Why Allocate to Non-U.S. Small-Caps?—Royce
article 08-10-2021

With Headlines Like These, Why Allocate to Non-U.S. Small-Caps?

Senior Investment Strategist Steve Lipper makes his contrarian case for investing in non-U.S. small caps today.


A Contrarian Opportunity

An investor perusing the headlines from around the world might pause before thinking about an allocation to non-U.S. small caps. The news out of China alone might engender hesitation, if not unwillingness, to invest outside the U.S. right now. The decision by the People’s Bank of China to pivot toward easing in mid-July was taken as a sign that the world’s second-largest economy was slowing. More recently, the Chinese government surprised global observers by suddenly cracking down on for-profit education and calling for potential re-regulation of the gaming industry. The apparently escalating tension with U.S. listed Chinese companies is yet another source of concern. In addition, China and other Asian nations have been hit hard by the Delta COVID variant, adversely affecting already compromised global supply chains. These developments have already led certain analysts to downgrade their growth forecasts.

Europe has been relatively better. The 19-nation euro area rebounded in the second quarter due to business reopenings. Economic output rose by 2%, beating economists’ estimates as several nations shook off the effects of lockdowns that persisted through the winter months. However, Germany—the linchpin of European trade with China—disappointed, expanding by only 1.5%. The country has already seen forecasts for its own economy downgraded. Back in June, the Ifo Institute, one of the country’s largest economic think tanks, claimed that the German economy will grow by a weaker-than-expected 3.3% in 2021 as supply bottlenecks in manufacturing continue to hold back industrial output. With global supply chains encountering unforeseen challenges, this could spell trouble.

As experienced global small-cap investors, however, we have learned that contrarian investing is often rewarded, especially when discipline and a long-term perspective are added to the mix, and we think that may be the case for non-U.S. small caps today.

"As experienced global small-cap investors, we have learned that contrarian investing is often rewarded, especially when discipline and a long-term perspective are added to the mix, and we think that may be the case for non-U.S. small caps today.” — Steve Lipper

Current headlines aside, we often find that investors’ reluctance to invest in non-U.S. small caps originates in a misperception about the asset class’s incremental risk.

To be sure, many clients and shareholders are surprised to learn that non-U.S. small-caps have shown lower volatility than their U.S. cousins—and only marginally higher volatility than international large caps—based on monthly rolling five-year standard deviation.1 For the monthly rolling five-year periods from 5/31/94 (the inception of the MSCI ACWI Indexes) through 6/30/21, the MSCI ACWI ex USA Small Cap’s average standard deviation was 17.1% versus an average standard deviation of 16.6% for the MSCI ACWI ex USA Large Cap. Over the same period, the Russell 2000 Index’s average standard deviation was 19.5%.

We also think it’s helpful to know that the non-U.S. small cap universe consists of a globally diverse set of companies in 46 countries that rarely occupy the same place in their respective economic cycles. This geographic diversification helps to dampen the price volatility of any specific security. Also helping to potentially reduce volatility is the prevalence of dividend-paying companies: approximately 87% of the stocks in the MSCI ACWI ex USA Small Cap Index paid dividends as of 12/31/20.

Attractive Valuations

The timely case for non-U.S. small caps starts with the valuation metric that has been among the most useful during this period of record low interest rates—the equity risk premium (ERP).2 This metric shows that non-U.S. small caps, which had a 220 basis point equity risk premium as of 6/30/21, were significantly undervalued compared with their 20-year average of 60 basis points, as shown on the chart below:

MSCI ACWI ex US Small Cap Equity Risk Premium
Relative Weighted Median FCF/EV-10-Year Treasury* from 1/31/03 to 6/30/21

International Equity Risk Premium

* Free Cash Flow divided by Enterprise Value minus 10-Year Treasury Yield
Source: FactSet

We find it highly encouraging that over the past 20 years the subsequent one-year returns from this high level of ERP have been very attractive, averaging 19.2%., as shown in the chart below:

Historically, High Equity Risk Premium Has Led to High Returns
Average Subsequent MSCI ACWI x US SC 1-Year Performance in Equity Risk Premium Ranges* from 1/31/03 to 6/30/21

Equity Premium By Return Levels

* Equity Risk Premium = Latest Twelve Months Free Cash Flow divided by Enterprise Value minus 10-Year Treasury Yield.
Past performance is no guarantee of future results.
Source: FactSet

