H1 Smaller Companies' Outlook
H1 Smaller Companies' Outlook
Executive summary
Over the last century small caps have outperformed their larger peers by 2.1% p.a. in the U.S. and 3.2% p.a. in the in the UK.
- Since 2011 small caps have underperformed by -1.3% p.a. with a recent significant deterioration.
- We show that all the outperformance of the All-Country World Index (ACWI) over the ACWI Small Cap since 2019 can be attributed to the current top ten constituents which include the Magnificent Seven. The outperformance of the current top ten has driven index concentration to levels not seen since the dot-com bubble.
- This period was followed by a particularly strong period of smaller company outperformance.
- As measured by relative price to sales the ACWI index is at its most expensive relative to ACWI Small Cap since 2003. We believe these factors presage a period of relative strength in smaller companies.
Commentary
The Global Investment Returns Yearbook (henceforth refereed as Yearbook) by Elroy Dimson, Paul Marsh and Mike Staunton is a tour de force in clear articulation of complex return data and meta-analysis of its drivers.
In figure 1 (shown below) we reference a chart showing the long-run cumulative performance of stocks in different size bands in the US and UK. From 1926 to 2023 U.S. small-caps outperformed larger-caps by 2.1% p.a., compounding to a huge 9.7x difference in terminal value. The outperformance of smaller companies was even more dramatic in the UK.
Figure 1 – Long-run cumulative performance of US stocks in different size bands
However, the Yearbook also shows that while the small cap premium persists, there are prolonged periods when it is substantially diminished. In figure 2 we show that over the last 25.5 years MSCI ACWI Small Cap has outperformed MSCI ACWI by 2.3% p.a. on a total return basis which is broadly consistent with the long-term data for the U.S. and UK markets. Figure 2 demonstrates is that is has been a game of two halves with small cap underperforming by -1.3% p.a. since 2011 and -3.3% p.a. since 2019. What has driven this outperformance, and will it continue?
Figure 2 – The relative annual performance of MSCI ACWI Small Cap vs MSCI ACWI
Regarding the first part of the question, over the five and a half years to 28 June 2024, MSCI ACWI has delivered a total return of 99.2% in USD. This has easily surpassed MSCI ACWI Small Cap’s 63.6%, by 35.6%. The top ten stocks in the ACWI (Apple, NVIDIA, Microsoft, Amazon.com, Meta Platforms, Alphabet, Eli Lilly, TSMC, Broadcom and Novo Nordisk) now account for 22.9%, up from an average of 12.5% over the last 12 years.
Figure 3 – Gross index return (%), weight in index (%)
In 2023, concentration in the MSCI ACWI Index reached its highest level since 1999.
Figure 3 shows the current level of concentration in the top ten has now surpassed the 21% reached at the height of the dot-com bubble in 2000. The subsequent period saw a diminished contribution from the top ten, and a decline in concentration. As seen in figure 2, this coincided with a 16-year period, 2000 to 2016, that saw relatively robust performance for MSCI ACWI Small Cap, a period over which small caps outperformed in 75% of the time. What figure 3 also shows is that the top ten concentration is a result of exceptional performance. We estimate the top ten as of 28 June 2024 has returned a simple average of 706% and have accounted for 35.2% of ACWI’s total return, the vast majority of ACWI’s outperformance of ACWI Small Cap.
Turning to the second part of the question, will it continue? We anticipate many of these businesses will continue to develop in a favourable manner, innovating at scale, entrenching their market positions, while driving substantial growth. So much so, we invest in five of them in the Heriot Global Fund. However, price is what you pay, value is what you get, and fundamental progress is not always commensurate with shareholder returns. These ten companies now represent $18.5 trillion in total market capitalization as of 28 June 2024, a considerable proportion of global gross domestic product which the World Bank estimated at $97.5 trillion for 2021. If the returns of the past five and a half years are prologue and the top ten again return 706%, their total market cap would exceed $130 trillion, and global GDP. These businesses have changed the world, and they can continue to do so, but will the consume the world and their equity markets? While this is highly unlikely, their quality and fundamentals are not reminiscent of previous periods of high concentration such as the dot-com bubble. As such, it is perfectly possible they continue to outperform, just to a lesser extent.
