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Small but powerful: why disruption isn’t just for tech giants.

April 2022

Key points

As the Baillie Gifford International Smaller Companies Fund marks its third anniversary, its managers explain how the Fund’s ‘radar research framework’ picks up the signals of small caps that can deliver growth.

The value of an investment, and any income from it, can fall as well as rise and investors may not get back the amount invested.

The biggest change in the global investment landscape in recent decades is that digital technology has reshaped stock markets. Where once they were dominated by oil companies such as Chevron and ExxonMobil, now they’re driven by tech giants such as Apple and Microsoft.

Yet tech doesn’t have to be big to be successful. In its first three years, International Smaller Companies (ISC) has invested in a host of companies at an earlier stage in their growth but still capitalising on the disruptive power of technology.

“We’re firm believers in the disruption that digitalisation poses,” Charlie Broughton, a member of the strategy's portfolio construction group (PCG), explained to clients in a recent webinar.

“Almost every legacy industry is seeing itself disrupted.”

Broughton pointed to the success of Avanza Bank, an online-only stockbroker and savings account provider that has disrupted Sweden’s banking sector.

Brian Lum, chair of the strategy's PCG, added: “Many of the themes present in the portfolio – whether it’s automation or digitalisation or healthcare innovation – remain very relevant and won’t go away, even if there’s a small element of bounce-back from two years of Covid.”

Culture is key

Technological disruption can also go hand-in-hand with cultural disruption, as in the case of Avanza Bank.

“Not only do you have disruption in the product they’re offering, but there’s a broader point around culture,” Broughton said.

“It’s a business that has incredible returns-to-scale. The bigger it gets, the more profitable it becomes.”

“But rather than returning all those earnings to us in the form of dividends, they are reinvesting them all into price.” In other words, as Avanza sees unit costs fall, it converts these savings into lower prices and better customer service, keeping prices low and customers happy.

Maytronics, the Israeli firm behind the Dolphin robotic swimming pool cleaner, is another company that combines technological and cultural disruption.

A 56 per cent stake in the business is owned by a kibbutz or collective community based around a citrus farm at Yizre’el in Northern Israel.

“For them, the survival and prosperity of Maytronics is intrinsically linked to the survival and prosperity of their entire community,” added Broughton.

“When it comes to long-term alignment, it doesn’t get much better than that.”

Using the strategy's ‘radar’

Lum estimates that there could be 20,000 or more companies within the small cap universe from which to select ISC’s stocks.

“It is a hopeless task to cover the universe, and we're not trying to do that,” he said.

Instead, the strategy's PCG uses what it calls its ‘radar research framework’ to select the right stocks. The radar (see below) is proving a vital tool in assessing potential small cap targets.

On our radar: How we assess potential small cap targets

“Over the past 12 months, we’ve put a lot of thought into specific spokes of our radar – particularly opportunity and sustainability,” explained Broughton.

“One of the big benefits of our universe is how poorly it is covered. This is a huge advantage for real bottom-up research.”

Next steps

At the moment, Broughton, Lum, and their fellow PCG members are using the radar to examine companies in fields as diverse as video games, alternative proteins, and the energy transition.

“The video games industry is now bigger than the music and film industries combined,” explained Broughton.

“This offers an incredible opportunity for the owners of intellectual property. We have a number in the portfolio, including Team17, which publishes small independent games.

“We also think there are broader opportunities for businesses like Keywords Studios, which is an outsourcer for video games. It provides the ‘picks and shovels’ that big studios use to build the minutiae within their video games, like the character art for your Fortnite game avatars.”

Lum added: “We are primarily bottom-up stock pickers, but sometimes we do dive into themes a bit more systematically.”

Those themes currently include alternative proteins, with ISC subscribing for shares during the initial public offering from Veganz, a German plant-based food company.

Lum has also been carrying out research into companies that will benefit from the energy transition away from fossil fuels towards renewable power.

From small cap to large cap

In 2020, ISC sold its stake in Li-Ning because the Chinese sports apparel brand’s market capitalisation broke through the strategy's $10 billion ceiling.

Li-Ning may have left ISC’s small cap universe, but the stock has since been bought by a number of Baillie Gifford’s large cap strategies.

“We fulfilled our role as an incubator within Baillie Gifford. Part of our purpose is to discover the great up-and-coming names before they’re picked up more widely,” said Broughton.

“Our goal is not to buy ‘small’ companies – we’re looking to find big businesses, just beforehand.”

Other companies in the portfolio are also fulfilling the growth potential we spotted in them from the beginning. These include the Italian digital consultancy Reply and Taiwanese pneumatic equipment manufacturer AirTAC.

Yet, with 20,000 or more small cap companies listed on stock markets, ISC won’t be short of choices from its ever-expanding universe to replace any departing stocks. As client director and PCG member Richard Gall put it:

“We’re still just scratching the surface of what is an incredibly broad and deep opportunity.”

Watch the International Smaller Companies’ three-year anniversary webinar.

Annual Discrete Performance to 31 March (Net %)
  2018 2019 2020 2021 2022
Baillie Gifford International
Smaller Companies Composite
N/A  N/A  -13.3  86.3  -13.7 
Small Cap 
N/A  N/A  -20.8  70.4  0.4
Annualised Performance to 31 March 2022 (Net %)
   1 Year 3  Years Since inception* 
Baillie Gifford International
Smaller Companies Composite
 -13.7 11.7 11.5 
Small Cap
0.4  10.7 10.4
Source: Baillie Gifford & Co, MSCI. USD. Past performance is not a guide to future returns. *International Smaller Companies inception date: 19 December 2018.

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