Discovering International Small-Caps

Jeff DeMaso:

Hello and welcome to another The Adviser You Can Talk To Podcast. I’m Jeff DeMaso, director of research here at Adviser Investments, and today I’m joined by Liz Laprade. Liz is a research analyst on the team, and some of you may know Liz from her weekly market takeaways videos. If you haven’t seen them or want to hear more from Liz after this conversation, you can find her videos on our website every Tuesday.

Jeff DeMaso:

Sorry, Liz, I couldn’t resist plugging your videos. Either way, welcome back to the pod.

Liz Laprade:

No, I appreciate it. Hi, Jeff. Thanks for having me.

Jeff DeMaso:

Great. I’m glad you’re here because today I wanted to pull back the curtain on some of the research you’ve been working on, specifically around foreign small-cap stocks. I know with U.S. stocks well ahead of foreign markets over the past decade, most people these days are asking, “Why even bother with foreign stocks at all?” let alone smaller companies outside of our borders. Said another way, smaller foreign companies simply aren’t even on most people’s radars and therein potentially lies the opportunity because clearly we think investors should give foreign small-cap stocks some consideration, or we wouldn’t be having this conversation today.

Jeff DeMaso:

So before we get to our research, Liz, let’s address that elephant in the room. Should an investor even bother with foreign stocks at all, given how well U.S stocks have done over the past decade or so?

Liz Laprade:

Right. Jeff, that’s an absolutely fair question. Look, I’m not about to say put all your money in this part of the market, that’s just honestly not great portfolio management, but diversification is important for a portfolio over time and I think that small-cap international stocks are a great part of the market to include. The U.S. stock market absolutely has outperformed international over the last decade, but there are some tailwinds right now with the weakening dollar and different global economies emerging from this crisis at different times. So I still think it’s prudent to be diversified internationally.

Jeff DeMaso:

Okay, good to hear some short-term tailwinds, but I’d like to just emphasize that point about diversification. Owning stocks across the globe just makes for a more robust portfolio. When we build portfolios, we want them to be able to perform in multiple futures. As we’ve seen this past year, no one can predict what the road ahead has in store for us, and you don’t need to go overboard with it, but including some foreign stocks improves your odds of earning a satisfactory return in multiple scenarios.

Jeff DeMaso:

So yes, we believe in owning stocks in companies across the globe, so let’s get straight into your research, Liz, on foreign small-cap stocks. I think I said that, foreign small-cap stocks, enough times in the intro, and maybe that’s the place to start is can you just define the universe? What do we mean by foreign small-cap stocks?

Liz Laprade:

Sure. I think there are a few ways to define the space, but roughly I’m going to draw the line at under $2 billion market-cap company outside the United States. For example, Vanguard’s ex.-United States small-cap index has about 4,000 stocks. Now if you actually compare that to the Russell 2000, which is domestic, that’s about double the investment opportunities right there. And then if you compare say Vanguard All-World, so the entire investible universe, that’s about 9,000 stocks. So small-cap international actually makes up about 45% of the entire investible universe.

Jeff DeMaso:

Okay, so it’s clearly a lot of stocks. What else about the space grabbed your interest?

Liz Laprade:

So I think given location and volume, I find that this part of the market is highly under followed and then thus, under discovered. So for example, there are about 40 analysts right now covering just the earnings estimates for the fourth quarter of this year for Amazon. At any given time, there are only, on average, about five analysts covering a small-cap international company. So this also means that portfolios are historically underweight this area of the market. So throughout my research found that about only 1% of U.S. investors are allocated there.

Liz Laprade:

Anecdotally, I honestly can’t even tell you, Jeff, how many 401k plans I’ve personally reviewed over the last three to five years where I don’t think I’ve ever seen a small-cap international option. If I have, maybe one or two plans at most. So just kind of from my own experience, I can also say I know that it’s not highly offered.

Jeff DeMaso:

Okay. Okay. So lots of stocks under-followed. I can see where you’re going with this. You’re going to talk to me about active management next, aren’t you?

Liz Laprade:

You got me. Yes, I think it’s a great place for stock-pickers. So in my mind, right, there’s two ways to outperform your benchmark or peers. First, find the right company, and then buy them at the right price and wait. When you think about say a more consolidated universe, like large-cap domestic stocks, active managers are looking at small universe, so say a thousand stocks. And so a lot of people will complain that all the large-cap active domestic managers have the same stocks.