Figure 4 shows the Price to Sales ratio of the MSCI World, MSCI World Small Cap and the ratio of the two from 29 December 2000 to 28 June 2024. I have used the Price to Sales ratio to control for earnings adjustments and margin volatility, but other ratios are just as valid. The Price to Sales ratio of the World index (in orange) has been on a steady upward trend while the World Small Cap index (in white) has barely moved since 2013. The result is that on this measure, the World index is at its most expensive relative to the World Small Cap index since 2003. The gold line in figure 4 shows the ratio of the two Price to Sales ratios and stands at 2.2x, around the same level as the previous high in index concentration shown in figure 3. Today, it is 38% higher than the 23-year average of 1.6x.
Figure 4 – MSCI World P/S, MSCI World Small Cap P/S, Ratio of the two
If we are at or nearing the zenith of “top ten exceptionalism” what does this mean for investors? Again, turning to the Yearbook Dimson, Marsh and Staunton conclude their section on smaller companies by observing the variability but persistence of the premium and that “…we can see no case for underweighting smaller companies.” Stock selection is our forte not asset allocation. Offering MSCI’s definition of smaller companies as the bottom 15% of global market capitalization establishes the “neutral” allocation.
Closing of this valuation gap, a decline in index concentration and the relative outperformance of smaller companies would be consistent with history. There is a plethora of catalysts for this including an inflection in interest rates, earnings of the Magnificent Seven failing to meet high expectations, and the gradual reallocation of capital to relative value. To echo Dimson, Marsh and Staunton’s conclusion we can see no case for underweighting smaller companies and can see a compelling case to be overweight.
Disclaimer
Dundas Global Investors is the trading name of Dundas Partners LLP. Dundas Partners LLP is authorised and regulated by the Financial Conduct Authority (FCA) in the UK, the Securities and Exchange Commission (SEC) in the USA, and the Australian Securities and Investment Commission (ASIC) in Australia. The Authorised Corporate Director for the Heriot Investment Funds is Waystone Management (UK) Limited which is also authorised and regulated by the Financial Conduct Authority.
Dundas Partners LLP provides investment management services to clients in the UK, USA, Australia, and New Zealand. In this communication Dundas Partners LLP may be referred to as DGI, Dundas or Dundas Global Investors.
This document is a financial promotion and intended for professional, eligible counterparty and institutional investors only. The information presented is for the intended recipient(s) and is not to be share or disseminated without our prior approval. This material has not been prepared for retail clients.
Investors are reminded that the price of shares and the income derived from them is not guaranteed and may go down as well as up. Past performance is not a reliable indicator of future results. This document contains information produced by Dundas and sourced from others where stated. The images used are for illustrative purposes only. The views expressed are those of Dundas and are based on current market conditions. They do not constitute investment advice or a recommendation to buy any security which has been highlighted in this material. Although this communication is based on sources of information that Dundas believes to be reliable, no guarantee is given as to its accuracy or completeness.
In relation to FCA handbook ESG 4.3, Dundas does not market these funds as a ‘sustainability product’. Use of any sustainability related terms in describing the characteristics of the strategy, or inclusion of any third-party information which measures sustainability of our portfolios are for information purposes only.
The MSCI® information contained herein: (1) is provided ‘‘as is,’’ (2) is proprietary to MSCI and/or its content providers, (3) may not be used to create any financial instruments or products or any indexes and (4) may not be copied or distributed without MSCI’s express written consent. MSCI disclaims all warranties with respect to the information. Neither MSCI nor its content providers are responsible for any damages or losses arising from any use of this information.
