Why choose emerging small cap equities?
Eye-catching acronyms, notably Jim O’Neill’s “BRICs”, combined with the rise of China as an economic powerhouse, have enhanced global awareness of an exciting asset class.
- Emerging market small cap equities provide greater exposure to sectors likely to benefit from the rise of the middle classes.
- Small cap indices have actually displayed lower volatility than large cap exchanges in recent years.
- A lack of meaningful analyst coverage provides opportunities to identify market inefficiencies and generate significant returns.
- Combined with the less liquid nature of the class, this information gap requires investors to adopt a three to five year horizon.
Emerging economies have been driving global GDP growth for much of the last decade. Rising household incomes, growing middle classes, rapidly expanding workforces, rising productivity and stable inflation have all underpinned this expansion. Accounting for less than one fifth of the total worth of the world’s publicly listed equity markets, emerging markets still offer considerable scope for growth.
Small cap equities
The great attraction of investing in small-cap companies in emerging markets is the fact they are exposed predominantly to domestic demand. According to Ernst & Young, the global middle class will expand by another three billion people – almost exclusively in the emerging world1. Once basic needs have been met, history suggests that demand will shift towards growth in consumer products and services, housing, infrastructure and healthcare.
Higher exposure to prime sectors
Smaller companies provide much greater exposure to the sectors most likely to benefit from from rapid income growth, such as domestic retailers, healthcare and industrial stocks. By contrast, large companies within emerging markets are dominated by energy companies, commodity producers, large national banking institutions and heavy industry.
Under-researched, under the radar
Small-cap companies tend to be covered by fewer analysts than corresponding large caps, a phenomenon that also holds true for emerging markets. Indeed, many small-cap companies are not followed at all, while the quality of research on those that are covered frequently amounts to little more than a brief commentary on results. This absence of meaningful research provides a great opportunity to identify market inefficiencies, discover new investment opportunities, and generate significant returns.
Risk v reward
In developed markets, the shares of smaller companies have traditionally been more volatile than those of their large-cap peers. That is partly because they often focus on a single line of business, and also because their shares tend to be less liquid. Higher returns have historically compensated for this additional risk.
The great attraction of investing in small-cap companies in emerging markets is the fact they are exposed predominantly to domestic demand
Head of Emerging Markets and Asia Pacific Equities
Less volatility than large-cap
Small-cap shares in emerging markets are no different – but interestingly with lower levels of volatility than their large-cap peers. Indeed, the risk profile small-cap shares are not dissimilar to developed market equities. The relative illiquidity of emerging-market small-cap stocks has made them less susceptible to the international flows, especially from ETFs and passive investors, that have had such a big influence on larger emerging-market stocks.
Emerging-market smaller companies are more exposed to domestic growth. They have significantly different sector biases compared to larger companies. And they are less exposed to passive and ETF capital flows. As markets become increasingly correlated, this results in some of the most attractive diversification benefits compared to other mainstream equities. Used effectively within an appropriately constructed portfolio, this can help to improve risk-adjusted returns.
Exploiting the opportunity
Even so, emerging market small-caps require patience. The less liquid nature of the asset class, combined with higher transaction costs, is the first barrier to short-term investments. Poor investment coverage and slow information dissemination can result in a more gradual discovery process. Finally, these investments are specifically made to benefit from long-term growth.
Emerging-market small-cap companies offer investors the clearest means of accessing growth within emerging countries. Their shares have historically offered investors better risk-adjusted returns with lower volatility than comparable large-cap investments. These shares tend to be less liquid. But a robust investment process, focused on selecting high-quality companies trading at attractive valuations, provides exposure to an attractive long-term investment.
1. Source: Ernst & Young, Hitting the sweet spot, The growth of the middle class in emerging markets, 2013.
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