During times of heightened uncertainty, investors often seek the perceived safety and liquidity of large-cap stocks. However, history suggests that a valuation-driven approach can sometimes challenge this instinct. If the biggest companies have led the market rally, the undervalued and overlooked stocks may actually provide better downside protection. This was the case during the dot-com bust of 2000, and today’s setup looks strikingly similar.

Recent market moves support this view, small caps (particularly global ex-U.S.) and emerging market stocks have remained resilient, even posting gains, while the S&P 500 and the "Magnificent 7" tech giants have seen sharp declines. But what about long-term return potential? Looking ahead, a well-constructed, high-conviction global small-cap strategy may offer both strong diversification benefits and a more reliable path to achieving 10%+ annualised returns over the next five years.

A Selective Approach to Small Caps

Greg Dean from Langdon Equity Partners focuses on building a concentrated portfolio of high-quality small-cap compounders globally. Dean targets businesses capable of growing cash flows by 10-15% annually, regardless of macroeconomic conditions. Crucially, this approach does not rely on multiple expansion for returns. Instead, it prioritises the compounding power of underlying businesses, allowing for attractive returns even in volatile or declining market environments.

This business-focused, valuation-disciplined approach promotes meaningful diversification away from the factor and concentration risks embedded in large cap indexes. The MSCI World Index has over 60% exposure to the U.S. mega cap technology and consumer discretionary sectors, creating vulnerability to localised economic and regulatory risks. While the small cap strategy does invest selectively in the U.S., Dean is willing to underweight the region when more attractive geographic alternatives emerge, as has been the case recently with Europe.

The portfolio also seeks to diversify across sub-industries and business models within broad sector categories. For example, while the strategy has exposure to financial services, the Dean eschews highly-leveraged, spread-based lenders in favour of capital-light, fee-based financial platforms that are both higher-quality and less correlated to traditional bank risks. This creates a more all-weather return profile that can shine in a wider range of market environments.

Complementing Large Cap Exposure

Importantly, the small cap strategy provides a complement, not a replacement, for large cap global equity exposure. Small caps offer fertile ground for active management, as they tend to be under-followed and more frequently mis-priced by the market. Dean’s focus on off-the-beaten-path, idiosyncratic ideas, such as under-the-radar insurance companies with long runways for growth, creates potential for significant alpha generation uncorrelated with broader equity markets.

Of course, small cap equities are not immune from volatility, and even the highest-quality businesses can see their share prices punished in a risk-off environment. But for long-term investors who embrace such volatility as an opportunity to acquire stakes in durable compounders at attractive prices, this small cap strategy can be a powerful tool for both risk mitigation and return enhancement within a balanced global equity portfolio. And who knows, if things go your way you might get the growth without the volatility, as we saw during the slow grinding recession of 2001-2003 when bricks and mortar small caps were up 30% just as the high flying Nasdaq tech stocks lost 70% of their value.

Next week we will explore another niche with arguably even higher growth potential – Emerging Markets Consumer Growth.