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World-wide investing in small caps

Written by Hans Oudshoorn | 7 minutes
THU 31-12-2020
Many lawsuits that have all come to nothing further, Mitch McConnell - the leader of the Republicans in the Senate - has acknowledged that the Americans have chosen a different president and vice president. "I would like to congratulate President-elect Joe Biden," McConnell said in the upper house of the US Parliament. Until recently, the powerful politician, like many party members, had refused to admit the loss of fellow party member Donald Trump. Now that the electoral college has officially declared Biden's victory, he has reluctantly acknowledged the defeat. Trump himself has still not acknowledged his Democratic opponent's victory, but the way for President Elect Joe Biden and Vice President Elect Kamala Harris to hold the highest U.S. office on Wednesday, January 20, 2020 is now officially clear. 

If you delve into the election manifesto and vision of Joe Biden and his team, you will encounter a number of spearheads that will have a major impact on the US economy and the stock markets. Because of America's dominant position, they usually have direct consequences for the rest of
the world. 

For example, under Joe Biden, a return to a more predictable trade and foreign policy can be expected. In other words, warm up the hypothermic relationship with China and its president Xi Jinping with the aim of ending the trade war. A better relationship with Europe is also on the menu. Not just by strengthening NATO ties, but also economically, by reducing current trade tariffs. Good news at first sight for the steel, aluminum and automotive industries. 

What else? Joe Biden wants to release large amounts of money to stimulate the US economy. Especially in the current corona times. The Democrat is also mainly aiming at a number of large infrastructure projects that can stimulate the construction and infrastructure sector. He will also want to work on cheaper healthcare that is available to more Americans. This can give an impulse to the medical sector. 

The energy sector will also find that Biden is much greener than Trump, who ignored the climate debate and stepped out of the Paris Treaty. Biden wants to reverse that and also invest heavily - about 2 trillion dollars - in an energy transition and making the American economy more sustainable. "Green" companies and other sustainable investments can benefit from this. 

In a broader perspective, domestically-oriented listed companies - especially small caps - are likely to benefit the most, while large companies and tech giants face higher taxes and stricter regulations. 

What are small caps?
Small cap is the term used to classify companies with a relatively small market capitalization. In general, a company is classified as a small cap when it has a market capitalization between 300 million and 2 billion euros.

Sometimes the limit is a bit higher. For example, fund houses - with professionally managed portfolios of shares in small listed companies worldwide - often apply a limit (market capitalization) of a maximum of 5 billion euros for an initial purchase. An American or Japanese small cap could then - translated to the Dutch market - be a mid cap or even AEX share in terms of stock market value. The other way around is also true, with this upper limit an AEX company could be a small cap share on an international scale. Although these are smaller companies, the interpretation of the meaning of small cap may differ somewhat per bank, broker, country, region or continent.

Why should you invest in small caps?
Smaller companies offer the opportunity for potentially higher returns, although this is not without risk. The returns of individual shares can fluctuate widely and the market is fairly inefficient: not all available information about the company is included in the price. There are simply more analysts who research AEX shares or American blue chips. Underexposed small cap stocks therefore have an increased risk of inefficient price formation and can offer an active investor who does his homework more opportunities for appreciation.

In addition, various studies have shown that (American) small caps outperform large caps in the long term. Sure, small caps also go through periods of underperformance. When financial markets experience price pressure, they regularly show larger falls in the short term than the established order with solid balance sheets and a proven track record. It is precisely this volatility "in frightened days" that causes investors to (too often) ignore small caps.

This is unfair, because small caps in particular can benefit from the S-curve, or "the sweet spot of growth". When companies are just starting out, they often have start-up problems that involve risks and hinder growth in sales and profits. Once listed on the stock exchange, these issues (teething troubles) have largely been resolved and the strongest growth phase for a company usually begins.

Small caps are also a way for investors to invest early in a new technology or a new market. Smaller companies are often the driving force behind disruption, taking advantage of this trend, rather than falling victim to it. They also suffer less from different management layers that large multinationals sometimes have to deal with, and there is also less fear of losing market share, for example, due to the introduction of new products. Especially the smaller companies that play an important role in the fast-growing markets of 'Artificial Intelligence' (AI), robotisation, 'Internet of Things' (IoT) and electric vehicles - often referred to in the financial world by the English term e-vehicles - are examples of disruptive small caps.

Small caps are also often more focused on the domestic economy. Suppose the world economy deteriorates, these types of companies can often still benefit from local growth factors. For example, last summer we saw that the Dutch people stayed home instead of going on holiday and bought a lot of outdoor stuff to enjoy in their own country. From fishing gear to hiking boots and bicycles, it was in great demand and smaller companies such as Accell have capitalized on it.

