The benefits of global mid and small cap investing

“Big companies have small moves; small companies have big moves.”
― Peter Lynch, One Up On Wall Street

Over the last ten years in Australia, we’ve witnessed some amazing mid and small-cap businesses evolve from an idea to established international businesses with market capitalisations of US$10 billion or more. A small sample of  these high quality compounders also known as “multi-baggers” include; Dominos (Pizza) up 23x; REA Group (Online real estate portal) up 15x; Resmed (Medical airflow devices) up 14x; CSL (Blood fractionation products) up 10x and James Hardie (Building products) up 9x.

If our experience in the Australian small and mid-cap universe is any indication of the potential for long-term value creation, we can expect the global investment universe would magnify such scope.

The global mid and small-cap universe is very dynamic and diverse and includes around 4,000 companies ranging from US$1 - $40 billion in market capitalisation. With a strong investment discipline and consistent approach, we believe the global stage offers many opportunities to invest in tomorrow’s future leaders. Some examples of top performers are included in the table below:

The mid-cap universe is home to many potential multi-baggers. The segment is under-researched compared to their large-cap brethren. Fewer investors researching these names increases the likelihood of high-quality business flying under the radar, allowing for mispriced opportunities. Investors also tend to miss the forest for the trees, not realising that there are well-established businesses with strong track records alongside the more obvious listings of newer companies and business models.

Many of these businesses are also founder-led. This increases the likelihood that management teams are innovative, agile, and their interests are strongly aligned with outside shareholders. In our experience, the best ideas or ‘future leaders’ in the global mid and small-cap universe are typically business models that are either structural winners, technology disruptors, innovators, category killers and/or brand leaders. Sometimes these businesses are unique niche operators or specialists, who dominate their field. At other times they are part of a large global theme. Sectors such as technology, healthcare, globally focused consumer, and industrials have more recently been home to such business models.

A world of opportunities: Risk-Return analysis highlights solid outcomes

So, why should investors think about an explicit allocation to global small and mid-cap equities within their portfolio?

Mid-caps in particular sit at what you might call the “sweet spot”. They’re likely to offer more growth than large-caps and carry less risk and volatility than small and micro-caps. Indeed, if we look back over the past quarter of a century or so, global mid-caps have generated higher returns than large caps.

Large cap names such as Amazon, Facebook and Tesla which have dominated recent headlines provide a great example for the growth potential available in the mid-cap universe. Facebook for instance, was a mid-cap segment opportunity when it listed in May 2012 with a market value of US$ 24 billion and stayed in the sub US$ 40 billion range for the next nine months.

For a broader assessment, we’ve looked at the rolling 10-year view of average annual returns of international small cap universe versus its large cap counterpart. As the graph below demonstrates, mid-caps have outperformed large caps 90% over this time. Over a shorter 5-year timeframe, mid-caps have outperformed more than 70% of the time.

Balancing risk and return

Mid to small-caps tend to be riskier investments than large-cap companies. They have greater growth potential and tend to offer better returns over the long-term, but without the resources of larger companies which makes them more vulnerable to sentiment and negative events such as the pandemic. This increased volatility is offset by higher growth potential as demonstrated by the below chart which shows mid-caps performing strongly on a risk-adjusted return basis against their larger peers.

The recent crisis has highlighted the importance of investing in high-quality names, characterised by sound balance sheet structures that enable companies to weather more challenging environments. An active investment approach offers crucial advantages for investors as it allows investment teams to select opportunities from a much broader universe than those available in the Index. The advantage to investors is twofold: greater diversification across countries, sectors and companies, and importantly enables managers to focus on research and choose investments selectively.

With around 1000 companies in the MSCI World Mid Cap Index, and almost 4000 companies in the investible universe the opportunities are vast. This can be daunting for investors however it’s the size and diversity that makes mid to small-cap equity investing at the global level so attractive. Of course, research plays a vital role in finding companies in their earlier stages of growth, which is why it’s important to choose a fund manager, like Fidelity, with the global reach to help inform investment decisions.