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Size doesn’t matter when it comes to risk

By Gino Rossi, Spheria Global Microcap Fund Portfolio Manager

I’d like to suggest to readers that there’s more risk in those global large cap allocations in your portfolios than you might think.

And yes, I’m the portfolio manager of a global microcap Fund. I have a vested interest, but bear with me.

I’m not saying dump your large cap exposure, I’m simply advocating for a little more diversity than most investors I speak with currently have.

Here’s why.

The end of the cycle?

Right now, there are various data points that suggest we are approaching the end of a significant market cycle. One in which I believe has been extended by COVID-19.

In the chart below I have taken the decade-long run-up of the NASDAQ during the dotcom era and compared it to the run-up of the NASADQ in the current growth cycle (calling a November 2021 cycle peak).

The run-up is almost identical, but for a global pandemic pushing the peak back 12 months.

People say dotcom was different. They say it was ridiculous.

But there’s been many a ridiculous phenomenon during this cycle – profitless tech on nose-bleed multiples, cryptocurrencies, SPACs, war-time-like fiscal stimulus, negative real interest rates.

Now, with many large cap tech names selling off materially in recent months it appears risk off, is back on.

A great awakening perhaps for many investors who’ve been enthralled by an enduring period of easy money.

But many remain asleep to concentration risk

 Concentration risk is something we often hear about in the context of Australian equities – “too many Australian investors are overweight the big 4 banks, BHP and Telstra”, the pundits say.

But what is spoken about far less, is the enormous concentration risk investors are currently taking on in global equities.

The impact of the proliferation of passive investing has been immense when it comes to market concentration. Passive is now around 55% of US equity funds. Throughout the 90’s it was 5%.

In my view, there is no doubt that passive investments are the main conduit in which the tidal wave of Federal Reserve QE has entered the market.

The result, as you can see below, is the most concentrated market in history.

Furthermore, when we hone in on the funds management industry here in Australia, the concentration persists.

Here I have compared three popular Australian actively managed global equities Funds. We see many crowded trades and much homogeneity.

I don’t deny many of these are currently exceptional businesses, but I do want to challenge the perception that large caps are too large to fail.

Take a look at the S&P 500’s top 10 over time. It needs little explanation; history shows us it’s not easy to stay at the top of the pile.

So, where do you want to be as the cycle turns?

If you break it down into some of the most well-known recent market turnings points, you can see at the dot-com peak the market was overweight tech. At the GFC, it was financials.

The question is what are investors overweight today as the cycle turns?

There’s strong historical evidence that shows allocating to stocks outside of the big end of town can strengthen portfolios at this juncture in time. The MSCI World Small Cap Index outperformed the larger MSCI World by 14% on the way down during the dotcom bust. While the MSCI World Microcap Index does not extend that far back, if the GFC and COVID are a guide, it would have outperformed by a similar magnitude.

Working with the microcap data we do have, a look at the dotcom decline (below) shows the Wilshire US Microcap Index (the only microcap index at the time) outperformed both the NASDAQ and the S&P 500.

You can see microcaps were initially caught up in the risk-off before a plateau then a burst of strong outperformance as the global economy began to recover – something this asset class is best at.

To highlight this further, below we have plotted the performance of global microcap relative to global large caps (dark blue line) against the 12-month change in US PMI.

In simple terms – you can see as the economy accelerates, microcaps outperform and as the economy decelerated microcaps underperform. While the asset class led markets out of the dotcom era, the GFC and COVID-19, there was only marginal underperformance on the way down.

This asymmetry during large market events provides investors a powerful asset allocation enhancement.

Demystifying global microcaps

Finally, global microcaps are a relatively underexplored and misunderstood asset class. We’re talking about developed market securities with market caps of under US$1 billion (more akin to what we know as small cap Australian companies).

It’s the “little end of town” you might say. But in this universe, there are over 18,000 securities globally and the US is only 24% of the index.

And there are many misconceptions about this asset class, particularly when it comes to risk.

As bottom-up stock pickers, we believe our clients are best served favouring growing and innovating businesses, but all the while remaining mindful of free cash flow conversion.

Free cash flow conversion is measured as a ratio of earnings before interest & tax (EBIT) to free cash flow (operating cash flow less tangible and intangible capex). This ratio reflects how accounting profit (P&L) converts to cash profit, and is indicative of a company’s earnings quality. Smaller companies typically have low free cash flow conversion, resulting in less capital for growth and increasing their reliance on fickle capital markets. But you can see below how the Spheria Global Microcap Fund is optimised to provide quality cash flow characteristics that surpass large caps.

We also focus on capital preservation, with valuation discipline being a critical component in protecting capital.

A portfolio of global microcaps constructed against this disciplined framework of active management is why we believe size doesn’t matter when it comes to risk, and how we think investors can better navigate a turning point in the market cycle.

Discover more about the Spheria Global Microcap Fund.