6 Reasons Why Global Small Caps May Have Room to Grow

Global small caps strongly rebounded in the last few months of 2020. This comeback helped them outpace large-cap stocks by nearly 26% since the first quarter’s lockdown-induced lows. (Source: FactSet.) Investor sentiment turned markedly positive in the fourth quarter thanks to encouraging COVID-19 vaccine news and the vaccine rollout’s potential impact on global economic growth.

This market optimism persisted despite an increasing possibility of weaker, near-term economic activity due to rising daily case rates and the threat of more shutdowns.

We also believe certain tailwinds are supportive of global small-cap returns in 2021:

1. The potential for strong and improving global GDP growth may support global small-cap returns.
2. The vaccine rollout and economic stimulus may support earnings recovery.
3. Rebounding merger and acquisition activity may accompany economic recovery.
4. Historically, small caps have outperformed during recovery periods.
5. Favorable macroeconomic and earnings backdrops may indicate small-cap recovery is still in its early stages.
6. We believe small-cap valuations are attractive relative to large caps.

1. Global small caps have historically delivered strong absolute and relative returns when global GDP growth exceeds 3% and improves year over year.

Global small caps are more cyclically exposed than their large-cap peers and have led the markets during past economic expansions. The expectations for strong and rebounding global economic growth have the potential to support global small-cap returns in 2021.

2. Vaccines and expectations for economic recovery may lead to sharply accelerating EPS recovery for global small caps.

On an equal-weighted basis, global small caps are expected to deliver 28% EPS growth in 2021, according to FactSet consensus estimates—a premium to their large-cap counterparts.

3. Merger and acquisition activity rebounded in the second half of 2020 and is expected to remain strong in 2021.

Small caps have historically been the key beneficiaries of merger and acquisition activity. Despite the pandemic, 2020 was a record year of capital raising, exceeding $3.6 trillion globally. Small caps may benefit if this capital raising spurs large caps to acquire small caps as economies recover. We also have witnessed several global small-cap companies strengthen their competitive positions by accessing either the debt or equity markets in 2020 to help fund bolt-on acquisitions. For small-cap companies with strong management teams and a disciplined approach to mergers and acquisitions, this may further accelerate earnings growth.

4. Small caps have typically led the markets during recovery periods.

Historically, global small caps have rallied much quicker than their large-cap counterparts in the one-year period post-drawdown.

5. Global small caps have outperformed large caps since the market trough in March 2020.

However, at the end of the first quarter of 2020 global small caps had substantially underperformed large caps in the preceding five years. A favorable macroeconomic and earnings backdrop for small caps may indicate we are still early in the cycle of small caps outperforming large caps. Additionally, periods of small-cap outperformance have historically lasted several years.

6. While global small-cap valuations have expanded, they remain attractive relative to large caps.

We believe the combination of less expensive valuations and faster expected earnings growth relative to large caps may continue to support global small caps in 2021.

Bottom-Up Opportunities Are Driving Our Positive View on Global Small Caps

We are identifying small-cap companies that we believe will deliver accelerating and sustainable earnings growth across a broad array of regions and sectors. While optimistic, we continue to take a balanced approach to risks and opportunities at the stock and portfolio levels. In our view, it’s important to be both nimble and prudently diversified to navigate the volatility and uncertainty we expect to see through 2021.

We also think it’s important to consider a long-term strategic allocation to global small caps apart from any near-term tailwinds. We continue to believe global small caps are an inefficient asset class that may translate to strong alpha potential for well-resourced, disciplined and skilled active managers. In addition to the diversification benefits, in the examples below small caps have historically delivered superior long-term risk adjusted returns; they’ve consistently done so for investors with long-term time horizons (see charts below). For global small-cap investors, patience has typically been rewarded. Of course, past performance is no guarantee of future results.