This article first appeared in the AFR on 19 July 2024
When Australian investors think of global small to mid-cap stocks, they may tend to think of small or even mum-and-dad operations. But by standards Down Under, these stocks are more akin to the giants of the market spectrum, with valuations of up to $US40 billion.
Small and mid-cap companies also can outshine their larger counterparts in terms of long-term performance, says Maroun Younes, who has been managing the Fidelity Global Future Leaders Fund since its launch in September 2020.
Many Australian investors might perceive small and mid-cap companies as small-scale operations, but the reality is quite different on a global scale.
“Historically, small and mid-cap companies have outperformed large-cap companies over the long term,” says Younes.
These companies, which might be lesser-known names, provide a fertile ground for growth and innovation. However, these stocks are not just about potential; they also offer essential diversification opportunities for investor portfolios.
“They provide diversification benefits, due to less concentration in sectors and individual stocks, compared to large-cap indices,” Younes says.
This diversity helps in spreading out risk, making them an attractive option for those looking to build a well-rounded portfolio.
Global benchmark
The fund managed by Younes and co-manager James Abela uses the MSCI World Mid Cap Index as its benchmark, which gives it a broad exposure across different geographies.
“Our benchmark is the MSCI World Mid Cap Index, with significant exposure to US names, Japan, Europe, Canada, and a small portion in Australia,” says Younes. “The US names dominate this Index, comprising about 60 per cent, followed by Japan at around 10-11 per cent.”
This wide geographical spread is crucial because it can mitigate the risks associated with any single market or region. Investors get a taste of different economies and industries, which can help to provide a balanced risk-reward profile.
Interest rate sensitivity
One of the factors influencing the performance of small and mid-cap stocks is their sensitivity to interest rate changes.
These companies often have higher debt levels and weaker balance sheets compared to large-cap firms, making them more vulnerable to fluctuations in interest rates.
“Smaller and mid-cap companies are generally more sensitive to interest rate changes, due to weaker balance sheets and higher debt levels, compared to large-cap companies,” says Younes.
Historically, interest rate cuts have shown to be beneficial for small and mid-cap companies.
“Interest rate cuts can not only reduce their interest cost expense, which means more profits for them, but they can also help stimulate the economy, stimulate demand, and therefore help these companies grow their top line as well,” says Younes.
The importance of active management
Given the volatility and higher debt levels associated with small and mid-cap companies, active management plays a critical role.
“Active management is crucial due to the higher volatility and debt levels in small and mid-cap companies,” says Younes.
The ability to carefully select well-performing companies, while avoiding those with higher bankruptcy risks, is vital for navigating this space effectively.
Moreover, the dispersion in returns between the stocks that perform well and those that don’t is quite large.
“Dispersion in returns between the stocks that do well and the stocks that do poorly in our universe is quite large,” says Younes.
Investment horizon
Younes suggests that investors should adopt a patient approach when approaching the small and mid-cap asset class to fully capitalise on its potential benefits.
“Investors should approach this asset class with a long-term mindset (at least seven years) to benefit from compounding and ride out market downturns,” says Younes. “This perspective helps in capitalising on the growth potential, while mitigating short-term market fluctuations.”
Many Australian investors might perceive small and mid-cap companies as small-scale operations, but the reality is quite different on a global scale.
“Global small and mid-cap companies are larger and more established than commonly perceived by Australian investors,” Younes says.
“The market cap for global mid-caps can go up to $US40 billion, which is significantly larger than what Australians might typically expect.”
And these are not just speculative companies or new IPOs.
“By and large, the majority of the companies that we're looking at are well-established, profitable names that have been around for many generations,” says Younes.
This variety ensures that investors are not putting all their eggs in one basket, which is a fundamental principle of smart investing. “It's certainly not the wild, wild west of investing, put it that way,” he says.
Diversity of opportunity
“One of the most compelling aspects of global small to mid-cap stocks is the sheer diversity of investment opportunities available,” says Steven Tang, Head of Portfolio Solutions at leading independent researcher Zenith Investment Partners.
“If you look at the diversity index, there’s a lot from which to choose,” says Tang. “It has 20,000 stocks in which you could invest, so that gives you a wide variety.”
This diversity is particularly advantageous for active managers, which can leverage the broad array of options to find unique investment opportunities.
“From an active management perspective, that obviously brings lots of opportunity,” Tang says.
Valuation niche
Another attractive feature of global small to mid-cap stocks is their current valuation.
“Their valuation is a compelling component at the moment, which is why it's one of our clients' higher convictions, in terms of where we're allocating client money,” says Tang.
“Valuations between large and small cap universes are as wide as they've been in history.”
Tang agrees global small to mid-cap stocks are also influenced by interest rate movements, which can affect their valuations and performance.
“Interest rates are not the only impediment at the moment to small caps performing,” says Tang.
“Smaller companies often rely more heavily on bank loans, making them more sensitive to interest rate changes.”
“This is not the case with larger companies in this universe, who do have access to capital markets – but which are still subject to broader economic sentiment, so where we are in the cycle is an important consideration,” he says.
Historically, falling interest rates have often led to rallies in small caps, he says.
“You almost have to see the interest rate cutting cycle happen before you actually see the rally really take hold,” Tang says.
However, he cautions that other factors, such as macroeconomic conditions, also play a significant role.
“Once you start seeing that clarity around interest rates coming down, that certainly has helped small caps' performance historically,” he says.
Making better investment decisions
Active management is particularly beneficial when investing in global small to mid-cap stocks, says Tang.
The large and diverse universe of potential investments allows active managers to make more informed and strategic decisions.
“We've seen a bit of volatility in the market, which has been beneficial to active managers. If you look across the peer group, a lot of our active managers are doing quite well, relative to the broad indices.”
“There's a lot more volatility in those stocks relative to each other, which provides opportunities for active managers to capitalise on market inefficiencies.”
Coverage from sell-side analysts is also often less comprehensive for small and mid-cap stocks compared to large-cap stocks.
This lack of coverage means that active managers can gain an informational advantage by conducting their own research and analysis.