Supportive Economic Environment

Moreover, the expected economic environment is supportive for strong non-U.S. small cap returns. As many investors know, small caps are more cyclical than their large cap siblings. Consequently, both U.S. and non-U.S. small caps often post returns that are above their own respective averages—and above large cap returns—in periods of above average economic growth. Specifically, in periods when U.S. nominal GDP growth exceeded 5%, non-U.S. small caps beat non-U.S. large caps in 90% of rolling one-year periods by an average of more than 700 basis points. (While we used U.S. nominal GDP growth to analyze the relationship between economic growth and non-U.S. small cap returns, we expect the pattern would still hold using non-U.S. economic growth.) Given this relationship, it’s helpful to know that consensus expectations for 2022 nominal growth exceed 5% for both U.S. and global GDP.

Economic indicators and financial conditions outside the U.S. are also supportive of solid small cap returns. Leading Economic Indicators (LEIs) are strong across Europe, though admittedly not as strong in Asia. Global PMI’s, at 55.4 in their latest reading, are solidly in expansionary territory. The European Central Bank has adopted a new symmetrical inflation fighting framework that should allow the bank to keep interest rates lower for longer than their prior framework, which is generally supportive of European equity valuations.

As thorough analysts, we have to acknowledge that not all indicators are positive. While China’s recent reduction in banks’ required reserves should help China’s economy, it’s reasonable to assume that the Chinese government took this action because they anticipate a meaningful slowdown ahead, possibly due to the consequences of the Delta variant. A slower growing China will lead to slower global growth and will generally put downward pressure on earnings expectations for more cyclically oriented companies, including many small caps. Additionally, any resumption of restrictions resulting from the spread of the Delta variant in the U.S. and/or Europe could also be expected to depress equity prices, and perhaps small caps more so. Still, we would suggest that this would likely have a relatively short-term impact.

The Stealth Rally and Lean into Quality

We have been struck by what we’d call “The Story No One Is Talking About,” which in our small cap world is the nascent, four-plus month rally in non-U.S. small caps compared with their U.S. counterparts. From the end of March through August 6th, the MSCI ACWI ex-USA Small Cap Index rose 7.7%, while the Russell 2000 increased by a meager 1.5% over the same period. By the time relative price movements are being widely discussed, investors are wise to ask whether the relative move is largely complete. That’s hardly the case with the so-far stealthy relative strength in non-U.S. small caps.

Within this vast universe of stocks (more than 4,000), we think an area that is poised for robust returns is high quality companies. At Royce, we define high-quality companies as those with superior returns on invested capital (ROIC) and low to moderate leverage. In our experience, high-quality companies historically tend to cluster disproportionately in some countries more than others. For example, based on the methods we use to gauge high quality, Japan boasts some of the highest numbers of these companies. And that country’s small-cap market has been a regular source of active research for our non-U.S. investment professionals for more than a decade.

While this cohort of companies boasts a superior long-term record compared with the overall non-U.S. asset class, there’s also a particularly timely and notable signal. In our experience, higher quality strategies have historically enjoyed some of their greatest outperformance, i.e., largest excess returns, in periods that began with low high-yield bonds spreads. With both U.S. and euro high yield spreads near historic lows, that’s one more indicator that suggests, despite the current headlines, this may be a very opportune time to invest in high quality non-U.S. small caps.

1Standard Deviation is a measure that quantifies the amount of variation or dispersion in a data set. The greater the standard deviation, the greater a portfolio’s volatility. Roughly 68% of the data values are within one standard deviation of the mean.
2 Equity Risk Premium = Latest Twelve Months Free Cash Flow divided by Enterprise Value minus 10-Year Treasury Yield. Past performance is no guarantee of future results.




Important Disclosure Information

Mr. Lipper’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Return on Invested Capital (“ROIC”) is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its average invested capital (total equity, less cash and cash equivalents, plus total debt, minority interest, and preferred stock).

Cyclical and Defensive are defined as follows: Cyclical: Communication Services, Consumer Discretionary, Energy, Financials, Industrials, Information Technology, and Materials. Defensive: Consumer Staples, Health Care, Real Estate, Utilities.

There can be no assurance that companies that currently pay a dividend will continue to do so in the future.
Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The MSCI ACWI ex USA Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. The MSCI ACWI ex USA Large Cap Index is an unmanaged, capitalization-weighted index of global large cap stocks, excluding the United States. Index returns include net reinvested dividends and/or interest income. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)



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