The Case for International Small-Cap

International small-cap stocks are often under-utilized in a portfolio. An allocation may offer investors the potential to generate higher absolute and risk-adjusted returns.


Executive Summary

Most investors would agree that investing in domestic small-cap stocks has become an essential element to building a well-diversified investment program. Over time, small-cap stocks have provided exposure to a segment of the equity market that has offered faster growth, good risk-adjusted returns, and relatively low correlation with larger-cap stocks and other asset classes. Yet often when investors make an allocation to the international markets they tend to ignore the substantial universe of smaller-cap stocks that are available overseas, quite possibly thinking they are getting significant small-cap exposure by investing in emerging markets.

We believe investors are missing an opportunity to further add value and increase diversification by ignoring a large segment of the international equity market. In this analysis, we show that international small-cap stocks provide the same benefits that U.S. small-cap stocks offer, along with some additional benefits. They: 

  • Substantially increase the investment opportunity set and potential for adding alpha
  • Complete the "cap range" of an international portfolio, as emerging market benchmarks derive approximately 10% of their weighting from companies with market capitalizations less than $5 Billion1
  • Have demonstrated added diversification benefits
  • Historically have provided good absolute and risk-adjusted returns, allowing investors the opportunity to enhance their portfolio return

As a result, we believe investors should reassess their allocation to international small-cap stocks, with the goal of increasing their weighting to a target of 5%-10% of their total equity allocation.2

1 Source: Factset, MSCI as of 12/31/18.
2 Investors should consider their particular circumstances and/or speak with their advisors to determine the specific allocation that is appropriate for them.

The Global Small-Cap Market

International benchmarks and investors do not have a uniform capitalization definition of small cap stocks. Some consider $2 Billion as the cutoff, while others prefer $3 or $5 Billion. One of the most popular index providers, Morgan Stanley Capital International (“MSCI”), defines small cap stocks as those that represent the bottom 10%–15% of global market capitalization. Using recent MSCI data, small cap stocks represented 12% of the global equity market, roughly split between domestic and non-U.S. stocks (as of 12/31/18). (Chart 1)

The global small cap stock universe, as measured by the MSCI All Country World Index ex USA Small Cap (“MSCI ACWI SC”) and the Russell 2000® Index, contains approximately 6,300 stocks, with roughly 4,100 of those outside the United States (as of 12/31/18). This universe represents a sizable pool of stocks for active international managers to choose from—one that has more than twice as many stocks as the U.S. small cap market. (Chart 2)

Chart 1

Global Investable Universe
Total World Equity Market Cap $74.2 Trillion

Source: Factset, MSCI, 12/31/18.

Chart 2

Characteristics (as of 12/31/18)

Source: Factset, MSCI, 12/31/18.
1 MSCI All Country World Index ex USA Small Cap (“MSCI ACWI ex USA SC”)

Even though the non-U.S. small/mid cap stock universe is large and represents 7% of the global marketplace, international small cap stocks are substantially underweighted in investors’ portfolios. According to Morningstar, international small/mid-cap stocks represent only 2% of equity mutual fund assets (Chart 3) and 2% of separate account equity assets (Chart 4), signifying investors are underweight a meaningful portion of the global capital markets. The underweight to international small cap stocks is likely attributable to one or more of the following factors:

  • Most non-U.S. exposure is concentrated in products that are benchmarked against broad international indexes, such as the MSCI EAFE® Index and the MSCI All Country World Index ex USA (“MSCI ACWI ex USA”). These indices each have less than a 1% weighting in small cap stocks (less than $2 Billion market capitalization).1
  • Investors may believe they are achieving small cap exposure by allocating assets to emerging markets. In reality, the MSCI Emerging Markets Index has less than a 1% weighting to stock with market capitalizations below $2 Billion and less than a 13% weighting to stock with a market capitalization below $5 Billion.1
  • Investors may be unaware of the opportunity or the significance of the opportunity.
  • Investors may perceive that international small cap stocks are too risky and/or do not offer compelling diversification benefits, although history does not support this perception (particularly compared with the experience of U.S. small cap stocks).

