Over the past three years the MSCI EMU Small Cap Index has been outperforming the MSCI EMU Large Cap. Investors interested in European stocks might focus on small cap companies to generate alpha, but what if you have a mandate to invest in large cap companies only?
This article investigates the possibility of generating alpha from a top-down perspective by looking at the performance of top and bottom fifty companies with respect to their revenue exposure to eurozone, U.S., and Asia. While this analysis is not intended as investment advice, the findings help highlight the potential hidden in a top-down approach to stock selection based on growth rate of certain economies at different times.
The blue portion of Chart 1 below shows the performance difference between the 50 MSCI EMU companies with highest exposure to eurozone versus those 50 companies with lowest revenue exposure to eurozone. This means that the Bottom 50 companies, (i.e. the companies with lowest exposure to the eurozone) outperformed the 50 companies with highest exposure to eurozone. Looking at the size characteristics for these two groups as shown in Table 1 we notice that the Bottom 50 companies are large cap companies.
A similar study focusing on MSCI EMU companies with highest vs lowest U.S. revenue exposure is shown in Chart 2. In this chart the 50 companies with highest U.S. revenue exposure have outperformed the 50 companies with lowest U.S. revenue exposure while the exchange rate conditions were favorable. However, as the U.S. Dollar weakened against the EURO as highlighted by the red line in the chart 2, companies with highest revenue exposure to the U.S. underperformed.
| Cumulative Return | GeoRev % Average Exposure | Average MCap | Average P/E | |||||
| Region | Top 50 | Bottom 50 | Top 50 | Bottom 50 | Top 50 | Bottom 50 | Top 50 | Bottom 50 |
| Eurozone | 7.5 | 28.8 | 91 | 15 | 7,952 | 19,934 | 19.4 | 29.4 |
| U.S. | 19.8 | 9.7 | 35 | 2 | 20,147 | 11,913 | 28.0 | 21.1 |
| Asia | 35.2 | 19.8 | 27 | 2 | 19,576 | 15,793 | 25.6 | 23.7 |
Another similar example compares companies with highest vs lowest revenue exposure to Asia. Chart 3 shows the performance spread of Top 50 MSCI EMU companies with highest exposure to Asia vs the fifty companies with lowest exposure to the same region. Here the picture looks slightly different from the previous examples.
A currency overlay for both JPY (chart 3) and Renminbi (chart 4) vs EURO shows that these companies are not as sensitive to the two major Asian currencies as those companies with high exposure to the U.S. dollar. This is also supported by the correlation study in charts 5-7. The correlation is strongest between the 50 Day Moving Average USD/EUR and the rolling 6m performance spread between Top 50 and Bottom 50 companies exposed to the U.S. (chart 5). This may indicate that companies with high revenue exposure to the U.S. pose a higher currency risk to the portfolio performance than companies with high Asia exposure. This risk can of course be alleviated with a proper currency hedge.
With these results in hand the original question can be evaluated; is it possible to outperform the MSCI EMU Small Cap index by investing in certain Large Caps?
The answer appears to be yes. There seems to be an opportunity to generate more alpha by using regional or country economic growth indicators such as GDP growth estimates (as shown in Chart 8) to identify economies that are expected to do well within a defined timeframe and then identifying companies with high revenue exposure to these economies.
Applying this strategy to a standard investment universe, MSCI EMU index, and equal weighting the fifty companies for simplicity, the portfolio outperforms the benchmark as shown by the red line in Chart 9 below.
FactSet RBICS with Revenue, which classifies each of a company’s segment revenues (rather than whole companies), can be used to ensure there’s no sector bias. As shown in Chart 10, the revenues generated by our portfolio companies are well distributed across multiple sectors
The results are compelling both from an alpha generation perspective as well as for risk factor analyses such as exchange rate fluctuations. To summarize, this exercise demonstrates how a simple factor such as geographic revenue exposure can be used in combination with your own macro views to help identify companies with potential for outperformance. Similarly, the same approach can be used to reduce the risk of drawdowns caused by portfolio companies’ hidden economic exposures.
Ali Hedayat, Vice President, Principal Product Manager, Content Strategy also contributed to this article.