INTRODUCTION
Since the documentation of the size premium, a market participants have increasingly seen small-cap stocks as a distinct asset class and have started to maintain a dedicated, separate allocation apart from large caps. In recent years, research has shown that quality is the prominent driver of returns in the small-cap space.b Asness et al. found that the variability of the size effect mainly stemmed from the volatile performance of low-quality, or junk, small-cap firms. When junk or low quality is controlled for, the size premium becomes more robust in nature and is found across industries, time periods, and 23 different markets.
Based on evidence found in “A Tale of Two Benchmarks: Five Years Later” and effectiveness across regions in Asness et al., we investigated whether quality has earned a similar premium in international small-cap benchmarks. We tested a number of profitability metrics and found that for international small-cap universes, companies with positive earnings, or higher profitability ratios, incorporated as an inclusion requirement outperformed portfolios without such a requirement. The results were consistent regardless of the profitability metric used and region tested.
In order to capture the positive earnings return premia seen in the profitability metrics testing results, the S&P Global SmallCap Select Index Series was launched in late 2018. The series is designed to measure the performance of small-cap companies with positive earnings, with most based on the S&P Global BMI universe. The series includes indices representing multiple regions, such as global, global ex-U.S., developed exU.S., and emerging markets. It provides several key benefits over traditional small-cap benchmarks, including improved risk-adjusted returns (see Exhibit 2), low tracking error, and enhanced liquidity. We additionally found that the series raises the bar for active manager performance measurement relative to the traditional small-cap benchmarks (see Exhibit 19).
EARNINGS RETURN PREDICTABILITY
A profitability requirement—even something as simple as screening out unprofitable companies using earnings per share (EPS)—could have a positive return impact for an international small-cap benchmark.
To determine if profitability is a driver of performance in the international small-cap space, we explored six common measures of profitability. These are EPS,1 asset turnover, gross profit margin, gross profitability, return on assets (ROA), and return on equity (ROE).2 We compared the six-month forward returns of companies with positive (or higher) profits to ones with negative (or lower) profits. To check if geographical differences played a role, we tested the metrics across four universes, including global, global ex-U.S., developed ex-U.S., and emerging markets.
Monthly, we ranked companies in each universe and grouped them into quintiles, with the most profitable (highest) companies placed into the Quintile 1 and least profitable (lowest) companies placed into Quintile 5. For EPS, we placed companies in two groups, companies with positive earnings and companies with negative earnings. We equally weighted companies within each group to avoid size bias and calculated returns in local currency to avoid currency effect. Exhibit 3 shows the average of the forward six-month returns for each metric from November 1999 to April 2018.
