• Global marketplace allows us to invest in the very best
• We use an active approach to identify companies with sustainable competitive advantages
• Returns have consistently outstripped large cap counterparts

Big is best is not an adage that we subscribe to with the Threadneedle Global Smaller Companies strategy: we concentrate on high-quality growing companies that we believe are undervalued by the market - and we do so on a global scale. We believe these companies make for strong long-term investments because the market tends to underappreciate the value of competitive advantages, which enable some firms to sustain high returns; and we believe targeting such firms on a global scale allows us to uncover the best investment opportunities.

Small companies...

The case for small cap is well known: smaller companies tend to be more entrepreneurial than their larger peers, focusing on specific niches. A high proportion of owner-managed businesses, as well as greater corporate flexibility, yields better long-term capital allocation to value-creating investments.

In addition to its superior growth dynamics, the smaller companies' universe has a number of attributes that can generate alpha for the active investor:

1) The market becomes less efficient the lower down the market cap scale we go. The level of research, and indeed media coverage, tends to be lower for smaller companies. Consequently, broader investor understanding of companies' business models, corporate cultures and earnings potential is diminished. This creates a valuable opportunity for the diligent investor to identify mispriced securities.

2) Smaller companies are less liquid. Lower liquidity adds to the inefficiency of the asset class, potentially resulting in stocks being mispriced for long periods of time. In times of crisis or market corrections the active investor can take advantage of this market inefficiency.

3) Undiluted exposure to investment themes.There are numerous product niches and investment themes that large cap investors can struggle to get exposure to. Where large conglomerates are present, the value of these businesses can often be diluted by legacy business and central overheads. Smaller company investing allows portfolio managers to gain pure exposures to the most attractive themes in the market.

As such, global small caps have delivered consistent long-term growth over global large caps (Figure 1): 10.3% per annum since 1998 for the small cap index versus 5.2% for large caps, resulting in a cumulative 143% outperformance.

Figure 1: Small cap vs large cap performance

Source: MSCI, Bloomberg, as at 31 December 2017. Shows total return since 31 December 1998. Past performance is not a guide to future returns. All returns shown in US dollars.

Not only has global small cap delivered better returns than global large cap, but it is also at only marginal additional risk (Figure 2).

Figure 2: Small cap index risk/reward comparison vs global large cap

Source: MSCI, Bloomberg, as at 31 December 2017. Past performance is not a guide to future returns. All returns shown in US dollars.

...grand scale

With all this in mind, it is when these opportunities are then exploited on a global stage that we believe the real strength of small cap investing lies.

Sustainability is embedded in what we do at Columbia Threadneedle Investments, and we believe the rationale for long-term responsible investment is clear: strong business models with strong management that look to the future have the potential to deliver stronger, more sustainable investment returns.

The most important point about the global marketplace is that its sheer diversity means we can construct a well-diversified portfolio of best-in-class business models with pure exposures to the most promising investment themes.

Greater opportunities

The second point about the global marketplace is that it has an enormous opportunity set, which gives investors access to a variety of investment themes. The breadth of companies in the small cap space - more than 4,000 in the MSCI Global Smaller Companies Index - makes it an ideal hunting ground for active managers looking to exploit investment opportunities, and offers a bigger spread of potential returns than the large cap index.

Regional economies move at different speeds to one another, so portfolio managers can identify when one market is looking overvalued and can switch their attention to another market where there still may be bargains.

This does require a significant amount of knowledge to be able to identify accurately such opportunities, but the Threadneedle Global Smaller Companies strategy is run in such a way as to capitalise on this.

Teamwork and global expertise delivers alpha

Against such a diverse and exciting market, we implement a clear and consistent investment approach that has allowed us to deliver strong risk-adjusted returns for our clients.

With key investment personnel across the globe - in the UK, Europe, US and Asia - we are able to draw on deep regional expertise to identify the really quality investments, as we consistently seek out high-quality businesses offering sustainable competitive advantages.

This team takes a robust, consistent, active approach to analysing the thousands of available stocks in the global small cap universe and assessing potential returns. While the regional small cap portfolios do not all adopt the same approach, there is a quality bias to them all, and that means there is a consistent stream of fresh ideas filtering from them into the global portfolio.

Figure 3: Investment philosophy

Source: Columbia Threadneedle Investments

The overarching strategy is about putting together a portfolio of companies under a single philosophy. We achieve this through implementing our industry and business model analysis. We look at returns on capital: what is the margin profile, how volatile is the cashflow, how much cash should be reinvested to achieve growth potential? We look at sustainability: how sustainable is a firm's profitability, what will happen to its competitive position, is it at risk of disruption? And we look at growth potential: can a business compound in size and value in the long term, do we believe it will be larger in five or 10 years, how is market saturation?

