As Mark Twain once said, “It’s not the size of the dog in the fight, it’s the size of the fight in the dog.” We recognize that smaller, less researched stocks can offer valuation discounts and more growth potential than their larger capitalization peers. But what is the most effective method to exploit those pricing inefficiencies? Quantitative research and portfolio construction typically have flexibility in investment style and the agility to react to upside opportunities. Combine that quantitative rigor with fundamental industry knowledge, and the result can exceed what either investment approach could do in isolation.
With both developed and emerging markets in the MSCI ACWI ex USA Small Cap Index (“ACWI ex-US Small Cap Index”) as our hunting grounds, we have launched the Causeway International Small Cap Fund. To learn more about the Fund, we spoke to Causeway portfolio managers Arjun Jayaraman, Duff Kuhnert, and Joe Gubler, the architects of Causeway’s International Small Cap strategy.
Arjun, what makes international small-cap equities attractive?
AJ: We believe that the intersection of international equities and smaller capitalization companies creates a recipe for inefficiency. Many international stocks – especially those in emerging markets – have less sell-side research coverage than their U.S. peers, and their share prices often do not fully reflect publicly available information. The relatively lower liquidity of international
small cap companies also discourages research coverage, prolongs information dissemination, and expands pricing inefficiencies. For instance, the average free float market value of the ACWI ex-US Small Cap Index was U.S. $665 million as of August 31, 2014. These smaller stocks require an equivalent research effort to their larger brethren. Yet, with liquidity and size limitations, many stocks with market capitalizations under $1 billion just are not worth the effort for many larger funds because their average position size would overwhelm available daily trading volumes. Additionally, many emerging markets impose regulatory hurdles to short selling. Coupled with increased borrowing difficulties, these hurdles largely silence the perspective of short sellers in those markets. The net result is that investors often ignore many non-US small cap equities, making them fertile ground for stock selection for those able and nimble enough to take advantage of the opportunity.
Why invest in small caps now, in the wake of such a prolonged equity bull market?
DK: We believe international small cap stocks currently offer higher growth compared with their larger peers, while trading in line with global benchmarks from a valuation perspective. The weighted average expected next-twelve-month (NTM) earnings-per-share (EPS) growth rate for ACWI ex-US Small Cap Index constituents is 9%, nearly double the rate of the MSCI World Index and five times that of the MSCI EAFE Index, with its large exposure to Europe. Meanwhile, valuation of the companies in the ACWI ex-US Small Cap Index is still reasonable at a price-to-earnings ratio of 14.3x NTM earnings. Relative to the ACWI ex-US Small Cap Index, we anticipate positioning the Causeway International Small Cap portfolio to combine better growth potential with a meaningful valuation discount.
Arjun, why does it make sense to use a quantitative strategy to select small cap stocks?
AJ: Either a fundamental or a quantitative approach can work effectively in the world of small cap stocks. Each approach has its own advantages and drawbacks. We believe that the major advantages of quantitative analysis are its rapid assessment of multiple alpha sources and its risk management capabilities. Fundamental research is a time-intensive process, and a large fundamental research team would be required to effectively cover the thousands of stocks in our investment universe. Fundamental in-depth research is more easily allocated to fewer, larger stocks that can absorb more investment dollars. We believe that our quantitative tools allow us to screen for minimum liquidity thresholds, model the expected market impact from a new position, and incorporate this directly into our net estimate for expected alpha. In our view, these extra liquidity inputs are essential for small cap stocks.
JG: A disproportionate number of small cap stocks also reside in emerging markets, and we believe that our experience investing in these markets over the past seven years gives us an advantage. While stocks based in emerging markets represent only 22% of the weight in the ACWI ex-US Small Cap Index, these emerging markets stocks represent 43% of the constituent names. We believe that a quantitative process allows more efficient access to emerging markets small cap stocks, which may include some of the most lucrative sources of alpha in the ACWI ex-US Small Cap Index.
How does your investment process seek to exploit opportunities in the small cap equity universe?
AJ: We examine a multitude of factors within four main categories to gauge the return potential of a stock. First, we seek relatively inexpensive valuations. Second, we want to see accelerating earnings growth prospects and upward earnings estimate revisions from the sell-side analysts who cover the stock. Third, we want to see positive recent momentum, since recent trends tend to persist. And fourth, we want to find financial strength by seeking stocks with a focus on strong free cash flow generation rather than simply sales growth. We then rank the stocks on these factors to identify candidates that will produce the most attractive risk-adjusted returns. Additionally, as with our other quantitatively-managed strategies at Causeway, we believe that fundamental input can strengthen our portfolio and further reduce risk. Before we establish new positions, our fundamental portfolio managers and analysts review stocks in their sector of coverage and report any “red flags” that may be outside the scope of quantitative analysis. For instance, our fundamental analysts may identify significant corporate actions or management changes, or be aware of pending regulatory changes, litigation risk, merger and acquisition activity, or off-balance sheet liabilities that may be difficult to anticipate or detect with a purely quantitative approach. Small caps may have impressive return potential, but they also bring significant risk.
How do you control for risk in individual stocks as well as for overall portfolio volatility?
