Why smaller companies matter to us

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At Baillie Gifford, we have invested in smaller companies for decades. In 2018, we launched our Baillie Gifford International Smaller Companies Fund 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

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

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

RISK FACTORS

This content contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.

As with all mutual funds, the value of an investment in the fund could decline, so you could lose money.

The most significant risks of an investment in the Baillie Gifford International Smaller Companies Fund are, Small-and Medium Capitalization Securities Risk, Growth Stock Risk, Investment Style Risk, Long-Term Investment Strategy Risk, and Non-U.S. Investment Risk. The shares of small-and medium -capitalization companies can be more volatile than larger companies. This can be more evident during market downturns as they may have potentially reduced liquidity and shorter operating histories. The prices of growth stocks can be based largely on expectations of future earnings and can decline significantly in reaction to negative news. The Fund is managed on a bottom-up basis and stock selection is likely to be the main driver of investment returns. Returns are unlikely to track the movements of the benchmark. The Fund is managed on a long-term outlook, meaning that the Fund managers look for investments that they think will make returns over a number of years, rather than over shorter time periods. Non-U.S. securities are subject to additional risks, including less liquidity, increased volatility, less transparency, withholding or other taxes and increased vulnerability to adverse changes in local and global economic conditions. Other Fund risks include: Asia Risk, Conflicts of Interest Risk, Currency Risk, Emerging Markets Risk, Equity Securities Risk, Environmental, Social and Governance Risk, Focused Investment Risk, Geographic Focus Risk, Government and Regulatory Risk, Information Technology Risk, Initial Public Offering Risk, Japan Risk, Liquidity Risk, Market Disruption and Geopolitical Risk, Market Risk, New and Smaller-Sized Funds Risks, Service Provider Risk, Settlement Risk and Valuation Risk.

For more information about these and other risks of an investment in the fund, see “Principal Investment Risks” and “Additional Investment Strategies” in the prospectus. The Baillie Gifford International Smaller Companies Fund seeks capital appreciation. There can be no assurance, however, that the fund will achieve its investment objective.

The fund is distributed by Baillie Gifford Funds Services LLC. Baillie Gifford Funds Services LLC is registered as a broker-dealer with the SEC, a member of FINRA and is an affiliate of Baillie Gifford Overseas Limited.

All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.

The images used in this article are for illustrative purposes only.

Top Ten Holdings. As at 31 March 2024. 

It should not be assumed that recommendations/transactions made in the future will be profitable or will equal performance of the securities mentioned. A full list of holdings is available on request. The composition of the fund's holdings is subject to change. Percentages are based on securities at market value. 

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