International Small Cap Update
7 min read
International small-cap stocks are attractively valued and have historically generated better returns than large caps. They offer a broader, more diverse, less correlated, and undiscovered universe of opportunities.
We believe today is a particularly attractive entry point for small-cap stocks internationally. Despite rising 85% since the depths of COVID, international small-cap stocks are trading at near-generational lows relative to international large-cap stocks (Exhibit 1).
WHY SMALL CAP?
Small-cap investing is a cousin of value investing. While small-cap investors search among undiscovered stocks, value investors search among unpopular stocks. As such, it should not be surprising that pairing small-cap with value investing has generated superior historical returns.
THE SMALL-CAP ADVANTAGE
Small-cap stocks, especially those outside the US, provide access to a wide array of niche businesses, currencies, economies, regulatory regimes, languages, and market cycles. Understanding these nuances across different geographical areas can present lucrative opportunities; however, specific skills and judgment are required.
Historically, although small caps have exhibited higher short-term volatility than their large-cap counterparts, they have generated better risk-adjusted returns, while offering a broader, more diverse, and less correlated universe of stocks.
Performance: International small-cap stocks have beaten their large-cap equivalents by approximately 60 basis points per year since 1975, and small-cap value stocks have beaten the style-neutral broader small-cap index by approximately 480 basis points per year (Exhibit 2).
THE VALUE OPPORTUNITY IN SMALL CAP
We believe it is a particularly attractive time for international small-cap value. The current fundamentals of the cheapest quintile of small-cap stocks are significantly better than those of the most expensive stocks. The cheapest stocks have also performed considerably better historically.
ACTIVE ADVANTAGE IN SMALL CAP
As an underallocated, underfollowed asset class, small-cap investing is especially attractive for active management, because it is a less crowded corner of the equity universe.
Undiscovered: Small-cap value stocks – and small-cap stocks more generally – tend to attract less attention from equity research firms than large caps. Thirty-four percent of international small-cap stocks are followed by fewer than four analysts, compared with just three percent of international large-cap stocks (source: FactSet). The lack of analyst coverage is partly due to the large number of companies within the small-cap universe relative to the large-cap universe. Thin analyst coverage typically manifests in less company information available to the investment community, which may lead to investment controversy not being widely understood. With less Wall Street analyst coverage, earnings estimates and annual returns are also more dispersed (Exhibit 4).
Uncertainty around cashflows and earnings creates opportunities for active managers to outperform through deep fundamental research. Successfully investing in a universe with a dearth of analyst coverage requires a dedicated research team with a disciplined process; our team canvasses the globe, sifting through the broad and diverse international small-cap universe in efforts to find truly outstanding potential investment opportunities.
THE PZENA ADVANTAGE
As with all strategies at Pzena, we manage our International Small Cap Focused Value strategy with a focus on building concentrated portfolios of undervalued businesses, often experiencing temporary issues.
We utilize our proprietary screening tool StockAnalyzer to sift through the cheapest 20% of the vast small-cap investment universe for potential research candidates and assign research priority to the most interesting companies.
Our 30 research analysts cover companies according to global industry. When we research a small-cap company, our industry analysts often already have a deep knowledge of the competitive landscape, as well as the customer and supplier bases across the globe. The impact of this knowledge base is particularly crucial in the small cap universe, given the underfollowed nature and the unique dynamics of the companies in the universe, many of which operate in niche businesses.
The product of our process is an educated estimate of normalized earnings, as well as a thesis for how company management can turn around the business. Crucial to outperforming is focusing on purchasing good companies trading at steep discounts, due to temporary distress, which is often idiosyncratic and company-specific in nature.
Our rigorous fundamental research, paired with a structured process to uncover potential ideas across a broad, underfollowed, underallocated universe, gives us the opportunity to achieve meaningful outperformance over the long term.
FURTHER INFORMATION
This document is intended solely for informational purposes. The views expressed reflect the current views of Pzena Investment Management (“PIM”) as of the date hereof and are subject to change. PIM is a registered investment adviser registered with the United States Securities and Exchange Commission. PIM does not undertake to advise you of any changes in the views expressed herein. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance is not indicative of future results. All investments involve risk, including risk of total loss.
This document does not constitute a current or past recommendation, an offer, or solicitation of an offer to purchase any securities or provide investment advisory services and should not be construed as such. The information contained herein is general in nature and does not constitute legal, tax, or investment advice. PIM does not make any warranty, express or implied, as to the information’s accuracy or completeness. Prospective investors are encouraged to consult their own professional advisers as to the implications of making an investment in any securities or investment advisory services.
All investments involve risk, including loss of principal. The price of equity securities may rise or fall because of economic or political changes or changes in a company’s financial condition, sometimes rapidly or unpredictably. Investments in foreign securities involve political, economic and currency risks, greater volatility and differences in accounting methods. These risks are greater for investments in Emerging Markets. Investments in small-cap or mid-cap companies involve additional risks such as limited liquidity and greater volatility than larger companies. PIM’s strategies emphasize a “value” style of investing, which targets undervalued companies with characteristics for improved valuations. This style of investing is subject to the risk that the valuations never improve or that returns on “value” securities may not move in tandem with the returns on other styles of investing or the stock market in general.
The Russell 2000® Value Index measures the performance of small-cap value segment of the US equity universe. It includes those Russell 2000® companies with lower price-to-book ratios and lower forecasted growth values. The S&P 500® Index seeks to track the performance of an index composed of 500 large-cap U.S. companies. These indices cannot be invested in directly.
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