Find the hidden gems in emerging markets

When it comes to investing, size isn't everything in fact, smaller firms regularly outperform large ones. The story's no different in emerging markets and there are bargains to be had, says Cris Sholto Heaton.

Most investors are familiar with the emerging markets investment story by now. How could they not be? Emerging markets have beaten developed ones over the past ten years. The MSCI Emerging Markets index has returned an average of 13% per year over the past decade, for example, while the average for the MSCI World is just 0.5%. And with most emerging economies still looking in far better shape than many of their Western peers, there seems a good chance that this will continue.

Of course, after that sort of period of outperformance, investors take notice. Emerging markets are now very much mainstream, to the point where some players in the sector are muttering about 'bubbles'. But to my mind, there's still plenty of opportunity. You just need to know where to look.

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For the most part, if investors think much about what to buy beyond going to the nearest fund with 'emerging' in the title, they confine themselves to considering regions, countries, or maybe sectors. But if you're really looking to profit from long-term growth in emerging markets, here's what you should remember: in investing, smaller is often better.

Let's start with the evidence. While emerging markets beat developed ones comfortably over the last decade, small emerging stocks did even better, reports Standard and Poor's. The S&P Emerging Small Cap index return an average of 16.6% per year, while the S&P Emerging Large Mid Cap index returned 13.2% (see chart below).

That held true across all regions: in Asia, Europe, Latin America and the Middle East and Africa, small caps outperformed. It was the case for nine out of the ten main industry sectors, and it applied for both value investing (focusing on firms with low valuations) and growth investing (companies with the prospect of faster growth) styles. In other words, this wasn't just a freak result caused by high-performing all-or-nothing shots in sectors such as mining and technology small caps produced consistently better returns.

Should we be surprised that small caps have beaten their larger peers? Probably not. It's well known in developed markets that small caps have tended to do better than larger ones. That's not true all the time, of course; small caps tend to get hit harder in a severe bear market, such as 2007-2009. But they more than make up for it when times are good. Why is this? Believers in the efficient market will tell you that it's because small caps are riskier than larger stocks and so investors need to have higher potential rewards to invest in them. There's some truth in this. But it's unlikely that's the whole story.

There are two obvious and related reasons why small caps are likely to do better over time. The first is that they can grow faster than larger ones: it's much easier for a $10m firm to double in size than a $1bn one. And the other is that this growth potential is often undervalued at first, because fewer investors are scrutinising these stocks. Cheaper shares and stronger growth is a good recipe for better performance.

Both of these factors should work in favour of emerging-market small caps. Emerging markets are not just growing more quickly than the developed world, but are also undergoing rapid change. This is exactly the environment that creates opportunities for small, innovative companies to expand quickly.

Secondly and probably even more importantly if small caps are under-researched in the developed world, they are even more neglected in emerging markets. According to US small-cap specialist Wasatch, around 18% of emerging small caps have no research coverage; 36% have fewer than two analysts following them. By comparison, a major developed-world blue chip like BP might have 40 analysts following it.

There's a good reason for this. Brokers don't cover shares out of the goodness of their hearts, but to generate sales and commissions. And it's usually much harder to sell a smaller stock to institutional investors who are the majority of buyers than a larger one. Small stocks pose liquidity problems for funds, who generally want to be able to get in and out of a position quickly without affecting the price too much.

Small caps also create career risk, which should never be underestimated when thinking about what drives your fund manager. If you gamble on a small stock that blows up, your reputation is much more at risk than if you buy a large cap that has a BP-style accident, because half the industry will be in the same boat.

The result is that understandably enough most funds will avoid smaller firms. Some firms will even set this in stone, restricting what shares a manager can purchase for his funds to those on an "approved list" of stocks, chosen on criteria such as liquidity, market cap and amount of analyst coverage.

In short, smaller companies are usually more trouble than they're worth for most funds. That gives private investors and specialist small-cap funds an advantage, since they can fish for the overlooked opportunities. And perhaps the most interesting thing about emerging-market small caps is that this fishing has only recently got underway.

