Tobias Bucks, Co-Manager of the Marlborough Global SmallCap Fund, explores the philosophy and science behind global small-cap investing, and reveals why disciplined, selective analysis is essential to uncovering tomorrow’s market leaders.
Bertrand Russell once lamented that philosophy is routinely robbed of its greatest triumphs. Whenever an idea enters the realm of “definite knowledge”, he explained, it ceases to be deemed philosophical and instead becomes the stuff of science.
Small-cap investors may experience a similar phenomenon. A smaller company that proves conspicuously successful inevitably moves up the market-capitalisation spectrum, venturing into mid-cap territory or beyond and thus becoming part of a quite different sphere.
Yet this is hardly a tragedy. In fact, it’s exactly what small-cap investors should want to happen. No-one invests in a business in the hope that it will never gain in value. Ideally, we invest in a business in the expectation that it will deliver substantial long-term growth.
Needless to say, the trick lies in finding companies capable of realising this goal. Given that the global small-cap universe consists of thousands of businesses, some sort of methodology tends to be helpful.
Broadly speaking, approaches can be divided into three camps. Of these, in my opinion, only one is genuinely geared towards optimum outcomes. Let’s briefly examine each in turn.
The bias-driven approach
Irrespective of whether they regard themselves as investors, most people are actually quite good at making decisions. What they’re not especially brilliant at is identifying opportunities.
This is usually because they don’t have the right information. Their own preconceived notions – in other words, their biases – are frequently what land them in this sorry predicament.
By way of illustration, imagine an investor – let’s call him Mr A – reads that a certain company has enjoyed a sensational couple of months performance-wise. His interest piqued, he seeks further coverage of its stellar showing.
This represents a potentially dangerous combination of recency bias and confirmation bias. Mr A’s decision to invest is predicated only on what has occurred lately and what he would like to hear. Huge chunks of the bigger picture have been ignored.
Mr A’s biggest problem is that he believes what he thinks is of supreme importance. In reality, both in investing as a whole and in the small-cap arena in particular, what everyone else thinks is usually far more significant.
The scattergun approach
As noted earlier, the global small-cap universe is comprised of thousands of companies. The MSCI World Small Cap Index, which covers 23 developed markets, is home to more than 3,800.
Of course, the marvels of passive investing mean it’s possible to take a stake in every one of them at a stroke. Perhaps this qualifies as one means of shaking off the aforementioned biases.
Yet such an approach invariably entails investing in a sizeable number of underperforming businesses, some of which may also have policies and practices that harm society and the environment. In tandem, logically, it also involves banking on their losses being agreeably outweighed by others’ gains.
This issue isn’t confined to small-caps. In the mega-cap-dotted S&P 500, for instance, most stocks underperform the benchmark over the course of a year – with no fewer than 360 falling short in 2024[1].
This imbalance still produced an overall gain of 24% for the index that year[2] – not exactly a figure to be sneezed at. Nonetheless, there remains an argument for being a sniper – that is, zeroing in on preferred targets – rather than resorting to a scattergun attack.
The precision approach
As active managers, my colleagues and I prefer to be selective. We understand that our opinions are of limited relevance and that what truly matters is why other people consider a specific company attractive or otherwise – and, crucially, whether they might be wrong.
Our process is rooted in discovering high-quality businesses with a capacity for growth – and preferably growth of the unrecognised variety. This requires us to assess sectors and regions in their entirety and then gradually whittle down the field through a combination of quantitative and qualitative analysis.
Eventually, having crunched all the numbers and engaged directly with the brightest prospects and their stakeholders, we construct a model to project future earnings. We then check the market consensus – what everyone else thinks – to see if we’re at odds with the herd.
This is how we try to avoid biases. It’s how we aim to beat the market – as opposed to settling for merely being the market. It’s how we access major investment themes without failing to see beyond them. And it’s how we find companies that can move up the market-cap spectrum – often leaving us to bid them a fond farewell and turn our attention elsewhere.
Building on Russell’s lament, acclaimed science writer John Horgan once suggested philosophers don’t really want to arrive at definitive answers, as they would then have nothing to do. For small-cap investors, by contrast, the happy news is that the challenge of digging ever deeper and producing new triumphs never ends.
Tobias Bucks, Co-manager of the Marlborough Global SmallCap Fund.
[1] See, for example, Motley Fool: “360 stocks in the S&P 500 underperformed the benchmark’s 2024 gain of 24%”, December 29 2024 – https://www.fool.com/investing/2024/12/29/stocks-sp-500-underperform-in-2024-high-yield-buy/.
[2] Ibid.
