Emerging market small cap: the untapped potential

Jonathan Boyd
Emerging market small cap: the untapped potential

Claire Franklin talks through the recent launch of BMO Global Asset Management’s small cap fund targeting emerging markets and why she believes this space offers a fertile hunting ground for stock pickers

Why launch the BMO LGM Global Emerging Markets Smaller Companies fund now?

The philosophy and process, which we have developed and executed across the frontier and more traditional emerging market space, have produced very encouraging returns for our clients. When we looked across the Emerging Markets (EM) universe, we noticed that we were finding more and more high quality, well managed, market leaders in the small cap space. What is even more interesting is that many of these companies are simply overlooked by the wider investment community, particularly on the sell side.

Our process is based on independent thinking and in-house research. We recognised that the relatively under-researched part of the EM market i.e. small cap, could provide us with a huge and largely untapped universe of growth potential – something we felt we wanted to give our clients direct and specific access to.

We applied the same investment approach and principles that we do to all our funds, to a ‘model’ portfolio in September 2014 and have seen strong simulated
performance since then. An existing client who appreciated the merits of applying our philosophy to the small cap market, seeded the fund and it’s been all systems go since then.

Talk us through the mechanics of ‘launch day’ of the fund.

Mechanics for day 1 are exactly the same as for any other fund but with one key difference…the relatively lower liquidity in small caps, which can have implications on cash levels, meant we needed a more ‘dynamic’ approach when launching the fund. We wanted to get the fund off to the best possible start, and so made the decision to trade the Asian market live in order to have the flexibility to pick up blocks in the less liquid names if they became available. This meant a 2am start – for us and the traders. We sat with them as EM markets opened across the globe. This enabled us to be flexible with our capital allocation, taking tactical decisions on whether to pay a bit more for a stock, where  we felt the underlying quality and valuation warranted it, and vice versa. The strategy paid off and we were able to deploy the funds faster than we had anticipated and we were comfortable with the price paid.

What kind of company makes it into your portfolio?

We have a very clear framework for investment which is based on trust, quality, and valuation. We believe that a company’s value is ultimately dictated by their ability to generate cash and how they use this, either by reinvesting or by returning it to the shareholders.

Trust is at the core of everything we do. It drives our investment process, governance structure and risk management. We are aware of the responsibility that accompanies each of our client’s decision entrusting us with the management of their capital, and we in turn need to trust the management of the companies that we invest in.

A quality company to us is one that has a sustainable business model, uses debt prudently, and has a strong track record of allocating cash, which is a good reflection of their respect for minority shareholders as well as the management’s credibility.

An attractive valuation is very important. Put very simply: we will not overpay for a company, no matter how high quality we deem it to be.

Why does active management make sense, especially down the cap scale?

Indices are backward looking and could reflect negative selection bias if a stock falls from mid/large cap into a small cap index due to a flawed business model. That’s why we believe active investment is essential, but with 8,000 companies in the universe this can sound like a tall order! However, once you focus on cash flow generation and  companies that actually have a sustainable competitive advantage, it becomes more targeted. You really need to know your companies, with a focus on good governance and understanding of the strategy and motivations of the key decision makers.

I am proud that LGM Investment’s track record shows that this added value really has made a difference in giving our clients access to some of the best opportunities within emerging markets. So, what’s next?

It’s great when years of hard work comes to fruition, and although we have total conviction in the philosophy behind all of our funds, we never get complacent, there’s always more hard work to be done and more exciting opportunities
to uncover across the whole EM cap scale.

Claire Franklin is a fund manager at LGM Investments, the emerging market specialists at BMO Global Asset Management

For professional investors only. Past performance should not be seen as an indication of future performance. The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.
Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any products that may be mentioned.
Please note the fund may not be registered for sale in all countries – get in touch with your usual BMO Global Asset Management contact for details. Please note the fund may not be registered for sale in all countries – get in touch with your usual BMO Global Asset Management contact for details.
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