While many asset allocators are less aware of the benefits of allocating to global small-caps, others have been active in the asset class for some time and so are more likely to ask which investment approach may produce favorable outcomes, especially compared with a passive investment. This paper makes the case for investing in global small-caps using a quality approach. We review the historical results on a variety of parameters of a high-quality segment of stocks drawn from the MSCI ACWI Small Cap Index compared to the risk and returns of the index as a whole. We think that when allocators see the compelling research we present in this paper, they will understand the persuasive rationale for considering a quality approach to global small-cap investing.

The term ‘quality’ has historically been less clearly defined as an investment factor than other factors such as value, size, momentum, or profitability. We chose to anchor our definition of quality on profitability, which we believe can fuel outperformance. This view is supported by the 2013 study by Robert Novy-Marx, which concluded that high profitability companies generate significantly higher returns than the average company, despite having much higher valuation ratios. (This study measured profitability by gross profits-to-assets.) Similarly, Fama and French added profitability in 2015 when they evolved their well-known three-factor model to five, an addition based on their observation that stocks with high operating profitability performed better. We see profitability as the underlying principle driving what we call the “Iron Law” of Value Creation. Companies must have a return on invested capital (ROIC) that exceeds their cost of capital in order to create long-term “shareholder value,” by which we mean companies that realize increases in market capitalization and dividends paid to investors. Our view is that this theory suggests a foundational financial truth—hence “Iron Law”—and not an opinion. From this foundation, it naturally flows that companies with higher ROIC which can sustain those high returns over the long run should be able to create greater shareholder value. They accomplish this desirable result by compounding intrinsic value in ways that should ultimately be recognized and rewarded by the market. These higher ROIC companies have historically generated attractive investor returns—and we expect should continue to do so.

Specifically, this paper defines the high-quality segment of global small-cap stocks as those in the top decile of stocks in the MSCI ACWI Small Cap Index based on a combination of the last 12 months’ ROIC and the five-year stability of return on assets (ROA). By ‘stability,’ we mean the amount of variance in the five fiscal years of ROA for each company in the MSCI ACWI Small Cap Index. We chose this dual-metric definition in order to capture business models that have demonstrated the ability to sustain higher-than-index-average profitability (as opposed to enjoying just one great year). Our research in developing this multi-factor methodology showed that it is useful to have metrics that can measure different aspects of a business. We chose stability of ROA to identify businesses that have highly stable profitability profiles, which allowed us to favor those companies where their business model and/or market position led to consistent results over a multi-year period. Our multi-factor profitability metric tends to favor companies with consistently high profit margins or asset turnover, asset-light business models, and low debt. In our firm’s more than three decades of investing in high-quality small-cap businesses, these have become our preferred attributes.

Does the research support the hypothesis that high-quality segment of global small-cap companies, which we will also refer to in this paper as ‘Global Small-Cap Quality,’ has a good chance of continuing to outperform the broad global small-cap asset class? While the reader will have to decide for themselves, our perspective is that the research certainly shows this relative return pattern has been consistent historically. In this paper, we examine Global Small-Cap Quality from several perspectives, including:

1. Historical Research
We examine how the historical results where this high-quality segment of global small-cap stocks has:
• Amassed an impressive performance record on an absolute basis extending back almost two decades to 2003
• Shown remarkable consistency in outpacing the global small-cap asset class as a whole
• Accomplished this record with somewhat less volatility and a meaningfully better down- market record
• Generated a superior upside/downside return profile
• Boasted consistently superior risk-adjusted returns

2. Regime Analysis
We look at four different parameters—interest rates, credit spreads, manufacturing cyclicality, and overall economic growth—to show the environments in which Global Small-Cap Quality has had higher or lower excess returns and consistency of outperformance.

3. The Uneven Distribution of Quality
We show how high-quality small-caps are not proportionally spread among countries or industry groups.

4. The Active Management Opportunity
We discuss where there may be opportunities for active managers to exceed the impressive long- term results for Global Small-Cap Quality.

