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Due in part to the reflation trade taking shape, smaller stocks are off to stellar starts this year. As of Feb. 24, the S&P SmallCap 600 Index is up 18.6% year-to-date while the S&P MidCap 400 Index is higher by nearly 12%.
For those that need to be further impressed, the large-cap S&P 500 is up “just” 4.8%. Still, many investors are likely to overlook small stocks, particularly mid caps. And if they're glossing over smaller domestic stocks, chances are they're definitely doing so with international small- and mid-cap (SMID) fare. Advisors may be doing the same.
While international equities, particularly MSCI EAFE Index-type fare, were, broadly speaking, basically a lost cause for close to a decade, there is now substantial opportunity with the ex-US SMID group. Best of all, advisors don't have to expose clients to frothy valuations or junky, risky unprofitable companies when allocating to smaller international stocks. In fact, the international SMID group sports favorable quality traits.
“Higher quality at a lower price is not a combination that’s easy to find. And yet, by almost all measures, international SMID companies are higher quality than US small- and mid-caps, yet they have been trading on average at a 50% discount to them,” according to Invesco research.
Surprising Quality Kicker
Market participants are often pre-conditioned to believe that there's a trade-off with smaller stocks. That sacrifice is purported to be growth over profitability and where company bleeding cash is found, so other are, usually, other poor financial metrics.
However, the size factor, even with its higher levels of volatility, works over the long-term. That end – long-term returns – justifies the means – embracing some smaller, less-than-sturdy companies in the name of growth. Indeed, major domestic small stock benchmarks are littered with companies with dubious profitability and financial health. It doesn't have to be this way and it's not with international SMIDs.
“On almost every statistic investors use to assess the quality and financial strength of a company — from return on equity to debt-to-capital ratios — international SMID companies (as represented by the MSCI ACWI ex US SMID Cap Index), on average, far surpass the averages of their US peers (as represented by the Russell 2500 Index),” notes Invesco. “On two key quality measures — return on equity and return on invested capital – the international SMID companies score 80% and 115% higher, respectively.”
Something else we're often pre-conditioned to believe when it comes to domestic stocks is that quality is expensive. Think the recent examples of companies like Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT), just to name a pair. However, the aforementioned quality available with ex-US SMIDs isn't costly. It's actually inexpensive at the moment.
“When it comes to valuations — as indicated by the trailing 12-month price/earnings ratios — these higher-quality international SMID companies have been available at just 50% of the price — (24.5 versus 48.0 trailing P/E ratios) — as of Dec. 31, 2020,” said Invesco. “That’s a 50% discount for higher quality.”
Other International SMID Benefits
Here's something interesting: The dividend yield on the MSCI ACWI ex US SMID Cap Index is 75% higher than that of the Russell 2500 Index and the former's payout ratio is more than double that of the latter's.
However, components in the international index can support that payout ratio (it's just 34.3%) because these stocks beat U.S. counterparts on return on equity, return on assets, return on invested and margins while sporting low long-term debt ratios.
The opportunity for advisors is clear. As Morningstar points out, the average U.S. investors doesn't even allocate 1% of a portfolio to international SMIDs. That says this fertile ground for an advisor/client conversation and for advisors to show their value by exposing clients to an asset class most are obviously ignoring.