Diamonds in the rough

Backed by recoveries of the past, international small-caps grounded in the quality factor are likely to be beneficiaries of a slow growth, post-recession environment.

While the markets watch on central banks do all they can to fight inflation, astute investors are looking for pockets of opportunities. Beneath the surface, dispersion within asset class returns across sectors and styles remains high.

Markets are hopeful, and seemingly priced for a ‘soft landing’ but the reality is a ‘hard landing’, that is when an economy enters recession after an interest rate hiking cycle, remains a persistent threat. Manoeuvring portfolios to meet the challenges and idiosyncrasies of these capital markets is no easy feat.

Savvy investors are reassessing portfolios and preparing for the next cycle following a hard landing, which leads to low growth and a period of recovery, as in the past, during this type of cycle, small-caps have offered more upside than large caps because they have fallen further in the market downturn.

Australian advisers are no strangers to Australian small companies but the world is far bigger than the ‘Small Ords’. The international small-cap universe presents over 4,000 companies and, as size is a relative term, many of these companies are not that small.

Bears and central banks on a tight rope

The market sell-off since, of ‘transitory’ the Fed declared at the end of last November “it was probably a good time to retire that word,” and started fighting inflation.

Globally, small- and mid-sized companies have been hit more than their large cap counterparts.

Figure 1: Global large- and small-cap performance 30 November 2021 to 6 July 2022

Savvy investors are starting to prepare their portfolios to navigate through potential growth/recovery setbacks such as a hard landing, COVID clusters and poor economic data.

One of the beneficiaries could potentially be international small companies.

Quality factor in low growth environments

Figure 1 below shows that international quality small-cap stocks, as represented by the MSCI World ex Australia Small Cap Quality 150 Index (QSML Index), has fallen further than the 19.85% fall of the large- and mid-cap MSCI World ex Australia Quality Index, posting a return of -21.42% so far in 2022. International quality small-cap companies also did well in previous recoveries following: 1) the global slowdown in the early part of the century following the dotcom bubble; and 2) for many of the low-growth years following the GFC.  

Figure 2: Calendar year performance - MSCI World ex Australia Small Cap Quality 150 Index and MSCI World ex Australia Quality Index

Both of these periods coincide with periods following a US recession (2001 & 2007 to 2009). There is a fear that the US is headed for a recession again, as the Fed tightens rates.

Small caps in the US, for example, relative to large caps, are at their lowest valuations in over 12 years.

Figure 3: Price to equity (P/E) of S&P 500 and S&P SmallCap 600

But as you know, with small companies investing, it pays to be prudent. The international benchmark, like the S&P/ASX Small Ordinaries, includes companies that are not attractive from an investment point of view, it also includes in excess of 4,000 companies. The same issue is true when you consider an international mid- and large- cap passive approach; not all of the 1,500 plus in the MSCI World ex Australia Universe are attractive from an investable point of view.