Beyond Borders: Profiting from International Small Caps

International small-cap equities represent a powerful yet often overlooked segment of the global market. By embracing these nimble companies, investors can tap into superior long-term returns and diversification that large caps may not deliver. In this comprehensive guide, we explore why international small caps deserve a place in every portfolio.

The Case for International Small Caps

Over the past two decades, international small caps have outperformed their large-cap counterparts on both total and risk-adjusted bases. While U.S. small caps have struggled to generate excess returns relative to U.S. large caps, overseas small caps have delivered consistent outperformance. This phenomenon arises from a combination of structural advantages, such as persistent small-cap size premium and attractive valuations compared to mature markets.

Moreover, small-cap firms outside the U.S. have demonstrated resilience during periods of declining interest rates and post-earnings downturns, often seeing their earnings per share grow faster than large firms. Emerging market small and mid-cap stocks have also benefited from sectoral shifts and local economic stimuli, adding further appeal.

Unleashing Diversification Benefits

Diversification lies at the heart of risk management, and international small caps offer unique benefits that domestic large-cap allocations cannot replicate. Despite correlations similar to those of large caps, small caps’ higher return profiles can significantly enhance a portfolio’s Sharpe ratio.

Key diversification advantages include:

• Exposure to diverse economies and growth cycles, reducing home country bias.
• Currency diversification that can mitigate U.S. dollar risk over time.
• Lower median pairwise correlation driven by idiosyncratic, company-specific returns.
• Reduced sensitivity to global tariffs and geopolitics, thanks to local revenue focus.

Harnessing the Size Premium Abroad

The size premium, or the historical advantage of smaller firms over larger ones, has proven stronger outside the United States. International small caps often possess better return on equity and profitability metrics, reflecting disciplined balance sheets and established business models. On average, these companies are older and more stable than their U.S. peers, with founding dates dating back to the early 1970s.

This maturity translates into consistent performance, as these firms avoid the speculative excesses seen in earlier-stage businesses. As capital access remains more challenging abroad, small caps trade at valuations that leave room for multi-year recovery, enhancing the long-term reward potential.

Valuation Discounts: A Margin of Safety

International small caps currently trade at substantial discounts relative to both international large caps and U.S. equities. Forward price-to-earnings ratios are trading near multi-decade lows, presenting an attractive entry point for value-minded investors. Historically, such valuation gaps have preceded strong rebounds, offering a built-in margin of safety in uncertain markets.

The high dispersion among small-cap stocks—exacerbated by limited analyst coverage—creates further opportunities for those who can identify undervalued gems. This inefficiency is where active strategies can truly shine.

Active Management: Seizing Inefficiencies

With index weights for individual international small-cap constituents often below 0.25%, passive vehicles may struggle to allocate effectively. In contrast, an active approach can exploit:

• High idiosyncratic volatility, allowing stock pickers to differentiate winners and losers.
• Patchy research coverage, where proprietary analysis uncovers mispriced opportunities.
• Dynamic factor tilts, shifting towards quality, value or momentum as market conditions evolve.

By leveraging deep local insights and fundamental research, active managers can navigate this segment’s nuances, avoiding issuer-specific risks and capitalizing on recovery stories.

Regional Tailwinds Driving Growth

Global economic developments have created distinct tailwinds across various regions. Investors can benefit from:

Quality Metrics and Stability

Despite common misconceptions, international small caps often display robust quality characteristics. Long-term metrics for debt-to-asset ratios and return on equity rival those of international large caps and U.S. small caps. Focusing on quality helps mitigate business-cycle swings, aligning with a broader strategy of owning disciplined, financially sound enterprises.

By integrating quality screens into a small-cap universe, investors can improve resilience during downturns, benefiting from reduced default rates and steadier cash flows.

Navigating Risks with Confidence

All investments carry risk, and small caps are no exception. Key considerations include heightened volatility, lower liquidity, and issuer-specific challenges such as management turnover or product missteps. Currency fluctuations also pose a short-term headwind, though they tend to oscillate over multiple years.

Approaches to risk mitigation:

• Diversified exposure across sectors and geographies to smooth idiosyncratic swings.
• Active oversight with stringent sell disciplines to manage drawdowns.
• Regular portfolio rebalancing to control concentration and capture gains.

With careful planning and a long-term horizon, these risks can be managed effectively, keeping portfolios positioned for future growth.

Building a Global Portfolio with Small Caps

Excluding international small caps from a global allocation is, in itself, an active decision. By embracing this asset class, investors can align with a more complete global market opportunity set, capturing growth in sectors and regions underrepresented in large-cap indices.

Key takeaways:

• International small caps offer superior risk-adjusted returns over the long term.
• Diversification across currencies and economies reduces overall portfolio volatility.
• Persistent size and value premiums create structural return advantages.
• Active management unlocks inefficiencies in a fragmented market.

Incorporating international small caps into your portfolio can be a transformative step toward achieving robust, diversified growth. As markets evolve and new growth centers emerge, these agile companies stand ready to deliver outsized gains for patient, informed investors.