Articles & stories

Small Countries Deliver Bigger Returns

Where should you invest? Which markets seem more profitable and trouble-proof? Many investors would answer: surely the large ones. Surprisingly, the recent Credit Suisse study, "The Success of Small Countries and Markets" demonstrates that it is small developed country stock markets that outperform and deliver impressive results.

The phrase "Thinking outside the box" may seem overused and banal, but its meaning remains valid, as proved by Michael O'Sullivan and Stefano Natella from the Credit Suisse Research Institute (CSRI). The experts took a step beyond the usual investment comparisons, be it large versus small capitalization stocks, value versus growth, or cyclical versus defensive sectors, and applied an original and unprecedented approach. Their novel market comparison examined financial assets returns for large and small countries. The results were far from banal – it turned out that in the long run small countries outperformed the large ones.

When creating their comparison, the experts looked at three groups of countries: large developed (Australia, France, Germany, Italy, Japan, Spain, UK and USA), small developed (Austria, Belgium, Denmark, Finland, Ireland, The Netherlands, Norway and Sweden) and small developing (Estonia, Hungary, UAE, Qatar, Slovakia, Iceland, Israel, Croatia, Latvia, Czech Rep, Portugal). For the first two groups, the examined data covers 50 years of equity total returns. For obvious reasons, only short term analysis was available for the third group of countries. 

David Versus Goliath

All indicators are unanimous and confirm that small developed countries are the winners. This is true for long- and short-term timeframe. Figure 1 shows 50 years of stock returns, validating that the outperformance of small countries is a steady trend present in markets for the last couple of decades. 

To examine the subject further, the experts decided to check operating performance and  profitability of companies in the tested countries. Again, small developed markets have better returns. As visualized on figure 2, over the last 20 years their CFROIC® (cash flow return on invested capital) steadily surpasses that of the large countries group (excluding the US market). What's more, the ratio between CFROI and the cost of capital (DR) within the small developed countries universe is consistently advantageous, meaning that these countries continue to create economic wealth.1

It is worth mentioning, that small developed countries note better results despite higher volatility (historically it is 1 percent greater in small countries).

Small Countries Strengths

One of the reasons behind such apparent market success of small developed countries, can be their sector composition. Figure 3 presents sectors shares in the developed and developing small countries markets. The dominant roles in both play financials and industrials, occupying nearly as much as 50% of the tested markets. The report data confirms that over the last nine years, one third of the annual excess return of small developed countries relative to large developed countries is explained by different sector weightings.

Another important factor is diversification. Small countries markets are less connected and less dependent from each other than stock markets in large countries. It makes investing in them more resistant to market shocks and global changes. The average pairwise correlation across the test groups is the lowest for small developing countries (0.45), small developed countries come second (0.57), while the large ones record the highest score (0.63).  

An additional winning category for small developed countries, is the quality of dominating industries. The export giants in large countries are tobacco producers, beverage companies and energy sector services providers (oil, gas, coal). While in small developed countries the dominating export sectors are drugs, cosmetics & health care, as well as chemicals, which belong to a higher value-added category, requiring higher financial expenses on R&D and highly qualified members of staff.

Investors, Don't Overlook Small Countries!

Small developed countries worked long and hard for their success and prosperity. They succeeded despite being acutely exposed to the economic and political challenges of a changing global environment. In order to keep up with their larger partners and protect their position in the business network, they need to anticipate upcoming changes or adverse conditions and act accordingly.

The evident outperformance of small developed countries would be impossible to achieve without  favorable background factors, which created suitable conditions for economic growth. These factors, called "intangible infrastructure", were defined by the Credit Suisse research team as: "the set of factors that develop human capability and permit the easy and efficient growth of business activity." They can be of political, legal or socio-economic nature and consist of five specific components – education, healthcare, finance, business service and technology.

Small developed countries are "intangible infrastructure" leaders, skilled and experienced in putting it to work in driving growth. They definitely deserve investors' attention.

1This comparison was made using HOLT data and methodology developed by Credit Suisse.