The Illusion of International Small-Cap Investing

The Illusion of International Small-Cap Investing

Drew Spangler
Grantham, Mayo, Van Otterloo & Co. LLC
March 2001

Investing in international small-cap is a complicated and deceptive business.  Many of the common assumptions used to justify international small-cap investing are misguided.  The sticker must read “caveat emptor.”


Many investors are attracted to international small-cap because they believe that small companies are capable of faster earnings growth.  They reason that higher growth rates will lead to superior performance.  But the great irony of small-cap investing is that these companies do not grow any faster than their larger peers.  

• In fact, the corporate financial performance of international small companies is below average.  
• The small universe is populated with mediocre companies because the common definition of small contains an implicit bias for stocks with low valuations.  
• Low stock valuations are often the consequence of inferior corporate results. 

However, the hidden tilt towards value stocks actually provides the international small sector with the engine for excess returns and ironically enables international small-cap investing to be potentially very lucrative.  In addition, this value bias can be used to assess the future prospects for small stocks in the international equity markets.  This paper seeks to reveal the true identity of international small stocks and thereby equip investors with the information, insight and tools.


Executive Summary

Investors are beginning to awaken to the compelling case for small stock investing in the international markets. Recent outperformance, low valuations and increasing diversification benefits are all reasons investors are becoming attracted to this sector. Before they jump in head first, however, investors need to be aware of a few issues that make assessing the risks and rewards of international small stocks more challenging.

1. First, it is not entirely clear how to define small-cap and there is a diversity of opinion about what method is most appropriate for identifying the small universe. In this paper, we compare and contrast the construction methodologies of the two leading international small-cap indices.
2. Second, most conventional methods for defining small use market capitalization to measure company size.This introduces an implicit bias for companies with low stock valuations relative to corporate fundamentals such as earnings or assets.
3. Third, it is the quality of cheapness rather than smallness that drives small stock performance and is a powerful tool for forecasting the future performance of these stocks.
4. Fourth, although investors are often tempted by small-cap because they perceive these stocks to be capable of higher earnings growth, our empirical analysis shows this to be a fallacy.  In fact, the fundamental corporate performance of small stocks is below average.

Finally, the diversification benefits of international small are alive and well. Not only have correlations with international large stocks decreased, but international small continues to be asynchronous with both US large and US small stocks.

In conclusion, while international small stocks currently present a compelling opportunity, investors need to be educated and informed in order to take full advantage of this potentially lucrative sector.


Read the full report here.