Your capital is at risk.
At Baillie Gifford, we have invested in smaller companies for decades. In 2018, we launched our International Smaller Companies (ISC) Strategy with a simple objective: make strong returns for our clients by investing in exceptional growth companies within the small cap universe.
The past three years have been a hugely challenging period for small cap growth investors. The macroeconomic environment has been unhelpful for growth companies as interest rates have risen and risk appetite has receded; smaller companies suffered further as many have relatively weak pricing power and balance sheets during a softer market backdrop. The overwhelming outperformance of large caps over small caps in the US recently has been well documented; this dynamic is also observed internationally (even without the ‘Magnificent Seven’ skewing results), albeit the gap is less pronounced.
The question for us to reflect on is: why do we bother with smaller companies at all?
Small Caps can yield big returns
Those of us involved in small cap investing will be familiar with Rolf Banz, whose seminal 1981 paper on ‘The Relationship between Return and Market Value’ triggered not only a body of research on the Small Cap Effect from academia but also catalysed the establishment of small caps as an asset class. Banz’s observation that small caps had higher risk adjusted returns than larger firms had been an empirical one. Since then, the small cap effect has largely diminished with various interpretations and challenges on why it existed in the first place (if it ever did).
Questioning the small cap effect may seem like an odd starting point for this paper. But to us as practitioners, the fact that overall returns from small caps are even competitive with large caps is striking. Frankly, most smaller companies are mediocre at best: undifferentiated products, uninspired management and unsustainable business practices are commonplace. Many still exist because they have not yet been tested thoroughly by the market’s Darwinian forces as most large, established companies have. However, far from being a detraction to small cap investing, the aggregate negative quality bias of small caps, simply hints at the tantalising potential for exceptional returns for those able to filter out the poor and the mediocre.
This is our team’s mission. Our investment process, the RADAR, is formulated to help us identify ~75-100 of the most exceptional small cap stocks in our vast investment universe. At the time of writing, there are close to 20 thousand companies internationally with a market cap between $100m and $2bn. Amongst this incredibly broad and diverse universe are many potential multi-baggers and some of the leading companies of the future.
In other words, we are not investing in small caps because they are small. We are investing in exceptional companies that happen to be small.
Assessing potential: Radar
Source: Baillie Gifford and Co.
Making the most of our collective insight
Effective active stock picking is more easily said than done. Our investment philosophy compels us to develop a strong understanding of not only a holding’s products and business model, but also its history, people, and culture. This research process takes time, and the challenge is compounded by the fact that information is often hard to come by for smaller companies. So, with ~20 thousand companies to potentially consider, how do we cover our universe with a team of seven?
Quant-based investors aside, we doubt any team of the same size realistically can. Fortunately, we have help from over 100 investment colleagues (in addition to external sources of expertise that we tap into), both directly and indirectly.
Over the past two years, colleagues outside our immediate team have contributed towards half of our new buys. Sometimes interesting small cap names emerge as we investigate the supply chains of large caps. In other instances, we meet smaller companies during trips and conferences and these serendipitous meetings have often led to new buys. Take Global Unichip as an example, it is a custom chip designer that we have held in our small cap portfolios for several years. TSMC, the leading semiconductor foundry in the world (and widely held by Baillie Gifford’s clients), is a customer and anchor shareholder. While TSMC is clearly too large to be held in a small cap portfolio, our appreciation of its strengths and the relationship between these two companies form the basis of Global Unichip’s investment case. Incidentally, Global Unichip is one of over 120 other listed companies headquartered in Hsinchu (Taiwan), of which only five, including TSMC, are above $10bn in market cap. Our investors’ frequent visits to Hsinchu naturally involve meeting lots of smaller companies. The sheer number of small companies, and the relative accessibility of senior management means small caps can be a fantastic source of information for all investors and are sometimes interesting enough to pursue directly. This is where the Smaller Companies Team comes in.
Internationally listed companies by Market Cap
Source: Baillie Gifford and Co.
Assistance from large cap colleagues goes beyond sharing exciting small cap ideas with us. Megatrends such as electrification, digitalisation (of everything) and healthcare innovation are powerful themes in the ISC portfolio. Our direct engagement with some of the leading companies (both public and private) that actively shape these megatrends provides us with invaluable context. Such insight is hard to come by through a siloed small cap approach. Ultimately, active investment is about the pursuit of insight – an important part of our small cap effort is built on filtering Baillie Gifford’s collective insight and expressing it through stock selection in a vast universe. Our team invests in small caps partly because we enjoy a structural edge.
