Investors looking for opportunities among small global caps, which are most diverse and least researched segments of the equity market and offer fertile territory for alpha generation, should take an approach that emphasises quality, valuation and time characteristics, Eaton Vance says.
In particular, when evaluating companies investors should look at durable and scalable business models, beneficiaries of structural growth and change, strong management teams and healthy balance sheets.
“In our experience, companies with these attributes tend to have the ability to maintain or grow market share during economic expansions and contractions, while also exhibiting better downside protection - a combination that we believe is critical for achieving better risk-adjusted returns throughout the business cycle,” Aidan Farrell, director of global small cap equity at Eaton Vance, said.
“Quality, valuation and time are vital to our investment approach: When we find that all three inputs are aligned, we typically add the stock to the portfolio at an appropriate risk position size.
“However, any company of sufficient quality without the necessary valuation and time conditions would continue to be monitored closely for a more suitable entry point.”
The firm divided the MSCI World Small Cap Index constituents into quintiles based on fundamental factors - with stocks sorted high to low using return on invested capital (ROIC) and return on equity (ROE) as the quality indicators, and free cash flow yield (FCFY) as the valuation indicator.
This means that stocks scoring in the first and second quintiles for quality and valuation - in this case, less expensive stocks – would outperform, while the lowest quality and most expensive stocks in the fifth quintile significantly underperformed.
At the same time, the annualized active returns demonstrated the magnitude of outperformance or underperformance that the ROIC, ROE and FCFY factors contributed across each performance quintile.
“We believe a focus on companies with high or improving quality attributes and reasonable valuations can make a meaningful difference when investing in the global small-cap equity sector for the long term,” Farrell said.
Performance of MSCI World Small Cap index versus MSCI World over one year to 30 September