While investors have been rewarded by strong performances from large and ‘mega-tech’ equities recently, smaller companies trading on exchanges outside the US are offering under-researched growth potential according to MFS Investment Management equity portfolio manager Eric Braz.

The Boston-based manager believes his new MFS Global New Discovery Fund, launched in Australia in August, can outperform the 7,500 names in the MSCI All Country World Small Mid Cap Index (SMID) which has returned close to an annualised 12 per cent over the past 10 years.

Braz, who co-manages the diversified portfolio of 100 companies with Michael Grossman in Boston and Peter Fruzzetti and Sandeep Mehta in London, says the fund is based on a long-term, value, growth and core investment strategy in public companies with a “sweet spot” market cap of between $US1 billion and $US15 billion; topping out at $US33 billion.

*This In Focus article is written in partnership with MFS Investment Management

Put into perspective, Australia is seen as a mid-cap market globally with stocks like Afterpay, valued at about $A33 billion on the ASX, and ANZ, which dipped below $A30 billion last year, at the top end of MFS’s target range.

Benefits for companies in this mid-cap ‘sweet spot’ include growth potential, better liquidity than smaller companies, and a host of mature companies in the mix, Braz says.

“We’re trying to identify what we view as high quality companies with good management teams and good industries with good addressable markets with favourable financial characteristics and we want to own them for a long time,’’ he says, highlighting MFS’s coverage in Europe with its European-based research and investment team, who are able to explore local opportunities at lower valuations.

This gives the manager an edge investing in this region compared to other US and Australian-centric managers, he adds.

The MSCI SMID benchmark is biased towards developed markets with 85 per cent of the index in the US (55), Europe (20) and Japan (10). Emerging market companies are also on the list but have a high bar to jump to be considered in the MFS portfolio, Braz says.

He expects the MFS strategy to have a similar focus on developed markets due to higher geopolitical and other risks for companies in emerging markets.

Core Strategy

Launching the Australian fund was driven by demand from Australian investors looking for a strategy beyond large and well-known companies, he says.

While other global small-mid cap managers see a defensive element to their funds – thanks to the tendency of the Australian dollar to depreciate relative to other developed world currencies in periods of economic stress, thus buffering unhedged Australian dollar returns – the MFS strategy is more pragmatic in its approach, Braz describes.

Given an appropriate holding period, a core investment strategy allows investors to own the fund at any time in the macroeconomic cycle, Braz says.

“We buy value, we buy growth and we buy core names,’’ he says.

“We have a growth bias overall as we look for quality companies and management teams. We’d rather seek a company that may grow 10 per cent persistently over the next decade than a company that may grow 50 per cent one year and then go into negative growth.

Mid-sized opportunities

“Everyone wants to own Amazon or Apple or Tencent or Alibaba. But a lot of the most successful companies over time start significantly smaller and we have an opportunity to canvas the world to find those opportunities and invest in them.

“So there’s a lot of opportunity that’s going to become big in the future and we have the chance to look at it first.”

The new MFS fund adds to almost 20 small and mid-sized focused funds available to Australian investors, up from just four funds a decade ago.

Demand has grown in step with the success of the segment as small and mid-caps have outperformed their large cap benchmark peers by almost three per cent over the past 10 years, says Zenith Investment Partners head of equities Quan Nguyen.

Australian boutique fund managers such as Ophir, Bell and Fairlight, as well as new US fund managers entering the Australian market, have contributed to the wider range of global small and mid-sized fund offerings for Australian investors, he says.

Australian investors are increasingly discovering the sector, which is 40 times the size of the Australian small to mid-sized market

Even with the recent strong performance of the mega-cap tech stocks, small caps offered higher returns over a longer time frame, and higher risk, but this could be minimised with active management, Nguyen says.

Global small and mid cap-focused funds, biased towards developed markets, were also a sounder alternative to large stocks in emerging markets both for generating alpha and reducing  risk, Nguyen says.

The Chinese government’s recent “crackdown” on tech companies, including mega tech company Alibaba which is valued at more than $US500 billion, saw its US-listed shares fall 14 per cent in July despite the company’s expected strong earnings results.

“I think the risk in emerging markets has become a bit more apparent, not to say that wasn’t there before but I think it’s a reminder to people,” Nguyen says.

Longer time horizon

Both Nguyen and Braz recommend a long-term investment time frame of between three to seven years.

“Global equities, particularly small caps, we expect to hold them for the longer term, and that’s our recommendation, at least seven years to maximize results as just one thing is sure that there will be a market correction there at some point,’’ Nguyen says.

Braz says active management is key to good performance over a longer time frame with the new MFS fund leveraging more than 60 analysts in nine countries to provide “bottom-up” ideas on investment candidates.

Weightings by sector and region are “outputs as opposed to inputs” and the fund avoids any companies reliant on interest rates, oil prices or heavy regulation such as energy, utilities and banks.

He says the advantage of small and mid-cap companies is less scrutiny from analysts which can uncover some hidden gems.

“As a research department we turn over a lot of rocks, MFS has had 2500 company meetings per year over the last three years with those having a market cap of less than $US30 billion.”


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