5. Can Quality’s Advantage Persist?
We conclude with some thoughts about whether the historical performance advantages of Global Small-Cap Quality are likely to persist.

1. Historical Research

We begin by comparing long-term monthly rolling average returns and the frequency of outperformance of Global Small-Cap Quality compared to the MSCI ACWI Small Cap. Based on rolling monthly annualized one-, three-, five-, and 10-year return periods from 1/31/03 through 12/31/21, the Global Small-Cap Quality segment posted significantly higher returns than the MSCI ACWI Small Cap. The high-quality segment averaged 15.6% versus 13.8% for the one-year period, 12.1% versus 9.8% for the rolling three-year periods, 11.2% versus 8.8% for the rolling five-year periods, and 11.9% versus 9.4% for the 10-year periods. Equally notable was the consistency of Global Small-Cap Quality’s relative advantage. As shown in the chart below, Global Small-Cap Quality outperformed the MSCI ACWI Small Cap in 84% of all three- year periods, 96% of all five-year periods, and 100% of all 10-year periods, a genuinely remarkable record.

% of Outperformance Periods for Global Small-Cap Quality vs. MSCI ACWI Small Cap
Monthly Rolling Average Annual Periods from 1/31/03 through 12/31/21

GSC Quality is the top decile of securities in the MSCI ACWI Small Cap, sorted by a combination of ROIC and stability of ROA rebalanced quarterly. Batting Average refers to the percentage of each period above in which Global Small Cap Quality outperformed the MSCI ACWI LC Index. Past performance is no guarantee of future results. All research extends back to 2003 as that is the earliest fundamental data we have to a broad universe of global small cap stocks.

One final observation: Global Small-Cap Quality also showed its consistency by outpacing the index as a whole across all return ranges for the monthly rolling five-year periods. While acknowledging that past performance is no guarantee of future results, we again wish to stress how noteworthy this consistent outperformance edge has been for Global Small-Cap Quality.

Monthly Rolling 5-Year Average Excess Returns: Global Small-Cap Quality Minus MSCI ACWI Small Cap
From 1/31/03 through 12/31/21

GSC Quality is the top decile of securities in the MSCI ACWI Small Cap, sorted by a combination of ROIC and stability of ROA rebalanced quarterly.

Average of Monthly Rolling 3-, 5- and 10-Year Periods
From 1/31/03–12/31/21

GSC Quality is the top decile of securities in the MSCI ACWI Small Cap, sorted by a combination of ROIC and stability of ROA rebalanced quarterly. Past performance is no guarantee of future results. The above chart is shown for illustrative purposes only and does not reflect the past performance, or project the future performance, of any investment. The performance of an index, such as those used above, does not represent any particular investment as you can not invest in an index.

There is another positive element to the case for Global Small-Cap Quality beyond its notably consistent pattern of outperformance with the global small- cap asset class, especially given that risk is nearly always a significant concern when investing in smaller companies.

Our research found a risk advantage, as measured by standard deviation, for the segment of high- quality global small-cap—which showed lower volatility than the MSCI ACWI Small Cap, as shown in the scatterplot, for the rolling three-, five-, and 10-year periods. Given the attributes that high-ROIC, quality companies possess, this was not a particularly surprising result. It also came as little surprise that Global Small-Cap Quality has regularly provided better risk- adjusted returns than global small-caps as a whole (as measured by Sharpe ratio), as well as an admirably high batting average of higher rolling monthly average risk-adjusted performance periods—83% of three-year periods, 94% of five-year periods, and 100% of 10-year periods from 1/31/03 through 12/31/21.

Relative Risk Adjusted Returns for Global Small-Cap Quality vs. MSCI ACWI Small Cap
Monthly Rolling Sharpe Ratios from 1/31/03 through 12/31/21

 

	PERIODS GLOBAL SMALL-CAP QUALITY BEAT GLOBAL SMALL CAPS		GSC QUALITY AVG*	MSCI ACWI SC AVG*
Three-Year	160/192 PERIODS	83%	0.82	0.68
Five-Year	158/168 PERIODS	94%	0.73	0.57
10-Year	108/108 PERIODS	100%	0.70	0.55

*Average of monthly rolling Sharpe ratios over the specified periods.
GSC Quality is the top decile of securities in the MSCI ACWI Small Cap, sorted by a combination of ROIC and stability of ROA rebalanced quarterly. Past performance is no guarantee of future results.

