Opportunities in global small cap

In a global context, though, small cap is not that small: there are more than 1,800 companies with a market capitalization greater than US$1 billion to choose from in the index. (There are only 240 such companies in the S&P/TSX Composite Index and 111 companies in the S&P/TSX Small Cap Index.)

The largest individual stock in the global small cap index represents only 0.17% of the index. In contrast, the largest individual stock in the S&P/TSX Composite Index represents 4.25% of its index,
and the largest 15 stocks account for 43% of the index. To achieve a similar representation in a global small cap context, you would need to invest in 680 companies, which highlights the broad investment opportunity set of the global small cap universe.

The diversification benefits of global small cap go beyond individual stocks. While the major Canadian indexes are heavily skewed to the energy, materials and financials sectors (see Sector Comparison Across Indexes, below), the global small cap market provides representation across a much broader range of sectors, including higher exposure to healthcare and consumer discretionary (i.e., companies in the restaurant, luxury goods and travel industries). When Canadian plan sponsors have looked to improve diversification of their non-domestic equity investments, they have historically added a dedicated allocation to emerging market equities. The global small cap market provides similar diversification benefits relative to emerging equity markets.

Possible rewards
While global small cap represents a different opportunity set, does “different” imply a good opportunity? Consider the following three potential benefits:

Growth opportunity
The most basic premise supporting an allocation to small cap equities is that large companies start small. If you can find the next generation of small companies that will grow faster and graduate into the large cap segment, the reward can be significant. It may be hard to believe, but as recently as November 2004, Apple Inc. graduated into the MSCI U.S. Large Cap Index. Global small cap companies tend to have a more focused line of business and higher insider ownership, resulting in greater alignment of interests between owners and shareholders.

Sector opportunity
Plan sponsors can benefit from the higher consumer discretionary and healthcare sectors representation offered by the global small cap index relative to other major indexes. The spending patterns in developed and emerging markets should see the consumer discretionary sector perform well over the long term. The healthcare sector should also benefit from aging baby boomers in the developed world and from demands in emerging markets for better healthcare services.

Active opportunity
Small cap companies also tend to be less externally researched by the analyst community. As a result, active managers have a greater opportunity to outperform their index benchmark by identifying companies whose share price does not fully reflect their intrinsic value or growth prospects. For example, according to eVestment Alliance, active managers over the five years ending Dec. 31, 2010, have delivered, on average, 1.7% per annum added value over the MSCI World Small Cap Index.

Not without risk
Global small cap equities are not without their challenges, however. While active managers can mitigate some of the risks through research and careful selection of individual stocks, investors should consider the following:

Liquidity risk
It can take longer to trade small cap stocks than large cap stocks. Small cap stocks also tend to be more sensitive to changes in market sentiment (such as a change from a bullish to a bearish outlook for a particular sector), which can contribute to greater volatility.

Limited information flow
While higher insider ownership aligns with the interests of investors, it can also lead to a lack of transparency and flow of information, which is commonly found with large cap investments.

Threats from large competitors
Due to their size, small companies do not have the same access to credit markets as larger companies. This may limit a small company from realizing its potential, to the benefit of a larger competitor.

One Small Step for Investors
For plan sponsors wishing to pursue a global small cap equity investment, the process is the same as for other asset classes. The consulting community maintains databases on global small cap managers in Canada and abroad, and it adopts the same due diligence approach for researching global small cap managers as for other mandates. An important consideration, however, is to understand a portfolio team’s specific tenure with global small cap investing.

The need for growth while being ever-mindful of total portfolio risk is still at the forefront of the minds of institutional investors. Recently, they have shifted to a global focus for large cap non-domestic equity portfolios. By extending this global focus to small cap equities, they may benefit from a broader opportunity set and enhanced portfolio diversification—not to mention improved odds of beating the index benchmark.

Peter Muldowney is senior vice-president, institutional strategy, with Connor, Clark & Lunn Financial Group. pmuldowney@cclgroup.com

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