The small-cap effect

by NBI Investments Team

For years, a tendency towards large cap or growth-oriented companies has been at the forefront of equity investing. The attractiveness of growth from many large or mega cap companies have overshadowed the potential for opportunities within the small-cap equity space, especially from a global scale.

Many companies in this space are often overlooked by both institutional and individual investors during bull markets. This has translated into potentially missed opportunities when maximizing returns. Below, we will break down a few concepts that can help make the case for global small-cap equities within a portfolio. 

Often overlooked

Quite often these companies fly under the radar given the mass exposure blue-chip names get in the business world. Analysts and investors alike will scrutinize every figure in the latest earnings report from larger cap stocks, yet smaller names are less likely to be covered in the same extent. Consequently, some of these names may potentially be inaccurately priced. For savvy investors, this offers an opportunity as they may potentially exhibit better performance because of their higher risk/reward profile.

Below shows a risk/return graph of both a global index and it’s small-cap counterpart with data dating back to January 2001. Over a long-term horizon, the small-cap index offers a greater risk/return opportunity for investors looking to enhance their existing portfolio. The potential for stronger returns over the long term is characterized by the extra room these companies have to grow.

Indeed, by tracing back to the last three major bear markets, small-cap equities have had the largest rebounds compared to large-cap equities.

Quality and quantity

Smaller companies are usually more nimble and agile, allowing them to respond quicker to secular trends and changing markets. This allows them to grow and tap into markets that can significantly enhance their growth potential. A perfect example of this was during the pandemic; when the once small video communications company Zoom grew from an initial $3 million seed startup to now, a household name with over $4 billion in revenue.

When it comes to global small-cap equities, investors also tend to have many options to choose from in several different sectors. The MSCI World Small Cap index offers over 4,300 constituents compared to just 1,500 or so, held in the MSCI World Index. The larger number of options in smaller companies allows for the likelihood of finding attractive opportunities of companies that have proper revenue growth and steady profits with an attractive valuation.

Enter the active manager

Investing in smaller cap names may require more active management with an investment professional that can regularly monitor small-cap equities. A professional portfolio management team with a sound fundamental investment process will help mitigate the risk surrounding this overlooked asset class and potently boost returns.

Many equity-based portfolios are often already heavily invested in large cap stocks. Allocating a portion of global small-cap equities can help enhance the diversification from a sectoral and geographical point of view with the potential to generate higher expected returns. In turn, the investor has compelling benefits that can add potentially robust growth potential to their portfolio, especially during market rebounds or after bear-market bottoms.

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https://nicolawealth.com/insights/understanding-opportunities-in-global-small-cap-equities. Dot.com October 2002; Global Financial Crisis March 2009; Covid-19 March 2020
https://investors.zoom.us/. As of January 31, 2023

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