22 Feb 2022
Over the past 10 years of abrdn global smaller companies investing, we’ve argued that small caps are too big to ignore. Although they account for just 15% of global benchmarks, small caps represent about 70% of global listed companies.1
This ratio has stayed roughly constant throughout those years, but the composition of markets has changed dramatically. Technology, as it always does, has facilitated transformation in areas that were barely visible 10 years ago.
Investor appetite and behaviour has evolved
Investor appetite and behaviour has also evolved. Most noticeably, the digitisation of everyday life, in the form of education, banking, consumption, has seen a seismic shift in adoption. So too has the awareness of our environmental and social responsibilities. An assessment of a company’s full ESG credentials is now a central part of our investment process.
In the course of an eventful decade we’ve also learned a lot as small-cap investors, including the following four key lessons:
Firstly, be objective. It is vital to be open to change and to listen to news flow. We must weigh-up data and impartially review how it affects a company. Only then can we make rational and informed decisions.
That’s why our proprietary quantitative screening tool, the Matrix, is invaluable. It consistently flags companies that meet our quality, growth and momentum criteria – as well as those that don’t.
The Matrix reduces the 6,000+ global small-cap universe to a more manageable size. It tracks 13 factors that our backtesting has found to be predictive of share price performance. These include measures of price and earnings momentum, valuation, earnings growth, and balance-sheet strength.
Company meetings, financial analysis, and team review allow us to cross-check the accuracy of our investment thesis. Our goal is to ensure only the best 100+ stocks are considered. Of these, only 45-65 stocks make it into our portfolio.
Secondly, never underestimate the simple, steady compounders. Businesses don’t need to be complicated or cutting-edge to be successful. Sometimes simple companies that do what they do exceptionally well go onto become multi-baggers (i.e. stocks that return more than 100%).
Our job is to uncover these gems by identifying their competitive advantage and the sustainability of their growth. Equally important is to remember that we are buying these companies at a nascent stage in their development. The dynamics that lead to outperformance can play out over many years, which is why it’s important to allow winners to keep running.
Ironically, the rise of passive investing has, to some extent, allowed bottom-up, active managers to exploit market inefficiencies to an even greater degree than before.
Macro trends can be difficult to predict and the exact ramifications for individual stocks can be even harder to ascertain. By focusing on the stock’s fundamentals, we are able to make assumptions and measure the impact of factors that are controlled by management. That way, we believe we have far higher understanding and conviction in the stocks we buy.
Over the past decade, a number of macro events have driven markets for short periods. We’ve witnessed the Eurozone crisis, Brexit, President Trump’s shock election win, the ‘taper tantrum’, Covid-19 and, recently, inflation/rate-rise concerns. For us, these events can be frustrating, as investors often ignore company fundamentals.
However, in our experience we’ve seen that over any reasonable period of time market participants usually reward companies that consistently grow their earnings over the long term. In other words, the very companies in which we seek to invest. So, the key takeaways from bouts of pronounced market turbulence? Follow your process, speak to your companies and always think long term.
The small-cap universe, by its nature, is constantly changing. It is a dynamic, growing and, crucially, unexplored area of equity markets. We believe investors need a clearly defined, proven process to decipher this universe. Exceptional access to company management is also an enormous advantage.
As we look ahead, challenges will inevitably present themselves. However, for small-cap investors there remains a wealth of high-quality, innovative companies that are growing across a variety of sectors. By sticking to our process, we will continue to seek out these names – giving our clients access to what we believe will be the large-cap leaders of tomorrow, today.
RISK WARNING
The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.