Equity

Global Small-Cap Allocation: A Catalyst to Portfolio Success

While institutional investors worldwide have traditionally focused on larger-cap stocks, increasingly, more asset owners and managers are strategically allocating to small caps as part of their global equity portfolios.
April 2018

Catherine Stanley

Director & Head of Global Small Cap (EMEA)

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While institutional investors worldwide have traditionally focused on larger-cap stocks, increasingly, more asset owners and managers are strategically allocating to small caps as part of their global equity portfolios. Catherine Stanley, Managing Director & Head of Global Small Cap at BMO Global Asset Management (EMEA), discusses what’s driving this growing trend, and the need to approach the sector with a long-term, quality-focused view that minimizes downside risk.

 

The Case for Global Small-Cap

While larger companies are traditionally associated with less risk and greater liquidity, it’s a well-established truth that smaller businesses are speedy, nimble and efficient allocators of capital. As a result of these qualities, and their initial size, small caps have historically generated superior earnings growth compared to their large-cap counterparts, which translates into better share price performance. And contrary to the claims of critics, small-cap outperformance isn’t exclusive to the U.S., the UK, or any developed market in particular – as shown below, it’s a global phenomenon that has captured increasingly more attention from international investors.

Indeed, the “small” in small cap leads to some mistaken preconceptions: the sector is actually a significant part of the market, representing 16.5% of the MSCI World benchmark index.1 Investing across all-cap segments, including the smaller end, provides exposure to the full equity risk premium, and allows asset managers to gain complete coverage of the global opportunity set.

In fact, a key benefit of small-cap investment is enhanced portfolio diversification, with more than 5,000 companies in our universe that can range up to approximately $10 billion in size, offering different sector composition and foreign exchange exposures than large-cap companies – an increasingly important benefit amid a volatile market environment. The largest individual stock in the MSCI World Small Cap Index represents only 0.3% of said benchmark, while the largest individual stock in the S&P/TSX Composite represents 6.7% of its index, highlighting the depth and breadth of options available in the global small-cap universe.²

The global small-cap market is also a prime breeding ground for value-add opportunities, where active managers can differentiate themselves through dedicated asset class expertise, by identifying companies whose share price does not fully reflect their intrinsic value and growth potential. As passive strategies continue to proliferate in the large-cap universe, small-cap investment has gained traction among risk-averse investors as a core, active complement designed to generate significant alpha. Even during market troughs, managers that implement careful, discerning, high-quality, small-cap stock selection can add enormous value.

6 compelling reasons to add global small caps to your portfolio:

  • Faster inherent growth potential – smaller initial size means companies can grow at higher rates for longer periods of time, equating to more attractive share price performance
  • Historic outperformance compared to large-cap companies – smaller companies tend to be speedy and efficient allocators of capital, with a more focused line of business and higher insider ownership, resulting in greater alignment of interests
  • Exposure to niche sectors and opportunities – otherwise unavailable for large-cap universe
  • Sizeable part of the global market – represents 16.5% of the MSCI World Benchmark Index¹
  • Broad diversification – more than 5,000 companies in the small-cap universe, with different fundamental drivers and sector representation
  • Active management benefit – market inefficiencies provide greater opportunity for disciplined, tactical managers

 

BMO Asset Management Global Small Cap Strategy: Disciplined Access to a Faster Growth Asset Class

As managers of BMO Asset Management Global Small Cap Strategy, we seek to maximize on these benefits and minimize asset class risk by selecting high-quality growth companies that can compound returns above the market rate and add value over time, focusing on a sweet spot of businesses ranging between $500 million to $10 billion in market capitalization – eliminating the higher-risk micro-cap end of the scale. Still, this sweet spot covers a wide range of companies and a multitude of sins, so we implement an active, bottom-up, long-term approach to facilitate success. Our high conviction portfolio of 75-95 holdings is supported by detailed scenario analysis, proprietary research and exhaustive due diligence, including hundreds of management meetings every year to gain first-hand knowledge from company leaders on their strategic business plans.

In the small-cap universe, choosing winning stocks is an art as well as a science. Investors are buying into the management team of these companies as much as anything else, and very often, they do not conform to what a pure spreadsheet analysis may suggest. We want to ensure they are not overly optimistic in their approach – and have a deliverable strategy and vision, with the right skills, track record and integrity to manage that delivery, and withstand any stresses that inevitably arise throughout the cycle.

