When it comes to tapping into big earnings growth around the world, sometimes it pays to think small.
Small-cap stocks are no longer a speculative bet on future growth prospects, says Andrew Neville, lead portfolio manager for AllianzGI Global Small-Cap Fund. Rather, they’ve matured into an essential building block of investor portfolios, one that accentuates the benefits of active management, he says. How? By taking advantage of pricing inefficiencies laid bare by less coverage from Wall Street analysts. They also offer an attractive risk/reward tradeoff. The result: Greater diversification and the potential for better risk-adjusted returns—but only if you stay invested for the long haul.
In the following interview, Neville explains the benefits of a strategic allocation to global small-cap stocks and how they’ll behave in the face of loose monetary policy. He also highlights how a deep understanding of local markets and frequent contact with management are difference makers when researching smaller companies.
How are low interest rates and accommodative monetary policies worldwide impacting small-cap stocks? What can we expect when a tightening cycle begins?
The actions central banks have taken in the past few years—pumping liquidity into the economy and keeping interest rates low—were designed to ensure that the economy starts growing again. Obviously, smaller-cap stocks have benefited from this stimulus along with all other stocks. In some places, it’s caused asset bubbles—real estate stocks in Southeast Asia, for example. When central banks withdraw QE or we see some tightening of monetary policy, rising interest rates shouldn’t actually harm smaller companies—as long as there’s economic growth and trading remains robust.
Small caps, as an asset class, stop making money when there’s economic contraction, which also stops them from outperforming larger companies. Tighter monetary policy on its own shouldn’t cause small-cap underperformance. But if a sudden, sharp rise in rates caused the economy to contract, then that would be an issue. The market has accepted that the Fed is tapering its asset purchases—and that doesn’t necessarily mean tightening is in the offing. So the taper timeline shouldn’t be a factor for investors mulling whether or not to go into small caps. If anything, it warrants taking another look at Europe, which should have a loose monetary policy for a long time. Meanwhile, the unwinding of QE in the United States has been priced in.
What does thin Wall Street analyst coverage of smaller companies mean for the role of active management?
First, investors should be able to generate more alpha in smaller companies—and do so consistently. That means we have to spend a lot of our time meeting with companies. The big investment banks don’t research small companies very well. There’s not much corporate activity or trading. In Germany’s DAX index, for example, there’s an average of 40 analysts covering each large-cap company in the index. For smaller companies, there are typically less than five analysts covering them. It’s all about fundamental stock selection with an acute focus on contact with corporate management teams.
Each of our small-cap portfolio managers are meeting nearly one company a day. That’s how we uncover the substantial inefficiencies in smaller companies. The management teams of smaller companies are local. And you’ve got to kick the tires. Not only do we have to meet with management, but also we have to understand the culture, local customs and speak the same language. For example, the heads of a Chinese supermarket chain are based in Beijing and they don’t speak English. It’s a very locally driven asset class.
The Upside of Less Coverage
Smaller companies have fewer sell-side analysts covering them, which can create pricing inefficiencies that active managers can exploit.
Average number of analysts covering a stock
Source: Bloomberg. Allianz Global Investors Capital Market Analysis. Data as of 4/2011.
PART I: For investors, has small cap evolved from a tactical or speculative play to a more strategic allocation?
To successfully market time smaller companies, investors have to be there at the bottom and enjoy the ride up. The problem is that most market timers tend to get the timing wrong and sell smaller companies on the way down. They didn’t invest in those stocks at the bottom. But for every rolling 10-year period since 1999 we’ve looked at, smaller companies have outperformed larger companies. During that time, we’ve seen many more clients appreciate that they have to hold smaller companies for the long haul. Global smaller companies have also generated a positive return over every 10-year rolling period, without reinvesting dividends.
Big Edge for Small Caps
Since 1999, small-cap stocks have outperformed
large-cap stocks in every rolling 10-year period.
Source: FactSet. MSCI. Rolling 10-year returns from 1/1/1999 to 12/31/2013.
Past performance is no guarantee of future results.
Further, sophisticated clients have risk budgets and they understand that if you add a portfolio of smaller companies to a portfolio of larger companies, you can get a noticeable increase in return for a minimal increase in risk. In other words, small caps carry higher risk but they can also offer a better risk-adjusted return when combined with larger stocks. That’s because some of that risk is diversified away. As a result, we’re seeing a lot more clients allocating to smaller companies and hold them through a full investment cycle. As an investor, you never want to be a forced seller of small companies.