 

1 Source: Factset, MSCI as of 12/31/18.

Chart 3

Allocations in equity mutual funds

Chart 4

Allocations in equity separate accounts


Source: Morningstar, 12/31/18.
Allocations based on total assets in Morningstar categories.
Charts may not total 100% due to rounding.

Domestic and International Small-Cap Stocks Have Similar Attributes

Good Absolute Return Potential

For the last few decades, U.S. investors have been attracted to domestic small cap stocks because of their strong returns. Since its inception in early-1979, the Russell 2000® Index (U.S. Small Cap) has earned an annualized return of 11.09% (as of 12/31/18).

As shown below, international small cap (as represented by the MSCI ACWI ex USA SC) has outperformed its large cap counterpart (as represented by the MSCI ACWI ex USA) over the trailing five- and ten-year periods. Over ten years, the annualized outperformance is 345 basis points. We think the outperformance is a testament to the more fragmented, less efficient nature of international small cap markets.

Table 1
Annualized returns (%) for periods ending 12/31/18

Index 1 Year
3 year
5 Year
10 year
MSCI ACWI ex USA SC -18.20 3.82 1.96 10.02
MSCI ACWI ex USA -14.20 4.48 0.68 6.57
Russell 1000® Index -4.78 9.09 8.21 13.28
Russell 2000® Index -11.01 7.36 4.41 11.97

Source: FactSet. Past performance is no guarantee of future results.

Good Risk-Adjusted Returns

Not only do non-U.S. small cap stocks offer good absolute return potential, historically over five- and ten-year periods, they have offered risk-adjusted returns better than those of large cap international stocks. Table 2 highlights Sharpe ratios for these same indices.1

Another interesting characteristic of the small cap stock universe, is that neither the Russell 2000® Index nor the MSCI ACWI ex USA SC have generated a negative 10-year return since their respective inception dates (based on rolling ten-year returns). Conversely, the Russell 1000® Index has done so 6.5% of the time since 1979.

Table 2
Sharpe ratios for periods ending 12/31/18

Index 3 year
5 Year
10 year
MSCI ACWI ex USA SC 0.23 0.11 0.57
MSCI ACWI ex USA 0.31 0.01 0.38
Russell 1000® 0.74 0.70 0.94
Russell 2000® 0.40 0.25 0.63

Source: Factset. Past performance is no guarantee of future results.
1
Sharpe ratio is a measure of risk-adjusted return that compares excess return above a risk-free rate to standard deviation. Standard deviation is used as a measure of an investment’s volatility.

Attractive Alpha Potential for Active Managers

As we’ve seen, the global small cap stock universe includes approximately 6,300 stocks, dwarfing the large cap market, which consists of approximately 3,000 stocks (as of 12/31/18). As a result, active managers have the opportunity to construct unique investment portfolios that may differ significantly from their funds’ benchmarks. The investment universe of almost 4,100 non-U.S. small cap stocks should allow active small cap international managers greater diversification potential and flexibility in portfolio construction.

Small cap stocks also offer investment managers an opportunity to exploit a less-covered segment of the capital markets. Since large cap stocks have significant Wall Street coverage and have become increasingly efficient, the ability to add value in this space is restricted. In the small cap universe, however, only five analysts, on average, cover each MSCI ACWI ex USA SC stock. This compares with an average of eight analysts for MSCI ACWI ex USA stocks and 16 analysts for the stocks in the Russell 1000® Index.2 More than 17% (or 737 companies) in the Index have no analyst coverage.2 This dearth of coverage provides active small cap managers an opportunity to exploit mispricings before they are recognized by others. Additionally, the majority of active managers have shown the ability to achieve even stronger returns than the Index.

  • 737 out of 4,148 companies in MSCI ACWI ex USA SC have no analyst coverage  

2 Source: Factset, MSCI as of 12/31/18.

Chart 5
Average analyst coverage

Source: FactSet, as of 12/31/18.