For full information on fund risks and costs and charges, please refer to the Key Investor Information Documents, Annual & Interim Reports, and the Prospectus, which are available on our website (https://www.dundasglobal.com). Recent performance information is also shown on factsheets, available on the website.
Executive summary
Over the last century small caps have outperformed their larger peers by 2.1% p.a. in the U.S. and 3.2% p.a. in the in the UK.
- Since 2011 small caps have underperformed by -1.3% p.a. with a recent significant deterioration.
- We show that all the outperformance of the All-Country World Index (ACWI) over the ACWI Small Cap since 2019 can be attributed to the current top ten constituents which include the Magnificent Seven. The outperformance of the current top ten has driven index concentration to levels not seen since the dot-com bubble.
- This period was followed by a particularly strong period of smaller company outperformance.
- As measured by relative price to sales the ACWI index is at its most expensive relative to ACWI Small Cap since 2003. We believe these factors presage a period of relative strength in smaller companies.
Commentary
The Global Investment Returns Yearbook (henceforth refereed as Yearbook) by Elroy Dimson, Paul Marsh and Mike Staunton is a tour de force in clear articulation of complex return data and meta-analysis of its drivers.
In figure 1 (shown below) we reference a chart showing the long-run cumulative performance of stocks in different size bands in the US and UK. From 1926 to 2023 U.S. small-caps outperformed larger-caps by 2.1% p.a., compounding to a huge 9.7x difference in terminal value. The outperformance of smaller companies was even more dramatic in the UK.
Figure 1 – Long-run cumulative performance of US stocks in different size bands
However, the Yearbook also shows that while the small cap premium persists, there are prolonged periods when it is substantially diminished. In figure 2 we show that over the last 25.5 years MSCI ACWI Small Cap has outperformed MSCI ACWI by 2.3% p.a. on a total return basis which is broadly consistent with the long-term data for the U.S. and UK markets. Figure 2 demonstrates is that is has been a game of two halves with small cap underperforming by -1.3% p.a. since 2011 and -3.3% p.a. since 2019. What has driven this outperformance, and will it continue?
Figure 2 – The relative annual performance of MSCI ACWI Small Cap vs MSCI ACWI
Regarding the first part of the question, over the five and a half years to 28 June 2024, MSCI ACWI has delivered a total return of 99.2% in USD. This has easily surpassed MSCI ACWI Small Cap’s 63.6%, by 35.6%. The top ten stocks in the ACWI (Apple, NVIDIA, Microsoft, Amazon.com, Meta Platforms, Alphabet, Eli Lilly, TSMC, Broadcom and Novo Nordisk) now account for 22.9%, up from an average of 12.5% over the last 12 years.
Figure 3 – Gross index return (%), weight in index (%)
In 2023, concentration in the MSCI ACWI Index reached its highest level since 1999.
Figure 3 shows the current level of concentration in the top ten has now surpassed the 21% reached at the height of the dot-com bubble in 2000. The subsequent period saw a diminished contribution from the top ten, and a decline in concentration. As seen in figure 2, this coincided with a 16-year period, 2000 to 2016, that saw relatively robust performance for MSCI ACWI Small Cap, a period over which small caps outperformed in 75% of the time. What figure 3 also shows is that the top ten concentration is a result of exceptional performance. We estimate the top ten as of 28 June 2024 has returned a simple average of 706% and have accounted for 35.2% of ACWI’s total return, the vast majority of ACWI’s outperformance of ACWI Small Cap.
Turning to the second part of the question, will it continue? We anticipate many of these businesses will continue to develop in a favourable manner, innovating at scale, entrenching their market positions, while driving substantial growth. So much so, we invest in five of them in the Heriot Global Fund. However, price is what you pay, value is what you get, and fundamental progress is not always commensurate with shareholder returns. These ten companies now represent $18.5 trillion in total market capitalization as 28 June 2024, a considerable proportion of global gross domestic product which the World Bank estimated at $97.5 trillion for 2021. If the returns of the past five and a half years are prologue and the top ten again return 706%, their total market cap would exceed $130 trillion, and global GDP. These businesses have changed the world, and they can continue to do so, but will the consume the world and their equity markets? While this is highly unlikely, their quality and fundamentals are not reminiscent of previous periods of high concentration such as the dot-com bubble. As such, it is perfectly possible they continue to outperform, just to a lesser extent.
