Big opportunities in emerging small caps

Indian dancers © iStock
Expect a tilt towards India

There’s been a tsunami of new listed funds over the last couple of months. One that could end up becoming a core investment idea for the long-term, adventurous investor is ScotGems (LSE: SGEM). The Scot bit is a slight distraction – the Gems bit is the crucial moniker on this investment trust.

Gems refer to global emerging markets (EMs), in this case with an emphasis on smaller companies. The asset manager behind this fund is Edinburgh-based Stewart Investors, an outgrowth of the much larger First State Investment. ScotGems is a play on global small-cap equities. You’re getting an experienced management team who will invest in a concentrated portfolio of 20-30 stocks with market capitalisations below $2.5bn and, initially at least, a bias towards Asia-Pacific.

Stewart Investors focuses on small-cap companies with strong franchises and balance sheets. Of course, every EM equity manager says they invest in carefully selected quality businesses, but with Stewart Investors you have a firm that has a great track record of doing precisely that.

We don’t yet know how the portfolio will take shape, but if the Stewart unit trusts (admittedly large-cap-focused) are anything to go by, you’ll get a tilt towards consumer businesses and places such as India. I’d also expect mainland China to be largely absent from the portfolio.

EM small-cap funds run by rivals such as Templeton, JPMorgan and Somerset Capital all have a similar bias towards the consumer sector (and financials) and markets such as India, South Korea and South Africa. The nearest equivalent investment trusts are Aberdeen’s Asian Smaller Companies Trust and Scottish Oriental Smaller Cos.

ScotGems differentiates itself from the latter two by being global in scope, although it is still likely to have an Asia Pacific tilt. There’s little difference in fees between ScotGem and its listed peers – ScotGem charges 1% in annual management charges, as does Aberdeen, while sibling fund Scottish Oriental charges a lower 0.75%, but has a 10% performance fee. All these trusts are generally a fair bit cheaper than their unit-trust peers.

For me, the big opportunity is that if you are going to invest in EMs, you should consider some exposure to small caps. For the extra volatility of small caps, you should expect to pick up some extra return – although be prepared for a very volatile long-term ride.

My view is that for every £2 or £3 invested in global EM (inevitably large-cap-focused) you might consider putting £1 to work on small caps. I also think that small-cap EM stocks are a perfect stockpicker’s environment (which rules out going for ETFs), and I’d personally prefer a listed investment trust, because they offer the opportunity to buy quality assets on the cheap every once in a while. For instance, I note that Scottish Oriental trust (LSE: SST) is trading at an 11% discount to net asset value. I also feel we are likely to see continued EM outperformance over developed world markets in the near term, which should provide a tailwind for the small caps in the ScotGems portfolio.

Activist watch

Shares in French yoghurt-maker Danone jumped by 3% on the news that activist fund Corvex Management has built up a $400m (roughly 0.75%) stake in the company, reports Bloomberg.com. The New York-based hedge fund reportedly views the company as “significantly undervalued”.

The maker of Activia yoghurt and Evian water had recently been “touted as a potential target” by suitors or activist shareholders, given that its profits are lower than many of its peers and its sales have disappointed recently, says Reuters. Corvex believes Danone stock will rebound if management improves operations and successfully positions the business to benefit from the health and wellness trend.

In the news…

• Asset manager Baillie Gifford plans to follow in the footsteps of hedge funds by using artificial intelligence (AI) to improve the performance of its investments, says Madison Marriage in the Financial Times. The Scottish fund group has hired a former mathematician to help with the project, with the goal of assessing whether AI can “eliminate mundane tasks that take up fund managers’ time”, enabling them to spend more time searching for market-beating ideas.

• The global shift in investor money from active to passive funds has slowed this year, according to data from fund data provider Morningstar. Last year assets managed by passive funds grew 4.5 times faster than money in active funds, reaching a global total of $6.7trn. And passive funds attracted five times more cash overall during 2016. But during the six months to the end of June, this figure slid to 1.4 times. This is partly due to strong recent performances from active funds in the US, as Johanna Bennett notes in Barron’s.

But investors also seem nervous that the long gobal bull run could falter, says the FT’s Attracta Mooney, bolstering the relative appeal of active management. Similarly, many investors seem to want a more hands-on approach to their fixed-income investments now that global growth has improved and central banks are reining in quantitative-easing programmes.