International Small Cap Equity Is Ripe For Active Management

by: Manning & Napier

As an asset class, international small cap equity is easily lost in the shuffle. Investors are familiar with both U.S. and international large cap companies, which are typically well-recognized, large corporations with products people buy and use every day. Even many domestic small cap companies would be known by the average investor. But the combination of international and small creates an investment universe that can be perceived as esoteric, and therefore something to avoid. Since this asset class typically flies under the radar, it has the potential to result in attractive investment opportunities, particularly when utilizing active management.

In general, the lack of attention to the space can translate into market inefficiencies. International small cap is a notably inefficient equity asset class, making it an excellent option for an active manager to generate alpha, and therefore wealth creation. The ACWIxUS Small Cap -- the most commonly used benchmark for international small cap equity -- includes more than 4,200 stocks from 45 countries. This highly fragmented universe of companies sets the foundation for why the space can be inefficient.

The asset class remains underinvested, in part because there is much less research available on international small cap stocks than their larger counterparts, which also contributes to inefficiency. For instance, a company such as Microsoft has dozens of sell-side analysts providing coverage. When a company is so heavily researched, it can be very difficult for an analyst or portfolio manager to generate a differing perspective. However, only a handful of sell-side analysts will research an international small cap company. As a result, from the perspective of exploiting price inefficiencies, it should be easier for an active manager who has done their homework to find opportunities in international small cap equity than large cap stocks.

Another factor contributing to inefficiency is that the multitude of long-term structural investment opportunities in international small cap tends to be over-shadowed by both larger companies in a particular country and the consensus view of that country's political headlines. Potential prospects in the space tend to be dismissed or ignored as a result. We believe one advantage of active management here is that it allows investors to own companies not because they are big, but because they have fundamental growth drivers and actual investment merit.

There could be concern among investors that the international small cap universe only contains new, untested companies, meaning there is a risk that they could be here today and gone tomorrow; however, many of the companies in the asset class have been in business for decades. We don't believe investors should be concerned that these businesses have not climbed up the market cap ladder. They remain small cap stocks because they often focus on a niche market or a smaller local economy or region of the world.

The inefficient nature of international small cap means it is an equity class that is generally ripe for active management. There are not many passive investment options that can replicate the exposure to international small cap stocks that active managers can provide, as there are very few ETF or index options. Nevertheless, it is still important to pick the right manager. The largest constituent of the ACWIxUS Small Cap makes up only 30 basis points of the index's weight, and the top ten constituents account for just 2.2%. This means that almost any investment in the asset class is an active decision against the benchmark. An experienced manager who has dedicated the time and resources necessary to understand the space can help cut through the mystery surrounding international small cap equity and find undervalued companies in which to invest.