The universe of international small capitalization (“cap”) stocks is unlike any other. We believe its inefficiencies and breadth provide the active investor a truly unique opportunity set. Because of their size, small caps generally receive much less attention from the sell-side and buy-side communities, and the home bias in investing further exacerbates this phenomenon among small caps outside the U.S. With more than twice the number of U.S. small cap stocks trading internationally, the active investor can access a much broader and diverse group of stocks by looking abroad. In most large cap universes, investors typically face tradeoffs in the characteristics of stocks. Want to build a value portfolio? Chances are you may have to sacrifice some growth and quality characteristics to achieve the inexpensive valuation. It is rare to find a stock with multiple attractive attributes, much less an entire portfolio of them.
That’s not what we see within international small caps. The MSCI ACWI ex USA Small Cap Index (“ISC Index”) represents just 15% of international equities by market value in the MSCI ACWI ex US IMI Index, but small caps account for 65% of the broader index by number. With over 4,300 constituents in the ISC Index, the universe is vast. And since most of its constituents are similar in size, the ISC Index is not dominated by a handful of stocks. The largest ten members have a mere 1.8% weight in the ISC Index, a stock picker’s dream. Exhibit 1 juxtaposes these statistics with those of various larger cap indices, each of which contains fewer stocks and higher concentration.
Not only is the ISC Index far less concentrated than various other indices, but the individual constituents are much more differentiated. One gauge of differentiation is the mean pairwise correlation, the average correlation between all pairs of stocks in an index. Exhibit 2 shows the mean pairwise correlation for the ISC Index over time and compares those values to larger cap indices. The ISC Index has consistently offered the lowest mean pairwise correlation, which tells us that returns on individual index constituents tend to be driven by unique sources. The low correlation is a product of the highly idiosyncratic nature of small cap returns, a feature particularly important now as macroeconomic headlines have come to dominate moves in large cap indices. Additionally, the lower the correlation among constituent stocks, the more total portfolio volatility can be lowered by combining the stocks.
Seeking to exploit the pricing inefficiencies of such a dynamic universe in a risk-conscious manner, the Causeway ISC strategy uses a quantitative approach for stock selection and portfolio construction. We examine the small cap universe along four major bottom-up factor dimensions to gauge return potential. In our view, the ideal candidate will exhibit relatively cheap valuations, accelerating earnings growth prospects, positive technical indicators, and superior competitive strength. We also consider various top-down factors to determine the relative attractiveness of countries. We believe a quantitative approach not only allows for a diversification of alpha sources, but also facilitates rigorous risk management. We use a proprietary risk model to examine each stock’s exposure to over one hundred risk factors. Then we form an optimized portfolio with the highest expected return per unit of risk.
The breadth of the universe means we frequently find stocks that, in our view, contain all the prized characteristics of winning stocks. Exhibit 3 displays the characteristics of Causeway’s ISC portfolio relative to the ISC Index as well as the Value/Growth variants of that Index. Our portfolio exhibits value metrics superior to the value variant of the ISC Index and growth metrics superior to the growth variant of the ISC Index, all while delivering better quality, sentiment, and momentum characteristics. This wide variety of attractive portfolio statistics would be difficult, if not impossible, to achieve in other universes.
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