HOME     RESEARCH    The Case for International Small Caps—Artisan Partners

The Case for International Small Caps—Artisan Partners

Jan 10, 2020 / International, Asset Class Research Research Alliance

Since Harry Markowitz’s seminal paper introducing Modern Portfolio Theory was published in 1952, it has been considered conventional wisdom that a well-diversified portfolio produces superior risk-adjusted returns over a sufficiently long investment horizon. The primary reason is that constructing a portfolio of non- (or at least less-) correlated assets implies a portfolio can have more exposure to higher-risk assets in smaller weights. That these assets aren’t perfectly correlated helps dampen volatility, while potentially allowing the investor to reap the higher rewards associated with the higher risk level.

A well-diversified portfolio will typically include an allocation to small-cap companies due to their historically attractive risk-adjusted returns, faster growth potential and relatively low correlations with their larger-cap peers. However, when investors allocate to international stocks, they often overlook small-cap companies—instead investing in broad indices that are heavily weighted toward large caps. For example, the MSCI ACWI ex USA Index is mainly a large-cap index with less than 6% of its weighting in companies with market capitalizations of $5bn or below (Exhibit 1). As a result, investors may be missing an opportunity to improve their risk-adjusted returns.

Exhibit 1: MSCI International Indexes—Market Cap Breakdown

Exhibit 1

Source: FactSet/MSCI. As of 30 Jun 2019.

Investing in small-cap stocks requires patience for even the most experienced investors. With a lower liquidity profile, smaller companies often experience higher volatility on a daily and even annual basis. Yet for disciplined investors with longer-term time horizons, there can be material benefits to investing in this asset class.

Attractive Risk-Adjusted Returns

International small-cap stocks (as represented by the MSCI ACWI ex USA Small Cap Index) have significantly outperformed large caps (as represented by the MSCI ACWI ex USA Large Cap Index) over trailing five-year, ten-year and twenty-year periods, while displaying only slightly higher levels of volatility—corresponding to higher risk-adjusted returns (Exhibit 2). For our analysis, we have chosen to show the large-cap index rather than the broader MSCI ACWI ex USA Index due to the longer performance history of the large-cap index.

Over the past 20 years (as of 6/30/19), the annualized outperformance of small caps versus large caps was 285 basis points. That may not seem significant, but a small variation in annualized performance can substantially impact long-term outcomes due to the power of compounding. For perspective, a $10,000 investment in the MSCI ACWI ex USA Small Cap Index would have grown to $37,927 over 20 years. That is nearly $16,000 more than the $22,098 that would have resulted from an equal investment in the large-cap index.

Exhibit 2: Historical Performance Trends

Exhibit 2

Source: FactSet/MSCI. As of 30 Jun 2019. Based on net returns of the MSCI All Country World ex USA Small Cap Index and the MSCI All Country World ex USA Large Cap Index. Annualized standard deviation and Sharpe ratios are based on monthly returns data. Past performance does not guarantee and is not a reliable indicator of future results.

However, these annualized returns may not accurately reflect individual investors’ experiences since even over multiple time horizons, returns can be significantly influenced by start and end points. For a better perspective on the consistency of small caps’ outperformance, one might look at rolling returns.

Rolling returns also demonstrate the consistency of the small cap risk premium. Over rolling 5-year periods since 1995, the international small cap index has averaged a return of 7.1% versus 4.6% for the large cap index (Exhibit 3). Over longer 10-year rolling periods, small caps’ performance edge is even more pronounced—averaging 8.0% versus 5.1% for large caps.

Exhibit 3: The Consistency of the Small Cap Premium

Chart Blank

Source: FactSet/MSCI. As of 30 Jun 2019. Based on net returns of the MSCI All Country World ex USA Small Cap Index and the MSCI All Country World ex USA Large Cap Index. Based on monthly returns data. Past performance does not guarantee and is not a reliable indicator of future results.

Are these higher returns compensation for higher risk? Measured as price volatility, there was little difference in the standard deviations of returns over five-, ten- and twenty-year periods (Exhibit 2). Still, for long-term investors, risk may be better viewed as the probability of permanent capital impairment or drawdown risk rather than price volatility. In terms of maximum and average drawdowns, there was little difference between large and small caps (Exhibit 4). Moreover, average drawdowns for the MSCI ACWI ex USA Small Cap Index were lower than those of the MSCI ACWI ex USA Large Cap Index over five, ten and twenty years. Considering international small caps’ higher returns and similar levels of volatility and drawdowns, their risk-adjusted return characteristics have been attractive historically.