Incubating ideas, cultivating relationships
Alongside harnessing insight from our colleagues, the Smaller Companies Team also gives back. This is one of the reasons that our small cap endeavour is strongly supported by the firm.
How do we contribute to Baillie Gifford’s broader investment efforts? We have already mentioned the value of smaller companies as a rich information source. In addition, we help incubate investment ideas – many small cap holdings have the potential to be the leading companies of the future. Given our firm’s long-term investment horizon, it makes sense for us to get to know these companies early as shareholders. As these companies develop, they may ‘graduate’ to other Baillie Gifford portfolios, with our small cap portfolios being viewed as a pipeline for our mainstream strategies.
This incubation period provides a window to learn about a company at a stage when its DNA is undiluted and to build trust with the management (who are often the founder/anchor shareholder) through engagement in a way that would have been more difficult to replicate had we come in at a later stage. Naturally, the conversations that we have with a company’s management team after a decade are much more open than the initial meetings.
In some cases, we may contribute towards the development of these companies. While as shareholders, we rarely contribute anything on an operational or technical level, our holdings are often far from mature organisationally. Therefore, our perspectives and quiet support, as one of the earlier international institutional investors on the shareholder register, are often highly appreciated. ‘Can you talk me through just how the capital markets work?’ – asked a founder-CEO of a small cap holding in a meeting before I got a chance to ask questions. You wouldn’t get this from a CEO of a large cap company!
Small Cap: a secret ingredient to insight?
Why do we invest in small caps? As mentioned, much of investing is about finding insight. Insight can come from two sources: we (or someone we trust) ‘out-analyse’ Mr Market by going deeper, or we make genuinely novel connections. While we aspire to the former (by hiring and training people from diverse, sometimes specialist, backgrounds who are also cleverer than we are), we feel it is the latter where we enjoy a structural edge. Our collaborative culture, generalist and long-term approach to investing is essential. The other fundamental ingredient is a broad set of inputs to make novel connections. This takes us to the vast small cap universe.
It is worth remembering of course that ‘small cap’ is purely a financial industry construct. I have yet to come across a CEO who refers to their own company as a ‘small cap.’ But this is how our own industry is typically organised, with many market participants often staying within these regional and/or market cap siloes through their entire careers. While these siloes probably make practical sense, as insight hunters, the scope for making novel connections is that much richer if we pay more attention to small caps – after all, most public companies are small!
We understand why the small cap asset class has been massively out of favour recently. Many smaller companies will suffer if the current economic environment persists, and the perception that ‘small = risky’ may be justified overall. Nevertheless, we are confident that our holdings’ long-term prospects are not defined by their ‘smallness.’ Most of our holdings are growing into markets that are many multiples of their current size. Most of them enjoy considerable (and sometimes strengthening) competitive edge. The majority are managed by aligned managers who are also significant owners. In aggregate, our portfolio’s balance sheet is healthy. For us, small caps in general, being overlooked simply means that this already remarkable investment universe is that much more fertile as a hunting ground.
MSCI ACWI ex US Small Cap vs MSCI ACWI ex US relative price to sales 1yr forward
Source: Baillie Gifford & Co, Factset, MSCI, Based on a representative International Smaller Companies portfolio. As at 31 March 2024. US dollar.
Risk factors
The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in June 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.
All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.
The images used in this communication are for illustrative purposes only.
Important Information
Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.
Baillie Gifford Overseas Limited provides investment management and advisory services to non-UK Professional/Institutional clients only. Baillie Gifford Overseas Limited is wholly owned by Baillie Gifford & Co. Baillie Gifford & Co and Baillie Gifford Overseas Limited are authorised and regulated by the FCA in the UK.
Persons resident or domiciled outside the UK should consult with their professional advisers as to whether they require any governmental or other consents in order to enable them to invest, and with their tax advisers for advice relevant to their own particular circumstances.
Financial Intermediaries
This communication is suitable for use of financial intermediaries. Financial intermediaries are solely responsible for any further distribution and Baillie Gifford takes no responsibility for the reliance on this document by any other person who did not receive this document directly from Baillie Gifford.