To further examine the performance of the Global Small-Cap Quality segment in more challenging market conditions, we looked at the group’s performance in down markets. There have been four periods in which the MSCI ACWI Small Cap declined 15% or more from 1/31/03: 10/31/07-2/28/09; 4/30/11-9/30/11; 8/31/18-12/31/18; and 12/31/19-3/31/20.

Down Market Performance Comparison of Global Small-Cap Quality vs. MSCI ACWI Small Cap
From 1/31/03 through 12/31/21 (%)

GSC Quality is the top decile of securities in the MSCI ACWI Small Cap, sorted by a combination of ROIC and stability of ROA rebalanced quarterly. Past performance is no guarantee of future results.

Global Small-Cap Quality outperformed the global small-cap index in all four down markets. The average return for Global Small-Cap Quality for these five periods was -28.6% versus -32.2% for the global small-cap index. We imagine many investors would not be surprised to find that higher-quality stocks outperformed the broader market during declines. However, the high-quality segment of global small-caps has complemented its superior down market results with outperformance in periods when the asset class is advancing—which is a rare and desirable trait for any segment of the equity market.

Another way to evaluate relative risk is to look at the outperformance percentage (or batting average) of Global Small-Cap Quality in rising versus falling markets. We think it is notable that this segment of high-quality small-caps has delivered outperformance in most positive and negative one-year periods.

In the 216 one-year monthly rolling average return periods from 1/31/03 through 12/31/21, 159 periods were positive for the global small-cap index, and Global Small-Cap Quality beat the index in 105 of them—66% of the time, with an average gain of 24.7% versus 23.2% for the MSCI ACWI Small Cap. The global small-cap index posted a negative monthly rolling one-year return in 57 out of 216 periods since 1/31/03. During these negative return periods, the high- quality segment beat the MSCI ACWI Small Cap in 41 of them—or 72% of the time—with an average loss of 9.7% versus 12.6% for the index as a whole.

2. Regime Analysis:

To further understand the superior performance record for the segment of high-quality global small-caps versus the index as a whole, we analyzed different economic regimes based on four indicators, each with enough history to be statistically significant: interest rates, where we used the 10-year U.S. Treasury yield as our proxy; cyclical activity, using the U.S. ISM Manufacturing Index; credit spreads, using U.S. Treasury high-yield spreads as the proxy; and the level of economic activity, using nominal U.S. GDP growth. We then calculated the rolling one-year returns.

Interest Rate Environments
Monthly Rolling Trailing 1-year Periods from 1/31/03 through 12/31/21

ISM Environments
Monthly Rolling Trailing 1-year Periods from 1/31/03 through 12/31/21

GSC Quality is the top decile of securities in the MSCI ACWI Small Cap, sorted by a combination of ROIC and stability of ROA rebalanced quarterly. The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements. The ISM Manufacturing Index (ISM) monitors employment, production, inventories, new orders and supplier deliveries. Source: Bloomberg.

We are sensitive to the comment that these are U.S.-centric regimes being used to evaluate a global small-cap approach. Having said that, we believe there are valid reasons for these choices: the 10-year U.S. Treasury yield is still the foundation for global interest rates; the U.S. ISM Manufacturing index has a longer history than Global PMI metrics; the U.S. high-yield market is the world’s largest; and nominal GDP Growth seems to show revealing results for this asset class. For the latter, we do agree that global nominal GDP might also be used as a regime definition.

