The opportunity for active management
Adding value through fundamental analysis in a large, under-researched universe
Where are the opportunities for active managers to add value when investing in smaller companies? How does this differ from their peers investing in larger companies? And how is the rise of passive and quant investing changing the picture?
Larger universe + fewer analysts = greater opportunity for active managers
There are fewer investment banking analysts per company for smaller companies than for large. This is due to the combination of a larger number of companies and their lower market capitalisation. Lower capitalisation means lower share turnover, which translates into lower revenue for the investment bankers. For the US market, which represents nearly half of the MSCI AC World Smaller Companies Index, there are 23 analysts covering large-cap companies on average compared to seven for small-caps1.
A Numis study of the UK market found that broker recommendations on small-cap stocks added value (except for stocks with just one recommendation)2. By contrast, this was not the case for large-cap stocks.
The stocks of smaller companies also have a wider range of investment outcomes, from best to worst performer. 26% of the stocks in the MSCI AC World Smaller Companies Index generated positive returns of over 50% in 2017 compared to 17% for the MSCI AC World Index3. 0.5% of the smaller companies index (70 stocks) saw negative returns of greater than 50%, compared to just 0.02% (five stocks) of large and mid-cap stocks. This reflects a wider range of fundamental outcomes. Smaller companies have more scope to grow, but also include a higher proportion of loss-makers: 16% for the MSCI AC World Smaller Companies Index versus 7% for the MSCI AC World Index in 2017.
Rising role of passive investors
The shift in assets from active to passive management has been a pervasive theme among large-cap portfolios, but is increasingly true for small-caps too. Smart beta products driven by quantitative models are growing. So too are macro managers, who buy and sell index products to implement their trading views. This means that a growing proportion of the market is held by managers who do not analyse individual companies. This increases the scope for stock-pickers to add value.
The cost of gathering and processing data has fallen while the number of investment professionals with quantitative skills has risen. Academic research can be rapidly turned into investment practice. However, anomalies that can be exploited by fundamental analysis persist among smaller companies due to higher trading costs and limited scope to implement short positions.
Few investors treat global smaller companies as a separate investment opportunity. Smaller companies funds make up just 2.5% of the Morningstar universe of global equity funds, large and small4. Yet smaller companies make up 14% of the MSCI All Country World IMI Index. What’s more, 33% of these small-cap funds are passively managed compared to 17% for large-cap.
Wide range of risks = wide range of opportunities
Extracting value from a large universe of global stocks requires a disciplined investment process. Some form of quantitative screening is a necessary first step in assessing over 6,000 companies, whether the subsequent decisions are based on judgement, quantitative analysis or a combination of the two.
The small-cap premium is not the only style premium available to investors in smaller companies. Value, quality, momentum and low-volatility strategies have also delivered long-term premiums, but also with significant periods of underperformance. For example, value has lagged even on a decade-long view.
Investors also need to be aware of country, industry and currency risks, whether they are actively targeted or a by-product of their stock selection process.
The dominant risk – and opportunity – in a smaller companies portfolio is stock-specific risk. A quantitative screen can highlight where to look for these opportunities but fundamental analysis provides investors with a deeper understanding. Portfolio managers who meet with company management teams can assess those aspects of investment that are hard to quantify, such as corporate strategy and environmental, social and governance (ESG) risks. ESG analysis is not only a necessary step in understanding risk, but also allows investors to encourage companies to change their behaviour. And it provides scope for investors to profit from changes to ESG ratings.
In conclusion, smaller companies are too big a portion of the global investment universe to ignore. They offer a return premium for long-term investors. They bring diversification benefits through exposure to different risks. And the combination of a large universe, fewer analysts and a growing portion of passive investors provides scope for active managers to add value above the index return.
1 Bloomberg, 2016
2 Professors Scott Evans, Paul Marsh and Elroy Dimson, Numis Smaller Companies Index 2018 Annual Review
4 Morningstar Direct as at 31/12/2017. Universe of funds in EAA sectors.
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