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The State of International Small-Cap - Royce Funds Commentary
Posted by: Holly LaFon (IP Logged)
Date: February 14, 2014 11:54AM
While some argue that domestic small-cap leadership in 2013 was a result of its heavy exposure to companies that tend to generate most of their income domestically, others contest that this greater focus on the U.S. may mean missing out on the benefits of faster-growing foreign economies.
We, on the other hand, choose to focus our attentions on individual companies, particularly those in more cyclical areas of the market that are more closely tied to the global economy.
There have always been generalizations about the economy and the stock market. Many possess a degree of truth, but at least an equal number are just as often exaggerated, misunderstood, or just plain wrong. This is particularly true when it comes to the small-cap asset class.
Considering the barrage of macro headlines that have affected global stock markets over the last several years, we thought it would be worthwhile to once again examine the state of international small-caps and the effect of international revenues on recent small-cap performance.
These issues interest us for two related reasons: Many of the cyclical sectors in which we routinely find bargains that we like—Industrials, Information Technology, Energy, and Materials—often derive a sizable chunk of their respective revenues from outside the U.S.
We also have been expanding our activities in non-U.S. investing over the last several years. All of this makes the state of international investing particularly interesting to us.
Earlier in 2013, some observers claimed that because many companies in the small-cap Russell 2000 Index are more closely tied to domestic growth, the index was able to hold an advantage over its large-cap counterparts. (This advantage held true for the year as a whole—small-cap led the domestic indexes, and all had higher returns than their non-U.S. counterparts.)
The argument developed the idea that greater stateside focus benefited smaller companies particularly earlier this year when investors were worried about economic growth in Europe and Asia.
2013's results notwithstanding, others see a greater focus on the U.S. as a potential disadvantage, believing that the typically higher percentage of domestically generated revenue for small companies may keep them from enjoying the benefits of faster-growing foreign economies.
We examine the source of revenues for each company that we look at, though we are only concerned with their geographic origin if our analysis suggests that location is a potential threat to their sustainability. However, we suspect that the weighted average percentage of revenue being generated outside of the U.S. for many of our portfolios that invest primarily in U.S. smaller companies would be greater than that of the Russell 2000.
This is in large part a matter of what we choose to own versus what we do not—a clear benefit of active management in our view. For example, we are generally underweight, or do not own, Utilities, real estate investment trusts, and small banks, all of which make up a good-sized portion of the Russell 2000 and generate most of their income domestically.
At the same time, we have greater exposure to more cyclical areas of the market that are more closely tied to the global economy, such as Information Technology, Industrials, Materials, and Energy.
Over the last 15 years, we have expanded our search for undervalued companies by moving beyond our borders. Our initial forays into international investing generally involved companies headquartered abroad that had a strong U.S. presence. We then began to expand our scope to include companies with sizeable operations outside the U.S.
Our commitment to international investing is rooted in the Royce tradition, which aims to capitalize on market inefficiencies to generate strong absolute returns while actively managing risk.
In addition, we embrace the idea that quality is a global concept that transcends borders. The same attributes that we seek in smaller U.S. companies—strong balance sheets, an established record of profitability, high returns on invested capital, and the ability to generate free cash flow—can be found in international businesses. This is why investing in non-U.S. companies has become an important part of our asset management efforts.
Important Disclosure Information
The thoughts in this essay concerning the stock market are solely those of Royce & Associates, LLC and, of course, there can be no assurance with regard to future market movements. Past performance is no guarantee of future results.
This material is not authorized for distribution unless preceded or accompanied by a currentprospectus. Please read the prospectus carefully before investing or sending money. Investments in securities of small-cap, micro-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (See "Primary Risks for Fund Investors" in the respective prospectus.) Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.) Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. 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 S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.
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