When interest rates were rising, both the high-quality segment and the MSCI ACWI Small Cap advanced well beyond their historical monthly rolling one-year average returns of 15.6% and 13.8%, respectively. Global Small-Cap Quality beat the global small-cap index in 48 out of 89 observations (or 54% of the time), with a narrow average gain advantage of 27.8% versus 27.6%. Unsurprisingly, since falling rates are often associated with moderating economic activity, both the segment of high-quality small-caps and the overall MSCI ACWI Small Cap had much lower (though positive) returns when rates were falling, yet quality held the performance advantage once again, up 7.1% versus 4.0%, though the outperformance rate of Global Small-Cap Quality improved to 77%. It’s important to keep in mind that rates do not rise or fall in a vacuum—other factors, such as the state of economic growth, also would have played a substantial role in global equity performance during these periods. However, astute observers will note an incrementally lower outperformance spread and batting average for Global Small-Cap Quality during periods of rising rates. One potential explanation is the absence of banks in this segment. As banks have often benefited from rising rates, their absence in the high-quality segment may partially explain the narrower outperformance spread in rising rate regimes.

As was the case when rates were rising, both the Global Small-Cap Quality and the MSCI ACWI Small Cap posted much higher-than-average 12-month returns when U.S. ISM readings were rising—indeed, periods of improving cyclical activity have often been accompanied by rising rates. When ISM activity was moving upward, the high-quality segment advanced 27.2% on average—and it outperformed in 73 of 102 observations, or 72% of the time—while the global small-cap index averaged 24.5%. Again unsurprisingly, both had far lower-than-average 12-month returns in the opposite scenario: When ISM measures were falling, the segment of high-quality small-caps averaged a 5.3% gain while the index rose 4.1% on average. Global Small-Cap Quality also beat the index in 73 out of 114 of these periods, or 64% of the time. The wider outperformance spread in regimes of rising ISM readings is consistent with the fact that Global Small-Cap Quality has lower weightings in non-cyclicals, such as Utilities and REITs, and greater exposure to cyclical sectors such as Consumer Discretionary and Information Technology. (We explore sector and industry group weight differences between Global Small-Cap Quality and the MSCI ACWI Small Cap in more depth in the next section.)

We observed a similar dynamic when examining credit spreads. When U.S. high-yield spreads were narrowing, each group had significantly above average performance, with Global Small- Cap Quality climbing 27.3% and the MSCI ACWI Small Cap rising 26.4%. The segment of high-quality small-caps was ahead of the global small-cap index in 78 of 127 periods—or 61% of the time. We found an expected reversal in absolute performance when high-yield spreads were widening—which has historically created challenges for small-cap performance, often being coincident with greater market volatility and uncertainty. Global Small-Cap Quality fell 1.0% on average while the global small-cap index as a whole declined 4.3%. The wider performance spread for Global Small-Cap Quality in periods of widening high-yield credit spreads seems reasonable, as the global small-cap index has a much higher weighting of lower-quality businesses and/or those with high debt balance sheets, which might be expected to lag in such periods.

High-Yield Spread Environments
Monthly Rolling Trailing 1-year Periods from 1/31/03-12/31/21

GSC Quality is the top decile of securities in the MSCI ACWI Small Cap, sorted by a combination of ROIC and stability of ROA rebalanced quarterly. The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements. High Yield Spread: ICE BofAML US High Yield Master II Option-Adjusted Spread between an index of below investment grade bonds and the spot Treasury curve. Source: Bloomberg.

Our final scenario involved an examination of each group’s average performance in periods of nominal U.S. GDP growth of less than 3%, those between 3% and 5%, and periods where it was greater than 5%. Once more, the results were mostly in favor of Global Small Cap Quality. We measured periods from 3/31/03 through 12/31/21, which gave us 72 observations. In 18 of these, nominal U.S. GDP grew by less than 3%. In these economically sluggish phases, the average return for the Global Small-Cap Quality was 10.9% while the global small-cap index rose only 4.8%. The same advantage could be seen when GDP growth was between 3% and 5%, when the high-quality segment advanced by a 13.8% average, outpacing the MSCI ACWI Small Cap, which averaged 12.4%.

