Despite headlines on slowing growth in emerging markets, global emerging market small cap stocks have outperformed most major equity indices so far this year1. In our view, managing investments in this diverse asset class actively can offer investors numerous benefits.
Emerging market (EM) small-cap companies are greater in number and more diverse than those in the main emerging market index. The MSCI Emerging Market Small Cap index has close to 1 900 stocks, almost a thousand more than the standard MSCI Emerging Market index.
And though there are many more of them, they are far less well researched. Analyst coverage of EM small-cap stocks is much lower than that of developed-market or larger EM companies. As of 29 May 2015, the median number of analysts covering a stock in the EM small-cap universe was three, compared with 14 for the MSCI Emerging Markets index and 18 for the S&P 500.
This set-up provides opportunities to achieve strong, uncorrelated performance from the EM small-cap asset class. Returns from EM small-cap stocks have outpaced the average returns from the broader EM universe, over the last one, three, five and 10 years as of the end of June 2015, as well as for seven of the last 10 calendar years.
Over the past decade, EM small-cap equities have not only delivered better absolute returns, but have also provided higher risk-adjusted returns than the broader EM universe.
Greater diversificationWe believe the EM small-cap asset class offers investors a great opportunity for geographic diversification. For example, it is far less exposed than larger-cap stocks to the BRIC countries and it can capture the benefits of a number of thematic exposures such as: - less exposure to global cyclicals (Brazil and Russia) - greater exposure to information technology (Taiwan) - greater exposure to countries with current account surpluses.
Emerging economies are growing faster than developed markets and small-cap companies’ relative independence from government involvement allows them to focus on delivering shareholder returns rather than fulfilling governments’ strategic agendas. And small, independent companies by their nature tend to be more entrepreneurial as management cannot rely on government backing or the diversity of their businesses for success.
On-the-ground insight is crucial
As said, information on EM small-cap stocks is much less readily available than for large caps, so gaining insight means more travel to local markets and greater interaction with management to understand a company’s strategies and challenges, along with local accounting nuances.
We believe our fundamental, research-driven investment process which focuses on finding quality companies with resilient business models that can grow shareholder value and sustain this through differentiation or competitive edge over the long run can work particularly well with EM small-caps.
Our team in Boston can draw on the expertise of an on-the-ground network of over 200 investment professionals located in many important emerging market countries including China, India, Brazil, South Korea and Turkey. Our local partners provide unique insights into management practices, corporate governance and industry dynamics.
Growing consumer demand = long-term value creation
In our view, the sector that best demonstrates the efficacy of a local orientation is consumer staples, with its stable earnings power and generally high return on invested capital (ROIC). EM consumer companies with strong brands have enjoyed robust demand growth over the last 15 years as incomes have risen, creating an expanding middle class.
In this segment, resilient market growth and high returns drive strong reinvestment opportunities and this has been reflected in its performance relative to the wider EM small-cap universe.
Other more cyclical sectors such as materials and financials have shown similar returns.
The better companies are more self-reliant
We find that financially productive and economically resilient businesses tend to make the most of challenging economic conditions by taking market share from weakened competitors. Additionally, the businesses we look to invest in are relatively capital light or are using capital very efficiently, so they do not necessarily rely on outside financing.
Market volatility around events such as the next move in US interest rates can present opportunities in emerging markets, allowing investors to add value over the long term by investing in well-run, quality growth companies at attractive valuations.
An asset class that offers a broad spectrum of opportunity
To summarise, EM small caps can offer investors a greater opportunity for outsized returns due to a broader, more inefficient universe, attractive risk-reward characteristics and diversification through greater exposure to domestically-oriented companies.