International Small-Cap: Surprising Quality

Looking beyond the U.S.

International Small-Cap: Surprising Quality

Why should investors consider maintaining a small but consistent allocation to this often-overlooked asset class? The answer is simple: superior risk-adjusted returns with very low correlation to traditional equities.

What aspects of international small-cap stocks are likely to surprise investors?

I think people are often surprised by the quality of the underlying businesses. I think that this asset class offers a quality premium, in the sense that if you think about being a $3- or $4 billion company from a market like Australia or Finland or even the UK, you’ve had to figure out how the whole world works. You operate across borders. You have multiple places where you’re producing product, you have a diversified customer base.

So in general, these are very, very sophisticated businesses. To provide a reference point in the U.S., you could sell just to the state of California and achieve a $3- to $4 billion market cap. So, the standard for these companies is extremely high.

There tends to be a very strong sense of permanence for these businesses; very long average CEO tenure, often a family ownership of the business, or at least a family involvement; they think very long term. Many return a lot of money to shareholders in the form of dividends. And so, I think the quality profile is extremely high within this asset class, and that does often surprise people.

I do think people are also surprised by how big the asset class is, because I think, primarily, asset allocators have tended to go to international large-cap when they think non-US.

But I think they would be surprised to know that there are about three times as many companies in the international small-cap asset class as there are in the comparable sized market cap in the US. And there’s about twice as much aggregate market cap. So, there’s a lot to choose from.

What about the risk factors?

The risk profile of international small-cap is also counterintuitive. I think the impression that people tend to have from watching the news or reading the news is that the international markets are extremely volatile, because there's always some sort of problem going on somewhere in the world.

The reality is, statistically, this is an asset class that has a superior standard deviation to domestic small-cap. It's comparable to international large-cap. On a risk-adjusted basis, it’s superior to both.

What sort of environments does international small-cap tend to do best in?

I think international small-cap tends to do particularly well in rising interest rate environments -- at least, that's what we found with our studies. It actually outperforms international large-cap in both declining rate environments and rising interest rate environments but the outperformance is greater in a rising rate environment than in a declining rate environment.

I think that's very relevant now. because with rates still at a very low level, we're probably more likely to be headed towards rising rates than further declines in rates.


IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.