Figure 4 shows the Price to Sales ratio of the MSCI World, MSCI World Small Cap and the ratio of the two from 29 December 2000 to 28 June 2024. I have used the Price to Sales ratio to control for earnings adjustments and margin volatility, but other ratios are just as valid. The Price to Sales ratio of the World index (in orange) has been on a steady upward trend while the World Small Cap index (in white) has barely moved since 2013. The result is that on this measure, the World index is at its most expensive relative to the World Small Cap index since 2003. The gold line in figure 4 shows the ratio of the two Price to Sales ratios and stands at 2.2x, around the same level as the previous high in index concentration shown in figure 3. Today, it is 38% higher than the 23-year average of 1.6x.
Figure 4 – MSCI World P/S, MSCI World Small Cap P/S, Ratio of the two
If we are at or nearing the zenith of “top ten exceptionalism” what does this mean for investors? Again, turning to the Yearbook Dimson, Marsh and Staunton conclude their section on smaller companies by observing the variability but persistence of the premium and that “…we can see no case for underweighting smaller companies.” Stock selection is our forte not asset allocation. Offering MSCI’s definition of smaller companies as the bottom 15% of global market capitalization establishes the “neutral” allocation.
Closing of this valuation gap, a decline in index concentration and the relative outperformance of smaller companies would be consistent with history. There is a plethora of catalysts for this including an inflection in interest rates, earnings of the Magnificent Seven failing to meet high expectations, and the gradual reallocation of capital to relative value. To echo Dimson, Marsh and Staunton’s conclusion we can see no case for underweighting smaller companies and can see a compelling case to be overweight.
DISCLAIMER:
Dundas Global Investors is the trading name of Dundas Partners LLP. Dundas Partners LLP is authorised and regulated by the Financial Conduct Authority (FCA) in the UK, the Securities and Exchange Commission (SEC) in the USA, and the Australian Securities and Investment Commission (ASIC) in Australia. The Authorised Corporate Director for the Heriot Investment Funds is Waystone Management (UK) Limited which is also authorised and regulated by the Financial Conduct Authority.
Dundas Partners LLP provides investment management services to clients in the UK, USA, Australia, and New Zealand. In this communication Dundas Partners LLP may be referred to as DGI, Dundas or Dundas Global Investors.
This document is a financial promotion and intended for professional, eligible counterparty and institutional investors only. The information presented is for the intended recipient(s) and is not to be share or disseminated without our prior approval. This material has not been prepared for retail clients.
Investors are reminded that the price of shares and the income derived from them is not guaranteed and may go down as well as up. Past performance is not a reliable indicator of future results. This document contains information produced by Dundas and sourced from others where stated. The images used are for illustrative purposes only. The views expressed are those of Dundas and are based on current market conditions. They do not constitute investment advice or a recommendation to buy any security which has been highlighted in this material. Although this communication is based on sources of information that Dundas believes to be reliable, no guarantee is given as to its accuracy or completeness.
In relation to FCA handbook ESG 4.3, Dundas does not market these funds as a ‘sustainability product’. Use of any sustainability related terms in describing the characteristics of the strategy, or inclusion of any third-party information which measures sustainability of our portfolios are for information purposes only.
The MSCI® information contained herein: (1) is provided ‘‘as is,’’ (2) is proprietary to MSCI and/or its content providers, (3) may not be used to create any financial instruments or products or any indexes and (4) may not be copied or distributed without MSCI’s express written consent. MSCI disclaims all warranties with respect to the information. Neither MSCI nor its content providers are responsible for any damages or losses arising from any use of this information.
