Emerging-Market Small Caps: A Distinct Growth Opportunity by Mark Mobius
Emerging markets remain at the forefront of the world’s most vibrant and fastest-growing economies, with overall gross domestic product (GDP) growth rates comfortably in excess of the developed world this year, despite much-publicized slowdowns in certain countries. The Templeton Emerging Markets team believes the challenges faced by some countries, sectors and companies—such as energy firms and Chinese banks—have obscured interesting opportunities within the emerging-market (EM) space. Here, my colleague Chetan Sehgal, executive vice president, managing director India, CIO, and director of global emerging markets/small cap strategies at Templeton Emerging Markets Group, and I present the team’s views on the distinct opportunities we see in EM small-capitalization (small-cap) stocks.
We believe small-cap stocks within EMs offer continued strong growth potential at attractive valuations. We also view the asset class as one that is overlooked by most investors—in part due to misconceptions regarding the volatility, liquidity and scale of this investment universe. There are several key positive attributes of EM small caps, both structural and tactical, which in aggregate we think support considering the inclusion of the asset class within a given exposure to EMs.
From a structural perspective, smaller EM companies provide investors with exposure to thousands of companies that we have seen as having ample liquidity. Smaller companies are typically under-researched and under-owned by foreign investors, leading to market inefficiencies that potentially can be exploited. In addition, the types of exposures the EM small-cap space typically represent complements the EM large-cap space, particularly in areas such as the health care and consumer sectors, fueled by demographics and a rising middle class. As such, we believe EM small caps in aggregate can deliver strong growth potential.
Tactically, we consider the recent selloff across EMs to have provided a particularly attractive valuation opportunity. In addition, smaller companies in EMs generally have greater local market exposure and as a result, have historically had reduced correlation (the degree they move in tandem) with their larger-cap counterparts. Like all EM equity investments (and equity investments generally), investing in smaller companies carries some inherent and perceived risks including loss of principal; smaller-company stocks have historically had more price volatility than large-company stocks, particularly over the short term. However, EM small caps are increasingly attracting institutional investor interest, and we think they offer attractive risk/return attributes in the current global economic environment.
A Vast Investment Universe with Substantial Liquidity
EM small caps are far from a niche investment, despite broad perceptions. The asset class represents more than 23,000 companies with an aggregate market capitalization of close to US$5 trillion1 and daily turnover of close to US$60 billion, constituting substantial proportions of overall emerging-market liquidity and market capitalization, as the chart below demonstrates. Accordingly, the sheer size of the EM small-cap investment universe provides abundant opportunities to uncover mispriced companies. Another aspect of the asset class (also highlighted in the chart) is that the aggregate liquidity is broadly comparable with that of large-cap stocks—again, contrary to common perception. In fact, EM small caps are typically disproportionately owned by domestic retail investors who often trade more frequently than foreign institutional investors due to the former usually having a far shorter investment horizon, boosting liquidity as a result.
Overlooked and Under-Researched
In the next chart, we look at the level of EM small-cap exposure within the MSCI Emerging Markets Index, a benchmark widely used to represent EM stocks as an asset class. Here, we find that EM small-cap exposure amounts to only 3% of this benchmark—compared to 28% of the market capitalization of the entire EM investment universe.2 This difference represents a structural underweight in the portfolios of investors who follow an index-based strategy.
Not only are smaller EM companies overlooked by many investors, they are also notably under-researched. This reflects not only the vast number of companies to cover, but also the paucity of information available and a limited investor base that such research can be distributed to. Unsurprisingly, the result is that the median number of research recommendations for EM small caps is far lower than for larger-cap EM stocks. Equally important to note is the vastly greater number of stocks with negligible, or effectively zero coverage. For a large number of EM small-cap stocks outside of the benchmark index, research availability is even more limited. The likelihood of a relatively unknown off-index EM small company stock being mispriced is far greater than for a large company with many research recommendations.
Local Emerging-Markets Exposure
Reflecting on the general long-term success of EMs as global economies and as an equity asset class, most of these countries have become ever more integrated into the world economy. Consequently, their largest and most successful companies have often expanded beyond domestic markets to export and invest globally. Accordingly, the share prices of many of these stocks are no longer primarily driven by domestic factors. Examples of such companies can include electronics, auto industry or consumer-related names that derive a substantial portion of their revenues from developed economies rather than those in which they are based. By contrast, smaller EM companies offer the very exposures that enticed investors to emerging markets in the first place, with domestic demand, favorable demographics, local reform initiatives and innovative niche products often being the primary determinants of growth. Consequently, the sectors to which EM small-cap investors are exposed differ notably from those of larger-cap stocks, as we can see in the next chart.
The MSCI Emerging Markets Index is disproportionately dominated by exposures in financials, energy, information technology and telecommunications/utilities. These sectors are typically more closely impacted by global or country-level macroeconomic trends—whether the debt associated with an economy’s property market, the global price of oil or government policies.
Furthermore, there is a greater preponderance of state-owned enterprises among larger-cap stocks, and while we find many such state-owned companies to be well managed, the interests of the ultimate owners are not always entirely aligned with those of minority investors.
EM small-cap exposures are concentrated in higher-growth sectors, such as consumer discretionary and health care. Such companies are typically more locally focused and many are relatively dominant players in smaller industries. The most successful smaller EM companies will leverage such local strength to expand internationally, supporting their transition into mid- or even large-cap companies over time. Even within a given sector, economic exposures can differ substantially. For example, in the materials sector, mining companies by their nature are generally large-cap names, and are impacted significantly by factors external to their home country, such as global commodity prices. Smaller EM materials companies likely include businesses, such as cement producers, with greater exposure to local economic development and demand dynamics.
The predominantly domestic economic exposures of smaller EM companies, combined with these stocks being generally under-researched, results not only in mispriced individual companies at times, but also broader market-level inefficiencies. India is a notable economy that exhibits such trends,