US Small vs. SMID Cap Equity Product Note August 2013

Transcription

1 US Small vs. SMID Cap Equity Product Note August 2013 Amsterdam Dubai London Montréal Munich New York Paris This report is solely for the use of client personnel. No part of it may be circulated, quoted, or reproduced outside the client organisation without prior written approval from. This material was used by during an oral presentation; it is not a complete record of the discussion.

2 Agenda Section Page 1. Why invest in Small / Mid Cap Equity 2. US Small & Mid Cap Equity Index Exposures & Selection 3. Mid Cap versus Small Cap & Experience 4. Historic performance drivers 5. Appendix 5.1 experience 5.2 Recent search example 2

3 Rising interest in Small Cap Equity Mandates Domestic-only equity mandates are in decline, while a growing number of pension fund sponsors are adding global equity allocations to their portfolios. US plans appear to be adding Global equity to their line-up and are slowly moving away from EAFE and US equity. For example, the California State Teachers Retirement System (CalSTRS), has approved a plan that would combine its existing US and international equity allocations into a single $102 bn global equity portfolio. This shift in allocation away from domestic / regional exposure has resulted in many clients having a very small or in many cases no exposure to the smaller cap segment of the market. Clients today are looking for diversification and return enhancement. This is why we believe small cap equity searches will grow in importance in coming years. There is a degree of overlap between the Mid Cap and Small Cap equity space and clients are often unsure as to how to determine an allocation in this space. This paper therefore provides some analysis to help clients in their decision making process in the small / mid cap equity space. 3

4 Benefits of Regional Small Cap Equity Mandates Advantages Limited analyst coverage may result in market inefficiencies and mis-pricings. In the US equity market, 3 analysts, on average, cover companies with under $250m market cap while 28 cover the six largest. Over the last five years, small cap companies have been acquired at an average 50% premium over current stock price. As the economy recovers, analysts are predicting an increase in M&A activity. Allows investors and investment managers more efficient allocation. Small cap stocks tend to be focused on a specific business area and therefore can gain a purer exposure to a business or industry. Small cap stocks tend to have a greater domestic footprint therefore allowing better allocation of investments in specific region. Investing in Global or Large cap managers can mean that you lose specialist regional boutique managers with on the ground expertise. Small caps offer greater growth prospects relative to large companies that will often struggle to grow as fast organically and end up diversifying into other areas or acquiring small competitors. Greater opportunity for active managers to add value in this space given its less efficient profile and the huge universe of stocks that managers could potentially select from in this space. Disadvantages Small and mid cap managers tend to have a higher volatility profile than large cap managers. Tendency to underperform in negative markets. However, one could argue that this depends on the relative starting valuation and time period assessed. Global managers tend to run more concentrated portfolios than their domestic and non-domestic counterparts, with correspondingly higher levels of volatility and active risk. Global mandates tend to increase the average market cap of a portfolio meaning that true small cap exposure is not captured. 4

5 US Small Cap and Mid Cap Equity Index Construction MSCI MSCI US Investable Market 2500 Index MSCI split their main stock index with a universe of 2500 stocks into three sub-indices: Large cap (containing the largest 300 stocks from the universe); MSCI US Large Cap 300 Index MSCI US Mid Cap 450 Index MSCI US Small Cap 1750 Index Mid cap (containing the middle 450 stocks from the universe); Russel Russell 2500 Index (SMID cap) Russell 3000 Broad Index Small cap (containing the smallest 1750 stocks from the universe). Russell split their main stock index with a universe of 3000 stocks into two sub-indices: Large cap (containing the largest 1000 stocks from the universe) and Small cap (containing the smallest 2000 stocks from the universe. Russell 2000 Index (Small Cap) Russell 1000 Index (Large Cap) Russell Mid Cap Index From the large cap index, the largest 200 stocks are dropped to arrive at the mid cap index. Additionally, from the initial 3000 stocks, the largest 500 are dropped to create the SMID cap index (the Russell 2500 Index). 5