Nominal U.S. GDP Environments
Quarterly Rolling Trailing 1-year Periods from 3/31/03-12/31/21

 GSC Quality is the top decile of securities in the MSCI ACWI Small Cap, sorted by a combination of ROIC and stability of ROA rebalanced quarterly. The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements. High Yield Spread: ICE BofAML US High Yield Master II Option-Adjusted Spread between an index of below investment grade bonds and the spot Treasury curve. Source: Bloomberg.

High-quality faced a disadvantage only in more robust periods of economic growth, though absolute returns were quite strong. For the 20 periods when nominal U.S. GDP growth exceeded 5%, the Global Small-Cap Quality segment averaged a gain of 22.6% compared to a 24.1% advance for the global small-cap index. This inverse relationship between the spread of Global Small-Cap Quality’s outperformance and the overall level of economic growth makes sense to us. The attractiveness to investors of high-quality firms’ durable growth attributes is more pronounced in periods of lackluster economic growth when there is presumably lower than average earnings growth for the overall asset class.

While the segment of high-quality small-caps outperformed in the vast majority of regimes and periods, there have been periods when it lagged, as shown below. Unfortunately, no investment approach outperforms in all environments, so it is a useful reminder that to reap the rewards of long term outperformance, investors must endure some periods of underperformance—ideally by also taking long-term advantage of these periods.

Global High-Quality vs. MSCI ACWI Small-Cap 3-Year Average Annualized Trailing Excess Returns
From 1/31/03 through 12/31/21

 

¹The 3-year average annual total return through 12/31/21 was 18.21% for the Global High Quality and 18.96% for the MSCI ACWI Small Cap. -0.75% represents the difference.

Global High Quality: The top decile of securities in the MSCI ACWI Small Cap sorted by a combination of ROIC and stability of ROA rebalanced quarterly. Past performance is no guarantee of future results.

3. The Uneven Distribution of Quality

The MSCI ACWI Small Cap Index consisted of 6,343 companies at 12/31/21, of which 468—or 7.4%—comprised the Global Small-Cap Quality segment This percentage is somewhat lower than one might expect in the top decile because companies must have five years of history to be considered for inclusion in the segment of the high-quality small-caps and they must have ROIC, which excludes all banks and insurance companies. It’s reasonable to expect that high-quality companies are not spread proportionally among the various countries and industries. For countries, there are vastly different histories, regulations, cultural contexts, and practices, all of which contribute to the number of more or less high-quality companies.

The graphic below shows the percentage of stocks for all countries with at least 1% of the number of stocks in the segment of high-quality small-caps compared with the percentage of stocks in the global small-cap index as a whole. While most countries have a comparable percentage in both (including Australia, Brazil, Canada, China, Finland, France, Germany, Hong Kong, Israel, Italy, Malaysia, Sweden, Turkey, and the United Kingdom), a handful of countries have proportionally more (e.g., Japan, India, and Taiwan) or fewer (such as the U.S. and South Korea) high-quality companies than their percentage in the overall global small-cap index.

 

GSC Quality is the top decile of securities in the MSCI ACWI Small Cap, sorted by a combination of ROIC and stability of ROA rebalanced quarterly.

Most active managers will diverge to some degree in their portfolios’ geographic concentrations from the table show below. Disclosure and governance practices, for example, often play their own critical role in the company selection process.

 

	Percentage of Companies In	Percentage of Companies In
As of 12/31/21 (%)	MSCI ACWI SC	GSC Quality
United States	30.2	10.9
Japan	13.7	26.5
South Korea	5.1	3.6
India	5.0	12.4
Taiwan	4.7	11.1
United Kingdom	4.3	3.2
Canada	3.5	1.7
Australia	3.1	2.8
China	2.9	2.4
Sweden	2.1	1.7
Hong Kong	2.1	2.1
Germany	1.8	1.7
Brazil	1.6	1.5
Israel	1.4	1.5
Switzerland	1.4	2.6
Italy	1.2	1.3
France	1.2	1.5
Malaysia	1.0	1.5
Turkey	0.6	1.1

*Based on number of stocks in universe.

