Are emerging market small caps being overlooked?

clock
Are emerging market small caps being overlooked?

The growing importance of emerging markets as a component of global growth, trade, and innovation has resulted in many investors having dedicated exposure in their portfolios. However, global investors have tended to overlook EM and Asian small-capitalisation stocks altogether and don't have meaningful exposure to the asset class.
 
The MSCI Emerging Markets Index focuses on Large-and Mid-Caps, and therefore companies with less than $5 billion market cap represent only 12% of the Index. We believe EM and Asian small-caps are an attractive proposition not only in the current investment climate, but as a structural complement to an overall portfolio as it can provide diversified exposure uncorrelated to developed markets and greater return potential less levered to macroeconomic and non-domestic growth conditions.
 
Wide pool of opportunities across EM and Asian universe
Despite perceptions, EM small-caps are far from niche. The asset class represents 32,000+ companies with an aggregate market cap of US$7.8 trillion and daily turnover of US$44 billion. Accordingly, the sheer size of the EM and Asian small-cap universe provides active managers abundant opportunities to uncover mispriced companies.
 
This provides a critical advantage for active managers that can research such companies as the opportunity of finding inefficiencies in small-cap stock prices is far greater than that for large companies with significant analyst coverage.
 
Rising wealth in Asia set to boost growth
Reflecting the long-term success of emerging markets and in particular Asia, most countries have become highly integrated into the world economy with their largest companies having often expanded beyond domestic markets to export and invest globally. Accordingly, the share prices of many larger stocks are no longer primarily driven by domestic factors and derive a substantial portion of revenue from developed economies rather than locally.
 
By contrast, Emerging Market and Asian small-caps generally offer the very exposures that enticed investors to emerging markets in the first place, with domestic demand, favourable demographics, local reform initiatives and innovative niche products often being the primary determinants of growth. We see rising wealth in Asia to be a secular driver we expect it to continue lifting demand for goods and services.
 
Low performance correlation across the market
Asian and emerging market small caps are typically disproportionately owned by domestic investors, who often invest in a different manner than global investors, which can generate non-correlated performance.
 
A key misconception surrounding EM small caps is that volatility is higher than their larger cap counterparts. Although individual stocks can be volatile, the pairwise correlations of different EM small cap companies are lower, we believe in part due to their domestic orientation and diversity of businesses This can help reduce risk at the asset class level.
 
Valuations have dropped due to lack of market confidence, under-researched small caps, 2018 market sell-off, and political and economic uncertainty, yet the fundamentals of these small caps have remained resilient.
 
Chetan Sehgal, senior managing director for Franklin Templeton Emerging Markets equity, discusses the sweet spots in emerging market small caps