Reducing the size of stocks can benefit the portfolio. The decision to invest in the Large Cap segment, which is populated by companies with a strong global vocation, can be an advantage if you are looking for companies that already have a large degree of diversification in terms of business and geographical areas, but it can be a limit if instead you want to reduce the degree of correlation with global markets.
How the correlation varies
The analysis of the correlation coefficients calculated on a sample of equity indices against the MSCI World Index (the world market benchmark) and over a 10-year time interval, shows how reducing the size lowers (slightly) the degree of dependence from international lists. From Figure 1 it can be seen how the coefficients relating to the Mid Cap indices of the various geographical areas are lower than those of the Large Cap ones and how they are further reduced when moving from the segment of medium cap stocks to that relating to small caps. This is a phenomenon that can be explained by the greater territorial roots of small companies which, having fewer resources to expand on global markets, tend to be more focused on the internal one. The largest spread between the correlation coefficients of Large and Small Caps is for Japanese, German and UK equities.
In this regard, Morningstar analysts have selected some investment ideas in the Mid and Small Cap segment that can create value in a portfolio that seeks to be more detached from global dynamics.
Among US Small Caps
Hostess Brands is an American Small Cap leader in the packaged food sector. The company has passed a critical period that culminated with the bankruptcy in 2012, but, analysts say, this financial stress situation has given it the opportunity to start a strong restructuring of the business which now allows it to make returns above-average capital.
“The group has managed to build an advantageous position within the sweet snack segment thanks to a high-value brand for which American consumers are willing to pay a generous premium-price and which allows it to have a certain power contract with the distribution network,” says Zain Akbari of Morningstar.
“The bankruptcy was a turning point for Hostess Brands. The company started out from a situation characterized by heavily indebtedness and a very complex operating structure, but in the last six years it has managed to eliminate inefficiencies and successfully experiment with new sales channels such as vending machines”.
Although the current trend in the United States and in all Western countries is to reduce the consumption of caloric foods and foods with a high sugar content, analysts do not expect this to have negative repercussions on the sales of Hostess Brands and forecast for average revenue growth of 5% over the next five years. Since the beginning of the year, the stock has lost more than 10% (in dollars as of June 20, 2018) and is now trading at a discount rate of 12% to its fair value of $15,40 (report updated May 18, 2018).
European Mid Caps
Babcock International is a British Mid-Cap company and is a market leader in engineering services supporting the defense sector (in the naval, aeronautical and land segments). The company is strongly exposed to the domestic market and this is demonstrated by the fact that it has managed to build a strong position of advantage over its competitors due to the close relationship with the British Government.
Under long-term agreements, the company offers the Royal Navy maintenance and refit of warships and nuclear submarines and fleet management for the army. It also has operational control of the country's main naval infrastructure and is a strategic partner of the army and navy. This guarantees it strong bargaining power vis-à-vis the Government, which is unlikely to decide to switch to a different supplier because it is aware of the risk of disclosing sensitive information.
Analysts' expectations for the next five years are for an average growth in earnings of 2%, higher than the market consensus. "Brexit will also have a negative impact on the government's defense budget, but Babcock should be able to benefit from the outsourcing of many operations through private outsourcing," says Michael Field of Morningstar.
GEA Group is a mid-cap German company and a market leader in food processing machinery such as refrigeration and packaging equipment.
Morningstar analysts recognize the German group as having a strong advantage within the sector due to the high entry barriers of new competitors, who find it difficult to establish themselves in a business such as that of food machinery since they must try to differentiate their offer and at the same time ensure the same level of reliability as established companies. GEA also manages to exercise strong bargaining power over its customers, and this is because food companies are very careful to avoid the risk that machinery problems could impact the quality of their products and hardly decide to replace reliable suppliers such as GEA only for price issues.
The stock has lost almost 20% since the beginning of the year, but analysts expect an average growth in turnover of 4% and estimate a fair value of 47 euros (report updated to 20 April 2018).
