Why global small caps deserve a permanent place in portfolios 

Many investors treat global small caps as a tactical call on interest rates. Sadhvi Gupta, Executive Director, Quantitative Investment Strategies at Goldman Sachs Asset Management and client portfolio manager of the Yarra Global Small Companies Fund, thinks the stronger case is structural, and it starts with diversifying against the assets most portfolios already hold. 

Anyone allocating to a US or global large cap portfolio is, in effect, buying the magnificent seven as individual stocks, and each additional large cap allocation adds to that exposure. Gupta says this need for diversification has become the starting point for many of the conversations her team now has with investment committees. 

The concentration problem 

The two indices hold very different mixes of businesses. Information technology makes up around 30 per cent of the MSCI World. It makes up less than 15 per cent of the MSCI World Small Cap. The small cap index carries a far larger share of industrials and financials.

Investors adding a small cap allocation are therefore buying a different economy. It is weighted towards the manufacturers, lenders and service businesses that barely register in a large cap benchmark.

The gap in concentration is wider again. Gupta notes that the top 10 stocks make up roughly 26 per cent of the MSCI World and about 4 per cent of its small cap counterpart. “The concentration in the way that it exists in the large cap space just doesn’t exist in small caps”, Gupta observes. 

Scale and coverage 

The companies themselves also sit at a different point in their growth. The average market capitalisation in the MSCI World is US$71 billion, against US$2.8 billion in the MSCI World Small Cap.

Gupta points to several AI-related names that start life in the small cap index. The large cap index promotes them after multi-fold returns. By the time the index promotes a company, much of its re-rating has perhaps already happened. A large cap investor meets it at a very different price.

“By buying them small and early, you have a chance that you’re getting in cheaper than you would be paying for them once they’ve been upgraded,” she says. 

Part of the traditional attraction of small caps has been the perception of structural inefficiency. Gupta argues that gap is narrowing more slowly than many expect. Data availability is improving everywhere, including in markets such as India and China where so much commerce is now digital.

Yet on average 43 analysts cover a US large cap company, compared with 12 for a small cap, and far fewer financial news articles are written about smaller businesses. 

That leaves room for systematic managers to be able to cover a very large universe. Gupta’s team considers more than 7,500 small cap companies for inclusion every day. A fundamental manager would struggle to research many of them with a conventional analyst team.

Alternative data also works harder at the smaller end of the market. A vendor selling credit card transaction data does not distinguish between an S&P 500 company and a Russell 2000 company, Gupta explains. It simply supplies the transactions for every listed stock.

“That goes a longer way in predicting the small cap stocks we want to invest in,” she says. 

Timing  

Gupta looks to underlying company fundamentals rather than the rates cycle when thinking about an entry point. Earnings per share growth expectations are attractive. The quality of small cap companies is improving and the valuation discount relative to large caps remains.

Her team feeds this data, such as earnings and valuation metrics, into its systematic process to identify names worth owning.

“If you look at the price that you are paying for them, based on those fundamentals, it is really a good entry point to get into these names,” she says. 

Even so, she stops short of treating the asset class as a trade. “It deserves, even if a small, but a permanent allocation in people’s books,” Gupta argues, “rather than trying to tactically time it with interest rate moves.”