If we go back to those performance figures earlier, they refer to the last decade and show convincing small-cap outperformance. But if you go back earlier, it's another story. Larger stocks beat smaller ones in emerging markets during the 1990s, according to S&P's data.

Emerging markets come of age

Why? The main reason was probably that emerging-market investing was in its infancy. Most investors were only just waking up to possibilities. Data was sketchy (even now, most stock data for most emerging markets is only available back to the 1990s) and information limited. So most newcomers focused on larger, better-known firms. And domestic investors, who might have known more about local small caps, were thin on the ground. It was foreign money that moved markets. As most foreign money went into large caps, large caps outperformed.

But a lot has changed in recent years. There are a growing number of niche funds that are more willing to invest in smaller emerging stocks or focus on them exclusively. These mostly cater to wealthy individuals, but a few are easily available to retail investors (see below for more). And while research coverage is still sketchy, it's improving. Foreign investor understanding of these markets is growing, encouraging them to look beyond the obvious large caps. And the number of domestic investors is growing. This has funnelled more money into small caps, which, combined with strong profit growth, has helped them to outperform.

This is likely to continue, because there are good reasons for investors to focus on smaller companies. One of the wider problems with emerging-markets investing is that the make-up of many stockmarkets is not very appealing when you look at them in detail. Large-cap indices tend to be heavily overweight in areas like financials, metals and mining, and perhaps telecoms, and light on the consumer-orientated sectors that investors are increasingly interested in. Also, they tend to feature large, state-controlled firms that are poorly run or liable to put the national interest ahead of shareholders. Take a close look at any exchange-traded fund (ETF) that tracks Hong Kong-listed Chinese stocks, such as the iShares FTSE/Xinhua China 25, or any fund that sticks close to the overall make-up of the market. Do you really want a fund that holds 50% of its assets in China's state-controlled banks, knowing that lending policy is ultimately determined by Beijing rather than what's profitable? I don't.

Investing in smaller firms doesn't solve all these problems. But they are more likely to be privately run, more likely to focus on sectors such as consumer goods, information technology and healthcare, and more likely to have profit as their driving motive. Take a look at the chart above, which shows the portfolios of the iShares Far East ex Japan and the iShares Far East ex Japan Small Cap. All else being equal, the small-cap funds' portfolio looks a better long-term bet.

Beware of the risks

Of course, small caps carry their own risks. When liquidity dries up, small-cap shares are hit much harder than larger ones; during the global financial crisis, there were solid, profitable, dividend-paying emerging small caps on p/e ratios of five or so. When conditions improve, they snap back again if you look back at the S&P comparison chart (on page 24), you can see that even if you'd invested in this index at the very peak of the market, you'd be back in the black. But had you sold during the panic, you'd have got a very poor price. So no money that you'll need in the near future should be in equities; that goes double for small caps.

While the lack of information on small caps is what makes it possible to find hidden gems, the same lack of scrutiny creates the risk of minority shareholders being ripped off, particularly if there's a single controlling shareholder usually the founder or his family. This isn't unique to small caps; there are plenty of examples of larger firms acting against shareholder interest. And a look at Western corporate scandals should convince you that it can happen anywhere. The flipside is that where a reputable management team are also the controlling shareholders, as is the case in many of the best small caps, outside investors are in a good position. Managers whose personal wealth is tied up in a firm have every reason to run it prudently and for the long term, rather than just trying to maximise their stock options in the short term, like many professional managers.

Pick your markets

It's worth bearing in mind that while small caps seem to have done well in most emerging markets, they're not outstanding everywhere. Take Hong Kong and Singapore; these countries technically aren't emerging, but because of their location, most of their listed firms are closely linked to conditions in developing Asia, and they are usually the first port of call for foreigners making their first investments in the region. But their performances have been very different over the last ten years.