6 US Small Cap and Mid Cap Equity Exposures Sector Breakdown (Russell) 25.00% Russell 1000 Index Russell Mid Cap Index Russell 2000 Index 20.00% 15.00% 10.00% 5.00% 0.00% Main Differences Mid Cap has a larger weight in utilities (6.5% for Mid Cap vs. 3.3% weight for Small Cap). Small Cap has a larger weight in IT (13.6% for Mid Cap vs. 17.7% weight for Small Cap). 6 Source: Bloomberg, as of July 31, 2013

7 US Small Cap and Mid Cap Equity Exposures Sector Breakdown (MSCI) 30.00% MSCI US Large Cap 300 Index MSCI Mid Cap 450 Index MSCI Small Cap 1750 Index 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Main Differences Mid Cap has a larger weight in consumer discretionary (20.5% for Mid Cap vs. 15.0% weight for Small Cap). Small Cap has a larger weight in financials (17.3% for Mid Cap vs. 23.5% weight for Small Cap). 7 Source: MSCI, as of July 31, 2013

8 US Small Cap and Mid Cap Equity Index Characteristics and Valuations Index Characteristics Index Valuations Index # of Stocks USD Billions Average Mkt Cap Median Mkt Cap Largest Mkt Cap Smallest Mkt Cap Russell Mid Cap Index Russell 2000 Index 1, Russell 2500 Index 2, MSCI Mid Cap 450 Index MSCI Small Cap 1750 Index 1, Russell Mid Cap Index Russell 2000 Index P/E (current) 20.4x 39.6x P/E (average since 1995) 21.3x 38.6x P/B (current) 2.6x 2.2x P/B (average since 1995) 2.4x 2.1x P/CF (current) 9.5x 15.3x P/CF (average since 1995) 10.2x 13.7x Div. Yield (current) 1.62% 1.19% Div. Yield (average since 2006) 1.66% 1.25% ROE (current) 12.17% 9.31% ROE (average since 2006) 18.04% 6.67% Total Debt / EBITDA (current) 3.5x 4.4x Total Debt / EBITDA (average since 1995) 3.8x 4.4x 8

9 Mid Cap versus Small Cap Equity Options Historically mid-cap stocks have delivered higher risk-adjusted returns than large-cap stocks over full market cycles, and lower volatility than small-cap stocks. A pure allocation to small caps has the potential to generate the highest returns but it also comes with the highest volatility. Most mid-cap stocks started as something else, either as small-cap stocks that grew into the mid-cap category ( up-andcomers ), large-cap companies that declined in size ( fallen angels ), or spin-offs from larger organizations. For some clients, Mid-cap companies can offer the higher growth potential of smaller companies, with the strength and stability generally offered by larger companies. Similar to small-cap companies, mid-cap companies often have an entrepreneurial approach to doing business and, because of their size, are able to respond swiftly to change and capitalise on unfolding opportunities more readily than large-cap companies. But they tend to have stronger balance sheets and have often weathered many of the growing pains that can disrupt small-cap companies. With proven management teams and well-established products, mid-caps may even be globally diversified similar to large-cap companies. However, unlike their large cap peers, mid-cap firms are not usually tempted to engage in dilutive acquisitions to boost their growth rates. Another important contributor to potential returns is that mid-cap stocks have tended to be prime targets for acquisition by deep-pocketed large-cap companies and often command take-out premiums. Corporate balance sheets are flush with cash and with interest rates currently at a level that makes industry consolidation ever more attractive, mid-cap companies are expected to be the strongest beneficiaries of continued strong merger-and-acquisition activity. has seen a happy medium between mid cap and small cap stocks with the majority of our US equity searches falling into the SMID cap space. 9

10 Mid Cap versus Small Cap Equity Options Number of Sell-Side Analysts Covering Select Companies and Fund Managers The table highlights the analyst coverage dispersion between the different market cap buckets. Interestingly, there are slightly more mutual funds in the small cap universe than the mid cap space 10

