That research effort also includes combing through publicly available source documentation and publications covering competitors, customers, suppliers and other pertinent industry participants, Peden said, adding that the team’s ability to generate repeatable, long-term alpha is in no small part due to the fact that the team’s research leads it to different conclusions than the broader market.
The unconstrained approach can produce what Feng called “meaningful” portfolio shifts in sector, country and market capitalization over time, based on where the team’s research uncovers the greatest relative business and underlying growth value. The one real constraint is a limit of 30% in emerging markets. Without that restriction, the portfolio could, at times, become an emerging markets mandate.
Portfolio tilts toward small cap
Currently, for example, the Invesco International Select Equity Strategy is showing a small-cap bias.
Feng explained that small-cap exposure doubled to 38% at the end of the third quarter last year from 19% at the end of the third quarter of 2017, and the shift has been based solely on individual security selection rather than top-down calls. Still, he said that some overarching market drivers have made the broad small-cap segment relatively more attractive over the past few years.
First, a surge of assets into large-cap passive strategies has likely helped fuel recent growing performance divergence between large- and small-cap stocks. Feng pointed to an increase in sales flows to the top international exchange-traded funds, which are predominantly composed of large- and mid-cap stocks. Because smaller-cap companies comprise a small percentage of most international stock indexes, these flows have had a much greater impact on the valuations of larger-cap company share prices.
In addition, some strategies might not own small-cap companies that are index constituents because full index replication is often inefficient and uneconomical, particularly for smaller, less liquid stocks.
Second, larger companies typically have greater Wall Street brokerage analyst coverage, which leads to greater interest in those company stocks. Feng said that more brokers are producing frequent and extensive research on larger, more actively traded companies and that research garners greater commission revenues. They thus produce sparse, if any, coverage on smaller and more illiquid companies that may be less profitable for them to cover.
Once again, Feng has an illustration to make the point. After examining the number of analysts covering each company in the Invesco International Select Equity Strategy, Feng and his team found, not surprisingly, that larger-cap companies received significantly greater — just over double, on average — analyst coverage than small companies. The three smallest companies in the portfolio were covered by a mere four analysts, on average, most of whom were employed by small regional brokerages.
“We believe greater analyst coverage translates into more investor interest and more widespread ownership,” Feng said. “Conversely, smaller and more illiquid companies are subject to thinner coverage and likely to draw less portfolio manager interest. Hence, these companies may be more prone to be overlooked.”
Bias Working
Peden explained how this bias has worked in the portfolio’s favor.
“We’ve been finding opportunities in less widely followed businesses that are off-benchmark or aren’t major components of the index,” he said. “Regionally, we have found several businesses in the U.K. that were indiscriminately sold off because of Brexit concerns. Although these businesses are domiciled in the U.K., they obtain most of their revenues globally.”
He added that the team has identified investment opportunities in Chinese domestic consumer-related industries as a result of tariff disputes depressing valuations. While the trade agreement signed in January between China and the U.S. eased investors’ concerns, it could still prove difficult to enforce and be potentially problematic.
“We believe the businesses we own will have strong demand for their products and services over the long term,” Peden said. “Any short-term weaknesses provide opportunities to buy more of the high-quality companies we own or new businesses trading at significant discounts to intrinsic value.”
Feng said the approach is bearing fruit.
“Over the past two years, our highly flexible portfolio approach combined with our independent research led us to double small-cap exposure in our international strategy, exploiting extensive broker coverage of larger, more liquid companies and strong flows into passive vehicles,” he said. “We have already begun to see the benefits of this positioning, as the market has begun to recognize the merits of many of our small-cap company holdings. Without the burden of excessive constraints, we are often able to buy into investment ideas at earlier stages and at more reasonable valuations, while passive vehicles and investors reliant on broker research and/or operating under constraints may be forced to buy at much higher valuations and at a later stage in the growth trajectory.”
The Invesco International Select Equity Strategy is tracked against the MSCI ACWI Ex USA index, which includes large and mid-cap companies across 22 developed markets, excluding the United States, and 26 emerging market countries. It captures about 85% of the global public equity universe outside the U.S.
The strategy can replace a diversified portfolio with lower active share or complement passive strategies. “It also allows our clients to gain all-cap international exposure to compliment large-cap strategies,” Feng said.•
