Smallcap stocks in emerging markets offer attractive prospects for active managers: Mark Mobius

So far in 2017, EM small-cap performance has been buoyant, with many countries and industries in the asset class advancing. Confidence in the market backdrop, economic environment, and corporate earnings have improved across EMs.

That confidence has come despite challenges such as actual and potential US interest-rate increases, uncertainty brought about by the new US administration and global geopolitical issues.

Addressing Some Common Misconceptions Surrounding EM Small Caps

It Is Not a “Niche” Asset Class. Despite broad perceptions, in our view, EM small caps are far from being a niche investment.

The asset class represents more than 20,000 companies with an aggregate market capitalization of over USD 5 trillion and daily turnover of over USD 40 billion, as the chart below demonstrates. Liquidity within EM small-cap markets is comparable to that of EM large caps.

Accordingly, we think the sheer size of the EM small-cap investment universe is a key advantage for active managers, providing abundant opportunities to uncover companies we think represent value.

Ownership of EM small caps disproportionately sits with retail investors. Retail investors tend to trade more frequently than foreign institutional investors because the former usually have a far shorter investment horizon—boosting liquidity as a result.

A good example of this is India, where investors have a vast number of smaller companies to choose from, and the skew of ownership is toward local investors.

A key difference between developed-market small caps and EM small caps is that EM small caps in many markets are often still significantly important locally.

A market capitalization of close to USD2 billion could represent a leading company in a certain country, index or sector—perhaps a well-established business with a long and successful track record.

Many of these companies are family owned or controlled, and many have stable profiles when compared with developed-market small caps.

It Is Not Necessarily a More Volatile Investment

Another key misconception about investing in EM small caps is that volatility is higher than their larger-cap counterparts. Like all investments, EM small caps come with real and perceived risks.

These include greater price volatility (particularly over the short term), relatively small revenues, limited product lines and a small market share. However, many of these risks are those associated with the EM equity universe overall, such as increased volatility relative to developed markets.

Small-Cap Opportunities for Active Investors

Overlooked and Under-researched. Not only do many investment managers overlook EM small caps, they are also notably under-researched on the sell side. This reflects not only the vast number of companies to cover, but also the relative lack of information available.

Unsurprisingly, the result is that the average number of stock research recommendations for EM small caps is much lower than for larger-cap stocks.

Also, many small-cap stocks have little or no research coverage. For a large number of EM small-cap stocks outside of the benchmark MSCI index, research availability is even more limited.

This can give a critical advantage to an active manager who can directly research such companies, especially if they have people on the ground in the region to evaluate them first hand.

The probability of finding a relatively unknown off-index EM small-cap stock being mispriced is far greater than for a large company with many analysts producing research recommendations on it.

Recapturing Access to Local Exposure to Complement Existing EM Portfolios

Reflecting on the general long-term success of emerging markets, as global economies and as an equity asset class, most of these countries have become ever-more integrated into the world economy.

Consequently, the largest and most successful EM companies have often expanded beyond their domestic markets to export and invest globally. Accordingly, domestic factors are no longer the primary drivers of the share prices of many of these stocks.

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.

Our Active Focus

At Templeton Emerging Markets Group, we believe the EM small-cap space is fertile ground for active managers who can focus on risk management and zero in on long-term growth drivers for the asset class.

Our EM small-cap research is driven by an extensive on-the-ground team of over 50 analysts in 20 offices globally, which allows us to have regular face-to-face meetings with prospective investments and our investee companies and gain first-hand understanding of the dynamics of the local markets in which they operate.

Our strong research efforts, with a focus on corporate governance and risk management, support our aim to deliver on the structural reasons for EM small-cap investing—seeking companies we believe are best positioned to benefit from the demographics and rising wealth of EM consumers, with sustainable and defendable business models.

Through our bottom-up approach, we look to invest in companies with good management teams where we feel conviction they can make the right strategic choices. Price is also crucial to our approach, with a value orientation driving our philosophy for EM investing, which has been honed over several decades

The above report is compiled from his blog titled 'An Active Look at Small-Cap Investing' https://goo.gl/wdGJSR

Disclaimer: The author is Executive Chairman, Templeton Emerging Markets Group. The views and investment tips expressed by investment experts on Moneycontrol are their own and not that of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.