Good Things From Small Packages
It was as recent as 2004 that APPLE graduated into the MSCI U.S. large stock index from small stock status. Wouldn’t investors love to find the next APPLE?
Diversified portfolios should have different investments that tend to offset each other. Investors want their individual investments to move in different directions and different times and under different t economic conditions. In other words, the investments should have low correlation to each other.
But in an investment world where a big macro broom has side-swiped most ALL investments at the same time, low correlation has been hard to come by. With broad indexes and entire asset classes moving up or down in tandem, both index investors and active investment managers have found it challenging to find some separation. Individual stock fundamentals have simply had relatively less impact on valuations.
An allocation to smaller and mid-sized company stocks might help. Small and mid-sized company stocks, at the right price, can provide diversification and complimentary risk characteristics to a large stock core portfolio.
One of the main selling points of smaller and mid-sized stocks has been their lower correlation with traditional investments. Lower correlation provides some zig to offset zag in a diversified investment portfolio. The effect is smoother performance.
Lower correlations might be explained in part by smaller companies being more domestically focused and therefore more influenced by regional factors. In contrast, larger companies tend to be more export oriented and therefore more influenced by globalization. And globalization has increased correlations between country level stock markets.
Lower correlation might also be explained in part by the longer term horizon required to evaluate smaller companies. While stocks get priced in real-time, risk is a function of time. Shorter-term risks and relative illiquidity mean smaller and mid-sized stocks need a longer time horizon for evaluation … more like 5 – 10 years rather than the usual 1 – 5 year measurement period for larger cap stocks. (Anything less than 5 years … one has to question any allocation to equities).
According to J.P. Morgan research, U.S. mid-cap stocks have a correlation of .76 to U.S. large-size stocks, .61 to Canadian large-size stocks but -0.01 to Canadian Universe bonds. Emerging market stocks chart a lot like smaller stocks and have a correlation of -0.27 to World government bonds.
So there is some opportunity for portfolio enhancement through lower correlation. The lower correlations tend to signal more focus on company fundamentals. (Which can move stocks both up or down). The wider the separation between individual stocks, the more opportunity for specialist small or mid-sized company investment managers to choose the best from the rest.
But there is more than just lower correlation.
Geographic and Sector Diversification
Small and mid-sized company stocks represent a broader investment opportunity set for Canadian investors in particular. Like most non-Canadian indexes, small and mid-sized company indexes provide complimentary industry and sector exposures that domestically oriented portfolios simply can’t offer.
While the MSCI U.S. large company index has 279 stocks that represent 70% of all U.S. stocks, the MSCI U.S. mid-sized company index adds an additional 325 stocks and a further 15% of all U.S. stocks. The FTSE global ex-U.S. smaller company index adds another 3,024 stocks. Meanwhile, Canada’s Large company index S&P/TSX composite index has only 244 stocks.
While Canadian Large company stock market is heavily skewed to energy (25%), financials (32%) and materials (18%), Canada’s S&P/TSX SmallCap index too has 67% natural resources exposure.
U.S. and global smaller company stocks are more evenly balanced across more diverse industries and sectors. A drill down further shows that individual industries and sectors themselves are more diversified because they are less dominated by a handful of large stocks. For example, Canada has six Banks. The FTSE Global Small cap ex-U.S. index has 96 Banks. While the largest industry exposure in the MSCI U.S. mid-sized company index is consumer discretionary at 20%, the largest stock is only 0.70% of the index. Indeed, the top 10 are only 6% versus the largest 10 Canadian stocks at 33% of the S&P/TSX composite index.
Investors can cast a wider investment net by including smaller and mid-sized companies rather than a large stock, Canadian-centric allocation alone.
Why not invest in Canadian small and mid-sized stocks? Well, Canada IS a small company market. The median size company in the MSCI Canada large company index is $7.5B. The median MSCI U.S. mid-sized stock is $6.3B. Small and mid-sized Canadian company stocks are akin to micro investments. The median size company in the S&P/TSX SmallCap index is $0.5B.