Importantly, we are not momentum, or pure growth-orientated investors that jump on the short-term bandwagon. We distinguish our approach by focusing on the long-term fundamentals, removing as much risk as possible by assessing three critical criteria: quality, risk and value, which may involve assessing anything from sources of competitive advantage, free cash generation and debt structures, to corporate culture, board composition and product quality. Our beliefs and considerations are grounded in the predictability, repeatability and consistency of returns; markets change and businesses disappear, so it is important to ensure that shareholder interests are protected. This does not mean investing in the highest-return company in the sector, as that growth may not persist over the longer term. In fact, a potential target for us could be special situations with current lower returns, but where catalysts for change and new strategies leading to sustained business performance improvement have been identified. If the environment for a particular business turns negative, ultimately, our goal is to seek characteristics which still provide support for shareholder value, such as assets, intellectual property, cash flows or an offer that will lead to market share gains from weaker competitors.

Risk-Aware: Covering All the Bases

Our enhanced risk focus is also evident in the diversification of our portfolio across sectors, providing us with inherent protection. We do not duplicate businesses; instead, we seek companies that play on different themes, and initially screen out any small caps that demonstrate a lack of growth, poor liquidity, excessive debt, or are located in a region with which we are not familiar.

Levering a track record of outperformance and a depth of asset class expertise with more than $2.4 billion invested in smaller companies,3 our ideas and convictions are informed by a team of five sector specialists, averaging 18 years of industry experience. This collaborative team approach is a true differentiator for BMO Asset Management Global Small Cap Strategy, as not only does it provide an abundance of resources, but also an efficient division of labour that fosters focused areas of specialization. It also further minimizes risk by allowing for the natural – and effective – competition of capital within the small-cap arena, again reflecting true diversification and the broad opportunity set available in the space.

Further, our portfolio decisions are supported by wider teams across our global enterprise, such as BMO’s Governance and Sustainable Investment (GSI) experts, which conduct research on material ESG concerns, such as governance, supply chain management and ethical behaviour, as well as provide post-investment analysis, monitoring and engagement.

 

Premium Growth, without Excessive Risk: Two Shining Examples

Dechra Pharmaceuticals – a UK-based veterinary pharmaceutical business with an international footprint developing and selling companion food, and animal medicines.

What we like: Dechra operates in an attractive, defensive growth market with limited cyclicality. With an aging population, the number of companion animals are on the rise, resulting in a long runway path of growth ahead. The Company also has strong positions in areas, such as dermatology, endocrinology and equine pharmaceuticals, with an established track record of organic and acquisitive growth and a robust product pipeline. It also benefits from a less costly and faster product development process than human pharmaceuticals, leading to higher rates of return on research and development investment. Dechra is typical of our long-term compounder criteria, complete with compelling intellectual property, balance sheet flexibility, exemplary management capabilities, high barriers to entry, and a diverse product range. Importantly, the Company has assets that carry value – regardless of market conditions.

Vail Resorts – an owner and operator of luxury ski resorts, including Perisher in Australia, Vail and Beaver Creek in the U.S. and Whistler in Canada.

What we like: Vail has a domestic and international customer base, and while it operates these premium ski resorts, it also owns the mountain and respective lodgings, which ensures strong asset backing to the business. While there is a weather factor, most of the Company’s revenues are derived from advanced season-pass sales, which reduces volatility and provides earnings visibility. With a long-term revenue stream and a resilient spend profile, Vail also benefits from a defined M&A strategy that is aiming to drive synergies in its pass systems and to diversify its locations.

 

History Repeats Itself: Small-Cap Strength to Persist

Looking ahead, the macroeconomic backdrop is generally supportive of smaller-cap companies as a whole, with stock selection remaining a main driver of performance. While rising rates present uncertainty across markets, over the long term, we believe that history will play out, and that small-cap outperformance (relative to large cap) will persist. Though certain pockets of our portfolio currently outshine in terms of performance, including the Real Estate, Consumer Staples and Industrials sectors, we are finding a wealth of opportunities with strong fundamentals and sensible balance sheets across our universe that are likely to hold premium ratings.

Certainly, while macro variables factor into our scenario analysis and portfolio construction, BMO Asset Management Global Small Cap Strategy is ultimately a reflection of our high-conviction stock picks: companies that we believe have successful business strategies and a management team capable of compounding shareholder capital over several years, generating superior risk-adjusted returns.

Amid this increasingly volatile and yield-oriented market environment, the need for growth, while being mindful and aware of overall portfolio risk, is now a main concern for institutional investors worldwide. By extending their global focus to small-cap equities – with an active team like ours distinguished by its specialized expertise, disciplined process and its strong emphasis on consistency and downside risk – asset managers stand to benefit from significant alpha generation, faster growth and enhanced diversification, while remaining protected today, and tomorrow.

Disclosures

  1. BMO Global Asset Management, as of December 31, 2017.
  2. “The Case for Global Small Cap Equities,” Connor, Clark & Lunn Financial Group’s Strategic Exchange.
  3. BMO Global Asset Management, as of December 31, 2017. Represents assets under management in small-cap mandates, including segregated mandates managed by BMO Global Asset Management London small-cap managers.

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