global all cap, Global SMID and Global Small, performed during two major market corrections since 2000, namely the Tech Crash and the GFC and the subsequent two year periods. Specifically, both Global SMID and Global Small cap stocks on average pulled back less than the World and on average provided more upside, pointing to size acting as a more effective portfolio construction tool. Additionally, a similar picture is concluded when compared to Value, Growth and Quality styles, suggesting that style diversification has not saved portfolios from meaningful losses in drawdowns, nor allowed for participation in maximum upside in subsequent years. 

 Source: MSCI and Bloomberg

 

Global SMID provides strong performance characteristics and attributes

  • Is the only style bucket with the optimal blend of high Upside market capture and low Downside market captureAnalysing the performance characteristics of the major style and size buckets in all market conditions over the last 20 years in Chart 2 below shows Global Quality and Global SMID to have preserved capital well and offered the best downside protection, whilst Global Growth has not done well. Particularly interesting is the outcome for Global SMID which is somewhat counter-intuitive but points to many of the advantages it may hold as an asset class made earlier.   

 

Chart 2:  MSCI Index Global Style and Size Buckets:  Upside and Downside Capture

 

 

 

Source: eVestment Alliance: +MSCI Indices is the median of the five indices shown in the chart. Period is for 20 years ending June 2017, run on a monthly basis. All results are in AUD terms and measured against MSCI World-ND.

 

  • Offers meaningfully positive actual return and risk outcomes. Chart 3 below shows over a 20 year period, MSCI World, Global Value and Global Growth have all produced a similar level of return, with an increasing level of risk respectively. And whilst Global growth and Global SMID have virtually identical risk levels, Global SMID provided higher returns.

 

Chart 3:  MSCI Index Global Style Buckets:  Risk and Return 

 

 

Source: eVestment Alliance: +MSCI Indices is the median of the five indices shown in the chart. Period is for 20 years ending June 2017, run on a monthly basis. All results are in AUD terms and measured against MSCI World-ND.

 

  • Proven to act as a solid preserver of capital. Chart 4 below shows since 2000, an allocation to Global SMID would have generated 0.8x outperformance against Global Value, 1.4x against Global Growth and 0.7x against Global Quality[7]. Notwithstanding the fact that Global SMID has also proven to act as a solid preserver of capital during this period.

  

Chart 4:  MSCI Index Performance (growth of $100 from 2000)

Source:  eVestment Alliance

 

To conclude, a discrete investment allocation to Global SMID companies could be seen as a compliment to Global small cap exposure with better liquidity, with the potential growth option that historically has been available within emerging markets but without the macro and political risks associated with these markets, and with superior risk adjusted return characteristics to the broader, and particularly larger, global benchmarks.

Additionally, as traditional style bucketing is becoming increasingly challenged, greater diversification at a market cap level also provides for positive risk / return characteristics and can further help create great investment opportunities for fundamental / active investors.

 

 

Footnotes: 

[1] Past performance is no indication of future performance

[2] Growth asset classes include Global Emerging markets, Global Small cap and Global SMID

[3] Global Large caps include MSCI ACWI and MSCI World

[4] Bloomberg

[5] Bloomberg

[6] www.forbes.com

[7] Past performance is no indication of future performance 


Important information:This has been produced by Bell Asset Management Limited (BAM) ABN 84 092 278 647, AFSL 231091. This has been prepared by BAM for information purposes only and does not take into consideration the investment objectives, financial circumstances or needs of any particular recipient – it contains general information only. Before making any investment decision, you should consider your needs and objectives, consult with a licensed financial adviser and obtain a copy of the relevant offering document. No representation or warranty, express or implied, is made as to the accuracy, completeness or reasonableness of any assumption contained herein. To the maximum extent permitted by law, none of BAM and its directors, employees or agents accepts any liability for any loss arising, including from negligence, from the use of this document or its contents. This document shall not constitute an offer to sell or a solicitation of an offer to purchase or advice in relation to any securities within or of units in any investment fund or other investment product described herein. Any such offer shall only be made pursuant to an appropriate offer document. Past performance is not necessarily indicative of expected future performance.

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