Liz Laprade:

Well, that’s because they do, right? Their pool is smaller to pick from so suddenly picking the right price and the weight becomes more important than picking the right company because a lot of you guys are going to pick the right company when Apple’s a great company. But if you think about a universe as large as small-cap international, which is 4,000 to 5,000 stocks with significantly less active managers, you’re going to end up finding some companies that other people might not be looking at. So if that’s the case, you can get alpha from both of the company and the right price and weight. Does that make sense?

Jeff DeMaso:

It does make sense. You’re saying that there’s fewer stocks in that large-cap pool in the U.S. so all the managers own the same stocks are kind of trading with each other, whereas when you compare that overseas, it sounds like you’re saying there’s lots of stocks to pick from, often managers’ portfolios looks totally different from the next manager, even though they’re both foreign small-cap managers. So they’re probably trading against different people, not necessarily against each other, kind of a different level of skill matching each side of the trade. Is that what you’re saying? Do I have that right?

Liz Laprade:

Yes. Yeah, no, that’s absolutely correct. And there are actually numbers to back this up. So over the last three years, only 25% of the 375 active managers in the large-cap domestic growth space outperformed the S&P 500. On the small-cap international side, there are only 39 active funds, but of those 39, 44% have outperformed the index.

Jeff DeMaso:

Wow, that’s … Definitely as a person who’s looking at active funds, sounds like a more attractive opportunity set there to be looking at.

Liz Laprade:

Exactly.

Jeff DeMaso:

All right. But what I don’t want to lose sight of is the side of risks. We always talk about people’s concerns are as important as their returns, and we are talking about small-cap stocks, but we’re also talking about foreign small-cap stocks, which seems like maybe a double dose of risk.

Liz Laprade:

I see. I see what you’re saying, and I think that’s potentially biased by the relationship that we’re used to here in the U.S. The risk profile abroad, so between small-cap and large-cap, is actually very different than here. So here in the U.S. small-cap stocks tend to be riskier. The small-cap index has a standard deviation of 25, while large-caps have a standard deviation of 19. Abroad, however, the relationship between small and large is very different. Small-caps standard deviation is 17, while large- is at 15. So small-caps are actually not that much more risky than large-caps internationally.

Jeff DeMaso:

Okay. So standard deviations, kind of how volatile stocks are, what about drawdowns or how far you are from a prior high. What do they perform like in bear markets?

Liz Laprade:

So in past bear markets or market corrections, we have found that historically small-cap international stocks do go down a little bit harder than large-cap international stocks. However, they do tend to rebound a lot faster.

Jeff DeMaso:

Okay. So there is a bit more risk there when we’re going small-cap versus large-cap, but maybe not to the same degree that we see in the U.S. Why? Why is that different?

Liz Laprade:

So that was the track record. Historically, what we’ve seen…no guarantees for the future, but I do think it comes down to the types of companies. So in the U.S., the largest allocation by sub-sector and the Russell 2000, are biotech companies. Typically, these companies are not profitable when they go public, or even maybe for a long time after that, and their stock prices rely on binary outcomes, which can lead to big stock price swings if a trial or something doesn’t go as expected. I mean, we’ve actually seen a lot of that this year. Internationally, however, small-cap international space tends to be more concentrated in real estate, banks and broader industrial companies, which are more likely to be profitable when they go public.

Jeff DeMaso:

Okay. So pretty different makeup of the type of companies that are in the two universes in the U.S. and outside.

Jeff DeMaso:

Liz, I think you’ve covered a lot of ground here. Let me see if I can recap the different points you’ve made here on foreign small-cap stocks. The first is that there’s just a lot of companies out there, and many of them are not closely followed, and that this potentially makes a good environment for active managers.

Jeff DeMaso:

And on top of that, when we consider the risk profile of foreign small-cap stocks, they’re pretty similar to what you might see from foreign large-cap stocks. So you’ve been able to get a little bit of a return boost with foreign stocks without necessarily taking on all that much more risk. At least that’s what the historic record tells us.

Liz Laprade:

Right. Yep.

Jeff DeMaso:

And it sounds like a pretty good story to me. I hope it gives investors something to consider.

Liz Laprade:

Me too.

Jeff DeMaso:

Okay. This has been Jeff DeMaso and Liz Laprade from Adviser Investments thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show. You can check us out at adviserInvestments.com/podcasts. Your feedback really is always welcome. If you have any questions or topics that you’d like us to explore, please email us at info@adviserinvestments.com. Once again, I’d like to thank our editors, Kailey Steele and Ashlyn Melvin, for making this podcast a reality. And thank you for listening and happy holidays.