We also use Professor Michael Porter's framework - 'Porter's Five Forces' - as a tool to evaluate the strength of a company versus its competitors. Meetings with company managements are undertaken to fully understand business models.

This helps us identify potential high returns with a long-term view - we want to buy and hold a company for as long as possible - and allows us to whittle down the investable universe from around 4,000 stocks to a high conviction, diversified and balanced portfolio of 70-90 holdings, once again helping us to manage risk through diversification.

There are numerous attributes of a business model or industry that may give a company a sustainable competitive advantage and superior long-term profitability. Below we highlight a few.

The advantage of scale

Scale itself will not necessarily prevent new entrants, but it can create an enormous hurdle. Cargojet* is a Canadian air freight operator that controls 95% of its domestic overnight cargo market. Its near-monopolistic position is further supported by so called 'cabotage' regulations which prevent overseas players from entering the market. With a fleet of 20 planes, Cargojet offers a unique and comprehensive air freight solution for major freight forwarders such as DHL and UPS whose volume growth is accelerating on the back of rising next day online retail sales. Cargojet serves all the major freight forwarders and can maintain optimum capacity utilisation of its fleet and maximise return on investment. To compete with Cargojet a new entrant would not only need to invest an enormous amount of capital in its network, but also operate at very low utilisation rates, whilst building up its client base. Given the long-term contracts Cargojet has with its customers, this could prove a long and expensive process.

Consolidating cottage industries

Highly fragmented industries can have enormous inefficiencies. Companies that can consolidate such markets can attain significant cost synergies and improve aggregate operating performance. After 17 years of rolling up the market, SiteOne Landscape Supply* is the largest wholesale distributor of landscape supplies in the US. In so doing it is professionalising what has long been a highly fragmented cottage industry. Although it only has a 10% market share, it is four times larger than its nearest competitor. Thanks to its scale, SiteOne offers the broadest product offering (more than 100,000 different products sourced from more than 3,000 suppliers) to a highly fragmented but time-sensitive customer base, and is able to leverage its marketing budget and brands across a larger network. In addition to being a compelling one-stop shop for its customers, its superior purchasing power and a more efficient supply chain enable it to offer attractive prices. Every business that it acquires brings new insights as to how the whole organisation can further improve its efficiency.

Customer stickiness

Where a product or service is deeply embedded in its customers' operations it can be prohibitively expensive and risky to switch supplier. Sartorius* is a supplier to the biopharmaceutical industry. Its products are used in the manufacturing of biologics such as oncology drugs, and they have very high switching costs. This is because the equipment used to manufacture the drugs becomes part of a validated process that must receive approval by regulators such as the FDA. Once a customer has selected Sartorius as a supplier it would be costly to revalidate the manufacturing process. Therefore, its products will be used for the life of the drug, which can be 10-20 years. This raises the barriers to entry, as the pharmaceutical company will only select suppliers it knows can supply in high quantities at the required quality for many years. Sartorius's products also cost a small proportion against the eventual revenue that the pharmaceutical company will make, further decreasing the incentive to switch suppliers. Biological drugs form more than 40% of the pipeline for pharmaceutical companies, ensuring growth opportunities for Sartorius to win new business. Biosimilars (generic versions of biopharmaceutical drugs) are another opportunity that is emerging, which has created a new customer base for Sartorius.

Performance as proof

The Threadneedle Global Small Cap strategy has delivered strong and consistent risk-adjusted returns since the portfolio manager, Mark Heslop, has run the strategy from November 2013.

Mark has a proven track record and significant expertise in smaller company investing, having joined the company in 2008 as a smaller companies' analyst in the European equities team. He also manages the Threadneedle Pan European Small Cap Opportunities strategy and the Threadneedle European Smaller Companies strategy.

Conclusion

Global small caps have outperformed their large cap counterparts for many years, offering better absolute and risk-adjusted returns. We believe they have the potential to do so in the future, given the inherent factors outlined above, such as superior growth prospects, a more entrepreneurial and focused management.

The sector is also ideally suited to active management given factors such as the under-researched nature of the asset class and the wider dispersion of share price performance compared to the large cap sector. Finally, we believe the best way of gaining exposure to the attractive return potential of global small caps is through a long-term managed strategy focused on the strongest business models with pure exposures to sustainable growth markets.

^* The mention of specific stocks is not a recommendation to deal.

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