11 US Small Cap and Mid Cap Equity Performance Comparison (Russell) Russell 1000 Index Russell Mid Cap Index Russell 2000 Index Russell 2500 Index Index Russell 1000 Index 13.9% -0.5% 13.9% 25.5% -39.0% 3.9% 13.3% 4.4% 9.5% Russell Mid Cap Index 15.2% -3.1% 23.5% 37.7% -42.6% 4.1% 13.5% 11.0% 18.4% Russell 2000 Index 14.6% -5.5% 25.3% 25.2% -34.8% -2.7% 17.0% 3.3% 17.0% Russell 2500 Index 16.0% -3.9% 25.0% 32.2% -37.9% 0.1% 14.7% 6.7% 16.7% 11

12 US Small Cap and Mid Cap Equity Performance Comparison (MSCI) MSCI US Large Cap 300 Index MSCI Mid Cap 450 Index MSCI Small Cap 1750 Index Index MSCI US Large Cap 13.5% 0.2% 11.6% 22.5% -37.6% 4.4% 13.9% 2.7% 7.8% MSCI Mid Cap 14.2% -3.3% 24.0% 38.1% -42.8% 4.8% 12.2% 12.4% 18.9% MSCI Small Cap 16.3% -4.0% 26.2% 34.0% -37.2% 0.0% 14.3% 6.1% 18.5% 12

13 US Small Cap and Mid Cap Equity Performance Comparison Annualised Performance Annualised Volatility Index 1Y 3Y 5Y 10Y 3Y 5Y 10Y Russell 1000 Index 23.5% 15.6% 6.2% 5.9% 13.7% 19.0% 15.0% Russell Mid Cap Index 30.2% 17.1% 8.1% 9.1% 15.6% 22.4% 17.7% Russell 2000 Index 32.8% 17.1% 7.9% 8.2% 18.6% 24.2% 19.7% Russell 2500 Index 32.7% 17.7% 8.8% NA 17.4% 23.3% NA MSCI US Large Cap 300 Index 21.3% 15.1% 5.7% 5.3% 13.2% 18.1% 14.3% MSCI Mid Cap 450 Index 30.3% 16.9% 8.4% 9.2% 16.0% 22.2% 17.8% MSCI Small Cap 1750 Index 33.6% 18.3% 9.6% 9.5% 18.1% 24.5% 19.7% Key Points Monotonically increasing volatility (for all annualised periods) as we move from large cap indices to mid cap indices, and from mid cap indices to small cap indices. For the Russell indices, small caps have slightly outperformed or equally performed mid caps in recent periods, but have underperformed mid caps over longer time periods. For the MSCI indices, small caps have outperformed mid caps for all time periods considered. Mid caps and small caps have outperformed large caps for all time periods considered. 13

14 US Small Cap and Mid Cap Equity Style Analysis Russell Mid Cap Value Index Russell 2000 Value Index Russell Mid Cap Growth Index Russell 2000 Growth Index Over the 10 year period, growth has outperformed value. Mid Cap and Small Cap growth have returned very similar returns. The small cap value index has been the worst performer. 14

15 US Small Cap and Mid Cap Equity Performance Comparison During Up and Down Markets 10Y Up Market Analysis Index Benchmark No. of months [A] Index average monthly return [B] Benchmark average monthly return [C] No. of months w here index > 0 No. of months where index > benchmark [D] Success ratio [D/A] Capture ratio [B/C] Russell Mid Cap Index Russell 1000 Index % 2.88% % 123% Russell 2000 Index Russell 1000 Index % 2.88% % 132% 10Y Dow n Market Analysis Index Benchmark No. of months [A] Index average monthly return [B] Benchmark average monthly return [C] No. of months w here index > 0 No. of months where index > benchmark [D] Success ratio [D/A] Protection ratio [B/C] Russell Mid Cap Index Russell 1000 Index % -4.04% % 111% Russell 2000 Index Russell 1000 Index % -4.04% % 128% = Best 15

16 US Small Cap and Mid Cap Performance Analysis in 2012 and Outlook Consumer durables and other late-cyclical consumer stocks tied to the U.S. housing and economic recovery emerged as the biggest winners in Solid housing and economic data also help whet US consumers appetite for big ticket purchases in autos, leisure products and apparel accessories. With any meaningful economic recovery, the most economically sensitive segments such as industrial, retail, and hotels, should benefit from the potential fundamental improvement. The more defensive real estate segments such as multi-family residential, health care and residential mortgages would likely lag. A trend that we see playing out is in the software space for firms focused on areas like supply chain software, which is benefiting from increased demand from multi-channel retailers that need to integrate ecommerce with physical stores in order to keep up with the on-line retailers and its top-tier supply chain. 16

