Invest In EU Small Caps For Alpha

| About: iShares MSCI (IEUS)

Summary

Certain segments of the financial market are more inefficient than others.

EU Small Caps are today very attractively valued compared to US Small Caps.

The EU Small Cap market is likely to be more inefficient and have larger alpha than the US Small Cap market.

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How inefficient is the financial market today? How can you increase my chances of beating the market? These are questions that you have had to probably ask yourself if you are today actively managing your investment portfolio instead of allocating your capital in Index Funds. You must be confident that you are better than the market and that your superior stock picking skills will result in higher returns over time.

I believe this to be an unreasonable expectation for most of individual investors. Let's be realistic, you are just unlikely to beat the market, especially if you are investing in the most efficient segments of the financial market.

Individual investors pay investment managers hefty fees to do one thing: beat the market and they fail. Fund managers dedicate their whole life to trying to beat the market, they invest hundreds of thousands of dollars in getting a superior financial education and they still cannot accomplish this task most of the time. The "experts" have historically failed miserably at this task, so how can you realistically expect to outperform?

You better have a unique strategy and differentiated processes to possibly produce some Alpha. If you are solely investing in large cap US stocks you are likely to be wasting your time at stock picking.

A staggering 90% of active US large cap fund managers failed to beat their benchmarks during the last 5 years. If this is not enough to prove that the US large cap market is pretty efficient, then nothing does. Now note that I am not saying that outperforming in the US large cap segment is impossible, however it clearly is exceptionally difficult. The US large cap segment of the stock market is indeed probably the most efficient segment of the whole global financial market. It is ultra-competitive and if any alpha present itself, it is likely to disappear very quickly as investors from all the around the world fight for opportunities in the US large cap segment. Keep in mind that generating Alpha is 0 sum game: when you win, someone losses. When you know that you are competing with professional full time investors from all around the world, how much alpha can you really produce?

If you really want to generate alpha, there are better places to look for opportunities.

So which segment of the financial market is more inefficient than the US large cap segment?

Let's start by pointing out that small caps are more inefficiently valued than large caps. The reason for this is simple. It is a less competitive market with less market participants fighting for opportunities that could create Alpha. Big institutional investors often cannot participate in this segment of the market as their investment volumes are too large for the small company sizes. There simply is not enough liquidity for them to invest large amounts of capital and hence they are often limited to the large cap segment. So for the stock picker that seeks to beat indexes, US small caps are likely to be a better alternative than US large caps.

Is there a better market than the US small caps to generate Alpha?

The problem with US small caps is that today everybody already knows that they have had more alpha in the past than large caps. In consequence lots of money has been flowing into this market segment and the alpha has certainly been reduced. Financial knowledge is quickly assimilated in the US financial market which is generally more efficient than other global financial markets.

Today, they are plenty of Small cap funds in the US that fight for opportunities in the small cap segment. Despite being more inefficient than the large cap market, it is slowly becoming more efficient as a function from all the institutional investors moving into this segment.

The Alpha is richer in the EU Small cap market…

The European financial markets are generally less developed than the US markets. Investors are more risk adverse in Europe and are less sophisticated than American investors. I was born in Finland, raised in France and I have studied finance in Germany, the UK and the USA. What is clear to me is that the US is 20 years ahead from Europe when it comes to financial knowledge. Concepts such as Value investing and small cap investing are still widely undiscovered in Europe relative to the US. There are a great deal of financial literature and great books on these alpha producing investment strategies available in the US, but less in Europe.

The UK is likely to be the most efficient of European markets and Germany one of the least efficient. German people are extremely risk adverse and have no understanding of risk except the short term market volatility. In consequence, value investing and small cap investing are strategies that are significantly less utilized in the German stock market. In the US, everybody trades with these strategies today. In Germany, people are still asking themselves what stocks really represent. I am exaggerating a little, but I have always been amazed by how little financial knowledge in general German people have. At the university in Germany, I was taught how financial markets are dangerous and very efficient. In the US, on the other hand I was taught Behavioral Finance and strategies that have historically outperformed the market.

I cannot prove to you that the EU small cap market is more inefficient than the US small cap market. However, it is quite clear which is one is likely to present more opportunities when European investors are less sophisticated, more focused on short term volatility and taught to not try anything that could beat the market.

Today the MSCI Europe Small Cap (NASDAQ:IEUS) trades at 19 times its earnings and only 15 times its next year's earnings. To put that into perspective, the MSCI USA Small Cap trades today at 36 times its earnings. Even without producing alpha, you have good chances of obtaining higher expected returns by investing in EU small caps since on an aggregate basis they are much cheaper today.

Final Thoughts

If you really want to outperform, you have to differentiate yourself from the crowd. You should develop a unique strategy and exercise stock picking in a segment of the financial market that is likely to be more inefficient than average. It should be clear that focusing on the most efficient market in the world, the US large caps is unlikely to be the best strategy out there to create Alpha. It is certainly possible for a sophisticated investor with the right investment philosophy to outperform in the large cap segment, but opportunities are so much larger and more frequent in the EU small cap field. One last benefit for USD-denominated investors is that the American dollar is very strong currently relative to the Euro and other European currencies. It enables you to buy equities even cheaper and possibly achieve even stronger long term returns.

Additional sources: CNBC European inefficiency; WSJ European risk aversity;

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.