Global smaller companies: A different kind of diversification

Harry Markowitz, the Nobel Prize-winning economist and father of modern portfolio theory, is credited with the idea that diversification offers the only "free lunch" in investing. Despite his endorsement, diversification appears to have slipped down the menu in recent years.

Global tracker funds regularly top the bestseller charts. In the words one of their leading providers, they aim to “minimise costs” and offer "a balanced and diversified mix of investments". Certainly, their fees are low. But as for being balanced and diversified? That might be less true. While they are diversified by number of holdings, they have become increasingly concentrated by country, sector and company. 

Anyone tracking the MSCI AC World Index will find that 64% of their portfolio¹ is invested the US. And, because market indices reflect past success, around 24% of the assets of anyone buying a global tracker fund as a ‘one and done’ investment will be directed into the shares of the Magnificent Seven². With the exception of Apple, all of these companies are placing significant financial bets on their artificial intelligence businesses. Whether by design or accident, passive investors find themselves long in the US, long in tech stocks and long in AI.  

Does that degree of concentration – by country, sector and theme – make sense? Particularly at a time when trade tariffs and geopolitical tensions are intensifying the retreat from globalisation – and when profit growth among the hyperscalers is slowing and worries about an AI bubble are growing. Might there be an argument for spreading your risk more widely? And, if so, where might you find genuine diversification? 

We acknowledge that many investors have historically regarded smaller companies as part of their 'risk' bucket. But we might suggest that making a meaningful allocation to some of the world's modestly valued smaller companies may have something to offer in terms of diversification too. 

More balance between sectors 

Just one sector, information technology, accounts for 31% of the MSCI AC World index³. Its weighting in the MSCI AC World Smaller Companies index is roughly half that, at 16%⁴.  

The Artemis SmartGARP Global Smaller Companies portfolio, however, looks quite different to both indices. As at 31 July, just 9% of its assets were invested in technology stocks. Instead, it has overweight allocations to companies with hard assets in the industrials (13%), materials (14%) and oil & gas (14%) sectors⁵. 

The US still dominates, but less so… 

The US accounts for 64% of the MSCI AC World index⁶. At 53%, its weighting in the AC World Smaller Companies index is significantly less pronounced⁷. Once again, however, the difference between market-cap weighted global indices and the Artemis SmartGARP Global Smaller Companies portfolio is clear.  

While around 40% of our portfolio is invested in the US, it has significantly higher allocations to emerging markets such as China (11%), Taiwan (6%) and Brazil (4%)⁸. This because the structure of our portfolio reflects the fundamental strength of the investment ideas highlighted by SmartGARP® rather than market-cap weightings. 

SmartGARP highlights attractive valuations in global smaller companies  

The argument for smaller companies is not, however, simply about adding diversification to your portfolio. We would argue that the fundamentals are attractive too.  

On a price-to-earnings (p/e) basis, our portfolio of small caps traded on a forward p/e of 9.4x at the end of July versus 17x for the MSCI AC World index⁹. This does not reflect any lack of growth in the stocks we own. At the end of July, analysts’ earnings forecasts for our holdings were being revised up by 6.8% – a faster rate than the 4.2% uplift in their earnings projections for the wider global market¹⁰. 

Our portfolio offers a free cashflow yield of 7.3% versus 3.5% for the all-cap index¹¹. As shareholders, we receive some of that cash through a 3.5% dividend yield (as opposed to 1.7% for the MSCI AC World index) as well as through share buybacks¹².  

Clearly, smaller companies would not be immune to widespread turmoil in financial markets. But we believe that some of the characteristics SmartGARP points us towards (such as companies with below-average valuation multiples, above-average free cashflows and attractive dividends) could make our portfolio less vulnerable to a compression in valuation multiples than more highly rated parts of the market, should there be a sudden deterioration in sentiment.  

Smaller companies can bring instant diversification to most portfolios, particularly for investors who already have a high degree of exposure to the mega-cap US technology stocks that now dominate all-cap market indices. We can’t offer a single silver bullet to protect your assets in an uncertain world. But allocating part of your portfolio to a carefully selected portfolio of smaller companies might offer the next best thing.