Comparable Correlation Benefits

In addition to good historical long-term returns and strong alpha potential, international small cap stocks also provide good diversification when paired with other broad market indexes. Since the inception of the MSCI ACWI ex USA SC in January 2009 to December 2018, it has produced a correlation coefficient of +0.83 with the Russell 1000® Index, +0.75 with the Russell 2000® Index and +0.06 with the Bloomberg Barclays U.S. Aggregate Bond Index. Over the same time period, the Russell 2000® Index produced a correlation of +0.91 with Russell 1000® Index and -0.14 with the Bloomberg Barclays U.S. Aggregate Bond Index. Just as lower correlation may be a benefit to U.S. small cap investors, international small cap offers similar diversification advantages to a portfolio. (Table 3)

Similar Risk Profile

Some investors may perceive international small cap stocks to be more risky than their U.S. small cap counterparts. Certainly, this segment shares the same types of risks, such as currency and political risk, with all the international markets. International small cap stocks may be somewhat more vulnerable to political risk, because their performance is often more closely aligned with the economy of their home country than is the performance of large multinational corporations. Nevertheless, some political risk is associated with all non-U.S. investments. We believe diversification and proven management skill are the best ways to manage political risk.

Liquidity is another perceived risk. As is the case when investing in U.S. small cap equities, investors need to be proactive in managing liquidity and capacity. This makes it imperative that active portfolio managers diligently oversee their investment portfolios to ensure adequate liquidity.

Another perception is that international small cap stocks have significantly higher volatility than other segments. This is partly true because non-U.S. small cap stocks do have higher standard deviations than large cap stocks (both U.S. and non-U.S.). Their standard deviation, however, is essentially comparable to that of U.S. small cap stock, particularly over longer time periods. (Table 4) Some also consider non-U.S. small cap stocks to be a “low-quality” segment of the global equity markets. As a result, it is perceived to be inherently more risky. The reality is that international small cap stocks have better quality statistics than domestic small cap stocks. (Table 5)

Whether viewing ROE, ROA or debt ratios, non-U.S. small cap equities look very attractive when compared with U.S. small cap equities.

Table 3
Correlations Based on monthly returns: 07/2008 to 12/2018

Index MSCI ACWI ex US SC
MSCI ACWI ex US
Russell 1000® Russell 2000® Bloomberg Barclays U.S.
Aggregate
MSCI ACWI ex USA SC 1.00 0.97 0.83 0.75 0.06
MSCI ACWI ex USA 0.97 1.00 0.87 0.75 0.05
Russell 1000® 0.83 0.87 1.00 0.91 -0.06
Russell 2000® 0.75 0.75 0.91 1.00 -0.14
Bloomberg Barclays U.S. Aggregate 0.06 0.05 -0.06 -0.14 1.00

Source: FactSet. Past performance is no guarantee of future results.

Table 4
Standard deviation for periods ending 12/31/18

Index 3 Year
5 Year
10 Year
MSCI ACWI ex USA SC 12.34 11.78 16.94
MSCI ACWI ex USA 11.38 11.82 16.31
Russell 1000® Index 10.95 10.91 13.70
Russell 2000® Index 15.79 15.30 18.36

Source: FactSet. Past performance is no guarantee of future results.

Table 5

Characteristic (as of 06/30/18) MSCI ACWIxUS SC Russell 2000® Index
Forward EPS Growth* 12.6 15.0
ROE 12.1 6.1
ROA 6.3 1.0
LT Debt / Capital 24.3 33.1
P/E Ratio (weighted harmonic average)2 13.1 14.3
Dividend Yield (%) 2.9 1.6

Source: Factset, MSCI, Russell. Past performance is no guarantee of future results.
* Estimated 3 to 5 year forward EPS growth.
** Estimated using FY1 (current forecast year).

Forward earnings per share (EPS) growth—Growth of forecasted, or estimated, portion of a company’s profit allocation to each outstanding share of common stock.
Return on Equity (ROE)—The amount of net income returned as a percentage of shareholders equity.
Return on Assets (ROA)—An indicator of how profitable a company is relative to its total assets. Calculated by dividing a company’s annual earnings by its total assets.
Long-term debt-to-capital ratio—A measurement of a company’s financial leverage, calculated as the company’s long-term debt divided by its total capital.
Price to Earnings ratio (P/E ratio)—A ratio for valuing a company that measures its current share price relative to its per-share earnings.
Dividend Yield—A ratio that indicates how much a company pays out in dividends each year relative to its share price.