Exhibit 4: Maximum & Average Drawdown

Chart Blank

Source: FactSet/MSCI. As of 30 Jun 2019. Based on net monthly returns of the MSCI All Country World ex USA Small Cap Index and the MSCI All Country World ex USA Large Cap Index. Drawdown is shown as the percentage decline between the peak and the subsequent trough during a specific period of investment. Past performance does not guarantee and is not a reliable indicator of future results.

Faster Growth Potential

Compared to international large caps, international small caps can potentially provide investors exposure to faster growth outside the US while selling at similar valuations. Moreover, international small caps have also generated faster earnings growth than US small caps over the past five years and currently have higher returns on capital, boast better balance sheets, pay higher dividend yields and sell more cheaply (Exhibit 5).

Exhibit 5: Index Characteristics

Characteristic MSCI ACWI
ex USA Large Cap
MSCI ACWI
ex USA Small Cap
Russell 1000 Russell 2000
ROE 16.1 12.0 20.6 5.1
ROA 6.8 6.3 9.3 1.8
LT Debt/Capital 31.0 26.4 43.5 33.1
Historical 5 Year EPS Growth Rate 9.0 11.6 14.2 10.0
Estimated 3-5 Year EPS Growth 9.4 10.8 14.4 13.1
P/E Ratio (TTM)1 14.3 14.3 20.2 17.8
P/E Ratio (FY1)1 13.2 14.2 17.9 16.0
Dividend Yield 3.3 2.7 1.9 1.4


Source: FactSet/MSCI. As of 30 Jun 2019. 1Weighted Harmonic Average.

Lower Correlations

Allocating to international small caps also offers the potential benefit of added diversification. Relative to larger companies, which may have larger geographic footprints and operate multiple business lines, the fundamentals of the smaller companies are often affected by idiosyncratic factors to a greater extent. For the ten years ending June 2019, the correlation coefficient of the MSCI ACWI ex USA Small Cap Index was +0.84 with the Russell 1000® Index and +0.75 with the Russell 2000® Index (Exhibit 6).

Exhibit 6: Correlations

Index MSCI ACWI MSCI ACWI
ex USA Large
MSCI ACWI
ex USA Small
S&P 500® Russell 2000® MSCI EAFE MSCI
Emerging Markets
MSCI ACWI 1.00            
MSCI ACWI ex USA Large 0.97 1.00          
MSCI ACWI ex USA Small 0.94 0.96 1.00        
S&P 500® 0.96 0.86 0.83 1.00      
Russell 2000® 0.84 0.74 0.75 0.89 1.00    
MSCI EAFE 0.96 0.98 0.95 0.86 0.72 1.00  
MSCI Emerging Markets 0.87 0.92 0.89 0.75 0.65 0.84 1.00

 

Source: FactSet/MSCI. Based on monthly returns: 30 Jun 2009 – 30 Jun 2019. Correlation is a statistical measure of how two variables move in relation to each other. A perfect positive correlation is represented by the value +1.00, while 0.00 indicates no correlation and -1.00 indicates a perfect negative correlation. Past performance does not guarantee and is not a reliable indicator of future results.

A Case for Active Management

Further, we believe several inherent characteristics of the asset class offer seasoned managers ample opportunity to enhance alpha through active, fundamental stock selection—particularly one with the flexibility to invest in small and medium-sized companies around the world.

Larger Opportunity Set
First, the asset class offers a large opportunity set. Based on a market cap range between $300 million and $5 billion, small-cap companies outnumber large caps (defined as those with market caps of $10 billion or more) by more than 8 to 1 (Exhibit 7). The vast majority of these are outside the US—giving a manager of international small caps a significantly larger pool from which to identify superior investing opportunities. In the investable universe of non-US stocks, just 7.5% of names are large caps (excluding micro-cap stocks with market caps below $300 million).

Exhibit 7: Universe of Investible Companies (# of Companies)

Exhibit 7

Source: FactSet. As of Jul 2019. Market cap segments are determined as follows: Large Cap is $10 billion+, Mid Cap is $5 to $10 billion and Small Cap is $300 million to $5 billion. Companies with market caps less than $300 million are not represented. Geographic grouping is based on risk country.