Europe
Baillie Gifford Investment Management (Europe) Limited provides investment management and advisory services to European (excluding UK) clients. It was incorporated in Ireland in May 2018. Baillie Gifford Investment Management (Europe) Limited is authorised by the Central Bank of Ireland as an AIFM under the AIFM Regulations and as a UCITS management company under the UCITS Regulation. Baillie Gifford Investment Management (Europe) Limited is also authorised in accordance with Regulation 7 of the AIFM Regulations, to provide management of portfolios of investments, including Individual Portfolio Management (‘IPM’) and Non-Core Services. Baillie Gifford Investment Management (Europe) Limited has been appointed as UCITS management company to the following UCITS umbrella company; Baillie Gifford Worldwide Funds plc. Through passporting it has established Baillie Gifford Investment Management (Europe) Limited (Frankfurt Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in Germany. Similarly, it has established Baillie Gifford Investment Management (Europe) Limited (Amsterdam Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in The Netherlands. Baillie Gifford Investment Management (Europe) Limited also has a representative office in Zurich, Switzerland pursuant to Art. 58 of the Federal Act on Financial Institutions (“FinIA”). The representative office is authorised by the Swiss Financial Market Supervisory Authority (FINMA). The representative office does not constitute a branch and therefore does not have authority to commit Baillie Gifford Investment Management (Europe) Limited. Baillie Gifford Investment Management (Europe) Limited is a wholly owned subsidiary of Baillie Gifford Overseas Limited, which is wholly owned by Baillie Gifford & Co. Baillie Gifford Overseas Limited and Baillie Gifford & Co are authorised and regulated in the UK by the Financial Conduct Authority.
Hong Kong
Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 is wholly owned by Baillie Gifford Overseas Limited and holds a Type 1 and a Type 2 license from the Securities & Futures Commission of Hong Kong to market and distribute Baillie Gifford’s range of collective investment schemes to professional investors in Hong Kong. Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 can be contacted at Suites 2713-2715, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. Telephone +852 3756 5700.
South Korea
Baillie Gifford Overseas Limited is licensed with the Financial Services Commission in South Korea as a cross border Discretionary Investment Manager and Non-discretionary Investment Adviser.
Japan
Mitsubishi UFJ Baillie Gifford Asset Management Limited (‘MUBGAM’) is a joint venture company between Mitsubishi UFJ Trust & Banking Corporation and Baillie Gifford Overseas Limited. MUBGAM is authorised and regulated by the Financial Conduct Authority.
Australia
Baillie Gifford Overseas Limited (ARBN 118 567 178) is registered as a foreign company under the Corporations Act 2001 (Cth) and holds Foreign Australian Financial Services Licence No 528911. This material is provided to you on the basis that you are a “wholesale client” within the meaning of section 761G of the Corporations Act 2001 (Cth) (“Corporations Act”). Please advise Baillie Gifford Overseas Limited immediately if you are not a wholesale client. In no circumstances may this material be made available to a “retail client” within the meaning of section 761G of the Corporations Act.
This material contains general information only. It does not take into account any person’s objectives, financial situation or needs.
South Africa
Baillie Gifford Overseas Limited is registered as a Foreign Financial Services Provider with the Financial Sector Conduct Authority in South Africa.
North America
Baillie Gifford International LLC is wholly owned by Baillie Gifford Overseas Limited; it was formed in Delaware in 2005 and is registered with the SEC. It is the legal entity through which Baillie Gifford Overseas Limited provides client service and marketing functions in North America. Baillie Gifford Overseas Limited is registered with the SEC in the United States of America.
The Manager is not resident in Canada, its head office and principal place of business is in Edinburgh, Scotland. Baillie Gifford Overseas Limited is regulated in Canada as a portfolio manager and exempt market dealer with the Ontario Securities Commission ('OSC'). Its portfolio manager licence is currently passported into Alberta, Quebec, Saskatchewan, Manitoba and Newfoundland & Labrador whereas the exempt market dealer licence is passported across all Canadian provinces and territories. Baillie Gifford International LLC is regulated by the OSC as an exempt market and its licence is passported across all Canadian provinces and territories. Baillie Gifford Investment Management (Europe) Limited (‘BGE’) relies on the International Investment Fund Manager Exemption in the provinces of Ontario and Quebec.
Israel
Baillie Gifford Overseas Limited is not licensed under Israel’s Regulation of Investment Advising, Investment Marketing and Portfolio Management Law, 5755-1995 (the Advice Law) and does not carry insurance pursuant to the Advice Law. This material is only intended for those categories of Israeli residents who are qualified clients listed on the First Addendum to the Advice Law.
103931 10047613
