Sizing up: why a 10-20 per cent allocation to global small caps belongs in portfolios

Australian investors have done well by staying close to home. The ASX, on a total return basis, is one of the better-performing national markets in the world, and the familiarity of domestic equities has made them an easy default for portfolio construction.

But familiarity has a cost, and for most adviser portfolios, that cost is showing up as concentration in exactly the wrong place at exactly the wrong time.

Large-cap global equities have dominated allocations for fifteen years. Within those allocations, the bias has drifted further toward US mega-caps and the technology names that have powered returns since 2008.

The result is a portfolio landscape where most clients are heavily exposed to what has already worked, and significantly underweight what is quietly starting to move.

Tobias Bucks, portfolio manager at Ausbil Investment Management, has a clear view on where the next phase of returns is coming from.

His case is not that large caps will collapse, but that the conditions that made them dominant are changing, and that a part of the market most portfolios are not adequately accessing is becoming more important by the quarter.

“I believe the market is efficient, but it has no imagination,” he said. “And I believe there is always a bull market somewhere in those small caps.”

The opportunity set most advisers are underweight

Ausbil’s global small-cap strategy covers companies with market capitalisations from roughly $500 million to $25 to $30 billion, comparable to the ASX 50 to ASX 200 in domestic terms.

These are not speculative micro-caps. They are established businesses with real revenues, real margins and real market positions that advisers can hold with confidence.

The global small-cap opportunity set spans over 3,500 companies. Tobias is direct about the challenge that creates. “Humans are very good at making decisions, but they’re very bad at defining opportunity sets.” Ausbil addresses that through a quantitative screening process to rank and surface ideas before applying deeper fundamental research.

For advisers assessing managers in this space, that combination of systematic screening and fundamental conviction is the hallmark of a disciplined process.

His case study is Mueller Industries, a manufacturer of brass and copper fittings purchased by the fund in February 2022 at $29 a share. It had a market capitalisation of over $3.3 billion, was trading more than $10 million US dollars a day and had no analyst coverage.

Three weeks before Tobias spoke, the company beat consensus estimates by over 45 per cent. At the time of the presentation, it was trading at 16 times earnings while growing at over 55 per cent YoY.

“For a business that’s growing earnings at over 55 per cent YoY, and I think will grow earnings at over 40 per cent for the next three years, it’s now got 2 analysts and no one’s looking at it,” Tobias notes. It remains the largest position in the fund.

The structural shift advisers cannot afford to ignore

The broader argument is not simply about finding overlooked stocks. It is about where structural demand is concentrating and what that means for how advisers should be building international equity allocations right now.

Deglobalisation is fundamentally changing what the world needs to build. Small-cap industrials and materials businesses are at the centre of that shift. However, most adviser portfolios have no meaningful exposure to them.

“The world’s changing. Deglobalisation is what’s happening right now. That means, we need to replicate every single bit of steel, every single machine, all the turning and fitting devices. We need to replicate everything in every market: the electric grid, the defence infrastructure, the manufacturing. To do that, you need small caps.”

The global small caps allocation case

Tobias makes the argument for a 10 to 20 per cent allocation to global small caps within a broader global equities sleeve.

Global small caps sit on the efficient frontier and have historically offered a better Sharpe ratio over the longer term than large caps.

The most practical point is one advisers should take directly into their next portfolio review. A global large-cap allocation already captures mid and large caps.

To get genuine small-cap exposure, a dedicated allocation is required. Without it, advisers end up holding the most expensive part of the market twice over, paying for diversification they are not actually getting.

A small-cap allocation improves the risk-return profile, diversifies away from the factor biases already embedded in most large-cap holdings and gives clients access to the part of the market where the next cycle’s returns are being built right now.

The rotation has started. The question for advisers is not whether to have this conversation with clients. It is whether they are having it early enough to matter.