17 Appendix: Experience facts Conducted 12 Small Cap Equity searches for assets in excess of EUR 550m. manager database US Large Cap Equity >450 Managers US Small Cap Equity >100 Managers Typical Responses to Equity Searches All Cap / Large Cap Equity Mandates (typically range from 30 to 90 managers) Small Cap Equity (typically 30 to 50 managers) Typical Pre-Negotiated Manager Fees on EUR 50m Mandate The fees specified can be skewed by the size of the search and are those quoted to for specific deals which typically excludes some of the poorer performing / cheaper managers. Final fees paid can be substantially less. Large Cap Equity 45bps Small Cap Equity 80bps dedicated team Ian Shea (Head of Equity) Julien Barral (Associate) Jean-Noel Zegerman (Associate) Toby Goodworth (Head of Risk Management) 17

18 Appendix: Small Cap Equity Search Breakdown Client Domicile Client Type Mandate Benchmark Volume EURm Belgium Public Pension Fund US Small Cap Equity Russell Canada Corporate Pension Fund EAFE Small Cap Equity MSCI EAFE / ACWI ex-us Small Cap 25 Canada Corporate Pension Fund EAFE Small Cap Equity MSCI EAFE / ACWI ex-us Small Cap 20 UK Public Pension Fund UK Small Cap Equity FTSE Small Cap 15 Germany Private Trust US Small Cap Equity Russell Canada Public Institution EAFE Small Cap Equity MSCI EAFE / ACWI ex-us Small Cap 70 Netherlands Corporate Pension Fund Europe Small Cap Equity MSCI Europe Small Cap / HSBC Smaller Companies 65 Switzerland Corporate Pension Fund Japan Small Cap Equity MSCI / Russell Nomura Japan Small Cap 36 Canada Public Pension Fund US Small Cap Equity Russell Portugal Corporate Pension Fund US Small Cap Equity Russell Canada Corporate Pension Fund EAFE Small Cap Equity MSCI EAFE / ACWI ex-us Small Cap 35 Germany Corporate Pension Fund Europe Small Cap Equity MSCI Europe Small Cap / HSBC Smaller Companies 30 18

19 Appendix: Process Analysis process evaluates: Organisational Structure Team Resources / Stability Alignment of interest between key personnel and investors Investment philosophy / process Suitability of proposed product Performance & Risk Manager fees Key advantages of the approach & analysis when conducting a search: Analysis of entire universe of managers. This can include enhanced index managers right through to unconstrained high alpha managers Ability to provide wide range of combination analysis historical performance as well as current country / sector allocations, style, market cap exposures etc Current analysis of manager fee s enabling for the negotiation of very competitive fee s 19

20 Appendix: Example of an International Small Cap equity search The client conducted a comprehensive review of International Small Cap Equity managers with the view to investing EUR 70m with one manager The aim of the mandate was to find alpha over full market cycles with no set tracking error limits. Minimum requirements of the search included: 2 year track record and assets of at least EUR 400m in the strategy We received 15 manager submissions and assessed all managers in detail shortlisted 6 managers, 4 of who were met with by the client before taking 1 to a finals committee meeting in which that manager was appointed Manager characteristics: Most managers were pure bottom-up fundamental stock pickers (only 5 of the 15 had some topdown input). Large range in the number of holdings of different managers from 60 through to more than 500 stocks. Most of the managers consider themselves GARP or growth with only a handful of value managers. Holding of non-benchmark stocks is significant with a median of over 20%. The median weighted average market cap was around $2bn Fees were negotiated at different steps along the way with the resulting fees at a very competitive level. Median fees for the peer group were 87bps. The selected manager was negotiated down from an initial fee of: 1% to 0.6% and performance fee offered was 0.35% +20% of outperformance The manager appointed was a boutique specialist small cap manager with significant experience and a long successful track record 20