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Where the growth opportunities are with small and mid caps

By Ned Bell · April 26 2019
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Ned Bell
Where the growth opportunities are with small and mid caps

Where the growth opportunities are with small and mid caps

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By Ned Bell · April 26 2019
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egg
egg
egg
Ned Bell

Australian investors looking to use fresh capital or shake-up their portfolio would be well placed to consider alternative sub-asset classes to sustain growth for the rest of 2019.

The unfortunate reality is that we are in the very late stages of what has been an incredibly long bull market in equities. The multitude of risks in global markets are there for all of us to see and as investors, we are staring down a softer global economic backdrop and quite possibly a period of softening earnings.

Going for growth

For investors that were contemplating changes in their global equity portfolios in Q3 2018 but did not act – the year-to-date rally could prove to be a very timely opportunity to take some profit off the table and make some changes to sub allocations within global equity portfolios.

We would argue that changes to the “growth” component of a global equity allocation now could prove to be very pertinent. Simplistically, many large global portfolios “growth exposure” could be categorised into three buckets – 1. Large Cap Growth, 2. Emerging Markets, and 3. Global Small Caps.

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Large Cap Growth

Large Cap Growth has been the stellar performer in most portfolios for several years. Growth stocks have now become very expensive and if we do head into a period of slowing earnings, large cap growth stocks are particularly vulnerable to the ‘double whammy’ of earnings downgrades and multiple compression.

The fact that such stocks are so widely held by all forms of active and passive investment strategies arguably exacerbates the risk of drawdowns in such names. In summary, large and mega caps have been an amazing contributor to portfolio returns over several years but now could be a very good time to consider restructuring this growth component.

Emerging Markets

Emerging Markets has arguably also played a ‘growth role’ in most global portfolios for many years. While the long-term performance of EM has been very good, as an asset class it has been susceptible to quite sharp drawdowns (absolute and relative) when markets have retraced.

Thanks to a stellar 2017 for EM, over the three years to February 2019, the asset class has outperformed by 2.4 per cent annually. Having said that, the asset class is not without risk and as it becomes increasingly dominated by Chinese equities – the obvious geopolitical risks that we read about daily will continue to weigh on sentiment.

Global Small Caps

Global Small Caps is another ‘growth’ player in global portfolios that has outperformed over a long period of time. Liquidity and implementation issues seem to be the two interconnected issues that prevent asset allocators from making bigger allocations. In other words, there is a scarcity of managers who can manage reasonable assets in the Global Small Cap asset class.

In our view, much of the problem can be directed at the way the benchmark is constructed. According to the MSCI methodology, the Small Cap index has 4,344 constituents with an average market cap of $1.387 billion, compared with the MSCI World Index average market cap of $24.3 billion.

We would also make a broader observation that Small Cap stocks – because of the liquidity issues – can, in some cases, be vulnerable to periods of market volatility.

The little-known growth options

Global SMID Cap stocks are probably the least well-known or used of the aforementioned growth options used within global portfolios.

Companies such as Danish medical manufacturer Ambu, a cloud networking software company Arista and Partners Group, a Swiss Alternative Asset Management firm all sit within the stock picks for Global SMID.

Over 20 years, SMID cap stocks have outperformed all other sub asset classes in global equities and have better downside protection characteristics than their other growth comparables. We believe that they should play an important growth role in Global portfolios.

They have less valuation risk than large cap growth, less absolute risk than emerging markets and less liquidity risk than small caps.

From a timing perspective, we would argue that an allocation to Global SMID makes sense now. Over the last 5 years, Global SMID has lagged MSCI World by 0.81 per cent annually – which is not surprising given the mega cap-driven bull market we have been through.

Opportunity on the horizon

While it may seem somewhat counterintuitive, we feel that SMID Cap earnings as a whole will actually hold up better in what could be a softer earnings period for global equities.

The companies, by their very nature, tend to be more domestic-orientated and therefore less vulnerable to the various geopolitical issues – trade wars, Brexit etc – that can weigh on the mega cap global companies with geographically diversified earnings streams.

And as we move into a more volatile economic environment, we can see these large and mega caps looking vulnerable and we would argue that an allocation to Global SMID at these levels makes sense.

Ned Bell, chief investment officer at Bell Asset Management

 

 

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