Investors remain wary of volatility, says GSAM’s Farrell
Aidan Farrell, lead portfolio manager of the International Small Cap Equity strategy GSAM, looks at the opportunities and the risks ahead for the sector.
We’ve come through a period of historic volatility over the last five years, and as we look into the second half of 2013 and beyond, we are, as always, pondering the opportunities and risks that lie ahead. In today’s environment, many investors are scouring global markets for sources of growth and return, both scarce factors as the world gradually recovers from the financial crisis. Despite uneasy sentiment, the equity markets have been strong over the last few years, albeit not an even pace around the world or across the market cap spectrum. The US market has been particularly strong for returns and flows, reflective of its relative economic strength. However, investors remain wary of perceived areas of volatility, including more cyclical asset classes. The global small cap universe, with its growth potential and associated volatility, appears to sit at the nexus of today’s struggle for returns in the context of risk.
In reality, since mid-2007, small caps have fared no worse, and in some regions better, than large caps during one of the most volatile periods for global equity markets in decades. For the six-year period from 30-June-2007 to 30-June-2013, global small caps posted an annualized return of 2.4% with annualized volatility of 22.7%; global large caps returned 0.3% with 20.0% volatility over the same time period . If we take a wider view than the crisis and post-crisis era and examine long-term risk-adjusted returns, the outcome is even more pronounced; global small caps have had significantly stronger returns and risk-adjusted returns than large cap peers.
While historically strong risk-adjusted returns are one of the reasons many investors are attracted to global small caps, the inefficiency of this asset class relative to large caps creates even greater opportunity. The inefficiency begins with the sheer breadth of the universe. The global small cap universe is comprised of over 6000 stocks, with approximately two-thirds of those companies located outside the US . The vast reach of this universe, replete with dozens of niche subsectors, has also led to more sparse research coverage. For example, by some estimates, international large cap companies are on average covered by more than double the number of research analysts than international small cap companies . The structure of the universe and its coverage create inherent inefficiency, and the nature of small cap returns also makes for a favorable stock-picking environment. Compared to large cap returns, small cap performance tends to be driven more by stock-specific risk than macro factors or market risk, a point made all the more resonant as macro headlines continue to sway global markets on a daily basis. The chart below highlights this finding, with stock-specific factors driving approximately 80% of the small cap return profile versus roughly 65-70% for large cap returns (shown as percentage of cross-sectional volatility of returns from stock-specific factors).
Ultimately, the combination of a large universe with heightened stock-specific risk and sparse research coverage generates a wider dispersion of results for small caps versus large caps: in other words, a stock-picker’s dream. As depicted in the chart below, the dispersion of five-year trailing earnings growth is wider for global small caps (on the right) than for global large caps (on the left). Assuming they identify businesses near the top of the earnings growth spectrum and/or avoid businesses at the opposite end, global small cap managers can potentially generate significant returns (and can conversely generate significant losses if they get it wrong). The global small cap space is a structurally fertile hunting ground for active managers.
So, how do we assess stock-level opportunity in today’s market? As we search for investment candidates in the context of a more cyclical universe, and against the backdrop of a grudging global recovery, we focus on secular growth. We are looking for businesses that demonstrate structural growth versus their peer group through the cycle, so that, even in a crisis environment, they are still taking market share. We find these kinds of companies across a diverse array of sectors and regions, but they typically exhibit several common traits. Critically, they offer some kind of differentiated product or service that distinguishes their business from peers. Differentiation without “defendability,” however, is not attractive to us. We look for significant barriers to entry, so the advantage of differentiation can drive sustainable future earnings. Because we are looking for secular growth, the businesses we favor will by definition operate in scalable markets. Without the runway for growth, a small cap company, even a good one, will remain a small cap. Lastly, and certainly not least, we test the credibility of management teams by evaluating their track records and meeting with them regularly. In the wrong hands, even a good business model in a growing market can be a poor investment.
We look for the same kinds of qualitative factors in individual businesses across various market environments; the prices we pay for these stocks are, of course, changing constantly. Entry points are important, especially in a more cyclical market, but in our view, there isn’t one specific right time to invest in global small caps. Given the long-term risk/return benefits, the potential for portfolio diversification and the general underweight to small caps held by global investors today, we think this asset class holds significant potential.