Higher quality at a lower price is not a combination that can usually be found anywhere. But that is what has recently been available with international small- and mid-capitalization (SMID) stocks. On measures such as return on equity measures (See Figure 2), international SMID companies are higher quality, yet they have been trading on average at a 40% discount to US small- and mid-caps.1 Investors haven’t been taking advantage of this opportunity, with their average allocation to the international SMID asset class averaging just 1% vs. 13% to US SMID, according to Morningstar.
Why have international SMIDs been overlooked? We think it is because of the traits people associate with their US SMID peers: greater risk and lots of “me-too” and “also-ran” companies trying to compete against larger, entrenched players. But these traits often don’t apply in international markets. In fact, in multiple industries, and particularly in highly profitable niche markets, the global leader, based on market share, is often an international SMID company. (See Figure 1)
Figure 1: Many international small- and mid-cap companies are market share leaders in their industries
Consider a few examples of these international SMID companies that are global leaders for market share in their industries:
- England’s Abcam ($3.56-billion market cap as of 6/30/20), is known as the “Amazon of antibodies” and controls the world’s largest library of them in a niche industry that is growing annually at a rate of more than 7%.
- Switzerland’s LEM Holding ($1.68-billion market cap as of 6/30/20) designs and produces current and voltage transducers, where its 50% world market share makes it the industry’s global leader. Transducers are a mission-critical component of motor drives, power generators and converters, and energy measurement because they provide precise and contactless measurement of dynamic electrical current to enable safe and efficient operation.
- OdontoPrev ($1.37-billion market cap as of 6/30/20) is Brazil’s and Latin America’s number one provider of dental plans. Odontoprev’s business model is not unique in the world, but its position in its home market makes it very attractive. Brazil is far and away the world’s leading dental market, with 330,000 dentists compared with the runner-up, America, with 160,000.
- India’s AIA Engineering ($2.0-billion market cap, as of 6/30/20) manufactures, installs and services its proprietary high-chromium grinding media, which are performance-enhancing and energy-saving consumables serving the mining, cement and thermal power industries. More than 80% of AIA’s revenues can be considered recurring, and customer relationships tend to be long-lasting, with minimal churn.
Why the assumptions about US small and mid caps don’t apply internationally
Why are the quality characteristics of international SMID companies so different from those in the US? We think it’s largely because to achieve a market capitalization of $1 billion or more, companies hailing from countries such as Finland, New Zealand or Switzerland typically must surpass a higher hurdle than firms in the US have to clear. For an international company to reach “SMID-cap” status, we have found that it generally must be export-oriented, globally structured, innovative, and have a high to dominant share of a niche market, often one in which its US peers don’t compete effectively.
By contrast, few US SMID companies are market share leaders. We find that the asset class is dominated by “me-too” companies and those with relatively small market share, often because they have regional and not national operations. We believe very few of these companies set the global standard for their industry.
This dynamic is understandable because we’ve found US SMID companies rarely have to strive to be global leaders. They already benefit from operating in one of the easiest countries for commerce, as the US regularly places near the top in the World Bank’s annual rankings of countries for its ease of doing business.2 US SMID companies have access to a population of 330 million consumers who speak one language. They can do business under one set of national laws and regulations. And they operate in an economy that is explicitly centered around consumerism.
Investors in US equities face a dichotomy when it comes to market cap asset classes. The US excels at developing global businesses and is rightfully known for its large-capitalization and mega-cap companies. But we believe US SMID companies, as an asset class, often deserve their reputation as less reliable and more volatile investments.
International SMID companies, in our view, do not.
A quality premium at a 40% valuation discount
On almost every statistic investors use to assess the quality and financial strength of a company – from return on equity to debt-to-capital ratios – international SMID companies (as represented by the MSCI ACWI ex US SMID Cap Index), on average, far surpass the averages of their US peers (as represented by the Russell 2500 Index). On two key quality measures – return on equity and return on invested capital – the international SMID companies, on average, score 60% higher. When it comes to valuations – as indicated by the trailing 12-month trailing price/earnings ratios – these higher-quality international SMID companies have been available at just 60% of the price – (16.9 vs. 28.6 trailing P/E ratios) — as of June 30, 2020. That’s a 40% discount for higher quality.
Figure 2: International SMID stocks rank higher on multiple quality scores but have been trading at a 40% discount to their US peers
An overlooked opportunity
While US investors recognize the potential growth and diversification benefits US SMIDs offer – with 13.3% of their portfolios in them – they seem to have overlooked international SMIDs. According to Morningstar, they have just 0.8% of their portfolios in this asset class. Given the high quality and low valuations this asset class has offered, it seems to be an opportunity worth closer consideration.
Figure 3: US investors have less than 1% of their holdings in international SMIDs
The mention of specific companies or issuers does not constitute a recommendation by Invesco Distributors, Inc. Certain Invesco funds may hold the securities of the companies mentioned. A list of the top 10 holdings of each fund can be found by visiting invesco.com/us.
1 Source: FactSet Based on trailing 12-month price-to-earnings ratios of the MSCI ACWI ex US SMID Cap Index vs. the Russell 2500 as of 6/30/20. An investment cannot be made directly into an index. Past performance does not guarantee future results.
2 Source: World Bank, Doing Business, 2020, the US ranked 6th in ease of doing business among the 190 countries the World Bank ranked. (https://www.doingbusiness.org/en/rankings )
Image Credit: Chaoshu Li / Stocksy
The MSCI ACWI ex USA SMID Cap Index captures mid- and small-cap representation across 22 of 23 Developed Market countries (excluding the US) and 26 Emerging Markets countries. With 5,274 constituents, the index covers approximately 28% of the free float-adjusted market capitalization in each country.
The Russell 2500 Index measures the performance of the 2,500 smallest companies in the Russell 3000 Index, with a weighted average market capitalization of approximately $4.3 billion, median capitalization of $1.2 billion and market capitalization of the largest company of $18.7 billion.
The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company. It is the percentage of earnings paid to shareholders in dividends. The amount that is not paid to shareholders is retained by the company to pay off debt or to reinvest in core operations. It is sometimes simply referred to as the “payout ratio.”
The dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows how much a company pays out in dividends each year relative to its stock price.
Operating margin measures how much profit a company makes on a dollar of sales after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax. It is calculated by dividing a company’s operating income by its net sales.
Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea about how efficient a company’s management is at using its assets to generate earnings. Return on assets is displayed as a percentage.
Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets.
Return on invested capital (ROIC) is a calculation used to assess a company’s efficiency at allocating the capital under its control to profitable investments. The return on invested capital ratio gives a sense of how well a company is using its money to generate returns.
The debt-to-capital ratio is a measurement of a company’s financial leverage. The debt-to-capital ratio is calculated by taking the company’s interest-bearing debt, both short- and long-term liabilities and dividing it by the total capital. Total capital is all interest-bearing debt plus shareholders’ equity, which may include items such as common stock, preferred stock, and minority interest.
The trailing price-to-earnings (P/E) ratio is a relative valuation multiple that is based on the past 12 months of actual earnings. It is calculated by taking a company’s current stock price and dividing it by the trailing earnings per share (EPS) for the past 12 months. For an index, it is the average trailing P/E ratio of the companies in the index.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
The opinions referenced above are those of the authors as of October 6, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.