Investing globally in small caps

"He/she who does not honour small things, is not worthy of great things" is a saying. The remarkable thing is that investors generally focus on larger companies and often overlook the smaller ones. And that is a shame. Because various studies—more on this later in this article—have shown that (American) small caps perform better than large caps in the long term.

Also, the Inflation Reduction Act of 2022, the American law that aims to curb inflation, contains a number of pillars that can be favourable for small caps. Joe Biden, for instance, has made large sums available for infrastructure projects that could boost the construction and infrastructure sector. In addition, cheaper healthcare is coming closer (boost for the medical sector) and efforts are being made to make the American economy more sustainable (green companies can benefit from this). Because of America's dominant position, these steps usually have an immediate impact on the rest of the world and can influence stock markets.

With the Democrat's plans in mind and the opportunities this offers for small caps, I would like to share two ideas with you in this article, "with a global spread and an American flavour", to prepare the exchange market for the steps the country will be taking in the coming years.

What are small caps?

Small cap is the term used to classify companies with a relatively small market capitalisation. In general, a company is classified as a small cap when it has a market capitalisation between 300 million and 2 billion euros.

Sometimes the limit is somewhat higher. For example, fund houses—with professionally managed portfolios of shares in small listed companies worldwide—often use a limit (market capitalisation) of maximum 5 billion euros for an initial purchase. An American or Japanese small cap could then, when translated to the Dutch market, just be a mid cap or even an AEX share in terms of exchange market capitalisation. The reverse is also true: an AEX company could be a small cap share with this upper limit on an international scale. Although these are smaller companies, the interpretation of the meaning of small cap can differ per bank, broker, country, region or continent.

Why invest in small caps?

Smaller companies offer the chance of potentially higher returns, although this is not without risk. The returns of individual shares can fluctuate greatly and the market is fairly inefficient: not all the available information about the company is incorporated into the price. There are simply more analysts who research AEX shares or American blue chips. Underexposed small cap stocks therefore have an increased chance of inefficient price formation and can offer an active investor who does his/her homework well more opportunities for a value increase.

In addition, various studies show that (American) small caps perform better than large caps in the long run. Of course, small caps also go through periods of underperformance. When financial markets are under price pressure, they regularly show larger short-term declines than the established order with solid balance sheets and a proven track record. It is precisely this volatility in "anxious days" which causes investors to ignore small caps (too often).

Small caps are unjustly ignored—they specifically can profit from the S-curve, or "the sweet spot of growth". When companies are just starting out, they often have startup problems which entail risks and which impede the growth of turnover and profit. Once they are listed, these issues (teething troubles) are largely resolved and generally the strongest growth phase for a company commences.

Small caps are also a way for investors to invest early in a new technology or a new market. Smaller companies are often the driving force behind disruption and benefit from this trend rather than becoming its victim. They are also less burdened by the different layers of management that large multinationals sometimes have to deal with, and there is less fear of, for example, losing market share due to the introduction of new products. In particular, the smaller companies that play an important role in the fast-growing markets of Artificial Intelligence (AI), robotization, Internet of Things (IoT) and electric vehicles—often referred to as e-vehicles in the financial world—are examples of disruptive small caps.

Small caps are also often more focused on the domestic economy. If the global economy worsens, this type of company can often still benefit from local growth factors. Last summer, for example, we saw that many Dutch people stayed at home on holiday and bought a lot of outdoor equipment to enjoy within their own country. From fishing tackle to hiking boots and bicycles, the equipment was in great demand and smaller companies such as Accell capitalised on this.

Investing in small caps with an international spread

Those who want to invest in small caps have a wide choice: the supply is greater than that of mid or large caps. Because of the aforementioned inefficiency, it does mean that a thorough fundamental analysis must be made—nice but time-consuming and challenging job. If you go for individual shares, realise that this is generally riskier than spread investment by means of an investment fund or ETF.

The range of investment funds and ETFs (for individuals) is considerable, although many titles have a US bias. Due to the dominant economic role of the United States on the world stage and Joe Biden's plans, this is defensible, but international diversification reduces risk and does not have to come at the expense of returns. Even if you invest in small caps as an umbrella, one region may perform better or worse than another. And, the more international your spread, the less burden you have with currency risk. Currencies move like communicating vessels, so more currency diversification reduces risk.

Two titles with a focus on global small caps

With international diversification and an "American flavour" in mind, I came across two investment titles during my search that could serve as good additions to a portfolio:

• The iShares MSCI World Small Cap UCITS ETF (ISIN IE00BF4RFH31)
• The Kempen (Lux) Global Small-cap Fund - Class BN (ISIN LU1078127419)

The iShares index tracker currently holds 3,377 (!!) global shares in its portfolio, while the Kempen index tracker holds 62 shares. At the moment, both investment titles have money invested in Brunswick Corporation (US producer of leisure products, including bowling balls and lanes and Bayliner brand yachts), DeNa (Japanese supplier of mobile portals and ecommerce websites), Dialog Semiconductor (UK producer of integrated circuits), Fujitec (Japanese producer of lifts and escalators) and Jabil Circuit (US producer of electronic equipment), among others. Kempen's underlying portfolio is clearly more concentrated.

As for the US sauce, although both funds have a global spread, the United States is the main supplier in terms of stock position (iShares 57.85% and Kempen 52.1%). Japan also makes a contribution in both cases (iShares 11.16% and Kempen 14.9%). The rest is nicely distributed across the world, with a good portion for Europe.

Running costs are about 0.35% (iShares) and 1% (Kempen) per year respectively. The index tracker has different currency variants. The variant in this article is quoted in euros, as is Kempen's fund. Both investment products can be traded via Saxo. The iShares euro variant is available through the Frankfurt exchange market, and the Kempen fund through the mutual fund exchange FundSettle.

While the primary objective of iShares' ETF is to track the MSCI World Small Cap Index, an index of 4,188 small caps, Kempen's fund aims to beat the performance of that same index. iShares has managed to track the benchmark very closely since the ETF's inception on 27 March 2018. Sharp readers will notice the difference between the number of stocks the ETF invests in and the index they track: 3,377 to 4,188. iShares thus applies optimisation and still tracks the price movement of the index with fewer shares. The fund has three stars at Morningstar.

And Kempen? It receives a respectable four stars from Morningstar. Understandable, because since its inception 8 July 2014, the fund scores very well compared to the benchmark: 10.20% versus 9.50% per year. That makes the slightly higher cost of this fund defensible. Worth mentioning: Kempen's fund has a Morningstar Analyst Rating™ of Bronze.

And the dividend? For the iShares title, it is about 1.80% annually and is automatically reinvested. For the Kempen fund, it is around 2.60% annually. Still a bit higher than that of the index tracker. Kempen's dividend is optional: it is paid twice a year in January and July, and you can either receive it in cash or use it as a stock dividend to buy additional shares over time. Do note that the value—and thus also the dividend—of your investments may fluctuate. Past results are no guarantee for future performance.

There is a currency risk. As mentioned, the funds are listed in euros, but there are many foreign companies within them. And, of course, you run a market risk. In terms of investing like a football coach, they are midfielders with a good eye for goal.

In a nutshell, the titles are interesting for long-term investors who can and want to bear equity risk and who want to add a little nuance to their portfolios in light of the US investment plans in the coming years.

Would you like to know more? Read about the iShares fund or the Kempen fund.

Investing carries risks. Your investment may depreciate.