Inefficient Pricing

The scale of the universe can create another important advantage for managers with the resources and skills necessary to navigate this asset class. The sheer number of companies can make it difficult for sell-side researchers to fully cover global small caps. Exhibit 8 shows the average number of analysts that cover stocks in each capitalization range—large caps are covered 4-to-1 over small caps, and 9-to-1 over micro caps. For diligent researchers, it is not uncommon to find quality, well-positioned companies that are not yet covered by sell side research.

When companies are ignored, misunderstood or underappreciated, it can take longer for fundamental company news to be priced into the value of the stock. This inefficiency can create more opportunities for seasoned investors to exploit shorter-term mispricing.

Exhibit 8: Average Analyst Coverage per Company by Market Cap

Exhibit 8

Source: FactSet. As of Jul 2019. Based on the number of analyst ratings for a security in the FactSet Estimates database.

Wider Range of Outcomes

The international small-cap universe is massive and can experience inefficiency in market pricing. Further, smaller companies in earlier stages of development can also experience explosive growth—and the reverse can be true as well. These characteristics, combined with more variable liquidity profiles, can lead to a wider range of performance outcomes, contributing further to alpha-generating potential for this universe.

For example, over the past five years, passive investments in the MSCI ACWI ex USA Small Cap and MSCI ACWI ex USA Large Cap indexes would have generated annualized returns of 2.8% and 2.0%. Although small caps outperformed by approximately 80bps annualized, the stronger small-cap performance was inclusive of a wider range of outcomes seen in the performance of the index constituents (Exhibit 9). The bottom decile of stocks in the small-cap index had annualized returns of -20% or less compared to -12% or less for the large-cap index for this five-year period. Conversely, the top decile of small-cap stocks returned 14% or more compared to 10% or more for large caps.

The wider range of outcomes versus large caps suggests that seasoned small-cap managers following a differentiated investment approach have relatively more opportunity to add value above the benchmark—not only by choosing the leaders, but also by avoiding the laggards.

Exhibit 9: Range of Individual Company Returns Within the MSCI Indices Based on 5-Year Annualized Returns

Exhibit 9

Source: FactSet/MSCI. Based on the five-year period ended 30 Jun 2019. Past performance does not guarantee and is not a reliable indicator of future results.

Higher Idiosyncratic Behavior

A closer look into the drivers of small-cap performance can also argue for the opportunity for an active approach with high levels of investment freedom to add value. Historically, company-specific factors have accounted for a far higher share of volatility for small-cap stocks than for large-cap stocks as measured by cross-section volatility of returns (Exhibit 10). Cross section volatility is calculated as the standard deviation of asset returns over a single period. When dispersion of stock returns is high, active managers have greater opportunities to add value through stock selection. Since return dispersion in the small cap universe has on average been greater than in the large cap universe, one can conclude that there have been greater active management opportunities in the small-cap universe for active management.

Exhibit 10: Small-Cap Stock Returns Less Driven by Systematic Sources

Exhibit 10

Source: FactSet/MSCI. Past performance does not guarantee and is not a reliable indicator of future results. Cross-sectional volatility calculated for securities in the MSCI ACWI ex USA Large and MSCI ACWI ex USA Small Indexes.

Value-Added in Less Efficient Markets

The relationship between return dispersion and opportunities for active managers is also consistent with historical performance results over the past 25 years. Based on 5-year and 10-year rolling returns (monthly series) from 1995 to June 2019, managers in the Morningstar Foreign Small/Mid Blend category generated average annualized returns of about 9.0% and 9.2%, respectively. That compares to 7.1% and 8.0% for the MSCI ACWI ex USA Small Cap Index equating to excess returns of 188bps and 115bps (Exhibit 11). The magnitude of outperformance is even greater versus the MSCI ACWI ex USA SMID Cap Index. Conversely, in the Morningstar US Large Blend and Morningstar Foreign Large Blend categories—asset classes with fewer stocks and greater analyst coverage—the average active manager trailed their respective indices.

