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Small and Mid-Caps: a true source of diversification in EM

 

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I. Small and Mid-Caps – a true source of diversification in EM

It is a truth universally acknowledged, that an Emerging Markets investor must be in search of good growth. What is less recognised, is that good growth can equate with Small & Mid-Cap (SMID) companies just as well in Emerging Markets (EM) as in the Developed Markets. It is this niche, ripe with investment potential, that we will shed some light on in this issue of EM Academy.

1. Overview

SMID emerged as a distinct market segment within the Emerging Markets space in 2007, with the launch of the MSCI SMID Index. Within EM, MSCI classifies companies with a market capitalisation of between $2.8bn – 7.5bn as Mid-Caps, and $289m – $2.8bn as Small caps. These are approximately 50% smaller than the equivalent cut-off sizes in Developed Markets. The striking feature of this sub segment of the EM universe is the strong growth in the number of listed companies in the SMID segment as per the size classifications used by MSCI. With the MSCI EM SMID index used as a proxy, this segment has grown by 12% between 2007 and 2017.

 

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Even since the financial crisis in 2008, when listings materially slowed, the number of companies in the Small Cap index grew twice the rate of those in the main EM index: 1.5% vs. 0.7%. The SMID index registered a 1.2% increase. Hence it is essential for an EM Equity investor to be able to go beyond the traditional index and cover a large investable universe. Simply put, the larger the universe, the more investment opportunities.

2. Markets & the Real Economy

As Emerging Market investors, we tend to look for ways to gain exposure to the economy and trends ‘on the ground’ in the countries under our coverage; the key drivers of these markets’ strong growth tend to be the catch-up of banking and retail penetration, the formalisation away from “mom & pop” stores and the dynamism of local industries. The main MSCI EM index has 41% in what could be called global sectors: Energy, Materials, and IT, which are consequently less exposed to these themes. In the MSCI SMID index, these only represent 29%, leaving richer pickings among the Consumer, Industrial and Healthcare sectors.

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Running some numbers, we find that the part of a country’s GDP made up of commodity exports correlated quite convincingly – and inversely, as we would have expected – with the proportion of its market capitalisation composed of SMID companies. The thesis is self-evident: countries whose economies are dominated by mineral and energy extraction will tend to have indices dominated by the heavy-weight companies involved in these sectors. Russia’s national oil company Rosneft and Peru’s Southern Copper spring to mind

 

3. An attractive risk/reward profile

We would like to end on a high note, and what can be more enticing to a potential investor than an asset class with high returns and excess performance over large caps across almost all time periods.

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Moreover, the outperformance does not, perhaps as one might expect, come at the cost of higher volatility. On the contrary, we find that the SMID index systematically beats its large cap counterpart on this metric. This is likely due to a bigger number of SMID constituents than large caps (i.e. better diversification) and lower average correlation between SMID stock returns. In contrast, Large Caps tend to behave as the bellwethers of the equity markets, both in local and in global context. Besides, large caps volatility is fuelled by global institutional investors’ short term tactical calls through ETFs, whereas the SMID segment will tend to be spared.

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With such a risk/reward profile, small & mid cap companies should be an integral diversification tool for EM investors. Interestingly, this market cap segment also has a lower beta relative to the global equity markets. Again, SMID share prices are more dependent on company-specific developments, compared with Large Caps, whose performance is often driven by the global investor sentiment.

 

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The depth of opportunity that EM small & mid cap investing brings is tempered by several challenges, not least of which, liquidity. When it comes to portfolio construction, investing in EM SMID companies requires greater liquidity risk monitoring and care in order to avoid market impact on these smaller companies. The MSCI EM SMID Market Cap is 28% smaller with almost 3 times more constituents than the MSCI EM.

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Nevertheless, the wealth of opportunity and the unusually attractive risk/reward pairing should make this market segment a cornerstone of diversification for active EM equity managers.

 

 

 

 

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Pierre GIELEN, Investment Specialist
Valérie PHILLIPS, Investment Specialist
Barthelemy ROUX, Investment Specialist
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Small and Mid-Caps: a true source of diversification in EM
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