International Small Cap Investing

2018 was a tumultuous year for U.S. equity investors: the Russell 1000 and 2000 indices made new all-time highs late in Q3, only to give back all calendar-year gains in Q4, with declines of 20% and 14%, respectively. A confluence of worries triggered the decline, including global economic weakness, rising U.S. interest rates, and a U.S./China trade war. With both U.S. and international stocks in turmoil, international small caps outperformed in Q4, with the MSCI ACWI ex-US small cap index outperforming the Russell 1000 by 2.4%, the Russell 2000 by 8.8%, and the MSCI ACWI ex-US mid/large cap index by 3.0%.

In this report, we examine international small cap performance across various themes and provide actionable insights for both fundamental and quantitative investors, by identifying key drivers of small cap stock performance. We explore alpha potential from various data sources – including S&P Capital IQ Financials, S&P Global Ownership data, and SNL Bank fundamental data.

Our findings include:

• Valuation and Shareholder Yield Based Signals: Investing in companies with high free cash flow yield, earnings yield, dividend yields, and stock buybacks generated positive annualized long-short active returns ranging from 4.5% to 10.1% (Europe), 8.8% to 12.7% (Asia ex-Japan) and 3.6% to 11.0% (Japan), respectively; all significant at the 1% level. 
• Quality and Profitability Based Signals: Firms with higher levels of profit margins, higher operating efficiency, healthy leverage, and consistent earnings growth significantly outperformed their counterparts ranging from 3.2% to 7.9% (Europe), 4.3% to 9.1% (Asia ex-Japan) and 2.4% to 10.6% (Japan) annually.
• Liquidity and Volatility Based Signals: Selecting highly liquid and less volatile stocks yielded active long-short returns in Europe (7.9%), Asia ex-Japan (11.2%) and Japan (8.2%) annually with significance at the 1% level.
• Institutional Sentiment Based Signals: A composite of institutional ownership strategies yielded annualized long-short active returns in Europe (5.7%), Asia ex-Japan (8.4%) and Japan (6.7%), with significance at the 1% level.
• Industry Specific Banking Signals: Composites of Valuation and Quality strategies built upon the CAMELS (bank-specific) framework and SNL Financials generated active annual returns of 5.3% and 6.3%, respectively, significant at the 1% level.
• Performance is robust across different regimes and liquidity bands: Most strategies remain significant and effective when backtested across various scenarios.
• Before and after global financial crisis
• In various liquidity bands
• Across different regions or country