Exhibit 11: Active Manager Outperformance in International Small Caps

  — Average Rolling Returns —
Morningstar Categories/Benchmarks 5 Year 10 Year
US Fund Large Blend 6.4% 5.3%
Russell 1000® Index 7.8% 6.6%
Value Added -140bps -129bps
US Fund Small Blend 9.1% 8.3%
Russell 2000® Index 8.4% 7.8%
Value Added 70bps 49bps
US Fund Foreign Large Blend 4.4% 4.4%
MSCI ACWI ex USA Large Cap Index 4.6% 5.1%
Value Added -24bps -68bps
US Fund Foreign Small/Mid Blend 9.0% 9.2%
MSCI ACWI ex USA Small Cap Index 7.1% 8.0%
Value Added 188bps 115bps
US Fund Foreign Small/Mid Blend 9.0% 9.2%
MSCI ACWI ex USA SMID Cap Index 6.6% 7.5%
Value Added 231bps 169bps


Source: Morningstar/FactSet/MSCI. Based on rolling five- and ten-year returns (monthly) from 1 Jan 1995 to 30 Jun 2019. Past performance does not guarantee and is not a reliable indicator of future results.


About Artisan International Small-Mid Fund

Seasoned Leadership and A Long-Term Orientation

The investment team employs a fundamental stock selection process focused on identifying long-term growth opportunities to build a portfolio of primarily non-U. S. small- and mid-cap growth companies. The investment team leverages high degrees of experience and knowledge within a disciplined investment process.

Rezo Kanovich, Portfolio Manager - 20 Years Investment Experience

Seasoned Leadership
Rezo Kanovich is a managing director of Artisan Partners and the sole portfolio manager for the Artisan Non-U.S. Small-Mid Growth Strategy, including Artisan International Small-Mid Fund.

Prior to joining Artisan Partners in October 2018, Mr. Kanovich was a portfolio manager for OppenheimerFunds, where he managed the International Small-Mid Cap strategy from January 2012 through September 2018. Before that, Mr. Kanovich worked as an analyst with Boston Biomedical Consultants, an investment banker with the Lehman Brothers mergers & acquisitions team and as a consultant at PricewaterhouseCoopers. Mr. Kanovich holds a bachelor’s and master’s degree in international economics and finance from Brandeis University and a master’s degree in business administration, dual concentration in finance and health care systems, from the Wharton School, University of Pennsylvania.

A Long-Term Orientation

The team’s investment philosophy is oriented toward long-term outcomes. The team’s investment horizon is typically around five or more years. The team looks for high-quality businesses exposed to structural growth themes where it believes high returns on capital can be compounded over long periods of time. The investment team is more concerned that the markets for its holdings can grow many-fold over time than the false precision around what may occur over the next quarter or two. That is, the team seeks to invest in businesses that will evolve with their opportunity set and that hypothetically it never has to sell.

Investment Process

The team seeks high-quality businesses exposed to structural growth themes that can be acquired at sensible valuations in contrarian fashion and are led by strong management teams.

Investing with Tailwinds
The team identifies structural themes at the intersection of growth and change with the objective of investing in companies having meaningful exposure to these trends. Themes can be identified from both bottom-up and top-down perspectives.

High-Quality Businesses
The team seeks future leaders with attractive growth characteristics that can be owned for the long term. The team’s fundamental analysis focuses on those companies exhibiting unique and defensible business models, high barriers to entry, strong management teams, favorable positions within their industry value chains and high or improving returns on capital. In short, the team looks to invest in small companies that have potential to become large.

A Contrarian Approach to Valuation
The team seeks to invest in high-quality businesses in contrarian fashion. Mismatches between stock price and long-term business value are created by market dislocations, temporary slowdowns in individual businesses or misperceptions in the investment community. The team also examines business transformation brought about by management change or restructuring.

Manage Unique Risks of International Small- and Mid-Cap Equities
International small- and mid-cap equities are exposed to unique investment risks that require managing. The team defines risk as permanent loss of capital, not share price volatility. The team manages this risk by having a long-term ownership focus, understanding the direct and indirect security risks for each business, constructing the portfolio on a well-diversified basis and sizing positions according to individual risk characteristics.


 

Carefully consider the Fund’s investment objective, risks and charges and expenses. This and other important information is contained in the Fund’s prospectus and summary prospectus, which can be obtained by calling 800.454.1770. Read carefully before investing.

