On Why Emerging Market Small-Caps?
Emerging markets have seen a remarkable turnaround in both
sentiment and performance since the end of January of this year, advancing by
21% since then. As is almost always the case (the iron-clad rule of mean
reversion at work again!) , extreme bearish sentiment prevailing
over the prior three years (culminating in more than a trillion dollars
of outflows since mid 2014) was quickly replaced by the current
bullishness. As the market technician Mark Galaseiwski (and author of the
Asia-Pacific Financial Forecast) observes, Reuters reported on January 20, 2016
that many participants at the 2016 Davos feared that “investment returns
across the sector are unlikely to recover soon”. The MSCI EM index bottomed out
the next day!. So where does one now look for opportunities in the EM
sector? Mark Mobius and Chetan Sehgal from the Templeton EM team argue
the case for the small cap sector. To summarise:
-EM small cap stocks continue to offer strong growth potential at
attractive valuations, while being an overlooked sector due to
misconceptions regarding their volatility, liquidity and scale as an asset
class. However, EM small caps offer many advantage, structural and tactical for
investors.
-Structurally, smaller EM companies provide exposure to areas
which complement the large-cap sector, particularly in the health care and
consumer areas which are driven by favorable demographics and a rising middle
class. EM small caps are also under researched and under-owned by foreign
investors , have ample liquidity, thereby providing numerous
opportunities in terms of market inefficiencies.
-Tactically, the widespread sell-off across the EM space
over the last several years has created attractive valuations, while
having more local market exposure and lower correlation to the large-cap
sector. However, they also carry higher risk (of principal loss) and more
volatility than large companies. Looking ahead, with the sector evidencing
increasing interest from global institutional investors, it offers
an attractive risk/return profile over the coming years.
-The EM small-cap space comprises more than 23,000 companies with
a aggregate market cap of $5 trillion and daily turnover of close to $60
billion., with broad liquidity of the sector approaching that of the large-cap
space. EM small-cap stocks are disproportionately held by domestic retail
investors who typically trade more often, and with shorter time horizons than
foreign institutions, thereby boosting their liquidity.
-EM small-caps are only 3% of the MSCI EM index, while being 28%
of the market capitalization of all emerging market companies.
-EM small-caps stocks are more prone to be overlooked by overseas
investors as they are vastly under-researched, with many companies not
being covered at all (see chart below). This creates various mispricing
opportunities to be exploited.
-EM small-cap companies have greater exposure to domestic markets,
driven by domestic demand, favourable demographics, local reform initiatives
and innovative niche products. This results in differing exposure to sectors
than the large-cap space as illustrated by the chart below, particularly in
high growth areas like consumer discretionary and health care. By contrast the
large-cap companies have greater exposure to financials, energy,
information technology and telecom, which tend to be more affected by global
and country-level macro trends events. They also have a larger weighting in
state-owned companies which may not be as well managed.
-The market pricing inefficiencies prevailing in the EM small-cap
sector can be best illustrated by India, which has a vast number of such
companies and a notable skew towards ownership by domestic
investors. During the 2008-2014 period, domestic retail investors in
India allocated capital to real estate and gold, and any inflows from foreign
institutional investors were made through index-based investments which
were skewed towards the large-cap stocks. This is reflected in the 27%
ownership by foreign institutions in the broad market index, while having only
13% exposure to the small cap index. So Indian small-cap companies are not only
more exposed to the domestic economy, but to the local investor base as well.
-Therefore, from 2009 until 2013, the negative sentiment of
domestic investors towards equities led to notable valuation discount of
small-cap stocks to the large-cap sector. The sentiment change in 2014
with the election of the pro-business Narendra Modi led to a significant
rerating in the valuations of small-cap stocks.
-In a global low-growth environment, EM economies continue
(despite the slowdown in recent years) to offer considerably higher
growth opportunities than the developed world. Investing in EM
small-caps provide exposure to the fastest-growing companies in the fastest-growing
economies globally. This growth is also more organic that growth driven by
central bank induced macro-economic factors or financial engineering
techniques like share buybacks (particularly in the US). In addition, the
potential upside from being added to an index, increased research and being
targets of M&A activity offer further upside opportunities. Given the
higher risks in this sector relating to poor governance, poor quality of
management and other factors, it is important to be able to identify the likely
winners with thorough research or through an experienced manager with a
long track-record.
-Interesting piece which makes a forceful case for EM
stocks in general, and the small-cap sector in particular. However, has
the popularity of the asset class already reached excessive levels?
-Blackrock’s Global Chief Investment
Strategist, Richard
Turnill, wrote an interesting commentary recently:
-“The chart below shows
where the crowds are, based on our analysis of fund flows, fund positioning and
price momentum. We consider positions with scores between 1 and 2 (and -1 and
-2) as popular, and those with scores above 2 (and below -2) as very popular.
The higher the score, the more popular the overweight is. The lower the score,
the more popular the underweight is. The most popular investments today:
overweight U.K. government bonds (gilts), emerging market (EM) sovereign debt,
developed market credit and gold, as well as underweight eurozone equities.
-“We advocate reducing popular positions
where prices have moved beyond fundamentals (examples are gilts and
bond-proxies such as utility stocks). We also would resist taking contrarian
positions in sectors facing big structural challenges (e.g. European banks).
But popular overweights with supportive fundamentals and valuations (such
as EM debt and U.S. credit) are still worth considering
(see chart below) , and gold can offer portfolio diversification benefits.
Our overweight EM equity position doesn’t appear popular despite
recent inflows into the asset class. Be mindful of the short-term risks
embedded in consensus trades, and look for potential opportunities the crowds
haven’t yet reached.
-Regarding exposure to EM small cap stocks, there are a variety of
ETFs to choose from, but a fund with a solid long-term track-record could
be a better alternative given the risks associated with small cap
stocks. The Bloomberg chart below compares the performance of two such
funds (the Templeton TEMMX:US fund-yellow line - and the Wisdom Tree DEMSX:US
fund) versus the ETFs EWX and DGS. The outperformance by the two funds
over a 5 year period is clearly exhibited. In addition, single country
small cap ETFS and funds can offer interesting opportunities. While Indian
small caps have had a great run since late 2013 (index up 121% versus 43%
for the market index) and are prone to a short-term reversal, they
continue to offer solid long-term upside potential. Other countries like Brazil
(despite the recent move) , Russia and China also offer superior
upside over the medium to long term.
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