International Small Cap – Things to Consider

What do returns really look like, especially during drawdowns and recoveries?

One of the more conventional pieces of stock market wisdom is the idea that small cap stocks outperform large cap stocks during economic recoveries. There are two basic concepts supporting this hypothesis:

Earnings – First, smaller companies tend to receive a larger relative benefit from improvements in the economy—their smaller size and more limited geographies tend to make them more sensitive to changes in economic conditions.

Multiples – Second, small caps, given their greater vulnerability and volatility, tend to be liquidated to a greater extent for risk purposes in severe market drawdowns, thereby hitting multiples. They are then accumulated as economic and market recoveries unfold and risk appetites improve.

There is some reason to believe that these forces may have been magnified during the COVID-19 correction and global recession, with larger global businesses proving more defensive while smaller companies “took it on the chin” given greater susceptibility to shutdowns and other business disruptions.

We thought it would be interesting to test these assumptions in the international space, to see how smaller companies fared in both drawdowns and recoveries.

To recap, blue-chip larger stocks are seen by many investors as the lower risk option, particularly with international investments. When conditions deteriorate, riskier assets get sold, whether it is small caps within an international allocation or even international stocks in favor of domestic U.S. The pattern reflects both concerns about earnings and to some extent fear about multiples. This pattern operates in reverse when markets bottom and investors begin to contemplate recovery—small caps are seen as more geared to recovery vis-a-vis earnings, but they are also seen as attractive re-rating stories when investors contemplate taking on more risk.

What is the best way to think about the risks associated with small caps—is it really more risk for more return?

Interestingly the answer appears to be “no, not really.” International Small Cap as an asset class has indeed offered higher returns historically. But these higher returns do not appear to significantly increase risk (small cap risk-adjusted returns are indeed higher than large caps’). Somewhat surprisingly, it is emerging markets that appear less attractive—higher risks and lower returns drive less-than-compelling risk-adjusted returns for emerging market stocks.

In our view, this most likely reflects macro-level risks that often impact emerging market stocks as a group, such as tighter U.S. monetary policy, weaker E.M. currencies, and the resulting weakness in E.M. stocks. As such smaller allocations to E.M. stocks (say 10-15%) within an international small-cap portfolio, increasing diversification and ownership of high-quality companies at the same time, may make more sense than larger dedicated allocations to emerging market equities.

International Small Cap Portfolio Manager Todd Edwards details some of the most interesting performance patterns and why investors should be…