The MSCI Singapore Small Cap has delivered an average return of 14.9% a year, beating the larger cap MSCI Singapore at 7.3%. But the MSCI Hong Kong Small Cap has only just beaten its large cap peer, on 9.4% versus 8.8%.

Of course, there are some great individual smaller companies in Hong Kong. But for a variety of reasons, it's not the best market around for small caps. Singapore has been much more rewarding on that front and I'd expect that to continue.

Small caps aren't the be all and end all. But as the performance of a fund like the Scottish Oriental Smaller Companies (see the box on page 24) shows, they've delivered some pretty spectacular returns and they're likely to do so again. So while you certainly shouldn't have your entire portfolio in riskier assets like these, when thinking about China versus Brazil or financials versus IT, it's a good idea to be asking 'large versus small?' before everyone else starts doing so too.

ETFs available to retail investors

The number of emerging-market small-cap ETFs is growing rapidly. Most of the current line-up came to market in the past year. For a global fund, there's one London-listed option, the iShares MSCI Emerging Markets Small Cap fund (LSE: SEMS), and two in the US: the SPDR S&P Emerging Small Cap (US: EWX), which is based on the index used for performance figures in the above article; and the WisdomTree Emerging Markets SmallCap Dividend Fund (US: DGS), which selects stocks according to their dividend payouts.

Asia dominates the portfolio in all three, but the weightings vary: for example, Taiwan, the largest single country in each ETF, accounts for 30% of the portfolio in the SPDR fund and about 20% in the other two, followed by China and Korea. South Africa and Brazil are among the largest non-Asian contributors in all three, but WisdomTree also gives substantial weight to Turkey and Israel, making it the most geographically diverse.

If you're after a dedicated regional ETF, Asia is largely covered by the iShares Far East ex Japan Small Cap (LSE: ISFE), which is reasonably well balanced in terms of sectors (see chart on page 26), but has a geographical bias towards greater China; Taiwan accounts for 26%, China for 20% and Hong Kong for 14%. India doesn't feature in this fund, unlike the global ones mentioned above, because it's not in the Far East benchmark. Another regional option is Van Eck's recently launched Market Vectors Latin America Small Cap ETF (US: LATM). As usual with Latin America ETFs, this is heavily weighted (about 50%) towards Brazil, with Mexico and Chile the other significant components.

Single-country small-cap ETFs are proliferating so quickly that it's hard to keep an eye on them. Van Eck has trackers for India (US: SCIF) and Brazil (US: BRF). A niche provider called EG Shares also offers one for India (US: SCIN), while iShares has its own Brazil one (US: EMZS). China small-cap funds are available from iShares again (US: ECNS) and Guggenheim (US: HAO). Index IQ, another niche provider in the US, has funds for Korea (US: SKOR) and Taiwan (US: TWON). Total expense ratios vary, but most of the above are in the 0.6%-0.75% range.

A cheap ETF is better than a poorly managed fund why pay extra to have someone underperform the index? But since much of the draw of small caps is the prospect of finding something the market hasn't noticed yet, this is probably a market where a good manager is worth paying for. Two specialist investment trusts stand out, both focused on Asia. The Aberdeen Asian Smaller Companies fund (LSE: AAS), managed by Hugo Young and his team, is lighter on greater China than most Asian funds and has unusually large weightings in southeast Asian markets such as Malaysia, Thailand and Indonesia, all of which have heavily under-researched small-cap sectors. The total expense ratio is 1.4%. The current discount to net asset value (NAV) is 3.9%. Unusually, Aberdeen offers an Isa wrapper that allows regular investments of as little as £100 a month without dealing costs on purchases, making them attractive for steady investors.

The Scottish Oriental Small Companies Trust (LSE: SST), managed by Susie Rippingall, has a good track record (see chart above), and focuses on genuinely obscure opportunities, with a portfolio full of stocks that even knowledgeable investors in Asia won't have heard of. Major sectors include financials, consumer discretionary and IT. In country terms it's light on India and more heavily invested in southeast Asia. The total expense ratio is 1.03 and discount to NAV is 2.5%.