Small-cap stocks have long underperformed their large-cap counterparts, now trading at a discount. For those with a long-term perspective, this could represent a compelling entry point, says Scott Woods, manager of the Columbia Threadneedle Global Smaller Companies fund.
In a discussion with Investment Officer, Woods noted that small-cap stocks have struggled to match broader market returns for several years, and hopes for a resurgence in July failed to materialise. Large growth stocks have dominated the market landscape, capturing investor attention.
Despite these challenges, Woods remains optimistic. “Historically, small caps have consistently outperformed large caps over the long term,” he said. He attributes this to several factors, including faster growth potential, frequent acquisition interest, and fewer analysts covering small-cap stocks. “Additionally, small caps offer compensation for their lower liquidity,” Woods added.
Valuation opportunity
While Woods is cautious about pinpointing the exact catalyst for a small-cap recovery, he firmly believes it’s on the horizon. “Timing the outperformance of small caps is notoriously difficult, but the small-cap effect hasn’t disappeared. There are no structural reasons to suggest otherwise,” he said.
From a valuation perspective, Woods highlights the significant opportunity within small-cap stocks. “Normally, small caps trade at a premium to large caps due to their growth potential, but today they are at a discount due to recent underperformance. Relative to large caps, they’ve never been this cheap. Investors with patience can expect strong risk-adjusted returns,” Woods emphasised.
Woods also believes that looser monetary policy could provide a tailwind for small-cap stocks, which often carry higher debt ratios. However, he was quick to point out that the companies in his portfolio are not reliant on external capital markets. “Our small caps are financially sound with robust free cash flow. While lower interest rates may spark renewed M&A activity, we focus on quality companies with solid growth potential and strong market positions. If they become acquisition targets, that’s just a bonus.”
Focus on quality
According to Woods, the small-cap universe remains fertile ground for active management. “Smaller companies are less followed by analysts, so bottom-up research still adds significant value,” he said. Profit margins and return on invested capital are key indicators of quality in his portfolio, and Woods sees many investors underestimating small companies’ ability to maintain competitive advantages. “This is precisely where we find opportunities.”
Within the fund’s vast universe of 4,500 small-cap stocks, Woods sees many companies dominating niche markets with substantial pricing power. He cited the past few years of high inflation as a prime test of the strategy. “While the fund struggled in 2022, the underlying companies performed well. Most were able to pass on cost inflation, and many have emerged with structurally higher profit margins.”
Sector overweight and AI exposure
The Global Smaller Companies fund (ISIN: LU0570870567) has delivered an impressive average annual return of 13.3% over the past decade, outperforming the MSCI World Small Cap Index, which has returned 10.2%. Woods’ largest sector overweight is industrials, comprising 34% of the portfolio compared to the index’s 20.1%. Yet he downplays concerns over sector concentration. “These industrials aren’t correlated; they rely on different growth drivers.” He points to US-based consultancy Exponent, which specialises in aircraft disaster investigations and is uncorrelated with traditional industrial production.
The fund also taps into the artificial intelligence boom, investing in companies like air conditioning manufacturer Aaon, which provides cooling solutions for data centres, and semiconductor players such as Inficon and Besi.
Woods is comfortable paying a premium for these high-quality names. The portfolio trades at around 55 times forward earnings, compared with the benchmark’s price-earnings ratio of 28. This valuation is justified by the fund’s faster anticipated earnings growth, expected to average 19.6% annually over the next three to five years, compared to 12.7% for the index.
“We’re not buying struggling companies or turnaround stories. We focus on great businesses with long-term potential that the market undervalues,” Woods said. “I’m willing to pay a premium for that quality.”