Interestingly the FTSE global smaller company ex-U.S. index still provides a 16% exposure to smaller Canadian stocks. In fact Canada is the largest country weight and the top three stocks are Canadian.
An important reason for small and mid-sized company stock performance is faster growth. If revenue, profit and earnings growth drive stock price, then smaller and mid-sized companies will be able to grow faster than larger cap companies. It’s just math. It would be relatively difficult for Walmart to double in size. But adding a single customer could double the size of a smaller company.
Size of allocation
Mid-sized companies account for 15% of the global stock universe. Small-companies another 15%. (Thus small-sized companies are comparable to the relative size of emerging markets in global markets). In the global portfolio, small and mid-sized stocks ought to make up somewhere between 15% and 30%.
J.P. Morgan research says that U.S. mid-sized companies in particular are likely to benefit from acquisition activity by larger firms, given significant cash build-up on large-company balance sheets. GlobalAlpha adds that “99% of merger and acquisition transactions involve smaller companies, providing support to valuations.”
But both U.S. mid-sized and Global ex-U.S. small companies have already been strong performers over the last number of years. This is consistent with traditional understanding that smaller sized companies tend to lead in a recovery. (This could also mean the best is passed for this current cycle. See Timing below).
click chart for larger view
Clearly, small and mid-sized company stocks now trade at a premium to larger stocks. Global Alpha data indicates that at the beginning of 2012 this premium was ~30% (about ~18x PE for versus ~ 14x PE for large caps). One of the largest premia ever. Small and mid-sized company stock indexes now look pricey.
Using the charting tool at stockcharts.com, the U.S. mid-size stock (VO) and Global ex-U.S. small stock (VSS) indexes are currently well above their 200-day moving averages and it would take a 10% correction to bring them back to their 200-day moving average.
Again, selecting good from bad small and mid-sized company stocks while all are pricey sounds like a point in favour of active investment management over indexing.
Smaller and mid-sized company stocks tend to be more volatile and less liquid. Fundamentals can change fast. Think about it. A single customer order could double or halve sales for a smaller company whereas if you don’t shop at Wal-Mart they are likely to survive. Also, with fewer followers, smaller stock prices can swing widely with a single buy or sell. This can be a challenge for active managers trying to buy in or take profits.
Smaller and mid-sized companies may not have access to credit and at a reasonable price. As financial institutions continue to delever and raise the quality of their loan portfolio, smaller company funding won’t come easier any time soon.
Smaller companies tend to have more idiosyncratic risk. Information is not as transparent. Therefore there are greater risks and they require more hands-on monitoring. A specialist small and mid-size company analyst and firm need size to fund the resources required to monitor smaller companies. While the small and mid-sized stock space is the ideal playground for active managers, this risk has increased as brokerage houses and investment bankers downsize their staff.
Active managers quickly bump up against capacity issues as the small and mid-company market is only so big and a manager can’t make a market in the stocks they own by themselves. Dimensional Fund Advisors, however, seem to have gotten around this issue by essentially buying all stocks in the small and mid-sized company universe. (Sounds like indexing, no?)
Offsetting some risk is the fact that smaller company managers tend to also be owners. Owner’s interests tend to align better with those of shareholders more-so than managers in larger companies.
There is no easy or reliable way to consistently time the market.
Some investors will have trouble buying after prices have run up. And smaller company stocks tend to outperform early in the recovery stage of the cycle (see Valuation above). Is it too late? Has the easy money already been made? These are exactly the types of questions that institutional investors are supposed to ignore. So …
½ now and ½ later.
Dollar-cost-averaging will work well with mutual funds. DCA won’t work as well with Exchange Traded Funds (ETFs). VSS for example is $93 and investors will want to trade even lots of 100.
Select prices for a 10% or 20% correction. Wait.
_________________________________________________________________________Next time? More Risk Management. Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan