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INTERNATIONAL MICRO CAP

Christopher N. Cuesta, CFA CEO, Portfolio Manager, Principal

Keith E. Dickinson, CFAPortfolio Manager, Principal

Manish Maheshwari, CFAPortfolio Manager, Principal

JANUARY 2019

SMALL STOCKS, LARGE OPPORTUNITY

International micro cap equities are an overlooked asset class that can provide investors with an opportunity to generate significant alpha, increase diversification, and complete or enhance existing portfolio allocations. International micro cap, like its U.S. counterpart, exhibits favorable characteristics such as a large universe of companies, limited sell side coverage, similarities to private equity, few market participants, and low correlations with large capitalization equity indices.

Global diversification efforts have led many investors towards using primarily large capitalization equities while neglecting smaller capitalization ranges. Historically, micro caps have not received the attention of the other capitalization ranges due to the lack of a clear style box, limited capacity, and effort required to analyze the asset class and managers.

The inefficiency of the asset class is a benefit to active managers, but it also creates inconsistent conclusions when asset allocators use traditional analysis to create model portfolios while considering adding micro cap equities to a broader portfolio. Movement away from traditional style box investing combined with the increasing search activity for non-correlated, unique sources of alpha should lead to heightened interest in the asset class.

POTENTIAL BENEFITS OF INTERNATIONAL MICRO CAP:

• Strong absolute and risk-adjusted returns

• Exposure to a large, inefficient investable universe

• Diversification benefits

• Similarities to private equity

• Completion of existing small cap allocations

INCREASED OPPORTUNITY SET

Within the 22 developed markets (ex U.S.) there are approximately 4,900 micro cap securities compared to the 441 large cap stocks in the MSCI World ex USA Large Cap Index. That is ten times the opportunity set and almost double the number of companies within the small capitalization universe. The large opportunity set offers diversification benefits and multiple opportunities for active managers to deliver alpha.

NUMEROUS HIGH QUALITY / UNDERVALUED COMPANIES

The inefficiency of the universe creates multiple opportunities for active management to add value. There are numerous high quality, well capitalized and undervalued securities within the universe. For example, there are 1,957 companies trading at less than 1.5x EV/Sales and 1,052 companies with an ROIC greater than 10%. Managers can identify high quality, growing companies well before they are discovered by a broader set of market participants.

LIMITED SELL SIDE COVERAGE

Micro cap companies cannot generate the brokerage or investment banking economics needed to justify coverage from sell side brokerage firms. International micro companies have an average of less than 1 analyst per company and 60% have no sell side coverage at all. The lack of research coverage allows active managers to find mispriced, undiscovered securities and is fertile ground for strong stock selection.

LOWER INDEX CONCENTRATION

Large capitalization indices have very high concentration amongst the top holdings. For example, the top 10 holdings comprise 13.3% of the MSCI World ex USA Large Cap Index. This “crowding” effect may limit active management’s ability to diversify and add alpha versus the benchmark. Concentration within micro cap is much lower with the top 10 companies representing only 1.4% of the benchmark. High active share is much easier to achieve with lower levels of index concentration.

INTERNATIONAL MICRO CAP • SMALL STOCKS, LARGE OPPORTUNIT Y

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Source: Compustat

234

252

184

415

271

1,923

1,957

1,011

1,559

1,052

Source: MSCI, Factset

Source: MSCI

TOTAL NUMBER OF COMPANIES (MSCI World Indices ex USA)

TOP 10 HOLDINGS WEIGHTS (MSCI World ex USA)

AVERAGE ANALYST COVERAGE PER STOCK (MSCI World Indices ex USA)

MSCI WORLD EX USA OPPORTUNITY SET DETAIL (# of Companies)

Source: MSCI

200

Source: MSCI

RETU

RN

STANDARD DEVIATION

ALPHA POTENTIAL IN MICRO CAP EQUITIES

Micro cap stocks are often thought of as an extension of small caps or not analyzed at all due to the benchmarks not showing well versus other portfolio options when viewed through the lens of risk, return and correlations. This traditional method of analyzing the asset class ignores the nuances of the benchmarks and apparent alpha being delivered by existing managers operating in the space.

The sheer size and diversity of the micro cap universe is a perfect landscape for active managers, but the complexity of the benchmark renders simple asset allocation methods ineffective. Using benchmark returns and risk to weigh the merits of the asset class negate the very reasons the asset class is attractive. Inefficiency and large size of the universe make judging potential returns, risk and diversification benefits solely based on the benchmark a flawed exercise.

The nuanced nature of the micro cap benchmark is apparent when just considering profitability. Within the MSCI World ex USA benchmark, 75% of the companies are profitable versus 99% for MSCI World ex USA Large Cap. Simplistically assuming profitable companies will have better long term returns and lower risk and that most active managers will not base their approaches on owning a portfolio of unprofitable companies highlights the flaw in solely using the benchmarks when analyzing the asset class. Additionally, the lower market capitalization nature of the benchmark creates an inherent bias as the best companies (e.g. those with rising revenue, margin expansion and higher market capitalization) will be rebalanced out of the benchmark while poor performing companies from higher market capitalization ranges will be rebalanced in.

To comprehensively investigate inclusion into a broader portfolio, an analysis of the asset class must include the returns and data from the existing set of active managers. The longer-term (20 year), sustained alpha generation by U.S. micro cap managers validates that micro cap equities are a distinct asset class that differs from small cap and has similarities to private equity. It is also indicative of the inefficiency of the universe and potential for active management to substantially outperform the stated benchmarks.

HEIGHTENED DIVERSIFICATION

International micro cap companies can provide high levels of diversification benefits through country, currency, domestic economic conditions and stock specific opportunities. Micro cap companies tend to be primarily domestic in nature and have lower levels of international revenue when compared to larger, multinational corporations. This allows investors to receive the purest form of country diversification benefits. USD currency risk is reduced as smaller international companies have a low percentage of exports to the U.S.

MSCI WORLD EX USA 10 YEAR CORRELATION MATRIX (as of Oct 31, 2018)

Source: MSCI & S&P

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INTERNATIONAL MICRO CAP • SMALL STOCKS, LARGE OPPORTUNIT Y

% OF DOMESTIC REVENUE (MSCI World ex USA)

Source: Factset

INTERNATIONAL RISK/RETURN PLOT (10 Years as of Oct. 31, 2018)

U.S. 20 YEAR ANNUALIZED RETURNS (gross of fees; as of June 30, 2018)

*Cambridge Associates LLC US Private Equity Index Source: S&P, Russell, eVestment.

ALPHA POTENTIAL IN MICRO CAP EQUITIES CONTINUED

A three-year analysis of the international micro cap universe of managers shows results similar to the longer-term results witnessed in the U.S. marketplace. Active managers were able to add substantial alpha over the MSCI World ex USA Small Cap benchmark. We believe the short history is supportive of the points mentioned in this paper and is indicative of the potential for the asset class.

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INTERNATIONAL MICRO CAP • SMALL STOCKS, LARGE OPPORTUNIT Y

SIMILARITIES TO PRIVATE EQUITY

Size (as defined by market capitalization or deal value), performance returns, insider or founder ownership, domestic focus, stable cash flows, a large investable universe, and inefficiencies are all characteristics that international micro cap listed companies share with private equity. Rising levels of private equity dry powder combined with the attractive niche businesses should lead to higher levels of acquisitions of listed micro cap companies.

COMPLETION OF EXISTING SMALL CAP ALLOCATIONS

International small cap allocations have been increasing but the majority of the assets are not getting exposure to the large universe of companies at the smaller end of the market capitalization spectrum. The average international small cap manager has a weighted average market cap of $2.8B which is much higher than the median market cap of the larger developed market countries. Positive inflows have likely forced existing small cap managers to bias towards larger capitalization stocks within their universe while avoiding less liquid/small capitalization ones. Adding international micro cap to existing small cap allocations gives investors full coverage of the universe.

ATTRACTIVE CURRENT VALUATIONS

Valuations of international micro cap stocks are at a discount to large cap and small cap. As individual companies are discovered and institutionalized, there is a sizable multiple expansion opportunity.

Source: MSCI, eVestment

INTERNATIONAL 3 YEAR ANNUALIZED RETURNS (gross of fees; as of June 30, 2018)

Source: FactSet

% OF DEAL ACTIVITY BY MARKET CAP RANGE (Developed Markets ex USA; 2003-2017)

MARKET CAPITALIZATION ANALYSIS ($MIL)

*Weighted Average Market Cap Source: MSCI, eVestment

Japan Canada Australia Europe UK MSCI World ex USA Small Cap*

PRICE TO SALES VALUATION COMPARISON (MSCI World ex USA as of Oct 31, 2018)

Source: MSCI, Compustat

250

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INTERNATIONAL MICRO CAP • SMALL STOCKS, LARGE OPPORTUNIT Y

SUMMARY

International micro cap equities are an identifiable source of alpha

that can offer investors diversification benefits and premium

returns. Additionally, investors looking to complete their existing

small cap allocations or seek a liquid alternative to private equity

may find the asset class as an attractive option. The early adopters

of U.S. micro cap have been rewarded over the last 20 years as

median active managers annualized 13.1%, or 5.1% over the

Russell Small Cap Index. The size and quality of the international

opportunity set combined with a very small number of active

managers focused on the space point to a similar, if not greater

return potential for International micro cap equities.

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INTERNATIONAL MICRO CAP • SMALL STOCKS, LARGE OPPORTUNIT Y

APPENDIX

The MSCI World ex USA Large Cap Index captures large cap representation across 22 of 23 Developed Markets (DM) countries excluding the United States. With 441 constituents, the index covers approximately 70% of the free float-adjusted market capitalization in each country.

The MSCI World ex USA Small Cap Index captures small cap representation across 22 of 23 Developed Markets (DM) countries excluding the United States. With 2,559 constituents, the index covers approximately 14% of the free float-adjusted market capitalization in each country.

The MSCI World ex USA Micro Cap Index captures micro cap representation across 22 of 23 Developed Markets (DM) countries excluding the United States. With 4,829 constituents, the index covers approximately 1% of the free float-adjusted market capitalization in each country.

The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 3.4 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The index is maintained by FTSE Russell, a subsidiary of the London Stock Exchange Group.

Median U.S. Micro Cap Manager: per eVestment US Micro Cap Core Equity universe.

Median U.S. Large Cap Manager: per eVestment US Large Cap Core Equity universe.

Median International Micro Cap Manager: per eVestment EAFE geographic focus and weighted average market cap less than $1.2B as of Q2 2018.

Median International Large Cap Manager: per eVestment EAFE geographic focus and Large Cap equity capitalization.