The Potential Advantages of International Small-Cap Over U.S. Small-Cap

Faster Growth Potential

U.S. and international small-cap stocks have many positive similarities that may benefit investors. However, international small-cap stocks are distinct from U.S. small-cap stocks in several ways. First, international small-cap stocks offer exposure to faster growth outside the U.S. Over the coming years, many analysts are anticipating that non-U.S. economic growth will exceed U.S. economic growth. The International Monetary Fund predicts U.S. gross domestic product (“GDP”) will grow at an annualized rate of 2.1% over the next five years. Conversely, the 45 countries represented in the MSCI ACWI ex USA SC Index have an average expected GDP growth rate of 2.6%, with more than half expected to generate higher growth than the U.S. over the next five years.1

More Opportunity for Active Managers to Outperform

Another advantage that international small cap stocks have over U.S. small cap stocks is the size and diversity of the universe, and the ability of active managers to potentially take advantage of this breadth. The international small cap investment universe is much larger than the U.S. small cap space. It includes over 4,100 stocks across 46 countries, while the U.S. small cap segment only includes approximately 2,000 stocks—all located in one country.

Summary

International small-cap stocks may provide a meaningful enhancement to an already diversified global equity portfolio. An allocation to international small-cap stocks offers:

  • Good historical risk-adjusted returns
  • Exposure to faster growth outside the U.S. (based on predicted GDP growth)
  • Potentially enhanced diversification
  • Considerable alpha potential for active managers to capture
  • Characteristics similar to domestic small-cap stocks

Investors should reexamine their current allocation to determine how much international small cap stocks exposure they have truly gained via their other international equity holdings. Industry data would suggest that most investors are currently underweight international small cap stocks relative to the percentage international small cap stocks represent in the global equity market (see Charts 1 and 3 on pages 2 and 3). We believe a reasonable objective is to allocate 5%–10% of the total equity portion of a portfolio to international small cap stocks. Investors who already invest in U.S. small cap stocks are likely comfortable with the risks associated with international small cap stocks, and allocating to international small cap stocks may be a logical next step. An allocation to international small cap stocks may offer investors the potential to generate higher absolute and risk-adjusted returns.

1 IMF World Economic Outlook database—Report date: April 2017.

The views expressed constitute the firm’s judgment as of December, 31, 2018, and are subject to change based on market, economic or other conditions. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. All data referenced is from sources deemed to be reliable but cannot be guaranteed as to accuracy or completeness.

All investments are subject to risk including possible loss of principal.
Investments in small capitalization companies are subject to risks such as erratic earnings patterns, competitive conditions, limited earnings history and a reliance on one or a limited number of products.

Investments in international securities are subject to certain risks of overseas investing including currency fluctuations and changes in political and economic conditions, which could result in significant market fluctuations. These risks are magnified in emerging markets.
Diversification does not guarantee a profit or protect against a loss in declining markets.

The MSCI All Country World Index ex-USA Small Cap covers all investable small cap securities with a market capitalization below that of the companies in the MSCI Standard Indices (excluding USA), and targets approximately 14% of each market’s free-float adjusted market capitalization.

The MSCI All Country World Index ex USA is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The index consisted of 44 country indices comprising 23 developed and 21 emerging market country indices. 

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI EAFE Index consists of 22 developed market country indices.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of 21 emerging market country indices.

Please go to msci.com for most current list of countries represented by the MSCI indices. 

All MSCI data is provided ‘as is’. The products described herein are not sponsored or endorsed and have not been reviewed or passed on by MSCI. In no event shall MSCI, its affiliates, or any MSCI data provider have any liability of any kind in connection with the MSCI data or the products described herein. Copying  or redistributing the MSCI data is strictly prohibited.

The Russell 2000® Index is composed of the 2000 smallest stocks in the Russell 3000® Index and is widely regarded in the industry as the premier measure of small cap stock performance.

The Russell 1000® Index measures the performance of approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 92% of the U.S. market.

The Russell 2000 and 1000 Indices are trademarks of the London Stock Exchange Group companies.

The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.

Indices are unmanaged, are not available for investment, and do not incur expenses.

AMG Funds, a member of FINRA/SIPC.

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