For full information on fund risks and costs and charges, please refer to the Key Investor Information Documents, Annual & Interim Reports, and the Prospectus, which are available on our website (https://www.dundasglobal.com). Recent performance information is also shown on factsheets, available on the website.
SUSTAINABILITY DISCLOSURE:
Sustainability label. The Financial Conduct Authority (FCA) has issued new standards governing the use of sustainability vocabulary in the promotion and description of fund and asset management services. Funds may adopt one of four FCA labels describing their approach, or they may opt not to have a label. For reasons discussed below, Dundas has decided for the present to operate without a label for its two UK domiciled funds – Heriot Global and Heriot Smaller Companies.
Dundas makes investment decisions in large part based upon audited annual reports which in recent years have expanded to address wider sustainability matters. Disclosure on CO₂ emissions and sustainability has improved but remains incomplete, inconsistent, and heavily reliant on estimation. In response new IFRS Sustainability accounting standards were issued in 2023 (now out for adoption across the world outside the USA, where GAAP standards are moving in the same direction) effective 1 January 2024. Dundas welcomes the new standards. They are thorough, stringent and, when fully adopted, will raise and level the playing field for corporate sustainability reporting.
Dundas is already engaged with the companies in which it invests about the new standards. We will re-evaluate the appropriateness of adopting a label once our analysis of improved sustainability reporting is complete.
Sustainability Goal: to invest in companies with long-term growth potential that are simultaneously becoming more environmentally and socially sustainable. Progress will be measured largely via reporting under the new IFRS Sustainability standards. Dundas believes that companies which shoulder these responsibilities and communicate effectively will gain competitive advantage which is why we advocate for sustainable practices by those we invest in.
Investment Policy and Strategy: Dundas invests in global equities for dividend and capital growth with an investment horizon of five years or more. Where dividend growth leads, share prices follow. Sustained dividend growth is produced by well managed companies that respect all their stakeholders’ interests. The case for responsible investment in sustainable businesses is readily made by its opposite. A portfolio of irresponsible companies with unsustainable businesses will not meet clients’ long-term investment needs. The actions of the companies Dundas invests in (i.e. the enterprise contribution) are the main driver of sustainability metrics.
Stocks we decline to own on principle because their principal activity is one of the following:
• Manufacture, production or distribution of tobacco products;
• Manufacture of controversial and indiscriminate weapons (including cluster bombs or similar anti-personnel weapons);
• Corporate structures that deny investors title to the underlying operating business assets, such as Variable Interest Entities;
• State-owned or controlled companies where minority shareholders’ interests are not respected.
• Thermal coal mining or its use in power generation.
Relevant Metrics: Dundas monitors the progress of the businesses it invests in on behalf of clients against metrics such as: carbon footprint, carbon intensity, weighted average carbon intensity (all for Scope 1 and 2 emission), MSCI ESG ratings, board independence, workforce pay & conditions, employee turnover, productivity. We rely upon MSCI and Bloomberg reports whose accuracy will improve as IFRS Sustainability standards are applied.
• Progress on these metrics will be covered in our annual Stewardship Report and TCFD document along with discussion on quality and availability of data from audited sources.
Resources and Governance: The firm’s Investment Committee is responsible for all aspects of its investment activities, including sustainable investment policy. Within the investment committee, a partner has lead responsibility for Sustainability, supported by other team members.
Voting / associations: Dundas’ investor contribution includes voting all proxies aided by a proxy advisor. Its PRI report is available on the firm’s website. The firm’s Stewardship Report sets out how it upholds the UK Stewardship Code and the EU’s Shareholder Rights Directive II.
Lexicon: The FCA’s labels tighten up how the word ‘sustainable’ can be used in fund marketing. Whilst agreeing that greenwashing needed to be confronted, Dundas may use ‘sustained’ in reports and communications in its plain English sense of ‘something continuing into the future’. We’ll take care not to use it inappropriately.
Accessing other relevant information: the sustainability disclosures section of the Dundas website discloses all relevant information.