Global smaller companies: performing without the hype

Between the hype and genuine innovations a lot of mega-cap artificial intelligence dust was kicked up last year that obscured decent wins for other types of stock and strategies, especially among small caps.

Coming into the end of 2023, every IA sector, other than China, was positive, with smaller companies in Europe, the UK, and the US seeing a sharp rally in November and December. Admittedly this was a late rebound for small caps, after a difficult year where interest rates shot up and investors could suddenly make decent returns on much lower-risk assets.

But as we come into 2024 it’s worth taking a closer look at the hidden gems scattered throughout the global small-cap universe.

The appeal of global small cap

Smaller companies provide big opportunities in terms of not only the number of companies available — small caps account for more than 68% of all listed companies globally^ — but also their ability to deliver long-term performance in comparison with their larger peers.

The MSCI World Small Cap index has delivered an average annual return since 2000 of 8.95%, compared with 6.89% for the MSCI All Companies World Index*. (It is worth noting that the latter includes the performance of technology giants such as Meta, Alphabet, Apple and Microsoft.)

Smaller companies, regardless of geography, remain under-researched, which open up opportunities for active stock pickers to find compelling investment ideas. And, of course, smaller companies are renowned for their growth prospects and potential for long-term returns. By investing in smaller companies today, investors may be investing into tomorrow’s larger companies.

Opportunities abound

Kirsty Desson, manager of the abrdn Global Smaller Companies fund, has discovered a rich seam in three broad areas where she has seen the fund’s holdings outperform so far this year: structural changes in the energy market; infrastructure spending and diversified financial stocks.

With investment opportunities across digital infrastructure, renewable energy, healthcare and airport sectors, infrastructure is an example of a sector benefiting from strong global thematics. The total global requirement for infrastructure investment is estimated at $97 trillion by 2040**, with the greatest demands being in emerging markets. Whether as a result of climate change or simply due to lack of investment, governments and corporates around the world are upgrading aging infrastructure.

Kirsty invests in small caps Johns Lyng, an Australian contractor supplier for insurance repairs, and Napco, a US provider of communication equipment and locking systems, both of which are benefiting as a result, she says.

Digging around for next-gen performers is (quite literally) the name of the game for Baillie Gifford Global Discovery, another global small-cap fund which seeks out the most innovative and fast-growing smaller companies in the world.

Richie Vernon, investment specialist at Baillie Gifford, says some of the most exciting opportunities in the fund are companies transforming healthcare, and after a tough 2023, where the sector lagged the broader indices by the widest margin since 1999***, the outlook for 2024 is much more favourable.

Last year’s difficulties for healthcare “have obscured impressive progress by companies”, Richie says, and depressed valuations are a buying opportunity. Like, for example, Oxford Nanopore Technologies, which the fund invests in. It is helping bring down the cost of genomic sequencing, democratising the technology and unlocking its wider use in clinical practice, creating a new era of deeply personalised genetic medicine.

Gareth Powell, manager of the Polar Capital Global Healthcare Trust, tells us more about innovation in the healthcare sector in a recent interview.

A fresh focus for the year ahead

Nish Patel, co-manager on The Global Smaller Companies Trust, believes now is a good time to be invested in smaller companies as smaller companies have a good track record of outperforming after the first interest rate cut and as the economy recovers.

David Eiswert, manager of the T. Rowe Price Global Focused Growth Equity fund is also of the view that times are a changing. He thinks we are operating in a different environment from the one that supported equities for much of the period after the global financial crisis. Investors need to “not rely on past growth investing strategies of buying technology and duration and forgetting about the rest”, he says, and instead focus on different areas of the market to identify companies providing better earnings growth.

This is all to say, from 2023’s ‘just buy big tech’, in 2024 it looks like there are gains to be made from a fresh focus on fundamentals and the benefits from small caps in particular.

Global small caps are likely to prove a compelling option if the interest rate environment remains benign and economies experience a soft landing. Risks remain, but smaller companies have generally rewarded investors brave enough to invest when sentiment is poor.

^Source: Stocks in MSCI ACWI Small Cap as a percentage of stocks in MSCI ACWI Small Cap and MSCI ACWI. As at 31 January 2024.

*Source: MSCI index factsheet, 29 December 2023

**Source: European International Contractors, 17 November 2017

***Source: BNP Paribas Asset Management, 16 January 2024