In the short-term, small caps could be more volatile than large cap companies, but it is a misconception to think that equates to higher risk over the long-term, he said.
Risk-adjusted returns for smaller companies have historically been better than large cap companies, Paisley said.
He backed up his assertion by looking at returns of the MSCI All Country World Index and the MSCI All Country World Small Cap Index over a 15-year peirod (2001 -2016). The small cap index across all markets – with the exception of Asia-Pacific ex-Japan – outperformed the all country index.
Source: Standard Life Investments
Smaller companies also outperformed not just in longer time periods but also shorter time periods, he said.
“[Small caps] might be slightly more volatile, but actually the return you are getting is more than compensating for that additional risk,” he said.
Due to volatility, investors in small caps should have a long-term investment horizon and avoid trying to time market entry or exit, he added.
Screening Europe’s small caps
SLI’s European Smaller Companies Fund, which Paisley has been managing since 2014, only invests in developed European markets and looks at companies that have market capitalisation of below €6bn ($6.76bn).
In an ideal situation, the fund would invest in companies capitalised at €1bn and hold them as they progress through the market cap scale, he said. The fund has a holding period of around five years.
Paisley is aware of liquidity risk, which is why the fund does not invest in micro cap stocks or those that have a market cap of below €200m. It also does not invest in speculative businesses, such as an early-stage biotech company with a clear idea for a product but no profit or turnover yet.
The fund makes use of an in-house quant tool, which Paisley calls “the matrix”, that helps screen a universe of around 1,000 stocks and focus on the top 200 opportunities.
The matrix has 13 factors and is divided into five groups: price momentum, earnings momentum, value, growth and quality. Each company is given a total score, which is ranked on a quintile basis.
Paisley did not give a breakdown of how the 13 factors are weighed, but said that price momentum and earnings momentum account for about 60% of the overall score. “So there is a clear tilt toward momentum but also quality and growth,” he said.
According to him, high momentum companies are those that are not well-understood by the market and are going through some upgrade cycle. He finds opportunities where there are non-consensus views or where the market got it wrong.
The higher the score that the matrix gives, the higher the potential for a “valid non-consensus view”, he said.
Paisley noted that the matrix works 75% of the time. However, it falls short of that percentage when value stocks rally. “The key thing during these value rallies is to remain disciplined in the application process.”
Testing the view
Once the team has formed a non-consensus view on a company, they meet with company management to test that view, Paisley said. The team aims to meet with management at 400 companies per year, he added.
Citing an example, he said that there was one company that had a price-to-earnings ratio of around 21x, which made many investors avoid it. It was covered by only three analysts and their earnings forecasts were very conservative.
After meeting with the managment team, the SLI team decided that “growth would be much faster than the consensus was expecting”, he said, adding that the business eventually performed better than analyst expectations, prompting them to upgrade their forecasts.
“So the headline valuation actually got you to the wrong results and the reason for that was the market hadn’t understood the earnings of this business, and therefore the valuation element in isolation is not necessarily the key driver,” Paisley said.
The three-year performance of the Standard Life Investments European Smaller Companies Fund versus its benchmark, according to FE Analytics data.
The fund NAV and benchmark index have been converted to Euros.