Investing in small caps with international diversification
Those who want to invest in small caps have a wide choice, the range is larger than that of mid or large caps. Due to the aforementioned inefficiency, it does mean that a thorough fundamental analysis must be made. A fun, but time-consuming and challenging job. Should you go for individual stocks, be aware that this is generally riskier than diversified investing through a mutual fund or ETF.

The range of investment funds and ETFs (for private individuals) is considerable, although many titles are purely American in nature. Due to the dominant economic role of the United States on the world stage and the plans of Joe Biden justifiable, but international spreading has a risk-reducing effect, while this does not have to be at the expense of the possible return. Because even if you invest in small caps, one region sometimes performs better or worse than the other region. And, the more internationally you spread, the less you will be bothered by currency risk. Currencies move with each other like communicating vessels, so more currency spread has a risk-reducing effect.
Two titles with a focus on global small caps

With an international spread "with an American flavor" in mind, I came across two investment titles during my search that could serve as a good addition to the portfolio:
- iShares MSCI World Small Cap UCITS ETF (ISIN IE00BF4RFH31)
- het Kempen (Lux) Global Small-cap Fund - Class BN (ISIN LU1078127419)

The iShares index tracker currently has no fewer than 3,377 (!!) shares in its portfolio worldwide, while that of Kempen has 62 shares. Currently, both securities have invested money in Brunswick Corporation (American manufacturer of leisure products, including Bayliner bowling balls and lanes and yachts), DeNa (Japanese supplier of mobile portals and e-commerce websites), Dialog Semiconductor (English manufacturer of integrated circuits), Fujitec (Japanese manufacturer of elevators and escalators) and Jabil Circuit (American manufacturer of electronic equipment). Kempen's underlying portfolio is clearly more concentrated.

With regard to the American sauce: although both funds have a global spread, the United States is the main supplier in terms of equity positions (iShares 57.85% and Kempen 52.1%). Japan is also contributing in both cases (iShares 11.16% and Kempen 14.9%). The rest is neatly distributed around the world, with Europe playing a nice role.

The ongoing costs are approximately 0.35% (iShares) and 1% (Kempen) per year respectively. There are various currency variants of the index tracker. The variant in this article is quoted in euros, just like the Kempen fund. The iShares euro title via the Frankfurt stock exchange, the Kempen fund via the investment fund exchange FundSettle.

The primary objective of the iShares ETF is to track the MSCI World Small Cap Index - an index with 4188 small caps - the Kempen fund wants to beat the performance of that same index. iShares has been tracking the benchmark very closely since the ETF's inception on March 27, 2018. The keen readers will see that there is a difference between the number of stocks in which the ETF invests and the index they track: 3377 at 4188. iShares therefore applies optimization and still follows the price development of the index with fewer stocks. Due to its relatively short history, the title has not yet received any stars at Morningstar, but due to its performance so far, a good score (at least three stars) can be expected in the future.

And Kempen? They receive a neat four stars at Morningstar. This is understandable, because since its inception July 8, 2014, the fund has scored very well against the benchmark: 10.20% versus 9.50% per year. That makes the somewhat higher costs of this fund justifiable. Noteworthy, the Kempen fund has a Morningstar Analyst Rating ™ of Bronze.

And the dividend? For the iShares title, that's about 1.80% on an annual basis and is automatically reinvested. For the Kempen fund it is around 2.60% on an annual basis. Still a bit higher than that of the index tracker. Incidentally, at Kempen this is an optional dividend: payment is made twice a year - in January and July - and you can receive cash or use it as a stock dividend for the purchase of extra shares over time. 

The value - and hence the dividend - of your investment may fluctuate. Results achieved in the past are no guarantee for the future.

And the main risks? There is a currency risk. As mentioned, the titles are listed in euros, but there are many abroad


Hans Oudshoorn

Hans Oudshoorn is investment trainer at BinckBank. He wrote the Dutch book 'Beleggen voor Dummies' and writes columns in several Dutch newspapers such as DFT, FiscAlert and NRC Handelsblad. 

The information in this article should not be interpreted as individual investment advice.  Although BinckBank compiles and maintains these pages from reliable sources, BinckBank cannot guarantee that the information is accurate, complete and up-to-date. Any information used from this article without prior verification or advice, is at your own risk.  We advise that you only invest in products that fit your knowledge and experience and do not invest in financial instruments where you do not understand the risks. 

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