Small caps —Taking off the home-bias blinders

Considering only domestic small-cap equities could limit an investor’s ability to capitalize on global growth themes. But international small caps may provide unique access to these themes.

In terms of the number of companies, the small-cap equity universe dwarfs its large-cap equivalent (Chart 1). However, we think that even the investors who recognize the potential of small-cap equities may be overlooking international small caps.

Chart 1: The small-cap universe is more than twice the size of large cap

Source: MSCI, as of November 30, 2021.

Small caps are represented by the MSCI ACWI Small Cap Index. Large caps are represented by the MSCI ACWI Index. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Our research tells us that small caps could be a great way to invest in less-well-known companies benefitting from some of the biggest global trends, such as digitization, the energy transition and aging populations.

These shifts affect all asset classes, but we’ve argued that these global themes strongly support international smaller companies, which fall on different areas of the supply chain than their larger peers. For example, South Korea is home to small-cap companies that supply crucial components of electric vehicle (EV) batteries. These types of companies occupy an attractive place in the supply chain, with multiple customers, so they’re less exposed to the fortunes of a single auto brand.

However, there are also growth themes specific to international small-cap equities that warrant a closer look from small-cap investors with a domestic bias.

Luxury brands

Luxury companies could be a worthwhile consideration for an investment portfolio because they produce high-quality products that in many cases have stood the tests of time. Demand persists for luxury brand names because they’re exclusive and relay status, which gives these companies pricing power with consumers. As middle classes in emerging markets have grown and the global population has become wealthier, demand for luxury goods has increased. We expect this trend to continue.

Yet none of the old, storied luxury companies are based in the US. Most of the biggest names, including LVMH, Hermes, Ferrari, etc., are based in Europe. But there are other smaller luxury companies (perhaps with less household name recognition) in Europe, too. Many of these have used their heritage as artisanal manufacturers to constrain supply, thus increasing the desirability of their products – and thereby building extremely strong moats around their brands.

These brands often are based on sustainable sourcing techniques and eco-friendly business practices. This focus on “humanistic capitalism” is a competitive differentiator, as more and more consumers become preoccupied with companies that have an eco-conscience, meaning luxury brands with focus on these areas have room to grow.

Just as there’s a consumer appetite for the big-name luxury brands, there may be for these smaller ones, too. And consumer appetite can translate into company earnings and investment potential.

Research and development expertise

Europe and Asia are hubs for technological and pharmaceutical research and development (R&D). On the tech side, many non-US companies are vital players in the supply chain for the semiconductor ecosystem. Semiconductors are an integral component of electronic devices ranging from an iPhone to an electric vehicle. Semiconductors are at the source of innovations around the globe, yet much of their supply chain is located in Europe and Asia rather than the US.

Meanwhile in terms of pharmaceutical R&D, these regions are home to companies that have been important contributors to Covid vaccine development. There are also firms outside of the US committed to, for example, providing the systems used in the development of biological pharmaceuticals — a key part of existing and future drug development.

This is a promising growth area of the market because as quality of life around the globe increases in tandem with average household wealth, demands for better, more affordable healthcare are likely to increase. Cutting-edge pharmaceuticals that reduce consumer costs could play an important role in improved healthcare and smaller-companies that enable those developments may be poised for durable, long-term growth.

Emerging middle classes

Investors willing to look abroad for small-cap exposure may want to consider emerging markets (EMs), where middle classes are growing. This means that more people in these areas are enjoying newfound spending power and have aspirational lifestyles.

These markets are in much earlier stages of growth than the US or EU countries, which means there are unique investment opportunities. For example, there’s ongoing opportunity in these regions to increase formal retail market space, which isn’t necessarily something you see in developed nations where the retail market is saturated, and competitive intensity is higher. Smaller retail companies have more room to grow in these EMs.

Retail isn’t the only sector where EMs present small-cap opportunities. Middle-class growth in developing nations translates into demand for more education. In countries like Brazil, where upskilling and reskilling are key elements of future growth, small-cap education companies may have space to grow and succeed. Trends toward better education are likely to continue, too, well past the early stages of middle-class growth.

Sustainability focus can lead to lower stock-specific risk

While sustainability is a focus across all small caps, we think that there are unique opportunities to capitalize on this theme in international small caps. The US is behind the EU, the UK and parts of Asia in terms of reporting on environmental impact. This speaks to the fact that other regions have a better-established and longer-term view about sustainability and their businesses.

While companies touting sustainable business practices could see growth in the US as this trend takes firmer hold, European and Asian small caps that support sustainability – for example, environmental waste management companies – may present high-quality investment opportunities today.

Unique themes, unique opportunities?

In our view, home-country bias could be blinding US small-cap investors to these themes, unique to international small caps. If US investors open their eyes to what lies beyond their own borders, they may see potential in international small caps to capitalize on growing market trends, generate potentially attractive returns and improve diversification alongside existing large-cap and US small-cap allocations.

IMPORTANT INFORMATION

Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.

Foreign securities are more volatile, harder to price and less liquid than US securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.

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RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.