Setting the Table for Success in International Small Caps

Recent global economic conditions have been volatile, and we believe investors will continue to contend with persistent inflation, the implications of central bank decision making, and anticipation for the eventual deterioration of economic growth and rising recession risk due to tightening financial conditions.

Small cap equities, in particular, have been reacting to this deteriorating economic outlook as they tend to experience more severe weakness in this type of market environment. However, as exhibited in the graph below, since the inception of the MSCI EAFE Small Cap Index, the MSCI EAFE Index, which tracks large- and mid-cap developed market securities, has declined by more than 15% four times. Following the MSCI EAFE bottom, small caps have tended to lead, outperforming in all four of the 1-year from bottom periods for an average outperformance of 12.82%.

Source: Morningstar Direct, June 2023

Performance data shown represents past performance and is no guarantee of future results.

Most recently, the MSCI EAFE Index experienced a -28.95% decline from 9/6/2021 to 10/12/2022. Given the historical patterns demonstrated above, we think non-U.S. small caps are well positioned to recognize upside potential as equity markets recover, having delivered a 17.23% return (vs. the MSCI EAFE’s 24.35% return) from the MSCI EAFE bottom on 10/12/2022, through 6/30/2023.

Proof is in the Pudding

Moreover, we find it important to note that developed non-U.S. market dynamics differ from U.S. markets with respect to small caps vs. large caps. While small caps in the U.S. are often associated with higher risk and higher levels of volatility, the dynamic is notably different abroad where the MSCI EAFE Small Cap Index has largely been in-line with or slightly elevated to the volatility of its large cap counterpart.

Source: Morningstar Direct, June 2023

Performance data shown represents past performance and is no guarantee of future results.

In our view, the different dynamic abroad is primarily driven by the relative quality and profitability profile of non-U.S. small caps compared to non-U.S. large caps, which can be favorable in a potential downturn.

Source: Morningstar Direct, June 2023

Performance data shown represents past performance and is no guarantee of future results.

These factors have led to non-U.S. small caps consistently outperforming non-U.S. large caps, as seen above. Since the inception of the MSCI EAFE Small Index (through 6/30/2023), small caps have delivered a cumulative return of 380% vs. 139% for the MSCI EAFE over the same time period. As of 6/30/2023, non-U.S. small cap valuation levels sit at one of the lowest levels in more than a decade.

Source: Morningstar Direct, June 2023

FY1 denotes current unreported year.

Performance data shown represents past performance and is no guarantee of future results.

Subsequently, should there be an eventual reversion to the mean, this space may make an attractive investment opportunity, in our view.

Important Information

The views expressed herein may not be reflective of current opinions, are subject to change without prior notice, and should not be considered investment advice or a recommendation to purchase or sell a particular security.

Investing entails risk and there can be no assurance that any investment will achieve profits or avoid incurring losses. There is no guarantee any company or investing strategy will pay dividends.

All investments involve risk including the possible loss of principal. Stock prices can fall because of weakness in the broad market, a particular industry, or specific holdings.

Standard Deviation is a statistic that measures the dispersion of a dataset relative to its mean and is calculated as the square root of the variance.

Price-to-earnings (P/E) is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS).

Earnings per share is calculated as a company's profit divided by the outstanding shares of its common stock.

The MSCI EAFE (ND) Index is an unmanaged index generally representative of major overseas stock markets. The MSCI EAFE Small Cap (ND) Index is an equity index which captures small cap representation across developed market countries around the world, excluding the U.S. and Canada. The Standard & Poor's 500 Index is an unmanaged index generally representative of the U.S. market for large capitalization equities. The Russell 2000® Value Index is an unmanaged index representing the smallest 2000 stocks with the lowest price-to-book ratio and future earnings. The Russell 2000® Value Index and Russell® are trademarks of Frank Russell Company. These unmanaged indices do not reflect fees and expenses and are not available for direct investment.

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