Past performance does not guarantee future results. International investments involve special risks, including currency fluctuation, lower liquidity, different accounting methods and economic and political systems, and higher transaction costs. These risks typically are greater in emerging markets. Securities of small- and medium-sized companies tend to have a shorter history of operations, be more volatile and less liquid and may have underperformed securities of large companies during some periods. Growth securities may underperform other asset types during a given period. Diversification does not ensure a profit or protect against loss.

This summary represents the views of the portfolio managers as of 31 Aug 2019 and is subject to change without notice. While the information contained herein is believed to be reliable, there no guarantee as to the accuracy or completeness of any statement in the discussion.

MSCI All Country World ex USA Index measures the performance of developed and emerging markets, excluding the US. MSCI All Country World ex USA Large Cap Index measures the performance of large-cap companies in developed markets and emerging markets excluding the US. MSCI All Country World ex USA Mid Cap Index measures the performance of mid-cap companies in developed markets and emerging markets excluding the US. MSCI All Country World ex USA Small Cap Index measures the performance of small-cap companies in developed markets and emerging markets excluding the US. MSCI EAFE Index measures the performance of developed markets, excluding the US and Canada. MSCI EAFE Small Cap Index measures the performance of small-cap companies in developed markets, excluding the US and Canada. MSCI All Country World Index measures the performance of developed and emerging markets. MSCI All Country World ex USA SMID Index measures the performance of small- and mid-cap companies in developed and emerging markets excluding the US. Russell 1000® Index measures the performance of roughly 1,000 US large-cap companies. Russell 2000® Index measures the performance of roughly 2,000 US small-cap companies. The index(es) are unmanaged; include net reinvested dividends; do not reflect fees or expenses; and are not available for direct investment.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used to create indices or financial products. This report is not approved or produced by MSCI. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication.

Standard Deviation is a statistical measurement that is applied to the annual rate of return of an investment to measure the investment’s volatility. Sharpe Ratio is a statistical measure of risk-adjusted return calculated as an investment’s excess return per unit of standard deviation. ROE is a profitability ratio that measures the amount of net income returned as a percentage of shareholders’ equity. ROA is a profitability ratio that measures the amount of net income returned as a percentage of total assets. Long-Term Debt-to-Capital is a capitalization ratio that shows the financial leverage of a firm, calculated by dividing the long-term debt with the firm’s total capital. Earnings Per Share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock. Price-to-earnings is a valuation ratio of a company’s current share price compared to its per-share earnings. Dividend Yield is a stock’s annualized dividend divided by its current share price.

© 2020 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Morningstar Large Blend category portfolios are fairly representative of the overall US stock market in size, growth rates and price. Stocks in the top 70% of the capitalization of the US equity market are defined as large cap. Morningstar Small Blend category portfolios favor US firms at the smaller end of the market-capitalization range. Stocks in the bottom 10% of the capitalization of the U.S. equity market are defined as small cap. Morningstar Foreign Large Blend category portfolios invest in a variety of big international stocks. Most of these portfolios divide their assets among a dozen or more developed markets, including Japan, Britain, France, and Germany. These portfolios primarily invest in stocks that have market caps in the top 70% of each economically integrated market (such as Europe or Asia ex-Japan). Morningstar foreign small/mid-blend portfolios invest in a variety of international stocks that are smaller. These portfolios primarily invest in stocks that fall in the bottom 30% of each economically integrated market (such as Europe or Asia ex-Japan). The blend style is assigned to portfolios where neither growth nor value characteristics predominate.

This material is provided for informational purposes without regard to your particular investment needs. This material shall not be construed as investment or tax advice on which you may rely for your investment decisions. Investors should consult their financial and tax adviser before making investments in order to determine the appropriateness of any investment product discussed herein. We expressly confirm that neither Artisan Partners nor its affiliates have made or are making an investment recommendation, or have provided or are providing investment advice of any kind whatsoever (whether impartial or otherwise), in connection with any decision to hire Artisan Partners as an investment adviser, invest in or remain invested in any funds to which we serve as investment adviser or otherwise engage with Artisan Partners in a business relationship.

Artisan Partners Funds offered through Artisan Partners Distributors LLC (APDLLC), member FINRA. APDLLC is a wholly owned broker/dealer subsidiary of Artisan Partners Holdings LP. Artisan Partners Limited Partnership, an investment advisory firm and adviser to Artisan Partners Funds, is wholly owned by Artisan Partners Holdings LP.

© 2020 Artisan Partners. All Rights Reserved.

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