Screening for quality in international small caps is important, but what sort of “quality” should we look for, and can we find it without narrowing down our choice too much?

The universe of non-U.S., developed market small caps is vast. That makes it a source of great opportunity, but also a big challenge for the stockpicker. A large number of small cap companies, and even entire sectors on average, are not profitable or barely profitable. In this paper, we argue that this makes a strong case for a quality screen and explain why, for small caps in particular, it is important to use a quality screen that takes into account the amount and cost of the capital a company deploys to generate earnings.

We show that application of our systematic quality screen to a benchmark index does not exclude any sector—even the most capital-intensive. We also note that the smallest, least analyzed companies constitute a large proportion of the stocks in the quality-screened universe. We find very similar results when screening a much expanded universe of stocks.

While the quality of the total non-U.S. small cap universe is extremely variable, we believe there are hundreds of high-quality, currently profitable, under-analyzed companies that can form an attractive opportunity set for active management.

Executive Summary

  • We explain why we regard organic economic spread—the difference between Organic Return on Capital Employed (RoCE) and the Weighted Average Cost of Capital (WACC)—as the most appropriate measure of quality for international small companies.
  • We show how this measure differs from a simple measure of operating income margins: many sectors generating high operating income margins exhibit low or even negative profits once cost of capital is taken into account.
  • We screen the MSCI EAFE Small Cap Index (excluding Financials, and Real Estate) for stocks with a minimum Organic RoCE and a maximum debt-to-earnings (earnings before interest, tax, depreciation and amortization, EBITDA) ratio.
    • The quality-screened index exhibits higher median organic economic spread for every sector, and does not exclude any sector (the proportionate number of stocks in each sector remains very similar to what we see in the Index).
    • The smallest companies (market capitalization at or below $1 billion) make up a large proportion of the number of stocks in the quality-screened Index.
  • We expand the universe by adding every listed company (excluding Financials, and Real Estate) from the countries represented by the MSCI EAFE Small Caps Index, as well as every listed company in Canada, (which is not represented in the index) our quality-screened universe increases from 693 stocks to 1,396 stocks.
    • The proportionate number of stocks in each sector remains similar in this larger quality-screened universe, while median organic economic spread rises slightly from 18.2% to 21.4%.
    • The smallest companies (market capitalization at or below $1 billion) now make up an even larger proportion of the number of stocks in the universe, at 64.7%.
  • The conclusion from our analysis is that the non-U.S. small cap universe contains a large number of investable, high-quality, currently profitable companies across all sectors, and that the smallest, least-analyzed companies are by no means disfavored by our quality screen—indicating an attractive opportunity set for active management.

Roce and Operating Income Margins Are Both Measures of Profitability, but Very Different

Median operating income, Organic RoCE margins and Economic Spread (Organic RoCE – WACC) for the constituents of the MSCI EAFE Small Cap Index, equal-weighted and excluding financials and real estate

Sector % of Total Number of Stocks Operating Income Margins Organic RoCE Organic Economic Spread
Communication Services 6.2% 10.3% 12.5% 5.3%
Consumer Discretionary 18.7% 6.0% 10.1% 1.7%
Consumer Staples 8.7% 4.5% 10.0% 2.5%
Energy 2.9% 4.8% 7.8% 0.4%
Health Care 9.0% 7.5% 11.9% 4.4%
Industrials 28.6% 6.8% 12.3% 3.0%
Information Technology 13.2% 8.1% 19.4% 6.7%
Materials 10.4% 7.4% 8.1% -0.8%
Utilities 2.3% 12.0% 7.3% 0.0%
Total (1,831) 100% 7.6% 8.4% 0.0%

Source: Bloomberg, Neuberger Berman. The data is from each company’s most recent fiscal year, as of September 30, 2020. For illustrative purposes only. Companies with low organic capital employed might have an Organic ROCE well above 100%. In this case, we limit the ratio at 100%. Similarly, when the Organic ROCE is below -100%, we limit the ratio to -100% in our calculation. In this universe, there are 101 companies with an Organic ROCE above 100%, and 107 companies with an Organic ROCE below -100%.