The alpha generating capability of actively managed global small companies is set to soar after a crisis.
Small caps tend to outperform large caps over time. Global small caps have generated almost 7 percent a year return over the last 20 years, while global large caps have only returned about 3.5 percent. In saying that this has not been true over the last two to three years, with large caps actually outperforming small caps. That sets up small caps for a reversion, outperformance in the next three to five years, which is also a typical small cap response to most crises.
The small cap space not only offers active managers a fantastic opportunity to outperform the index over time, but also allows many investors to participate in what is a higher return space over a long period of time, and allows for better portfolio diversification.
But, it’s greatest characteristics are also the biggest deterrents for managers who aren’t small cap enthusiasts: the sheer size of the universe and the unknowns.
Universe size and underreporting
The small cap universe is massive. There are over 50,000 global small companies listed around the world. Of course, we don’t view the whole 50,000 as the investable universe, nonetheless, the universe is very broad, and very deep, and full of opportunities.
Now, unlike large and mid-cap companies that are well covered by numerous analysts, a lot of these small companies are chronically under-analysed and some are barely followed by sell side analysts. That under-the-radar nature of these stocks gives active managers a route to find very high-quality businesses that are under institutional radar, that will allow us to outperform over a long period of time.
The leverage for us is in the discipline around gathering research, providing very deep levels of insight and gaining an edge in understanding the businesses where mainstream analysis is lacking. For us, that means around 400 interactions with management teams a year, whether it be in-person meetings or call. This is next to impossible in the large cap space, but it’s certainly possible in the small cap space.
Alpha and the long term
Active management in the small cap space can generate significant alpha over time. A small cap investment philosophy should be honed around buying very high-quality businesses that will deliver excellent returns and offer the best long-term preservation of capital. We think buying high quality businesses with good balance sheets that will generate high returns and have an ability to recycle capital into their businesses and grow will deliver the best form of compounding for investors.
What separates us from a lot of other investors in this space is that we have a longer term investment horizon. Average annual turnover is about 40 percent over time, and our investment horizon matches that, which is about two to five years. We want to buy these businesses and allow the really good ones to compound for us for a long period of time.
Importantly, high quality small caps are the businesses in crises that tend to outperform pretty dramatically, take significant market share, bolster their competitive position, and frankly preserve capital better than the highly leveraged, more cyclical, lower quality businesses that we tend to avoid.
So, how did we make the most of a pandemic? Once you’re in a crisis, you need to be able to move quickly and act decisively; so we set two goals. One is to preserve capital in the short term, and the second is to use the crisis to acquire superior businesses that would really drive our portfolio for the next three to five years.
In terms of process, we dramatically increased our interactions with management teams. We had 178 interactions with management teams in a five-week period to really get onto the ground and understand what was going on in different industries.
Jon Moog – Pengana Global Small Companies Fund.
More info on the fund at: https://www.pengana.com/our-funds/international-equities/global-small-companies-fund/
Jon is the CIO and portfolio manager of Chicago-based Lizard International Investor.