In our experience, there is an even more disproportionate clustering of high-quality within selected industries. We think this result makes sense as the particular attributes and market structures of various industries often have a large effect on whether or not companies in those industries achieve or sustain high ROIC. In fact, industry market structure is one of our investment team’s first considerations when evaluating potential high-quality investment candidates.

As can be seen by the chart below, which shows industry group percentages, high-quality companies are often found among software & services, technology hardware & equipment, and commercial & professional services, three areas known for businesses with substantial intellectual property and often asset light.

Percentage of Companies in Industry Groups in Global Small Cap Quality vs. MSCI ACWI Small Cap
as of 12/31/21 based on the total number of companies in the MSCI ACWI SC (%)

 

GSC Quality is the top decile of securities in the MSCI ACWI Small Cap, sorted by a combination of ROIC and stability of ROA rebalanced quarterly.

4. Active Management’s Opportunity

The performance results of the segment of high-quality small-caps are so impressive that readers might wonder whether there is an opportunity for active managers to improve upon these historical returns. With more than three decades of investing in high-quality companies, we believe there is an opportunity for active managers to outperform, even compared to this high starting point. The segment of global small-cap companies that possess high quality as we’ve defined it can be further refined in an effort to enhance long-term performance in a number of ways. For example, on a quantitative basis a manager may opt to exclude companies with high valuations—which we see as those with a multiple of enterprise value to earnings before interest and taxes (EV/EBIT) that significantly exceeds the valuation of the MSCI ACWI Small Cap as a whole. From a qualitative perspective, an active manager might focus more on companies that have established resilient—or ‘sticky’—customer relationships to provide greater confidence in the persistence of high ROIC. Alternatively, a portfolio manager might integrate ESG measures into their evaluation to exclude companies with questionable practices. Finally, an active manager may identify a company that appears to be transitioning “from good to great,” where the company has not yet posted multiple years of high ROIC, but due to changes in the company or industry, the manager expects that they will. From our perspective, active managers following a high-quality approach have a robust toolkit to develop a portfolio of high-quality companies that can potentially outperform even the impressive results cited in this paper.

5. Will Quality’s Advantage Persist?

We believe this study has made a comprehensive case that a portfolio of high-quality global small-cap companies has consistently delivered superior returns, lower risk, and higher risk-adjusted returns. A reasonable follow-up question might be, do we think that quality’s advantage will persist? With all of the relevant caveats about past performance not guaranteeing future results, we think the answer is affirmative. While we agree that regression to the mean is a powerful force in financial markets, it can—in some cases—be overcome in commercial markets. Every company eventually attracts competitors that are constantly trying to erode the other’s leading market share, and all industries evolve over time as bargaining power alternates between buyers and sellers. Still, through intellectual property, market structure, network effects, and other competitive advantages, we believe select high-quality companies can retain market leadership for extended periods of time. Analyses of the valuation of high-quality companies tend to reveal an implied “decay curve,” which presumes that superior profitability eventually regresses back to the average for all companies. And this does occur most of the time. 

However, as long time high-quality investors, we have seen that certain companies can resist regression to the mean and persist with higher ROICs. These businesses are able to create long-term shareholder value and produce impressive investment results. We believe that the consistently strong results for the Global Small-Cap Quality segment over the nearly twenty years surveyed in our study—a period that encompasses a wide variety of market and economic environments—show that there is a subset of companies that can indeed resist degradation of their superior profitability. Moreover, the results presented here show that, over time, the long- term creation of intrinsic value is recognized by other investors and converted into shareholder value, thus validating the “Iron Law” of value creation.

Conclusion

Based on the attractive historical performance profile global small-cap quality segment, we would therefore suggest that allocators to the overall asset class think about the potential advantages of strategies centered on Global Small-Cap Quality. We believe that our study has shown how a meaningful weighting in the high-quality segment of the global small-cap universe can yield improved standard, risk-adjusted, and down market performance. Allocators who have used global equities or global small-caps have what we feel is a compelling opportunity to potentially enhance portfolio returns by considering the high-quality segment of global small-cap stocks.

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