(Aug 7): As interest in the US equity market wanes, Asian equities are back in vogue. Structural reforms and economic liberalisation in large markets such as China and India are expected to boost corporate earnings and investor sentiment. And growing consumption continues to be a valid investment theme for most countries in the region.

Chetan Sehgal, director of global emerging markets and small caps at the Templeton Emerging Markets Group, part of Franklin Templeton Investments, says EMs still offer plenty of growth as rising affluence brings opportunities for companies. “After a period of currency and commodity price adjustments and widespread political change, many of the emerging economies are now improving. Many of the factors that originally attracted investors to the EM equity asset class have come back into play, including stronger earnings growth, higher economic growth and robust consumer trends.”

How can investors get in on the action? Paul Rathband, a fund manager for Asia ex-Japan equities at Schroders, thinks it is important for investors to gain exposure to smaller companies. “It is far easier for smaller companies to grow at a faster clip. And where we see accelerated growth at an early stage in Asian companies, we also see returns,” says Rathband in a recent article circulated to the media. He also points out that many large caps in Asia are state-owned enterprises, which have “generally poor corporate governance and are often apathetic towards the interest of minority shareholders”.

Small caps, on the other hand, tend to be run by owner-managers. Elizabeth Soon, portfolio manager, Asia ex-Japan equities, at PineBridge Investments, says because of their large shareholdings, these owner-managers often share the same interest as minority shareholders, that is, maximising growth.

Templeton’s Sehgal says such an ownership structure is not always a positive. In fact, he notes, small caps “require additional due diligence... as in many cases, the companies are owned by first-generation entrepreneurs and have not professionalised their operations”. But he points out that these same entrepreneurs often have an edge over larger companies because they have “evolved their business models to operate in niches that remain unexplored by several large companies, or are dominant in sub-segments that remain lucrative”.

Small- and mid-cap stocks in EMs offer “more exposure to local market growth drivers and are less dependent on global macroeconomic developments”, Sehgal adds. “Moreover, EM small/mid-cap exposures are concentrated in higher-growth sectors, such as consumer discretionary and healthcare, [giving us] the potential to access small but fast-growing profitable companies to reach the burgeoning and rising wealth of consumers in EMs.”

In particular, Soon of Pinebridge says, small companies that have or are developing new technologies in the manufacturing, energy or automobile space have the potential to eventually become large caps. And because there is often limited information on these companies in EMs, investors have greater opportunity to derive alpha.

“Currently, 80% of listed companies in the Asia ex-Japan stock markets are small-caps. They are relatively less covered by market analysts, which means that some companies with strong business models and good management are not given the attention they deserve,” says Soon. “[This] offers a greater opportunity for investors to unleash the hidden value from the pricing inefficiency of these stocks.”

Flavia Cheong, Asia-Pacific ex-Japan head of equities at Aberdeen Asset Management, adds that small/mid-cap companies often become targets for mergers and acquisitions. “When their prospects or growth gets noticed and bigger rivals acquire them at a premium, it unlocks significant value for investors.”

Risks involved Cheong cautions that the risks of investing in small- and mid-caps are higher. “Smaller companies can also be more vulnerable to sudden changes in the macro and/or operating environment,” she says. “In some jurisdictions, banks may be less willing to lend to smaller companies, especially during times of stress, hence financing can be a problem.”

Illiquidity is another concern — smaller-cap companies are often not as actively traded on the stock market. Sehgal says he manages this risk by spreading his investments. According to him, there are over 24,000 EM small-cap stocks with a combined market cap of about US$9.7 trillion ($13.2 trillion) and daily turnover of US$57.5 billion. “We manage liquidity at a portfolio level, with the bulk of exposure in highly traded stocks. This enables us to invest in a tail of smaller, less-liquid companies, often off-benchmark. As these businesses grow, their market cap and daily turnover rise, a process that typically accelerates if they are added to the index, further fuelled by increasing international research coverage and ownership. As a result, what starts as a very small, less-liquid exposure can grow to become quite a substantial position with ample turnover,” he says.

Soon of Pinebridge adds that lower liquidity can also be an opportunity, “as our bottom-up approach allows us to uncover thinly traded stocks and keep hold of them until they reach their true potential”.

Are small/mid-cap funds for you? Cheong of Aberdeen says the type of fund an investor chooses is dependent on the individual’s risk appetite. “Smaller companies should, in theory, offer faster growth because they are at an earlier stage of development. Smaller companies are also more likely to be mispriced because research on these firms is less comprehensive or even non-existent. However, there are risks that may be less of an issue for larger companies. Therefore, it boils down to the individual’s investment objectives.”

Soon believes small/mid-cap funds are generally suited for longer-term investors. “Our approach to investing is akin to laying the foundation of a building, brick by brick. We follow a fundamental, research-driven, bottom- up, stock-picking process, where we study the company and evaluate the strength of its business. We look at factors such as product suite, longevity, barriers to entry, brand positioning and market share. We also assess the quality of the people who are running the day-to-day operations and those responsible for capital allocation decisions. We believe a strong management that is astute in the use of debt would enable the company to weather challenges,” she says. “Stocks are held with at least a medium-term investment horizon to allow alpha to accumulate over time.”

Small- and mid-cap funds may be a better way to play Asian growth story

Will the Rising Sun keep rising?

Fed signals higher-for-longer rates with hikes almost finished

EQT Impact Challenge offers platform for impact entrepreneurs to attain 'patient capital'

Singtel to sell 20% stake in regional data centre business valued at $5.5 bil

SoftBank has either reopened the IPO market or killed it

Small- and mid-cap funds may be a better way to play Asian growth story

Related News

Highlights

Will the Rising Sun keep rising?

Related News

Hong Kong investor and EPF pare stake in Interra Resources, Riverstone respectively

DBS and Sea: Two ends of a barbell?

SGX sticks to multi-asset push as MSCI ditches Singapore to cast its lot with Hong Kong