Small Caps and the Rewards for Risk
Global small-cap stocks have outperformed their larger-cap
peers for nearly 20 years while taking on only a modestly higher level of risk.
Source: Datastream, MSCI Total Return Indices, Allianz Global Investors Capital Markets & Thematic Research. Data reflects period from 1/1/1995-3/31/2014.
Past performance is no guarantee of future results.
PART II: While the return potential is greater, small cap is prone to bouts of high volatility. How do you manage this risk in the portfolio?
In AllianzGI Global Small-Cap Fund, we have sector constraints of plus or minus 10%. We watch closely the factors that aren’t stock-specific, such as currency risk, country risk or style risk. We don’t let factor risk get above 20%. When the market is down 20%, we’re going to be down too. So we don’t seek to protect on the downside. We just look to capture less of it. Historically, we’ve captured more of the upside of the market and less of the downside.
But that outperformance has been far more pronounced on the upside. In an asset class that can fall 20% in a year, we try to take advantage of volatility. For example, we viewed the US debt-ceiling negotiations—and the market uncertainty it created—as a buying opportunity. But if end markets were slowing down and the local economies were about to roll over, then we would be buying more defensively-oriented companies. It’s a very simple equity portfolio. We hold stocks and cash. There’s no hedging of any sort.
AllianzGI Global Small-Cap Fund emphasizes global diversification across four regional investment teams. Why is this important for investors and how do you divide resources across the regions?
Small-cap investing is all about picking the best companies. So small-cap managers outperform through stock selection, not through sector allocation or country allocation. Our portfolio is made up of four dedicated regional sub-portfolios in North America, Europe, Japan and Asia ex-Japan. Each team is accountable for their investment decisions. The portfolio managers of these four sleeves all specialize in smaller companies, they’re locally based and have been running regional small-cap funds for a long time. They can decide how much to allocate to each country, but we all take a bottom-up, region-neutral view.
Across the four portfolio sleeves, the style is similar: we’re all growth investors. We aim to invest in companies that grow faster and have a higher return-on-equity than the benchmark, the MSCI Small-Cap World Index. Essentially, we all have a quality bias. We want the stocks we own to reinvest their earnings back into their businesses to drive higher growth. Therefore, all four teams hold companies that have a lower dividend yield than that of the benchmark. If growth is negative, then we’ll be looking at more defensively oriented companies. Each team maintains its own unique investment process, however.
Personally, I’m responsible for three areas: risk control, accountability to clients and regulators and oversight of the strategy. I monitor the overall portfolio for any unintended risks that may bubble up to the surface when these four portfolios are combined. And I have the authority to step in to control risk. Beyond that, I don’t interfere with the day-to-day management of regional portfolios.
What do you look for in a stock before adding it to the portfolio? What’s your sell discipline?
We’re bottom-up stock pickers who focus on contact with corporate management. And we’re always looking for a stock that’s better than the ones we own. That means tapping our best ideas to displace existing holdings in an effort to achieve the optimal portfolio. Specifically, we’re looking for successful business models, preferably in niche markets where there are few competitors, and where the niche market is growing yet still small enough so that larger companies can’t barge in and be disruptive. We’re also looking for companies that have a technological advantage that gives them pricing power and creates a barrier to entry. That tends to lead to higher growth and higher profit margins.
Perhaps the most important factor is management you can believe in. We want to see a successful track record. We want to see management who, when they describe their strategy, we believe it’s viable. From a competitive standpoint, we also look for companies that can finance their own growth. Once we’ve found a fantastic franchise, we look at valuation. But it’s always valuation relative to its own growth, history and peers—not absolute valuation. We’re happy to buy a stock that’s trading at a premium to the market.
As for our sell discipline, the easy triggers are when there’s a better company out there or the company is no longer “small.” In global terms, we define small cap as companies capitalized up to $5 billion. Another sell signal is that a single holding becomes too large of a position in the portfolio. We’ll trim it to manage single-stock risk. There are cyclical factors too, such as challenging conditions in end markets. And if our conviction in the management team is waning and they’re not executing on their strategy, then that would be a red flag. Or if the investment thesis for owning the stock is no longer true.