Investors often overlook international small-cap stocks. However, we believe that there are compelling reasons to consider international small caps now, as markets face major thematic shifts: aging populations, the energy transition and an ever-more digital world. These trends are here to stay and international smaller companies help investors capitalize on market disruptions.

Don’t overlook international

The largest companies in the U.S. are so big that they’re more difficult to manage. ”Jack-of-all-trades” mega companies aren’t likely to be as nimble as small, niche companies that populate the small-cap universe. Larger companies may have a more difficult time identifying emerging trends and risk becoming outdated. Smaller companies, precisely because of their size, are able to pivot more effectively in the face of changing markets.

We believe that international small caps could strongly complement domestic holdings both large and small. This asset class isn’t as well understood, so there’s opportunity for active managers to find good companies flying under the radar.

International small caps are geared toward their local markets, so they’re exposed to different markets and earnings streams than U.S. companies. This means they could help diversify investment portfolios.

Furthermore, international small caps tend to have lower analyst coverage than their US peers (Chart 1). With fewer analysts scouring the market, the international small-cap space may be ripe with compelling, overlooked investment opportunities.

Average Analyst Coverage

Source: ASI, FactSet, June 30, 2021. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

We consider international small caps today against the backdrop of a shifting, changing world. Disruptions are many and are occurring across several markets. If investors want to prepare their portfolios for the challenges and opportunities that these disruptions can create, they may wish to keep in mind these three key themes that may influence equity markets today and tomorrow.

1. Demographic shift

Thanks to improving healthcare and lower infant mortality rates, the world population has skyrocketed since the 1950s, from 2.2 billion then to about 7.7 billion now.1 

But the global population isn’t just getting bigger — it’s getting older. In 2018, for the first time in history, there were more people older than 64 than there were children under four.2 This trend is very much underway in higher-income countries with lower fertility rates and increased life expectancies. Lower-income countries with higher fertility rates and lower life expectancies aren’t yet experiencing this trend. But, globally, we expect the number of children under five to peak and plateau in this century.3 

In the countries for which populations are already trending older (e.g., Japan, U.S., Sweden, etc.), the workforce has changed and will continue to change. With more older individuals aging out of the labor force and living for longer once they do, the ratio of working people supporting nonworking people decreases. This could hamper economic growth, unless the average retirement age increases. Aging populations may also shift demand for goods and services. An older population could cause demand for various products and services in the healthcare sector, for example, to increase.

Meanwhile, in lower-income countries (e.g., Brazil and Indonesia), there’s the potential for the proportion of productive, employed adults in the labor market to increase and fertility rates drop and life expectancies increase. This could support economic growth.

As these countries develop and the quality of life improves, not only will their labor forces change, but also their total wealth. We expect the middle class to grow in many emerging and frontier markets over the next several decades. As greater swaths of the global population accumulate more disposable income, the appetite for goods and services increases. These countries could see a rise in demand for leisure-related services or higher-quality goods, for example. They may also seek higher or extra-curricular educational services.

2. Demand for sustainability

As the climate crisis has become more dire, demand for sustainable practices has skyrocketed. This creates massive opportunities in various sectors.

Consumers and investors increasingly want products, services and practices that provide environmentally friendly solutions. The relatively newfound popularity of electric vehicles (EVs) speaks to this theme. Consider that certain EV manufacturers are household names — this wasn’t the case even in the early 2010s. While there are still relatively few EVs on the road compared to internal combustion engine vehicles, this marketplace will become more and more competitive in the coming years, driving demand through the supply chain for materials companies and manufacturers.

We also see this desire driving consumer taste toward ethically sourced products in the consumer discretionary and consumer staples sectors, as people are increasingly conscious of their environmental footprints.

In a similar vein, we see compelling opportunities in several niche industrial businesses that provide solutions to environmental issues, including companies that reduce water consumption and chemical usage, as well as provide renewable sources of power.

3. Going digital

The world was already becoming more digitized well before the pandemic. But during lockdowns, as more and more companies shifted toward work-from-home models and commerce moved almost entirely to online platforms, this trend accelerated.

This transition is creating new business models. For example, in the finance and consumer sectors, many companies have shifted toward cloud-based internet services and enabled remote working. The more people and businesses rely on their devices and the internet, the more opportunities open within the digital world.

For example, semiconductors are in higher demand as more people rely on their physical technology to get their jobs done from home. Cybersecurity is another example of a space where new opportunities are opening all the time. Working from home requires more robust, less centralized cybersecurity and providers are rising to the challenge.

Applying these themes to an international small-cap allocation
International small caps can provide investors with exposure to these trends through nimble, lesser-known companies that could help generate long-term value.

International small caps can provide investors with exposure to these trends through nimble, lesser-known companies that could help generate long-term value.

When contemplating the future of an aging population, why not consider small, focused clinical research and trials firms rather than behemoth pharmaceutical companies, for example? Both account for the potential increased demand for healthcare services. But smaller companies may have the potential to grow much more than their already very large peers.

Or, in the case of the growing middle classes in developing countries, investors may do well not to focus solely on big-box stores that dominate the large-cap universe. Instead or in addition, they may wish to consider the opportunities the smaller brands that supply these stores offer. Local education companies, such as medical training programs or college operators, could also benefit from a bigger middle class.

The renewables space is replete with investment opportunities among companies large and small. But why put all your eggs in the proverbial basket of a single EV manufacturer without at least considering the investment opportunities among the companies that supply the EV industry? The same goes for clean energy firms.

Within the digital sphere, there are several small software firms, data-gathering services and cybersecurity companies dotting the international small-cap landscape. Companies such as these may be poised to capitalize on trends toward digitization, with much more room to grow than tech giants.

These trends in demographics, sustainability and digitization are underway and picking up speed. And we believe that there are myriad high-quality international smaller companies well positioned to grow in tandem with these themes. This creates opportunity for active managers to find long-term growth potential for investors. In this case, keeping up with trends could mean creating value.