The Opportunity For Global Small Caps
The opportunity for smaller companies is a hot topic amongst investors at the moment. Smaller companies are often in the early stage of their corporate life cycle and can offer potential for above market growth. Further, they are typically less researched and offer potential for a valuation uplift as investors come to appreciate their business models. In this monthly note we compare the opportunity for Australian smaller companies compared to Global smaller companies.
Global Small Caps Outperform Australian Small Caps
In the last 22+ years, Global smaller companies have outshone Australian smaller companies. Figure 2 provides some key statistics. The MSCI World Small Caps Index has generated 8.39% p.a. and has outperformed the Australian smaller companies index by +2.90% p.a. and outperformed the MSCI World Index by 2.16% p.a. The Global small cap index has been associated with the highest earnings growth of 5.9% and lower volatility. In contrast, Australian smaller companies have delivered the lowest annualised returns, negative earnings growth (-1.3%) and been the most volatile.
Figure 2: Global Small Caps Outperforms Australian Small Caps With Higher Growth And Lower Volatility
| Return p.a. | Volatility p.a. | Beta | Earnings Growth p.a. | Dividend Yield (Median) | |
| MSCI World Small Cap Index | 8.39% | 17% | 1.09 | 5.9% | 2.2 |
| MSCI World Index | 6.22% | 15% | 1 | 5.2% | 2.6 |
| S&P/ASX 100 Index | 8.21% | 13% | 1 | 4.1% | 4.6 |
| S&P/ASX Small Ordinaries Index | 5.48% | 18% | 1.15 | -1.3% | 3.8 |
Source: FactSet, State Street Global Advisors from 31 January 2001 to 31 August 2023. Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Valuations Support Global Smaller Companies
Figure 3 provides a perspective on the relative valuation multiples for large and small companies, both overseas and in Australia. The key observation is global smaller companies are cheapest in absolute terms, and relative to history. Since 2001, global smaller companies are trading on a multiple of 15.3x well below historical averages at the 31st percentile. Compare this to the MSCI World Index trading at 16.8x or the 83rd percentile. Australian smaller companies are in fact the most expensive sitting at the 90th percentile since 2001.
Figure 3: Global Small Caps Offer The Greatest Valuation Opportunity, Australian Small Caps The Least
| Price Earnings (Current NTM) | Price Earnings Percentile since 2001 | |
| MSCI World Small Cap Index | 15.3 | 31% |
| MSCI World Index | 16.8 | 83% |
| S&P/ASX 100 Index | 15.6 | 70% |
| S&P/ASX Small Ordinaries Index | 18.4 | 90% |
Source: FactSet, State Street Global Advisors from 31 January 2001 to 31 August 2023. Past performance is not a reliable indicator of future performance. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Active Management Can Benefit From Larger Breadth
The MSCI World Small Cap Index has 4,313 constituents, compared to the S&P/ASX Small Ordinaries Index with only 198 constituents as at 31 August 2023. This is important as the opportunity for active portfolio management is greater in larger universes. A fundamental principle in active management implies that an active managers ability to generate risk adjusted excess returns (information ratio), is directly related to their stock picking ability (no surprise there) but also directly proportional to the number of independent active positions (perhaps some surprise here). The number of independent active positions is often referred to as breadth, and can be approximated by the square root of the number of independent positions. The formula for information ratio is described below:
Information Ratio α Information Coefficient x Breadth
Where:
- Information ratio is a measure of risk adjusted excess return
- Information coefficient = stock picking ability
- Breadth = the √number of independent positions or(√n)
Figure 4 highlights the potential for higher information ratio with larger breadth. For a constant level of stock picking ability, the risk adjusted excess return is expected to improve significantly with larger universes that offer larger breadth.
Figure 4: Theoretical Information Ratios At Various Levels Of Market Breadth
| Number of Independent Active Positions | |||
| 300 | 1,500 | 3,000 | |
| Information Ratio | 1.0 | 2.3 | 3.3 |
Source: State Street Global Advisors. A constant information coefficient of 6% is assumed. The information contained above is for illustrative purposes only.
The Bottom Line
Since 2001, global smaller companies have outperformed Australian smaller companies while also delivering higher growth with less volatility. Currently, global smaller companies also offer better absolute and relative value. A variety of approaches are available for investors to access opportunities in global smaller companies, including active management which should benefit from the larger breadth found in this universe.